SYNERGY

PROFESSIONALS

ACCA Paper FA
Financial Accounting

Lecture Notes
 A1Introduction to Financial Accounting

What is financial accounting?

Financial accounting is the process of recording, analysing, summarizing and interpreting

business transactions in order to provide information to the users of accounts about the
performance, financial position and changes in cash flow of an enterprise over an
accounting period.

Types of business entity

A business can be managed in any of the following three major ways:

 Sole trader

This form of business enterprise is owned and managed by one person. The sole trader is
fully and personally liable for any losses that the business might make.

 Partnership

This is a business owned jointly by two or more persons. The partners are jointly and
severally liable for any losses that the business might make.

 Limited liability Company

This form of business is owned by shareholders. As a group, the shareholders elect the
directors who run the business. As against other form of businesses, companies are almost
always limited companies. That is, the shareholders will not be personally liable for any
losses the company incurs. Their liability is limited to the nominal values of the shares that
they own.

Limited liability companies have certain advantages:

(a) Limited liability makes investment less risky than investing in a sole trader or
partnership
(b) Easier to raise finance
(c) Company has separate legal identity from its shareholders.
(d) Company is taxed as separate entity from owners
(e) It is relatively easy to transfer shares from one owner to another.

Disadvantages of trading as a limited liability company

(a) LLC (limited liability company) must publish annual financial statements
(b) Financial statements must comply with legal/accounting requirements
(c) Financial statements of larger LLC must be audited.
(d) Share issues are regulated by law. For example, it is difficult to reduce share capital.
Sole traders can.

For accounting purposes, all three forms of business enterprise are treated as separate
from their owners. This is called the business entity concept.

The money put up by the individual, partners or the shareholders, is referred to as the
business capital. This is divided into shares in the case of companies.
Users of Financial Statements

Users of financial statements also called stakeholders are people who have economic
interest in the activities and operations of an enterprise. The users and their information
needs can be summarized as follows:

Users of Accounts Information needs

Management Decision making and planning

Shareholders Investment decisions

Profitability and welfare

Business contacts assessment

Competitors Liquidity & profitability assessment

Financial analyst Public education and records

Government agencies Taxation assessment

General public Social responsibility assessment

Nature, principles and scope of financial reporting

You should be able to distinguish the following: Financial accounting • Management

accounting

Scope of Financial Reporting

Accounting System

Financial Accounting System Managerial Accounting System

Periodic financial statements and Detailed plans and continuous
related disclosures performance reports

External Decision Makers Internal Decision Makers

Investors, creditors, Managers throughout the
suppliers, customers, etc. organization

Financial accounting
 Concerned with the production of financial statements for external users.
 They provide historical information.
 Financial accounts are prepared using accepted accounting conventions and
standards

Management accounting

 Management require much more detailed and up-to-date information in order to

control the business and plan for the future.
 Is a management information system which analyses data to provide information
as a basis for managerial action.

The main elements of financial reports

Statement of financial position

Presents a company’s current financial position by disclosing assets and liabilities at a

specific point in time.

Assets:

An asset is a resource controlled by an enterprise as a result of past events and from

which future economic benefits to the enterprise are expected to flow.

Liabilities:

Debts of a business. They are the present obligations of an enterprise arising from past
events, the settlement of which is expected to result in an outflow of resources embodying
economic benefits; i.e. creditors claims on the resources of a company.

Capital or owners equity:

If the owner of the business introduces funds into the business we regard this as Capital. It
will increase each year by any new capital injected into the business and by the profit
made by the business.

It is recorded in a statement of financial position.

Income statement/Statement of comprehensive income

Is a record of revenue generated and expenditure incurred over a given period.

Forms part of the published annual Financial statements of a LLC will usually be for the
period of a year, commencing from the date of the previous year's statements.

Revenue and expenses/other comprehensive income:

Revenue is the income from goods sold in the year regardless of whether the goods have
been paid for.

Expenses are the costs of running the business for the same period, e.g wages, costs of
sales

Illustrations in class
 THE REGULATORY FRAMEWORK

The need for regulation

Regulation ensures that accounts are sufficiently reliable and useful, and prepared
without unnecessary delay.

• Financial accounts are used as the starting point for calculating taxable profits.

• The annual report and accounts is the main document used for reporting to
shareholders on the condition and performance of a company.

• The Inventory markets rely on the financial statements published by companies.

• International investors prefer information to be presented in a similar and comparable

way, no matter where the company is based.

Factors which have shaped financial accounting

To ensure regulation, IASB bore IAS and IFRS which are produced by the International
Accounting Standards Board (IASB).

• International accounting standards are the rules that govern accounting for
transactions.
• In 2003 IFRS 1 was issued and all new standards are now designated as IFRSs.
10 standards relevant to F3- IFRS 3, IAS 1,2,7,8,10,16, 18, 37, 38

IASB STRUCTURE
IASB was established in 2001 as part of the IASC. In 2010 the IASC foundation was
renamed the IFRS foundation. Governance rests with 22 trustees- appointing members of
the IASB and others and financing for the organisation.

IASB has 15 full time members – deal with approval of IFRS and related documents
(conceptual framework), exposure drafts

IFRSIC has 14 members appointed by the trustees. They prepare interpretations of IFRS for
approval by IASB, and timely guidance on financial reporting issues

IFRS advisory Council- participants have diverse geographical and functional

backgrounds. Gives advise to IASB on priorities, agenda decisions and on major standard-
setting projects.

The objectives of the IASB are:

a)To develop, a single set of high quality, understandable and enforceable global
accounting standards

(b) Promote use and rigorous application of those standards.

(c) To bring about convergence of national accounting standards.

The conceptual framework

Sets out the concepts that underlie the preparation and presentation of financial
statements for external users, and is designed to assist:

• the Board of the IASB in developing new standards and reviewing existing ones

• in harmonising accounting standards and procedures

• national standard-setting bodies in developing national standards

• preparers of financial statements in applying IASs/IFRSs

• auditors in forming an opinion as to whether financial statements conform with

IASs/IFRSs

• users of financial statements in interpreting FS

• provide those interested in the work of the IASB with information about its approach to
the formulation of IFRSs.

The scope of the framework

• the objective of financial statements

•the qualitative characteristics that determine the usefulness of information in financial

statements

• The elements of financial statements

•Underlying assumptions

• the definition, recognition and measurement of the elements from which financial
statements are constructed (not examinable at this level).

• concepts of capital and capital maintenance (not examinable at this level).

Objectives of financial statements

The objective of financial statements is to provide information about the financial position
(in Statement of financial position), performance (in Statement of comprehensive
Income) and cash flows (Statement of cash flows) of an entity that is useful to a wide
range of users in making economic decisions.

According to IAS 1, a complete set of financial statements includes the following

components.

(a) Statement of financial position

(b) Income statement/ statement of comprehensive income

(c) Statement of changes in equity

(d) Statement of Cash flows

(e) Accounting policies and explanatory notes

The preparation of these statements is the responsibility of the board of directors.

Qualitative characteristics of financial reporting

These are set of attributes which together make the information in the financial
statements useful to users.
Fundamental

Relevance:

This is a qualitative characteristic that affects the way an item has been included or stated
in the financial statement. That is, the contents of the accounts. An item is relevant if it could
assist users of accounts to evaluate past, present or future events or by confirming, or
correcting existing evaluations. It helps in assessing the future of the business. Relevance of
information is affected by its nature and materiality.

 Materiality and aggregation

All material items should be disclosed in the financial statements.

Faithful representation- must represent faithfully the transactions it purports to represent. 3

characteristics must be present completeness, neutrality and free from error.

• Neutrality – Information must be free from bias to be reliable.

• Completeness- within the restrictions of materiality and cost, to be reliable.
• Free from error - Amaterial error can cause the financial statements to be false or
misleading and thus unreliable and deficient in terms of their relevance.

Others- Prudence and substance over form not part of faithful representation

 Substance over form

 Transactions and other events are accounted for and presented in accordance
with their substance and economic reality and not merely legal form.

 Prudence

Inclusion of a degree of caution in the exercise of the judgments needed in making

estimates required under conditions of uncertainty, such that assets or income are
not overstated and liabilities or expenses are not understated. It is not permitted,
however, to create secret or hidden reserves.

 Completeness-

Financial information must be complete, within the restrictions of materiality and

cost, to be reliable.

Comparability:

This quality affects the way and manner financial statements are presented. It means that
financial statements should be comparable with the financial statements of other
companies and with the financial statements of the same company for earlier periods.

Enhancing

Understandability

 too much detail can also confuse the issue.

 info should be readily understandable by users
 Complex matters should not be left out
Comparability

Users must be able to compare an entity's financial statements:

(a) through time to identify trends; and

(b) with other entity's statements,
Timeliness

Having information available to decision makers in time to be capable of influencing their

decisions

Verifiability
Constraints on relevant and reliable information

Timeliness vs Relevance

Information may become irrelevant if there is a delay in reporting it.

Understandability vs completeness

If all aspects of the business are disclosed, the information becomes less comprehensible

Relevance vs reliability

Sometimes info that is the most relevant, is not the most reliable

Underlying assumptions in financial statements

Going concern

Assumption that the comapany will continue in business for the foreseeable future.

It is assumed that the entity has neither the intention nor the necessity of liquidation or of
curtailing materially the scale of its operations. The main significance is that the assets
should not be valued at their 'break-up' value; the amount they would sell for if they were
sold off piecemeal and the business were broken up.

Accruals basis of accounting

Financial statements aim to reflect transactions when they actually occur, not necessarily
when cash movements occur.
In computing profit revenue earned must be matched against the expenditure incurred
in earning it. This is also known as the matching convention.

Elements of financial statements

(a) Financial position

(i) Assets- Resources controlled by the enterprise as a result of past events and from
which future economic benefits are expected to flow to the enterprise.

(ii) Liabilities- present obligations of an enterprise arising from past events, the settlement
of which is expected to result in an outflow of resources embodying economic
benefits.

(iii) Equity- Residual interest in the assets after subtracting the liabilities.

(b) Performance

(i) Revenues- Income from the ordinary activities of the enterprise.

(ii) Expenses- Decreases in economic benefits in the form of outflows/ depletion of

assets/increases in liabilities resulting in decrease in equity

Fair presentation and compliance with IASs/IFRSs

Financial statements should present fairly the financial position, financial performance
and cash flows of an entity.

The following points made by IAS 1 expand on this principle-

(a) Compliance with IASs/IFRSs should be disclosed

(b) All relevant IASs/IFRSs must be followed if compliance with IASs/IFRSs is disclosed

(c) Use of an inappropriate accounting treatment cannot be rectified either by disclosure

of accounting policies or notes/explanatory material.

IAS 1 states what is required for a fair presentation is:

(a) Selection and application of accounting policies

(b) Presentation of information in a manner which provides relevant, reliable, comparable

and understandable information

(c) Additional disclosures where required

Recognition of the elements of financial statements:

An item should be recognized in the financial statements if:

 It meets one of the definitions of an element

 It is probable that any future economic benefit associated with the item will flow to
or from the entity

 The item can be measured at a monetary amount (cost or value) with sufficient
reliability

The recognition of assets and liabilities falls into three stages:

 Initial recognition (e.g. the purchase of a non-current asset)

 Subsequent measurement (e.g. revaluation of the above asset)

 Derecognition (e.g. sale of the asset)

Presentation requirements

Offsetting

IAS 1 does not allow assets and liabilities to be offset against each other unless such a
treatment is required or permitted by another IFRS.

Income and expenses can be offset only when one of the following applies:

(a) An IFRS requires/permits it.

(b) Gains, losses and related expenses arising from the same/similar transactions are not
material.

Comparative information-

IAS 1 requires it to be disclosed for the previous period for all numerical information, unless
another IFRS permits/requires otherwise. Give in narrative information where helpful.
Restate when presentation or classification of items in the FS is amended.

Consistency of presentation

The presentation and classification of items in the financial statements should stay the
same from one period to the next, except as follows:

(a) There is a significant change in the nature of the operations or a review of the
financial statements indicates a more appropriate presentation. Use motor vehicles
within Lagos but now need to start travelling

(b) A change in presentation is required by an IFRS.

 THE USE OF DOUBLE ENTRY AND ACCOUNTING SYSTEMS

SOURCE DOCUMENTS TO FINANCIAL STATEMENTS

The objective of this topic is to show the process of preparing the financial statements.
That is, from source documents to books of prime entry, the ledgers, the trial balance and
finally to the financial statements.

SOURCE DOCUMENTS

These are documents that show the evidence of transactions. For example; receipts,
payment vouchers, invoices, credit/debit notes, bank statements, e.t.c. They serve as the
basis of recording in other books of accounts.

BOOKS OF PRIME ENTRY/SUBSIDIARY BOOKS

These are books where transactions are first recorded on a daily basis for convenient sake
before they are transferred into the main books of accounts called the ledger.

Day books and their source documents:

S/N Day books Source documents

1. Cash book Cheques, receipts, payment vouchers, bank
statements,
cheque stubs.
2. Petty cash book Payment vouchers, invoices
3. Sales day book Sales orders or invoices
4. Purchases day book Purchases orders or invoices
5. Returns inward day Credit notes
book
 6. Returns outward day Debit notes
book
7. Journal proper Invoices, memos

Cash book

The cash book is a prime book of entry used to record transactions that are conducted
only on cash. It has two sides; a debit and a credit side. The debit side records money
collected in a period while the credit side records all payments in the same period. A
cash book is a dual function record, that is, it serves both as a day book and a ledger.

 As a day book; it records the first entry of all receipts and payments of money

 As a ledger; it has a debit and credit side which can be balanced at the end of
the period and be included in the trial balance.

Types of cash book

i. Single column cash book – this is used to record transactions that are all made in
cash, without the use of cheque.

ii. Double column cash book – this is used to record transactions that made both in
cash and by cheque, but without the issue of discounts.

In a situation where the business transfers money from bank to office (for office use) or
from the office to bank (for deposit), such transaction is known as contra entry as both
the debit and credit entries are made in the same cash book.

iii. Three column cash book – this is used to record transactions that are in cash and
by cheque at the same time, allows and receives discount.

Discount allowed is a rebate given to customer for prompt payment of money. It is shown
on the debit side of the cash book.

Discount received is a rebate from suppliers for prompt payment of money. It is shown on
the credit side of the cash book.
Petty cash book

This is a subsidiary book used to record petty/small expenses in order to reduce the
workload of the main cashier. The petty cash book is operated on an imprest system.

Imprest system is a system where a fixed amount called a float is given to a petty cashier
to finance small expenses in a specified period which is then re-imbursed at the end of
that period. Re-imbursement is the process of restoring the petty cashier to his former
position by giving him/her the sum equal to the amount spent.

It should be noted that the petty cash book is part of the double entry system. Hence, it
has a debit and credit side. The debit side is for the cash float received from the main
cashier as well as the re-imbursement amount. The credit side is to record all payments
made in a period.

Sales day book

This is a subsidiary book used to enter goods made on credit by an enterprise. As credit
sales occur, they are listed in the sales day book which is ruled to show among others, the
date of the sale, the customers’ name and amount.

The customer’s personal account is debited while the sales’ account is credited at the
end of a convenient period.

Purchases day book

This is used for the recording of goods bought on credit by an enterprise. The credit
purchases are listed in the purchases daybook as they occur.

In the ledger account, the suppliers’ accounts are credited while the purchases account
is debited.

Returns inward day book

This is used for recording goods initially sold to customers but later returned due to some
reasons which may be short of expectation in terms of quality or defectives.

The customers’ personal accounts are debited while the total amount is debited to
returns inward account

Returns outward day book

This is used for the recording of goods initially bought from suppliers but later returned to
them. The suppliers’ personal accounts are debited while the total amount is credited to
returns’ outward account.

General journal

This is used for the recording of any transaction that cannot be conveniently entered in
other day books. Examples include:

 The purchase and sale of non-current assets on credit

 Correction of errors

THE LEDGER

The ledger is the principal book that contains all the accounts of a business. An account is
a page in the ledger divided into debit and credit side to record transactions in detail.
Information are taken from all the subsidiary books to the ledger to complete the double
entry recording.

The Double Entry Principle

A ledger account is recorded by adopting a concept called the double entry principle.
This principle states that every business transaction must be recorded twice; one on the
debit side of one account and the other on the credit side of another account. Hence,
the double entry principle states that for every debit entry, there must be a corresponding
credit entry and vice-versa.

How to know which account to debit and which to credit

In order to apply the double entry principle, it is necessary to first identify the two
accounts required. Having done this, the next step is to identify the accounts which is
receiving the value of the transaction and the account which is giving the value. Having
identified the receiver and the giver, a debit entry shall be posted to the account which is
receiving, while a credit entry is made in the account which is giving. This is the double
entry rule, which is sometimes referred to as “debit the receiver, credit the giver”.

Types of accounts Accounting entries

Assets Debit entries
Liabilities Credit entries
Revenue Credit entries
expense Debit entries

A debit entry will:

• increase an asset (purchase of office furniture)• decrease a liability (paying a creditor)•

increase an expense (purchase of stationery)

A credit entry will:

• decrease an asset (making a cash payment)• increase a liability(buying goods on

credit)• increase income(sale)

THE JOURNAL

Record of prime entry for transactions which are not recorded in any of the other books
of prime entry.

When errors are discovered and need to be corrected. Illustrate entries here:

Format of a Compound General Journal Entry

 Date Accounts Debit Credit

mm/dd/year account to be debited xxxx.xx

account to be credited xxxx.xx

account to be credited xxxx.xx

(Remember: in due course, the ledger accounts will be written up to include the
transactions listed in the journal.)

For example, if an expense is incurred in which part of the expense is paid with cash and
the remainder transferred to accounts payable, then two lines would be used for the
credit - one for the cash portion and one for the accounts payable portion. The total of
the two credits must be equal to the debit amount.

Balancing ledger accounts-

If the total debits exceed the total credits there is said to be a debit balance on the
account; if the credits exceed the debits then the account has a credit balance.

The next step in our progress towards the financial statements is the trial balance.

THE TRIAL BALANCE

A basic rule of double-entry accounting is that for every credit there must be an
equal debit amount. From this concept, one can say that the sum of all debits must
equal the sum of all credits in the accounting system. If debits do not equal credits,
then an error has been made. The trial balance is a tool for detecting such errors.

The trial balance is calculated by summing the balances of all the ledger accounts.
The account balances are used because the balance summarizes the net effect of
all of the debits and credits in an account. To calculate the trial balance, construct
a table in the following format:
 THE ACCOUNTING EQUATION

The whole of financial accounting is based on this simple idea of accounting equation.
The equation says that the total asset of a business is equal to its total liabilities (including
capital as liability).

The accounting equation is:

Assets = Capital + Liabilities

That is, the resources of a business (its assets) are equal to the claims the owner(s) of the
business and third parties have over the business.

Expand the equation by introducing profits/losses and drawings.

Complete the columns to show the effects of the following transactions:

Effect upon:

Asse Liabilit Capit

ts ies al
1. We pay a creditor $70 in cash
2. Bought fixtures $200 paying by cheque
3. Bought goods on credit $275
4. The proprietor introduces another $500 cash
into the business
5. J. Walker lends the business $200 in cash
6. A debtor pays us $50 by cheque
7. We returned goods costing $60 to a supplier
whose bill we had
not paid
8. Bought additional premises paying $5,000 by
cheque
Complete the following table:

A/c to A/c to
S/N be be
debited
credited
1. Bought lorry for cash
2. Paid creditor, T. Lake, by cheque
3. Repaid P. Logan’s loan by cash
4. Sold lorry for cash
5. Goods sold for cash
6. A debtor, A. Hill, pays us by cash
7. A debtor, J. Cross, pays us by cheque
8. Proprietor puts a further amount into the
business by cheque
9. A loan of $200 in cash is received from L. Lowe
10. Paid a creditor, D. Lord, by cash

Subsidiary books, ledger accounts, trial balance and financial statements

Record the following details relating to a carpet retailer in the subsidiary books and
ledger accounts, extract a trial balance and prepare the financial statements for the
month of November 2007:

2010

Jan. 1 Started in business with $15,000 in the bank.

3 Bought goods on credit from: J Small $290; F Brown $1,200; T Rae $610; R

Charles $530.

5 Cash sales $610.

6 Paid rent by cheque $175

7 Paid business rates by cheque $130.

11 Sold goods on credit to: T Potts $85; J Field $48; T Gray $1,640.

17 Paid wages by cash $290.

18 We returned goods to: J Small $18; R Charles $27

19 Bought goods on credit from: R Charles $110; T Rae $320; F Jack $165.

20 Goods were returned to us by: J Field $6; T Potts $14.

21 Bought van on credit from Turnkey Motors $4,950.

 23 We paid the following by cheque: J Small $272: F Brown $1,200; T Rae 500.

25 Bought another van, paying by cheque immediately $6,200

26 Received a loan of $750 cash from B Bennet.

28 Received cheques from: T Potts $71; J Field $42.

30 Proprietor brings a further $900 into the business, by a payment into the business
bank account.

INVENTORY (IAS 2)

Inventory consists of:

 Goods purchased for resale

 Consumable stores
 Raw materials and components (used in the production process)
 Partly finished goods (WIP)
 Finished goods

Valuation of inventory

According to IAS 2, inventory should be valued at the lower of cost and net realizable
value (NRV).

Cost of inventories

We have:

(a) Purchase cost/price; plus Import duties and other taxes; Transport, handling and any
other cost directly attributable to the acquisition of finished goods, services and materials;
less trade discounts, rebates and other similar amounts

(b) Costs of conversion- Costs directly related to the units of production, eg (a)direct
materials, direct labour ; Fixed and variable production overheads that are incurred in
converting materials into finished goods, allocated on a systematic basis.

(c) Other costs incurred in bringing the inventories to their present location and condition

The standard emphasizes that fixed production overheads must be allocated to items of
inventory on the basis of the normal capacity of the production facilities.

Normal capacity is the expected achievable production based on the average over
several periods/seasons, under normal circumstances.

Other costs

Any other costs should only be recognised if they are incurred in bringing the inventories
to their present location and condition.

The standard lists types of cost which would not be included in cost of inventories:

• Abnormal amounts of wasted materials

 Labour or other production costs, Storage costs, administrative overheads not incurred
to bring inventories to their present location, Selling costs

Net realizable value

Revenue expected to be earned in the future when the goods are sold, less any cost to
be incurred in order to make the sale.

IAS2- ‘It is the estimated selling price in the ordinary course of business less estimated
costs of completion and the estimated costs necessary to make the sale’.

Principal situations in which NRV is likely to be less than cost:

(a) An increase in costs or a fall in selling price

(b) A physical deterioration in the condition of inventory

(c) Obsolescence in production.

(d) Decision as part of the company’s marketing strategy to manufacture and sell
products at a loss

(e) Errors in production or purchasing

Accounting for opening and closing inventories

In order to calculate the cost of goods sold it is necessary to have values for the opening
inventory (i.e. inventory in hand at the beginning of the accounting period) and closing
inventory (i.e. inventory in hand at the end of the accounting period).

Closing inventory

Items for resale that we have bought in but have not yet sold are an asset of the business.
The cost of these items must be transferred out of the cost of sales account, into the
inventory account (asset)

Opening inventory must be included in cost of sales as these goods are available for sale
along with purchases during the year.
Closing inventory must be deducted from cost of sales as these goods are held at the
period end and have not been sold.

Ledger accounting for inventories

Inventory account must be kept. This inventory account is only ever used at the end of an
accounting period, when the business counts up and values the inventory in hand, in an
inventory count

For purchases DEBIT Income statement CREDIT Purchases account

For closing inventory DEBIT Inventory account (closing inventory value) CREDIT
Income statement

Closing inventory at the end of one period becomes opening inventory at the start of the
next

Value of opening inventory is taken to the income statement:

Dr Income statement

Cr Inventory account (value of opening inventory]

The cost of carriage inwards and outwards

'Carriage' refers to the cost of transporting purchased goods from the supplier to the
premises of the business which has bought them.

• Carriage inwards is included in the cost of purchases.

• Carriage outwards is a selling expense. When the supplier pays, the cost to the
supplier is known as carriage outwards (out of the business) and purchaser pays for
carriage inwards

Goods written off or written down

 A trader might be unable to sell all the goods that he purchases, because a number of
things might happen to the goods before they can be sold. For example:

(a) Goods might be lost or stolen.

(b) Goods might be damaged, become worthless and so be thrown away.

(c) Goods might become obsolete or out of fashion.

When goods are lost, stolen or thrown away as worthless, the business will make a loss on
those goods because their 'sales value' will be nil.

If, at the end of an accounting period, a business still has goods in inventory which are
either worthless or worth less than their original cost, the value of the inventories should be
written down to:

(a) Nothing, if they are worthless

(b) Their net realisable value, if this is less than their original cost

Determining the purchase cost

Inventories may be raw materials, finished goods made by the business but not yet sold,
or work in the process of production (WIP)

Cost can be arrived at by using FIFO (first in-first out) or AVCO (weighted average
costing).

Method Key points

Only used when items of

This is the actual cost of purchasing
Unit cost inventory are individually
identifiable units of inventory.
distinguishable and of high value

FIFO – The cost of closing inventory is

For costing purposes, the first items of
the cost of those most
inventory received are assumed to be
first in-
the first ones sold.
first out recently purchased/produced

AVCO – The average cost can be

The cost of an item of inventory is
calculated periodically
calculated by taking the average of all
Average
inventory held.
cost or continuously
 Items of inventory purchased last are sold
first
Closing inventory are those first
LIFO
purchased
( NOT ALLOWED UNDER IAS 2 and is
therefore no longer in your syllabus)
 SALES TAX

This is an indirect tax levied on the sale of goods and services. It is usually borne by the final
consumer.

Sales tax charged on goods and services sold by a business is referred to as output sales
tax, while sales tax on goods and services bought in by a business is referred to as input
sales tax.

A business that is registered for sales tax acts as a collection agent for the government and
is also able to recover sales tax suffered on purchases. Hence, sales tax is excluded from
the reported sales and purchases of the business.

Irrecoverable sales tax

In circumstances where a business cannot recover sales tax paid on their inputs, it must be
regarded as part of the items purchased and included as an expense in the statement of
comprehensive income or in the statement of financial position as part of the cost of the
asset.

Some circumstances in which traders are not allowed to reclaim sales tax paid on their
inputs

• Non-registered persons( persons will pay sales tax on their inputs and, because they
are not registered, they cannot reclaim.

• Zero rated businesses need to record all input VAT. Will appear in Statement of
financial position as current assets

• Registered persons carrying on exempted activities (cannot reclaim sales tax paid
on their inputs. Do not record VAT

• Non-deductible inputs
Calculation of sales tax

To calculate sales tax depends on if the price given is exclusive of tax or inclusive of tax.

For:

Tax exclusive price = price * tax rate / 100

Tax inclusive price = price * tax rate / (100 + tax rate)

Accounting entries for sales tax

Input tax (sales tax on purchases)

Dr Purchases excluding sales tax (net cost)

Dr Sales tax sales tax

Cr Payables/cash cost including sales tax (gross cost)

Output tax (sales tax on sales)

Dr Receivables/cash sales price including sales tax (gross selling price)

Cr Sales sales price excluding sales tax (net selling price)

Cr Sales tax sales tax

Payment of sales tax (if output tax exceeds input tax)

Dr Sales tax Amount paid

Cr Cash Amount paid

Receipt of sales tax (if input tax exceeds output tax)

Dr Cash Amount received

Cr Sales tax Amount received

The main points

(a) Credit sales (b) Credit purchases

i. Include sales tax in sales day book i. Include sales tax in purchases day
separately book; show it separately.
ii. Include gross receipts from ii. Include gross payments in
receivables in cash book; no need cashbook; no need to show sales
to show sales tax separately tax separately.
iii. Exclude sales tax element from iii. Exclude recoverable sales tax
income statement from income statement.
iv. Credit sales tax payable with iv. Include irrecoverable sales tax in
output sales tax element of income statement
receivables invoiced v. Debit sales tax payable with
recoverable input sales tax
element of credit purchases

(c) Cash sales (d) Cash purchases

i. Include gross receipts in i. Include gross payments in
cashbook; show sales tax cashbook; show sales tax
separately. separately.
ii. Exclude sales tax element from ii. Exclude recoverable sales tax
income statement. from income statement
iii. Credit sales tax payable with iii. Include irrecoverable sales tax in
output sales tax element of cash income statement
sales. iv. Debit sales tax payable with
recoverable input sales tax
element of cash purchases.
 ACCRUALS AND PREPAYMENTS

The accruals concept

This concept is that income and expenses should be matched together and dealt with in
the statement of comprehensive income for the period to which they relate, regardless of
the period in which the cash was actually received or paid.

Requires that revenue be recorded when earned and expenses recorded when incurred,
irrespective of when related cash movements occur. They are a necessary part of the
accounting process and are designed to allocate an activity to the proper period

Accrued expenditure

Accruals or accrued expenses are expenses which are charged against the profit for a
particular period, even though they have not yet been paid for.

An accrual is a liability account and is therefore included in the Statement of financial

position as a current liability (payables)

Accounting entries:

 Dr: Expense account

 Cr : Accrual

Prepaid expenses

Prepayments or prepaid expenses on the other hand are payments which have been
made in one accounting period, but should not be charged against profit until a later
period, because they relate to that later period.

Deduct prepayments from expenses shown at year end to obtain expenses incurred.
Show prepayments under current assets.

Accounting entries:

 Dr: Prepayment
 Cr : Expense account

Both accruals and prepayments can be regarded as the means by which we move
charges into the correct accounting period. If we pay in this period for something that
relates to the next accounting period, we use a prepayment to transfer that charge
forward to the next period.

If we have incurred an expense in this period which will not be paid until next period, we
use an accrual to bring the charge back into this period.

Accrued income

Accrued income arises when income has been earned in the accounting period but has
not yet been received.

So you must record the extra income in the IS and create a corresponding asset in the
Statement of financial position (accrued income).

Accounting entries:

 Dr Accrued income (SOFP)

 Cr Income (SOCI)

Prepaid Income

Prepaid income arises where income has been received in the accounting period but
which relates to the next accounting period.

Remove the income not relating to the year from the income statement and create
corresponding liability in the Statement of financial position

Accounting entries:

 Dr Income (SOCI)
 Cr Prepaid income (SOFP)
Impact on profit and net assets of accruals and prepayments
Effect on income/ Effect on profit Effect on assets/
Expense liabilities
Accruals Increases Reduces Profit Increases liabilities
expenses
Prepayments Reduces expenses Increases profit Increases assets
Prepayments of Reduces income Reduces profit Increases liabilities
Income
 IRRECOVERABLE DEBTS AND ALLOWANCES FOR RECEIVABLES

Irrecoverable debts are amounts owing by credit customers that are considered to be
uncollectable. Irrecoverable debts are very likely to arise as long as an organization sells
to its customers on credit.

As it is deemed uncollectable, it is prudent to removed them from the receivables

account and recognize them in the Statement of Comprehensive income as an expense
for the period.

Accounting entries:

Credit sales:

 Dr Receivables
 Cr sales

However:

When it is decided that a particular debt will not be paid, this is an irrecoverable debt:

(a) Dr Irrecoverable debts account (expense) ;

(b) Cr Receivables

At the end of the accounting period, the balance on the irrecoverable debts account is
transferred to Income statement (like all other expense accounts).

(c) Dr Income statement;

(d) Cr Irrecoverable debts account.

Irrecoverable debt recovered

These are debts written off as irrecoverable in a particular period and now paid in
subsequent periods.
This will be recognized as an income in the accounting period that the debt was
recovered.

Accounting entries:

1. Reverse the initial write-off of receivables:

 Dr Receivables a/c
 Cr Irrecoverable debt expense a/c

2. Irrecoverable debt recovered:

 Dr Cash
 Cr Receivables

Doubtful debts

If there is some doubt whether customer can pay, allowance for receivables is created.
This means that the possible loss is accounted for immediately in line with the prudence
concept. The original debt still remains the books in event the customer pays.

These remain in the books as a part of accounts receivable but we will create an
allowance for receivables equal to the amount of any doubtful ones and leave a net
figure in the Statement of financial position.

Allowance for receivables

This is the process of recognizing as an expense in the Statement of comprehensive

income the possibility of not collecting some debt. At this point, the debt is not regarded
as irrecoverable, but there is considerable doubt over its collectability. The doubt might
be as a result of similar experience in the past or probably because the customer is going
through some financial difficulty, and as a result might not be able to pay.

As the debt is not yet regarded as irrecoverable, it will still be included in total receivable
figure. An allowance is set up which is a credit balance. This is netted off against trade
receivables in the Statement of financial position to give a net figure for receivables that
are probably recoverable.

Types of allowance for receivables

Specific allowance: this is a situation where you can identify that a particular customer
might not be able to pay what is outstanding for any reason.

General allowance: this is an estimate of what the organization thinks that it might not be
able to receive from its credit customers. The estimate will normally be based on past
experience.

Accounting for allowance for receivables

Initial allowance (i.e. when creating the allowance for the first time)

 Dr Irrecoverable debt expense

 Cr Allowance for receivables

Subsequently, only the movement in allowance (closing allowance minus opening

allowance) is charged in the Statement of comprehensive income. Increase in allowance
is recognized as an expense, while decrease in allowance is recognized as income.
Therefore, when there is an:

Increase in allowance:

 Dr Irrecoverable debt expense

 Cr Allowance for receivables

Decrease in allowance:

 Dr Allowance for receivables

 Cr Irrecoverable debt expense
Steps to calculate movement in allowance for receivables

Total receivables **

Irrecoverable debts (**)

**

Specific allowance (**)

** multiply this figure by the general allowance percentage

The addition of the specific and general allowance is equal to the closing allowance,
which will now be compared to the opening allowance to know the movement in
allowance.
 CONTROL ACCOUNTS

 So far in this text we have assumed that the bookkeeping and double entry (and
subsequent preparation of financial accounts) has been carried out by a business without
any mistakes. This is not likely to be the case in real life. Once an error has been detected, it
has to be corrected. We explain how errors can be detected, what kinds of error exist, and
how to post corrections and adjustments to produce financial statements.

 A control account is an account in the nominal ledger in which a record is kept of the total
value of a number of similar but individual items. Control accounts are used chiefly for
trade receivables and payables.

 The amount owed by all the receivables together (i.e. all the trade account receivables)
will be a balance on the receivables control account

 At any time the balance on the Receivables control account (RCA) should be equal to the
sum of the individual balances on the personal accounts in the receivables ledger.

 The reasons for having control accounts are as follows

(a) They provide a check on the accuracy of entries made in the personal accounts in
the receivables ledger and payables ledger i.e. Compare total balance on the RCA with
the total of individual balances on the PA in the Receivables ledger

(b) assist in the location of errors, where postings to the control accounts are made daily
or weekly, or even monthly

(c) provides an internal check (segregation of duties).

The control accounts should be balanced at least monthly, and the balance on the account
agreed with the sum of the individual debtors' or suppliers balances extracted from the
receivables or payables ledgers respectively. For one or more of the following reasons


(a) An incorrect amount may be posted to the control account because of a miscast of the
total in the book of original entry. A journal entry must then be made in the nominal ledger
to correct the control account and the corresponding sales or expense account

(b) A transposition error may occur in posting an individual's balance from the book of prime
entry to the memorandum ledger.

No accounting entry would be required to do this, except to alter the figure in C Cloning's
account.
 (c) A transaction may be recorded in the control account and not in the memo ledger, or
vice versa. This requires an entry in the ledger that has been missed out which means a
double posting if the control account has to be corrected, and a single posting if it is the
individual's balance in the memorandum ledger that is at fault.

(d) The sum of balances extracted from the memorandum ledger may be incorrectly
extracted or miscast. This would involve simply correcting the total of the balances.

Once these errors are detected, we must reconcile.

ontrol account reconciliation steps

 Compare balance on ledger account with the control a/c
 Review the list of errors to see which accounts need amending
 Set up a T account for the control accounts
 Prepare a reconciliation for the ledger account
TANGIBLE NON-CURRENT ASSETS AND DEPRECIATION

Concepts of capital and revenue expenditure

Capital expenditure is an expense either on the acquisition of non-current asset or to add

to the value of an existing non-current asset. It is long term in nature as the business
intends to receive the benefits of the expenditure over a long period of time.

Revenue expenditure on the other hand is an expense incurred on running the business
on a day-to-day basis. It relates to the current accounting period.

Tangible non-current assets

These are physical resources controlled by the organization and from which it intends to
derive benefits for more than one accounting period.

Characteristics

Non-current assets-

 Long term in nature- use of asset over an extended period

 Not acquired for resale;
  Used to generate income directly/indirectly for a business
 Cannot be easily converted to cash

Capital and Revenue expenditure

Capital expenditure results in the acquisition of or expenditure on non-current assets or an

improvement in their earning capacity.

• Occurs when a business spends money to add to the value of an existing asset ,
delivery costs, legal fees, enhancing costs
• Purchase or improvement of non-current assets, which are assets that will provide
benefits to the business in more than one accounting period, and which are not
acquired with a view to being resold in the normal course of trade.

• Interest costs associated with acquiring or constructing an asset that requires a long
period of time to prepare for use

• Not charged in full to the income statement of the period in which the purchase
occurs but depreciated

Double entry to record purchase of non - current assets:

Dr Non- current asset

Cr Bank/Payables

Revenue expenditure is expenditure which is incurred:

(a) For the purpose of running the business. Includes selling & distribution expenses, admin
expenses and finance charges

(b) To maintain the existing earning capacity of a Non -current asset, e.g. Repairs,
renewals, repainting

See table below for examples:

Determining cost of acquiring NCA (IAS 16)

Cost-

- Directly attributable costs incurred in bringing the asset to its present location and
condition

- acquire the asset

- Bring it into working condition

- Purchase price, import duties, inbound freight
- Initial estimates of dismantling, removing, site restoration
- Directly attributable costs
- costs of site preparation
- Initial delivery, and handling charges
- Installation and assembly costs
- related professional fees
- Insurance while in transit
- Testing before use whether asset is working properly

Excluded costs

- Advert and promotional costs

- Administration and general overheads
 - Training costs
- Initial operating losses
- Costs of relocating/re organising part or all of an entities operation
- Costs of introducing a new product/service.
- Costs incurred while asset is left idle
- Insurance when asset is in use
-

Subsequent expenditure

Is added to the carrying amount of the asset, but only when it is probable that future
economic benefits, in excess of the originally assessed standard of performance of the
existing asset, will flow to the enterprise.

Such expenditure include:

(a) Modification of an item of plant to extend its useful life, including increased capacity

(b) Upgrade of machine parts to improve the quality of output

(c) Adoption of a new production process leading to large reductions in operating costs

Depreciaton

Is the allocation of the depreciable amount of an asset over its estimated useful life.

We are spreading the cost of a non-current asset over its useful life, and so matching the
cost against the full period during which it earns profits for the business.

What are Causes of depreciation?

- Physical deterioration (wear/tear), economic factors (obsolescence), time, depletion

(mines, oil wells)

What is the estimated Useful life of an asset?

Period over which a depreciable asset is expected to be used by the enterprise.

Factors affecting estimated useful life-

  Expected physical wear and tear;
 Obsolescence;

Accumulated depreciation

Is amount set aside as a charge for the wearing out of NCA. Total accumulated
depreciation on a NCA builds up as the asset gets older

DEBIT Income statement (depreciation expense)

CREDIT Accumulated depreciation account (statement of financial position)

with the depreciation charge for the period.

Depreciation accounting

Since a non-current asset has a cost, a limited useful life, and its value eventually declines,
a charge should be made in the income statement to reflect the:

(1) use that is made of the asset by the business

(2) match to the revenue generated by the NCA. This Charge= depreciation.

(3) Also reduce the statement of financial position value of the NCA by cumulative
depreciation to reflect the wearing out.

Entries:

Dr Non current asset

Cr Bank with

with cost of asset purchased;

DR Income statement

Cr Accumulated depn

with depreciation charge for year

Before we proceed, we must understand the following concepts:

Residual value
Amount received when the asset is put out of use by the business, or the amount
company estimates it can sell asset for at end of useful life.

Illustration

Asset costing $22,000 is expected to have a residual value of $4,000 at the end of its 10 yr
life.

Each year, 22,000-4,000 (depreciable cost)/10= $1,800 will be recorded as depreciation

expense for the year.

Depreciation methods

These are the ways in which we charge depreciation on an asset.

Must be applied consistently from period to period unless altered circumstances justify a
change. When the method is changed, the effect should be quantified and disclosed and
the reason for the change should be stated.

Two methods of depreciation are specified in your syllabus:

The straight line method;

Reducing balance method

Straight line method

The total depreciable amount is charged in equal installments to each accounting

period over the expected useful life of the asset =

Cost of asset - residual value

Expected useful life of the asset

Illustration
 A non-current asset costing $100,000 with an estimated life of 5 years and no residual
value would be depreciated at the rate of:100,000/5= $20,000 per annum.

The reducing balance method

Allocates a relatively large proportion of the cost of an asset to the early years of the
assets useful life with a progressively lower charge in subsequent years and so on.

- Do not deduct the residual value of the asset

- The depreciation charge is a fixed % of NBV at end of previous year.

Illustration

An asset was purchased for $100,000 exactly 2 years ago. The business uses depreciation
of 20% reducing balance. Therefore the NBV now is

Yr 1 100,000 x 20%= 20,000; NBV= 100,000-20,000= 80,000;

Yr 2 80,000 x 20%= 16,000; NBV= 80,000-16,000= 64,000

Assets acquired in the middle of an accounting period

•Provide a full year’s depreciation in the year of acquisition and none in the year of
disposal

• Monthly/ pro-rata depreciation, based on the exact number of months that the asset
has been owned.

Change in method of depreciation

•If there are any changes in the expected pattern of use of the asset (and economic
benefit), then the method used should be changed.

•Remaining net book value is depreciated under the new method, but not
retrospectively.
Illustration

Paul purchased an asset for $100,000 on 1/1/2001. It had an estimated useful life of 5 yrs
and it was depreciated using the reducing balance method at a rate of 40%. On 1/1/2003
it was decided to change the method to straight line. Show the depreciation for each
year

Change in expected useful life or residual value of an asset

Depreciation charge on a NCA depends not only on the cost/value and its estimated
residual value but also on its estimated useful life

New depreciation = NBV at time of readjustment less residual value

Revised useful life

Non-current asset disposals

The difference between the book value and the amount actually realized from a sale of
an asset is called a gain (loss) on disposal.

Proceeds (cash or part disposal allowance) > NBV at disposal date= Profit

Proceeds (cash or part disposal allowance) < CV at disposal date= Loss

Proceeds (cash or part disposal allowance) = CV at disposal date= Neither profit or loss.

E.g. For example, let's say a company sells one of its delivery trucks for $3,000. That truck is
shown on the company records at its original cost of $20,000 less accumulated
depreciation of $18,000. When these two amounts are combined ("netted together") the
net amount is known as the book value (or the carrying value) of the asset. In the example,
the book value of the truck is $2,000 ($20,000 - $18,000).

Because the proceeds from the sale of the truck are $3,000 and the book value is $2,000
the difference of $1,000 is recorded in the account Gain on Sale of Truck—an income
statement account.
Disposal of assets- how it is recorded in the ledger accounts

On sale we remove the asset from our books

Difference between the net sale price of the asset and its net book value at the time of
disposal is equal to Profit or loss on disposal

This is a three-step process:

(1) Remove the original cost of the non-current asset from the ‘non-current asset’
account.

Dr Disposals a/c with original cost;

Cr Non current assets a/c with original cost

(2) Remove accumulated depreciation on the non-current asset from the ‘accumulated
depreciation’ account.

Dr Accumulated depreciation;

Cr Disposals a/c with Accumulated depreciation

(3) Record the cash proceeds.

Dr Cash with proceeds

Cr Disposals a/c with proceeds

The balance on the disposals account after this process is the profit or loss on disposal

Part exchange disposal

Where an old asset is provided in part payment for new one, balance of new being paid
in cash.

You record the part exchange allowance as proceeds=

Dr NC asset (part cost of new asset (Part exchange allowance)

Cr Disposal (Sale proceeds of old asset- part exchange allowance)

Record the cash paid for the new asset

Dr NC assets cash

Cr Cash with proceeds

2 debits to the NCA a/c- part exchange allowance and balance of cash to be paid.

Revaluation of non-current assets

Some non-current assets, such as land and buildings may rise in value over time. Businesses
may choose to reflect the current value of the asset in their statement of financial position.
This is known as revaluing the asset.

• The difference between the carrying value of the asset and the revalued amount
(normally a gain) is recorded in a revaluation reserve in the capital section of the statement
of financial position.

• This gain is not recorded in the income statement because it is unrealised, i.e. it is not
realised in the form of cash.

• IAS 1 requires that a revaluation gain (when sold) is disclosed in "other comprehensive
income" on the Statement of comprehensive income

Depreciation is charged on the revalued amount

Dr Accumulated depreciation (depreciation to date);

Dr Non-current asset (cost);

Cr Revaluation reserve (revaluation surplus)

After the revaluation, depreciation will be charged on the new rate of:

Revalued amount

Remaining useful life

Difference between old and new depreciation value is transferred from revaluation
reserves to retained earnings/accumulated profits. Entries are:

Dr revaluation reserve

Cr Retained earnings
A fall in the value of a non-current asset

If fall in value is expected to be permanent, the asset should be written down to its new
low market value.

Do the reverse i.e:

Dr Revaluation reserve with the devaluation and

CR Cost

A downward revaluation should be charged as an expense unless it reverses a previous

upward revaluation

The asset register

Details of Non- current assets are maintained in an assets register. It can be manual or
computerized.

It is also an internal check on the accuracy of the nominal ledger.

All asset movements and changes in value should be recorded against individual assets

Agree balances in the nominal ledger for cost and accumulated depreciation to what is
recorded in the register.

• The internal reference number (for physical identification purposes)

• Manufacturer's serial number (for maintenance purposes)

• Description of asset

• Location of asset

• Department which 'owns' asset

• Purchase date (for calculation of depreciation)

• Cost

• Depreciation method and estimated useful life (for calculation of depreciation)

• Net book value (or written down value).

Disclosure

IAS 16 also disclosure for each major class of depreciable asset-

 Depreciation methods used;

 Useful life or the depreciation rates used;
 Total depreciation allocated for the period;
 Gross amount of depreciable assets and the related accumulated depreciation

INTANGIBLE NON-CURRENT ASSETS

Intangible non-current assets are long-term assets which have a value to the business
because they have been paid for, but which do not have any physical substance.
Intangible assets include goodwill, intellectual rights (e.g. patents, performing rights and
authorship rights) as well as research and development costs. The most significant of such
intangible assets are research and deferred development costs.

A non-current asset can be either tangible or intangible. A non-current tangible asset is

something of value such as land, equipment, machinery, furnishings, or buildings, which is
used to produce a good or service

An intangible asset is an identifiable non-monetary asset without physical substance. The

asset must be:

 Controlled by the entity as a result of events in the past; and

 Something from which the entity expects future economic benefits to flow

Types of intangible assets

• Development costs
• Goodwill
• Trademarks
• Lisenses
• Patents
• Copyrights
• franchises
• Software
• Customer lists
Definitions

Control- Power to obtain future economic benefits generated by the item, and restrict
access of other entities to those benefits. Demonstrated by having legal rights to the item
e.g. copyright, patent

Future economic benefits- item creates revenues, cost savings, other benefits. E.g having
intellectual property that allows it to double efficiency of a production line

Identifiability- capable of being separated from the entity and exchanged, licensed,
rented sold, or transferred.

If item does not meet these criteria, then expense

Intangible assets- an identifiable non-monetary asset without physical substance.

Finite- amortise

Indefinite- no amortisation charge but subject to annual impairment testing

Research and development costs

• Research is original and planned investigation undertaken with the prospect of

gaining new scientific or technical knowledge and understanding. Expenditure on
research must always be written off in the period in which it is incurred.

• Development is the application of research findings or other knowledge to a plan or

design for the production of new or substantially improved materials, devices,
products, processes, systems or services prior to the commencement of commercial
production or use. Development costs are usually written off.

However, if the criteria laid down by IAS 38 are satisfied, development expenditure
can be capitalized as an intangible asset. If it has a finite useful life, it should then be
amortised over that life.

• Amortisation is the systematic allocation of the depreciable amount of an intangible

asset over its useful life. Amortisation period and amortisation method should be
reviewed at each financial year end.
The standard gives examples of activities which might be included in either research or
development, or which are neither but may be closely associated with both.

• Research

 Activities aimed at obtaining new knowledge

 The search for applications of research findings or other knowledge
 The search for product or process alternatives
 The formulation and design of possible new or improved product or process
alternatives

• Development

 The design, construction and testing of pre-production prototypes and models

 The design of tools, jigs, moulds and dies involving new technology
 The design, construction and operation of a pilot plant that is not of a scale
economically feasible for commercial production
 The design, construction and testing of a chosen alternative for new/improved
materials.
Components of research and development costs

Research and development costs will include all costs that are directly attributable to
research and development alternatives, or that can be allocated on a reasonable basis.

The standard lists the costs which may be included in R & D, where applicable (note that
selling costs are excluded).

• Salaries, wages and other employment related costs of personnel engaged in R &
D activities.

• Costs of materials and services consumed in R & D activities.

• Depreciation of property, plant and equipment to the extent that these assets are
used for R & D activities.

• Overhead costs, other than general administrative costs, related to R & D activities.

• Other costs, such as the amortisation of patents and licenses, to the extent that
these assets are used for R & D activities.
Recognition of R & D costs

Research costs

Research costs should be recognized as an expense in the period in which they are
incurred. They should not be recognized as an asset in a later period.

Development costs

Development costs will be recognized as an expense in the period in which they are
incurred unless the criteria for asset recognition identified below are met. Development
costs initially recognized as an expense should not be recognized as an asset in a later
period.

Development expenditure should be recognized as an asset only when the business can
demonstrate all of the following. Where the criteria are met, development expenditure
must be capitalized. PIRATE

1) How the intangible asset will generate probable future economic benefits. Among
other things, the entity should demonstrate the existence of a market for the output
of the intangible asset itself or, if it is to be used internally, the usefulness of then
intangible asset.
2) Its intention to complete the intangible asset and use or sell it.
3) The availability of adequate technical, financial and other resources to complete
the development and to use or sell the intangible asset.
4) Its ability to use or sell the intangible asset.

5) The technical feasibility of completing the intangible asset so that it will be

available for use or sale.

6) Its ability to measure reliably the expenditure attributable to the intangible asset
during its development.

Amortisation of development costs

Once capitalised as an asset, development costs must be amortised and recognized as

an expense to match the costs with the related revenue or cost savings. This must be
done on a systematic basis, so as to reflect the pattern in which the related economic
benefits are recognized.

It is unlikely to be possible to match exactly the economic benefits obtained with the costs
which are held as an asset simply because of the nature of development activities. The
entity should consider either:

a. The revenue or other benefits from the sale/use of the product/process

b. The period of time over which the product/process is expected to be sold/used.

Amounts to be capitalised as separate acquisition e.g. software

• Cash paid
• Import duties and non-refundable taxes less rebates
• Costs of employee benefits
• Directly related professional fees
• Costs of testing whether the asset is functioning properly
Excluded- costs of introducing a new product/service; operating losses; admin and other
general OH costs

Internally generated intangible assets such as customer lists publishing titles cannot be
recognised because, the cost of these items cannot be distinguished from the cost of
developing the business as a whole.

Impairment of development costs

As with all assets, impairment (fall in value) is a possibility. The development costs should be
written down to the extent that the unamortized balance is no longer probable of being
recovered from the expected future economic benefit.
 ACCRUALS AND PREPAYMENTS

Accruals and prepayments are the means by which we move charges into the correct
accounting period

Accrued expense

Expense incurred not paid at year end so is a liability.

Accruals concept - revenue and expenses are recorded when incurred irrespective of
when cash is received.

So revenues and expenses brought into income statements are those earned /incurred
during period.

Only expenses for the year in question are included.

Examples- Electricity, rates, rent, and telephone.

ACCOUNTING TREATMENT

• Add it to expenses for the year, and treat as current liabilities.

• Dr electricity a/c to increase expenses in the Income statement
Cr Accruals a/c to increase liabilities in the Statement of financial position

This accrual is reversed at the beginning of the next period.

Prepaid expense

Are expenses paid in advance, e.g. Pay rent at beginning of year for whole year, only
portion relating to current period is charged

Entries

Prepayment -Dr Prepayment - SOFP

Cr Rent a/c- IS
 Prepayment a/c is shown under current assets

Accrued income

• Income is earned in the accounting period but not yet received by year end- e.g.
interest receivable
• revenue earned prior to receiving cash
• Record outstanding income in the IS (rent and interest receivable, commission
receivable)
• Create corresponding asset in the SOFP called Accrued income ( or could be
called sundry receivable)
Entries

Dr Accrued income (SOFP)

Cr Income received (IS)

Prepaid income

• Received in the accounting period (AP) but relates to next AP.

• Is a liability of the company as you still owe service to the customer
Accounting treatment

• Remove the income not relating to the year from the income statement (IS) and
create corresponding liability in the statement of financial position (SOFP)
• Dr utility Income (IS/SOCI)
Cr sundry payables(SOFP)unearned revenue

Impact on profit and net assets of accruals and prepayments

 CORRECTION OF ERRORS

Introduction

Here, we shall deal with errors that may be corrected by means of the journal or a
suspense account.

We will also look at the correction of material errors from a prior period in IAS 8.

Categories of errors

There are two categories of errors:

A. Errors that can be detected by a trial balance

i. Items posted to the wrong side of a ledger account

ii Items for which the double entry is incomplete

iii Casting errors

iv Posting of entry on the wrong side of the trial balance

B. Errors that cannot be detected by a trial balance

i. Errors of principle

ii. Compensating error

iii Errors of transposition

ii. Errors of omission

iii. Errors of commission

Types of accounting errors

It is not really possible to draw up a complete list of all errors which might be made by
bookkeepers and accountants. However, it is possible to describe five types of errors which
cover most of the errors that might occur. There are five main types of error. Some can be
corrected by journal entry while some require the use of a suspense account.

Once an error has been detected, it needs to be corrected.

i. If the correction involves a double entry in the ledger accounts(errors not affecting
the trial balance), then it is done by using a journal entry.

ii. When the error breaks the rule of double entry, then it is corrected by the use of a
suspense account as well as a journal entry.

1. Errors of transposition

An error of transposition is when two digits in an amount are accidentally recorded

the wrong way round. The consequence of this error is that total debits will not be
equal to total credits. You can often detect a transposition error by checking
whether the difference between debits and credits can be divided exactly by 9.

2. Errors of omission

An error of omission means failing to record a transaction at all, or making a debit or

credit entry, but not the corresponding double entry. In the latter, the total credits
would not equal total debits.

3. Errors of principle

An error of principle involves making a double entry in the belief that the transaction
is being entered in the correct accounts, but subsequently finding out that the
accounting entries break the ‘rules’ of an accounting principle or concept. A typical
example of such error is to treat certain revenue expenditure incorrectly as capital
expenditure.
4. Errors of commission

Errors of commission are where the bookkeeper has made a mistake in carrying out
his or her task of recording transactions in the accounts. Here are two common types
of errors of commission.

5. Compensating errors

Compensating errors are errors which are, coincidentally, equal and opposite to one
another.

Correction of errors

Errors which leave total debits and credits in the ledger accounts in balance can be
corrected using journal entries. Otherwise a suspense account has to be opened first, and
later cleared by a journal entry.

Journal Entries

The journal is the record of prime entry for transactions which are not recorded in any of
the other books of prime entry. The journal keeps a record of unusual movement between
accounts. It is used to record any double entries made which do not arise from the other
books of prime entry.

For example, journal entries are made when errors are discovered and need to be
corrected. A narrative explanation must accompany each journal entry. It is required for
audit and control, to indicate the purpose and authority of every transaction which is not
first recorded in a book of original entry.

The format of a journal entry is:

Date Debit Credit

$ $

Account to be debited X
Account to be credited X

(Narrative to explain the transaction)

Example: Journal Entries

‘Journalise’ the following transactions:

a. The trainee accountant of an enterprise omits completely a credit sales invoice to

a debtor for $600.

b. The bookkeeper of a business reduces cash sales by $540 because she was not sure
what the money represented. It was actually a withdrawal on account of profit.

c. Electricity expenses of $250 are incorrectly debited to the repairs account.

d. A page in the purchases day book has been added up to $23,456 instead of
$26,345

e. A business sells $750 worth of goods on credit. What is the correct journal?

Suspense accounts

Suspense accounts, as well as being used to correct some errors, are also opened when it
is not known immediately where to post an amount. When the mystery is solved, the
suspense account is closed and

the amount correctly posted using a journal entry. A suspense account is an account
showing a balance equal to the difference in a trial balance.

It is a temporary account which can be opened for a number of reasons. The most
common reasons are as follows:

a. A trial balance is drawn up which does not balance

b. The bookkeeper of a business knows where to post the credit side of a transaction,
but does not know where to post the debit (or vice versa).
Posting to a suspense account are only made when the bookkeeper does not know yet
what to do, or when an error has occurred. Under no circumstances should there still be a
suspense account when it comes to preparing the statement of financial position of a
business.

The suspense account must be cleared and all the correcting entries made before the
final accounts are drawn up.

Errors and the Income statement

Errors not affecting the Income statement

If errors affect only the SOFP, original profit will not need to be changed. E.g. on 1/10/2010,
we paid $1,200 to a creditor Paul. It was correctly entered in the cash book but not entered
anywhere also. Net profit for the year is $10,500

Errors affecting the Income statement

If the error is in one of the items in the income statement, then original profit will be
amended

MATERIAL ERRORS (IAS 8)

IAS 8 Accounting policies, changes in accounting estimates and errors is an important

standard.

Errors

Errors discovered during a current period which relate to a prior period may arise through:

a. Mathematical mistakes

b. Mistakes in the application of accounting policies

c. Misinterpretation of facts

d. Oversights

e. Fraud
As laid down in IAS 8 the amount of the correction of a material error that relates to prior
periods should be reported adjusting the opening balance of retained earnings.
Comparative information should be restated (unless this is impracticable). This treatment
means that the financial statements appear as if the material error had been corrected in
the period it was made.

Various disclosures are required:

i. The nature of the material error

ii. Amount of the correction for the current period and for each prior period
presented

iii. Amount of the correction relating to period prior to those included in the
comparative information

iv. The fact that comparative information has been restated or that it is impracticable
to do so.

BANK RECONCILIATIONS

In theory, the entries appearing on a business’s bank statement should be the same as
those in the business cash book. The balance shown by the bank statement should be the
same as the cash book balance on the same date. However, there could be differences
between the two records.

Differences between the Cash book and the Bank statement arise for three reasons:

a) Errors in calculation, or recording income and payments, are most likely to have been
made by the accountant than the bank, but it is conceivable that the bank has
made a mistake too.

b) Omission such as bank charges or bank interest not posted in the cash book. The
bank might deduct charges for interest on an overdraft or for its services, which you
are not informed about until you receive the bank statement.

c) Timing differences
i. There might be some cheques that you have received and paid into the bank, but
which have not yet been ‘cleared’ and added to your account. These are known
as un credited lodgments.

ii. Similarly, you might have made some payments by cheque, and depleted the
balance in your account, but the person who receives the cheque might not bank
immediately. Even when it is banked, it takes a day or two for the banks to process it
and for the money to be deducted from your account. These are known as un
presented cheques.

A bank reconciliation is a comparison of a bank statement with the cash book. A bank
statement or an account statement is a summary of all financial transactions occurring
over a given period of time on a deposit account, a credit card, or any other type of
account offered by a financial institution.

The opening balance from the prior month combined with the net of all transactions during
the period should result in the closing balance for the current statement. A bank
reconciliation is needed to identify and account for differences between the cash book
and the bank statement.

What to look for when carrying out a bank reconciliation

a) Corrections and adjustments to the cash book

i. Standing order. Payments made into the account or from the account by way of
standing order which have not yet been entered in the cash book.

ii. Dividends received (on investments held by the business), paid directly into the bank
account but not yet entered in the cash book.

iii. Bank interest and bank charges, not yet entered in the cash book.

b) Items reconciling the correct cash book balance to the bank statement

i. Cheques drawn (ie paid) by the business and credited in the cash book, which have
not yet been presented to the bank, or ‘cleared’, and so do not yet appear on the
bank statement.
i. Cheques received by the business, paid into the bank and debited in the cash book,
but which have not yet been cleared and entered in the account by the bank, and
so do not yet appear on the bank statement.

Steps

Compare cashbook to bank statement

Look for items outstanding/errors/timing differences in each one

Correct errors in cashbook by posting adjustments, to obtain an adjusted cashbook

balance

Prepare bank reconciliation statement. Balance per bank must agree to the ACB

Format

Balance per bank statement xxx

Less:

Un presented cheques (xx)

Add/less bank errors xxx

Add:

Un credited lodgments xxx

Balance per cashbook (adjusted) xxx

Note that the sign changes when the account is overdrawn. Balance per bank statement
will now be in negative.
INCOMPLETE RECORDS
So far, we have assumed that a full set of records are kept. In practice many sole traders
do not keep a full set of records and you must apply certain techniques to arrive at the
necessary figures.

Many small businesses do not keep complete double entry records. For them, a simple cash
book to record receipts and payments may be enough. A system complete with day books
and ledgers would provide better information and be less susceptible to undetected error.

The trouble with incomplete records, when it comes to preparing period end financial
statements, is that they do not tell the whole story. There is no record of outstanding debtors
or creditors, or of stock, or, without analysis, of for what receipts and payments have been
received and paid, or, in some cases, of the split between revenue and capital items.

In a double entry system these would all be represented by ledger balances. In an

incomplete system the figures must be calculated, extrapolated, or extracted – in the case
of creditors and debtors by making ‘accruals’ and ‘pre-payment’ calculations.

Arriving at the year-end profit and loss account and balance sheet will rely heavily on
application of the concept of the ‘accounting equation’. This is defined as: assets equal
proprietors’ capital plus liabilities. Thus the value of capital can be determined at any point
in time.

Examination questions on incomplete records tend to focus on either sole trader or

partnership account. In such instances any change in capital structure will be influenced
by any one or a combination of the following transactions, events or results:

 introduction of capital;
 drawings; and/or
 trading profits or losses.

To understand what incomplete records are about, it will obviously be useful now to look
at what exactly might be incomplete. The items we shall consider in turn are:

(a) The opening position

(A = L + OE). Might provide information about the assets and liabilities of the business at the
beginning of the period under review, but then leave the balancing figure (proprietor's
business capital) unspecified
Profit = Closing capital + drawings - Capital introduced - Opening capital
Where there are no records, we derive profit from opening and closing net assets
We want to eliminate any movement caused by money paid in or taken out for personal
use by the trader.
(b) Credit sales and trade accounts receivable
Build up the information given to complete the necessary double entry. Involves
reconstructing control accounts for:
• Cash and bank
• Trade accounts receivable and payable

(c) Purchases and trade accounts payable

Similar relationship exists between purchases of inventory during a period, the opening and
closing balances for trade accounts payable, and amounts paid to suppliers during the
period.

(d) Purchases, inventory and the cost of sales

If these are unknown figure it will be necessary to use information on gross profit % to
construct a working for gross profit in which the unknown figure can be inserted as a
balance

(e) Stolen goods or goods destroyed

Are there items in cost of sales that have not been sold due to:

Theft of inventory, owner taking goods for own use, damage?

When an unknown quantity of goods is lost, whether they are stolen, destroyed in a fire, or
lost in any other way such that the quantity lost cannot be counted, then the cost of the
goods lost is the difference between 2 THINGS:

(a) The Cost of goods sold as calculated by ratios

(b) Opening inventory of the goods (at cost) plus purchases less Closing Inventory of the
goods (at cost)

In theory (a) = (b). However, if (b) > (a), it follows that the difference must be the cost of
the goods purchased and neither sold nor remaining in inventory, i.e. the cost of the
goods lost.

If lost goods are not insured, the business must bear the loss, shown in the net profit
(income and expenses)

Dr Expense a/c

Cr Cost of sales
If the lost goods were insured, the business will not suffer a loss, because the insurance will
pay back the cost of the lost goods. This means that there is no charge at all in the income
statement,

Dr Insurance claim account (receivable account);

Cr Cost of sales with the cost of the loss.

The insurance claim will then be a current asset, and shown in the Statement of financial
position of the business as such.

When the claim is paid, the account is then closed by:

Dr Cash

Cr Insurance claim account

Where such personal items of receipts or payments are made the following adjustments
should be made.

(a) Receipts should be set off against drawings

DR Cash

CR Drawings

(b) Payments should be charged to drawings on account; i.e:

DR Drawings

CR Cash

Ratios
Mark up and margins

Where inventory, sales or purchases is the unknown figure it will be necessary to use
information on gross profit percentages to construct a working for gross profit in which the
unknown figure can be inserted as a balance. Could be that the trader has kept proper
books of account but has forgotten to do an inventory count.

Mark-up is the gross profit expressed as a percentage of the cost= GP/COS x 100%
Gross profit margin is the gross profit expressed as a percentage of sales/selling price=
GP/Sales x 100%
 SUMMARY

Incomplete
records ID of individual a/c balances
Identification of
profit figure within financial statements
Lost records, stolen

Method Methods
Use ledger accounts
Use accounting
 Trade receivables
equation
 Total payables
 Cash
or Ratios
 Margin = GP/Sales x
100%
 Mark up = GP/COS x
100%

COMPANY ACCOUNTS

A company is a legal entity created by the association of a number of persons in

accordance with the law for the purpose of a defined object e.g. Mobil Plc.

Limited liability and accounting records

There are some important differences between the accounts of a limited liability
company and those of sole traders or partnerships.
The national legislation governing the activities of limited liability companies tends to be
very extensive

The owners of a company (its members or shareholders) may be very numerous

The capital of a limited company is divided into shares. Shares can be of any nominal
value- 10c, 25c, $1, $10 or any other amount per share. To become a shareholder, a
person must buy one or more of these shares.

If shareholders have paid in full for these shares, then liability is limited to what they have
already paid for these shares. Shareholders are therefore said to have limited liability,
hence company’s are known as Limited liability company.

The maximum amount that an owner stands to lose in the event that the company
becomes insolvent and cannot pay off its debts, is his share of the capital in the business

We have private and public companies- Public limited companies offer their shares to the
public for subscription at large while private companies restrict the right to transfer its
shares.

Advantages of trading as a limited liability:

(a) Limited liability makes investment less risky than investing in a sole trader or partnership

(b) Easier to raise finance

(c) Company has separate legal identity from its shareholders.

(d) Company is taxed as separate entity from its owners

(e) the shareholders have limited liability.

Disadvantages of trading as a limited liability company

(a) LLC must publish annual FS

(b) Financial statements must comply with legal/accounting requirements

(c) Financial statements of larger LLC must be audited.

(d) Costs of formation of the company

(e) Directors of a company are subject to greater legislative duties than others running an
unincorporated business

Unlimited liability means that if the business runs up debts that it is unable to pay, the
proprietors will become personally liable for the unpaid debts and would be required, if
necessary, to sell their private possessions to repay them.

As a business grows, it needs more capital to finance its operations, and significantly more
than the people currently managing the business can provide themselves. One way of
obtaining more capital is to invite investors from outside the business to invest in the
ownership or equity of the business.

Share Capital

A share is a unit of capital of a company allocated to an individual.

The proprietors' capital in a LLC consists of share capital. When a company is set up for
the first time, it issues shares, which are paid for by investors, who then become
shareholders of the company. Shares are denominated in units of 25 cents, 50 cents, $1 or
whatever seems appropriate. The 'face value' of the shares is called their par value or
legal value (or the nominal value which is equal to the issuing price)

Share capital could be authorised, issued, called-up or paid-up share capital

Authorised (or legal) capital is the maximum amount of share capital that a company is
empowered to issue. E.g. 5,000,000 ordinary shares of $1 each. Total capital applied for
by the company as expressed in the memo and articles and approved by the registrar of
companies.

Issued capital is the par amount of share capital that has been issued to shareholders
(that part of the capital the company invites people to buy) . The company with
authorised share capital of 5,000,000 ordinary shares of $1 might have issued 4,000,000
shares. This would leave it the option to issue 1,000,000 more shares later.

Called-up capital. When shares are issued or allotted, a company does not always
expect to be paid the full amount for the shares at once. It might instead call up only a
part of the issue price, and wait until a later time before it calls up the remainder. This
amount could be determined by the capital requirements of the company.
 The called up capital is that part of the issued capital which the company has asked the
shareholders to pay up.

Paid-up capital is the amount of called-up capital that has been paid to the company.

Entries:

A company will generally issue shares at above par (nominal) value. If they are issued
above par, they are said to be issued at a premium.

The double entry to record an ordinary share issue is:

Dr Cash with issue price x no. shares;

Cr Share capital (Statement of financial position) Nominal value x no. shares;

Cr Share premium ß

Both the share capital and share premium accounts are shown on the SOFP within the
‘Share Capital and Reserves’ section.

Types of shares

There are 2 types of shares Ordinary shares and preference (preferred) shares

• Preference shares carry the right to a final dividend which is expressed as a percentage
of their par value.
• Preference shareholders have a priority right over ordinary shareholders to a return of their
capital if the company goes into liquidation.
• Preference shares do not carry a right to vote.
• For cumulative preference shares before a company can pay an ordinary dividend it
must not only pay the current year's preference dividend, but also pay up any arrears of
preference dividends unpaid in previous years.
• Non-cumulative- case where amount paid< maximum agreed amountarrears is lost by
shareholder. Shortfall cannot be carried forward and paid in the future.
Types of preference shares

(a)Redeemable (b) Irredeemable

Redeemable
 Company will redeem (repay) the nominal value of the shares at a later date. Shares will
then be cancelled and no further dividend paid. They are treated like loans and included
as non-current liabilities in the SOFP.
The double entry to record a redeemable preference share issue is:

Dr Cash - Issue price x no. shares;

Cr Liability - Issue price x no. shares

Irredeemable

Form part of equity like other shares and their dividends treated as appropriations of
profit. They remain in existence indefinitely

Ordinary shares

Ordinary shares carry no right to a fixed dividend but are entitled to all profits left after
payment of any preference dividend.

Ordinary shares normally carry voting rights. Ordinary shareholders are thus the effective
owners of a company. They own the 'equity' of the business. They may receive dividends
from the company from its profits.

Dividends

The returns on shareholders capital are in the form of dividends. They are part of the net
profit of the company which have been set aside for distribution to shareholders.

Many companies pay dividends in two stages during the course of their accounting year.
(a) In mid year, after the half-year financial results are known, the company might pay an
interim dividend.
(b) At the end of the year, the company might propose a further final dividend. The total
dividend for the year is interim + final dividend.

Dividends which have been paid are shown in the statement of changes in equity. They
are not shown in the income statement, although they are deducted from retained
earnings in the Statement of financial position. Proposed dividends are not adjusted for,
they are simply disclosed by note.

Preference shares are shares carrying a fixed rate of dividend, the holders of which have
a prior claim to any company profits available for distribution.

A separate account will be kept for the dividends for each different class of shares (e.g.
preference, ordinary).
(i) Dividends declared out of profits will be disclosed in the notes if they are unpaid at the
year end.
(ii) When dividends are paid, we have: DEBIT Dividends paid account;
CREDIT Cash

Loan Inventory or bonds

There are long-term liabilities and in some countries they are described as loan capital
because they are a means of raising finance, in the same way as issuing share capital
raises finance. They are different from share capital in the following ways:

(a) Shareholders are members of a company, while providers of loan capital are
payables (since such loans must be repaid at a give date)

(b) Shareholders receive dividends (appropriations of profit) whereas the holders of loan
capital are entitled to a fixed rate of interest (an expense charged against revenue).

(c) Loan capital holders can take legal action against a company if their interest is not
paid when due, whereas shareholders cannot enforce the payment of dividends.

(d) Loan Inventory is often secured on company assets, whereas shares are not (could be
tied to a specific property, in event of default, the payable has the legal right to sell the
property)

Loan Inventory being a long-term liability will be shown as a credit balance in a loan
Inventory account.

Interest payable on such loans is not credited to the loan account, but is credited to a
separate payables account for interest until it is paid

Dr Interest account (an expense, chargeable against profits);

Cr Interest payable (a current liability until eventually paid).

On payment:

Dr Interest payable;

Cr Cash

Reserves

A reserve may be an amount set aside for say the repayment of a debt, payment of tax
or general business eventualities. There are 2 types:

Capital

Revenue

Shareholders' equity consists of the following:

(a) The par value of issued capital (minus any amounts not yet called up on issued shares)
(b) Other equity

All reserves are owned by the ordinary shareholders, who own the 'equity' in the
company.

'Other equity' consists of four elements. (Non statutory)

(a) Capital paid-up in excess of par value (share premium)

(b) Revaluation surplus

(c) Reserves

(d) Retained earnings

Profits are transferred to these reserves by making an appropriation out of profits, usually
profits for the year.

Share premium account

This account contains shares issued at a price higher than their nominal value.

When a company is first incorporated (set up) the issue price of its shares will probably be
the same as their par value and so there would be no share premium. If the company
does well, the market value of its shares will increase, but not the par value. If shares
having a par value of 50c were issued and sold for 60c, they would have been issued and
sold at a premium of 10c per share.

Cash received by the company less par value of the new shares issued is transferred to
the share premium account.

• A share premium account only comes into being when a company issues shares at
a price in excess of their par value.
• Once established, the share premium account constitutes capital of the company
which cannot be paid out in dividends, ie a capital reserve
• One common use of the share premium account, however, is to 'finance' the issue
of bonus shares, which are described later

Statement of changes in equity

In the published accounts, a company has to provide a statement of changes in equity

which details movements on its capital and reserves.

Example: Statement of changes in equity

Share Share Revaluation Retained

capital premium reserve earnings

Total

Balance at 31.12.X0 X X X X

Gain on property revaluation X X

Profit for the period X X

Dividends (X) (X)

Issue of share capital X X X

Balance at 31.12.X1 X X X X X

Bonus (capitalisation) issues

These are shares issued to existing shareholders free of charge. An alternative name is
scrip issue.

A company may wish to increase its share capital without needing to raise additional
finance by issuing new shares. Company may decide to re-classify some of its reserves as
share capital. This is purely a paper exercise which raises no funds.

Entries are:

DEBIT Share premium

Retained earnings

CREDIT Ordinary share capital

The following are usually applied in the issue of bonus shares

Retained profits, any other revenue reserve, share premium

The advantages are:

• Issued share capital is divided into a larger number of shares, thus making the market
value of each one less, and so more marketable.

• Issued share capital is brought more into line with assets employed in the company.

The disadvantages are:• the admin costs of making the bonus issue is high.

Ledger accounts

Taxation

Companies are charged corporation tax on their profits.

Taxation affects both the Statement of financial position and the income statement.
All companies pay some kind of corporate taxation on the profits they earn, which we will
call income tax (for the sake of simplicity), but which you may find called 'corporation
tax'. The rate of income tax will vary from country to country and there may be variations
in rate within individual countries for different types or size of company.

Note that because a company has a separate legal personality, its tax is included in its
accounts. An unincorporated business would not show personal income tax in its
accounts, as it would not be a business expense but the personal affair of the proprietors.

(a) The charge for income tax on profits for the year is shown as a deduction from net
profit.

(c) In the SOFP, tax payable to the government is generally shown as a current liability as
it is usually due within 12 months of the year end.

(c) For various reasons, the tax on profits in the income statement and the tax payable in
the SOFP are not normally the same amount.

• Accounting for tax is initially based on estimates, since a company’s tax bill is not
finalised and paid until nine months after its year end.

• This means that a company will normally under– or over-provide for tax in any given
year

• Tax will therefore appear in the year-end financial statements as: –

A charge to profits in the income statement being – Current year estimated tax +
previous year’s under-provision;

or – Current year estimated tax – previous year’s over-provision.

• A year end liability in the statement of financial position being the current year’s
estimated tax.

(i) Tax charged against profits will be accounted for by:

DEBIT Income statement

CREDIT Taxation account

(ii) The outstanding balance on the taxation account will be a liability in the SOFP, until
eventually paid, when the accounting entry would be:

DEBIT Taxation account

CREDIT Cash

Presentation of financial statements

IAS 1

The general content of financial statements is governed by IAS 1 Presentation of financial

statements.

How items are disclosed

IAS 1 specifies disclosures of certain items in certain ways.

• Some items must appear on the face of the balance sheet or income statement

• Other items can appear in a note to the financial statements instead

• Recommended formats are given which entities may or may not follow, depending on
their circumstances

IAS 1 incorporates the recommended formats for company published accounts. The
following financial summaries are required:

• statement of financial position

• income statement
• statement of comprehensive income (only examinable where a revaluation of non-
current assets has occurred)

• statement of changes in equity

• notes to the accounts (the F3 syllabus does not require knowledge of these)

• a statement of cash flows and supporting notes

Statement of financial position for XYZ at 31 December XXXX

$m $m
Non-current assets
Property, plant and equipment
Investments X
Intangibles X
——
X
Current assets
Inventories X
Trade and other receivables X
Prepayments X
Cash X
——
X
——
Total assets X
——
Equity
Ordinary share capital X
Irredeemable preference share capital X

X
Share premium
Reserves:
Accumulated profits X
——
X
Non-current liabilities
Loan notes X
Current liabilities
Trade and other payables X
Overdrafts X
Tax payable X
——
X
——
X
Total equity and liabilities
——

The current/non-current distinction

You should be aware of the issues surrounding the current/non-current distinction as well
as the disclosure requirements laid down in IAS 1.

Users of financial statements need to be able to identify current assets and current
liabilities in order to determine the company's financial position. Where current assets are
greater than current liabilities, the net excess is often called 'working capital' or 'net
current assets'.

Current assets

An asset should be classified as a current asset if it is:

• part of the enterprise’s operating cycle • held primarily for trading purposes • expected
to be realised within 12 months of the statement of financial position date; or • cash or a
cash equivalent.

All other assets should be classified as non-current assets.

Current liabilities

A liability should be classified as a current liability if:

• it is expected to be settled in the normal course of the enterprise’s operating cycle • it is

held primarily for the purpose of being traded • it is due to be settled within 12 months of
the statement of financial position date or • the company does not have an
unconditional right to defer settlement for at least 12 months after the statement of
financial position date. All other liabilities should be classified as non-current liabilities.
 Statement of comprehensive income for XYZ for the year ended 31 December XXXX
$m
Revenue X
(X)
Cost of sales
––––
Gross profit X
Distribution costs (X)
(X)
Administrative expenses
––––
Profit from operations X
X
Finance costs
––––
Profit before tax X
(X)
Tax expense
––––
Net profit for the period X
Other comprehensive income:
Gain/loss on property
revaluation X

––––
Total comprehensive income for
the
X
year

Revenue
Sales value of goods and services that have been supplied to customers.

Cost of sales

Costs of goods and service used up in the process of earning revenue.

Expenses

Consumption/outflow of resources due to the sale of goods or services

Finance cost

This is interest payable during the period.

Income tax expense

Once again this will include accruals for the tax due on the current year's profits.

Managers' salaries

The salary of a sole trader or a partner in a partnership is not a charge to the income
statement but is an appropriation of profit. The salary of a manager or member of
management board of a limited liability company, however, is an expense in the income
statement, even when the manager is a shareholder in the company. Management
salaries are included in administrative expenses.

Taxation

Tax levied on the profits of a company.

STATEMENT OF CASH FLOW (IAS 7)

 • Differentiate between profit and cash flow. Understand the need for management
to control cashflow
• Recognise the benefits and drawbacks to users of the financial statements of a
statement of cash flows.
• Classify the effect of transactions on cash flows.
• Calculate the figures needed for the statement of cash flows including:
(i) Cash flows from operating activities

(ii) Cash flows from investing activities

(iii) Cash flows from financing activities

Objective of IAS 7

• To provide information to users that assists in the assessment of their liquidity.

• Gives some idea of the firms financial strength

• Indicates the cash needs of the entity
• Provides historical information about cash and cash equivalents, classifying cash
flows between operating, investing and financing activities.

Cash and cash equivalents

• Cash equivalents are the temporary investments of cash not required at present by
the business e.g. funds put on short term deposit with a bank, Treasury bills, bank
overdraft.
• The components of cash and cash equivalents should be disclosed and a
reconciliation presented, showing the amounts in the cash flow statement
reconciled with the equivalent items reported in the Statement of financial position.

Profit vs cashflow
• Profits represents the increase in net assets in a business and looks at the profitability
of the business.
• Is the result of a deduction of cost from revenues both of which are measured on
an accrual basis.
• Cash flow on the other hand is looking at the liquidity position of the business.
• Measures actual cash inflows and outflows on account of both revenue and
capital items.

Benefits to users of financial statements of cashflow accounting

• Survival in business depends on the ability to generate cash.

• Cash flow is more comprehensive than 'profit' which is dependent on accounting
conventions and concepts.
• Provides a better means of comparing the results of different companies than profit
reporting.
• Satisfies the needs of all users better.
 • For management, it provides the sort of information on which decisions should be
taken.
• Cash flow forecasts are easier to prepare, more easily understood as well as more
useful, than profit forecasts.
• They can in some respects be audited more easily than accounts based on the
accruals concept.
• Past forecasts of cashflow information can be checked for accuracy as actual
figures emerge.

Drawbacks to users of financial statements of cash flow accounting

 Statement is backward looking

 No interpretation of the statement is provided within the accounts.

Methods- Indirect
Derives net cash flow from operations indirectly by carrying out a series of adjustments on
the NOI obtained from the income statement.
Format

Profit before interest and tax (income statement) X

Add : Non - cash items: depreciation X

Loss/ (profit) on sale of non-current assets X/(X)

Operating profit before working capital changes XX

(Increase)/decrease in inventories (X)/X

(Increase)/decrease in receivables (X)/X

Increase/(decrease) in payables X/(X)

Cash generated from operations XX

Direct (different only up to cash generated from operations)

Ascertains net cashflows from operating activities directly by summing together all cash
inflows arising explicitly from a firms normal operations

Cash flows from operating activities

Cash receipts from customers x

Cash paid to suppliers and employees (x)

Cash generated from operations x

Interest paid (x)

Income taxes paid (x)

Net cash from operating activities x

Cash flows from investing activities X

Proceeds from sale of equipment X

Purchase of PPE (x)

Interest received X

Dividend received X

Net cash from investing activities (X)/X

Cash flows from financing activities

Proceeds from issue of shares X

Repayment of loans (X)

Net cash from financing activities (X)/X

Net increase/decrease in cash and CE XX

Cash and cash equivalent at start of period xx

Cash and cash equivalent at end of period xx

Cash flows from Investing activities

Represents cash inflows and outflows pertaining to Long term investments in PPE.
Inflows- proceeds from investment sales, proceeds from sale of non-current assets, interest
and dividend received.

Outflows- purchase of investments, purchase of Property, plant and equipment(Non-

current assets)

Cash flows from financing activities

Records cash inflows and outflows pertaining to the corporation’s borrowings, LT liabilities
and Shareholders equity.
Examples are:

 Proceeds from borrowing money

 Repayment of borrowed money
 Payment of interest on debt capital
 Payment of cash dividends
  Proceeds from issue of new shares

Cash and cash equivalents reconciliation

Net cash from operating activities xxx

Net cash from investing activities xxx

Net cash from financing activities xxx

Net increase/decrease in cash & cash equivalents xxx

Cash & cash equivalents at the start of the period xxx

Cash and cash equivalents at the end xxx

Steps
 Determine the net profit before tax
 Look for non-cash items and add them back
 Adjust for working capital changes
 Obtain the net cash used in investing activities
 Obtain the net cash used in financing activities
 Determine the net increase/decrease in cash and cash equivalents
 Prepare a cash movement statement
 Interpretation of statement of cash flows

SIMPLE CONSOLIDATED FINANCIAL STATEMENTS

Definitions

Parent- Company that controls another company

Subsidiary- Company controlled by the parent company

Group- Parent coy plus its subsidiaries

Consolidated accounts- presenting the results of a group of companies as if they were a

single entity

Consolidated Statement of financial position

Purpose is to show all the assets and liabilities that are controlled by the parent company
effectively as though it is one big company.

 First establish the group structure

 Combine all the assets and liabilities of the company line by line.
 Look out for intercompany transactions and eliminate them.
 Consolidate as if you own everything
 Show the extent to which you do not own everything

What do we mean by NCI?

Non - controlling interest is the non-group shareholders' interest in the net assets of the
subsidiary.
 If Company A owns 60% of Company B’s shares, which is majority of the shares and other
shareholders own the other 40% of Company B’s shares, the party owning 40% are known
as minority shareholders or having a NCI

Consolidation where S has started to earn profits

(S1) Establish the group structure

A  B If a acquires all of B, A interest is 100%, while NCI is nil

Date of acquisition = today

(S2) Determine the net assets of the subsidiary.

Assets – Liabilities = OE= Share capital + reserves

Therefore, Net assets = Share capital + Reserves

At Acquisition At reporting date

Share Capital x x

Retained earnings x x

x x

Pre- acquisition profits

Up till now, P acquired S on incorporation

Often coy acquires another coy some years after incorporation in which case the
company will have earned profits by the time of acquisition.

Pre-acquisition retained earnings of a sub are not aggregated with P net earnings

Amount to be consolidated= Retained earnings P x

Plus: Post acquisition retained earnings S x

Consolidation when consideration is different from net assets acquired

(S3) Let us compare what P paid for S with the share of the net assets that were acquired
to see if any premium arose on acquisition (goodwill)

Up till now, P paid for the subsidiary an amount equal to the value of the subsidiary as
shown in the SOFP

i.e Investment in S = Net assets of S

Goodwill arising on consolidation

Sometimes P pays more than the fair value of assets and liabilities of the S acquired
because:
• NCA may have been worth more than the carrying value (L and B)
• they were acquiring the goodwill of the subsidiary. So Goodwill on consolidation is:

It will be the Difference between the total value of the business at the date of acquisition
and the fair value of all the assets less liabilities at the date of acquisition.

Goodwill at acquisition becomes:

Fair value of P consideration x

Add: FV of NCI at date of acquisition x

Less: FV of S net assets at acquisition (x)

Non controlling interest (NCI)

Let us consider what the NCI is in the subsidiary’s net assets at reporting date. The NCI is
the non-group shareholders interest in the net assets of the subsidiary.
Note: we are looking at net assets at the reporting date/year end

A acquires 60% of B, so NCI = 40%

Group retained earnings

(S5) This will be the parents retained earnings and its share of the profits made by the
subsidiary since acquisition
 P’s Retained earnings x

P % of S’s post acquisition profits x

Other reserves
Exam questions will often give other reserves (such as a revaluation surplus) as well as
retained earnings. These reserves should be treated in exactly the same way as retained
earnings, which we have already seen.

If the reserve is pre-acquisition it forms part of the calculation of net assets at the date of
acquisition and is therefore used in the goodwill calculation.

If the reserve is post-acquisition or there has been some movement on a reserve existing
at acquisition, the consolidated balance sheet will show the parent's reserve plus its share
of the movement on the subsidiary's reserve.

Introducing fair values

Fair value is the amount for which an asset could be exchanged, or a liability settled,
between knowledgeable, willing parties in an arm’s length transaction. (old definition)
Investment in the sub. must be recorded at the fair value of the consideration given.

This will affect: Non controlling interest

Goodwill

Net assets of subsidiary

Non controlling interest and fair values

The fair value of the NCI at acquisition is the value of the subsidiary’s shares not acquired
by the parent.
This is increased by the share of the subsidiaries post acquisition profits.

Fair value of the NCI at acquisition xxx

Add: NCI% of post acquisition profits xxx

xxx

If the subsidiary's financial statements are not adjusted to their fair values, where, for
example, an asset's value has risen since purchase, goodwill would be overstated (as it
would include the increase in value of the asset).

Under IFRS 3 the identifiable assets, liabilities and contingent liabilities of subsidiaries are
therefore required to be brought into the consolidated financial statements at their fair
value rather than their book value.

The difference between fair values and book values is a consolidation adjustment made
only for the purposes of the consolidated financial statements.

Other fair value adjustments

When a subsidiary is acquired, it is necessary to do a fair value review of the assets and
liabilities that are acquired by the group and thus fair value adjustments at the date of
acquisition might be necessary.

Consolidated a/c’s must reflect their cost to the group not their original cost to
the subsidiary. Cost to group is the fair value at date of acquisition.

These fair value consolidation adjustments increase the net assets of the subsidiary at the
date of acquisition.

Adjust the assets and liabilities to their fair values to reflect conditions at the date of
acquisition.

At acquisition At reporting
date

Ordinary share cap X X

Reserves X X

FV adjustments X X

X X
Adjust for the Fair value on face of Statement of financial position when adding across.

Intercompany trading
Types of intra-group trading-
• Current a/c between P and S
• Loans held by one coy in another
• Unrealized profits and sales of inventory
• Dividends and loan interest
On consolidation, we need to be aware of the following:

(a) We only want to show receivables and payables from outside the group
(b) We only want to record profits made as a result of sales outside the group
(c) Eliminate the 2 balances on consolidation

Provision for unrealized profit (PURP) on intercompany trading

Steps:

(a) Calculate the unrealised profit in inventory

(b) Reduce the inventory and reduce the retained earnings of the coy that has sold
the goods by the amount of unrealised profit
When P is the selling company, the whole PURP is deducted from the group profit.

Reduce from group profit and reduce from group inventory.

When S is seller, only P% of the PURP should be deducted from profits, and NCI% of PURP
deducted from NCI. Reduce from group profit P’s share, reduce from NCI with NCI share,
reduce from group inventory.

Sale by P to S:

Adjust in P's books

Dr Retained earnings of P

Cr Consolidated inventories

Sale by S to P:

Adjust in S's books

DR Retained earnings of S

DR NCI with their share of the PURP

CR Consolidated inventories

The (NCI will be affected by this adjustment because it is necessary to reduce their share
with the PURP portion attributable to them.

Acquisition of subsidiaries part way through the year

If P acquires a subsidiary mid-year:
(1) Retained earnings at the start of S year x

Plus: profits up to the date of acquisition x

Retained earnings at date of acquisition x

Use to calculate goodwill

(2) Profits earned after acquisition.

Use to calculate group retained earnings

It is normally assumed that S profit after tax accrues evenly over time.

Statement of Comprehensive income

Shows the profit generated by all resources disclosed in the related Consolidated
statement of financial position.

Principles

From revenue to profit include all of P’s income and expenses plus all of S’s income and
expenses subject to adjustments.

After profit for the year, show split of profit between amounts attributable to parents
shareholders and the non-controlling interest

Steps

 Group structure
 Net assets subsidiary at acquisition
 Goodwill calculation
 Non-controlling interest share of profit
  Do a calculation for cost of sales

Intra group trading

IAS 27 Consolidated and Separate Financial Statements states, 'Intragroup balances,
transactions, income and expenses shall be eliminated in full'.
The purpose of consolidation is to present the parent and its subsidiaries as if they are
trading as one entity.

Therefore, only amounts owing to or from outside the group should be included in the
balance sheet, and any assets should be stated at cost to the group.

Trading transactions will normally be recorded via a current account between the trading
companies, which would also keep a track of amounts received and/or paid.

The current account receivable in one company's books should equal the current
account payable in the other. These two balances should be cancelled on consolidation
as intra group receivables and payables should not be shown.

(a) Eliminate intra group transactions from the revenue and cost of sales figures:

DR Group revenue X

CR Group cost of sales X

With the total amount of the intra group sales between the companies. This adjustment is
needed regardless of whether any of the goods are still in inventories at the year end or
not.

PURP’s
Unrealised profit needs to be excluded from the group profit.
The value of the inventory needs to be adjusted to the lower of cost and NRV.

Reduce group profit by increasing the cost of sales for group by amount of unrealised
profit in inventory

Eliminate unrealised profit on goods still in inventories at the year end:

DR Cost of sales (I/S) X (PUP)

CR Inventories (B/S) X (PUP)

in the books of the company making the sale. As for the SFP this is only needed if there
are any goods still in inventories at the year end.

The provision for unrealised profit on inventories reduces the closing inventories figure. It is
therefore added to cost of sales in the working thereby reducing gross profit.
When it is the subsidiary that sells goods to other group companies which remain unsold
at the year end, any provision for unrealised profit must be shared between the group
and the minority interest.

Interest and dividends

Loans outstanding between group companies must be eliminated from the consolidated
income statement (CIS).
For dividends, a payment of a dividend by S to P will be eliminated. So only dividends
paid by P to its own shareholders will appear in the CSFP.

Non controlling interest

Owners of the ‘other shares’ in the subsidiary
NCI% x subsidiary profit after tax X

Less:

NCI % x PURP (X)

Acquisition of subsidiaries part way through the year for consolidated income statements
If subsidiary is acquired part way through the year, subsidiaries results should only be
consolidated from the date of acquisition (date on which control is obtained).
• Identify net assets of S at date of acquisition to calculate goodwill
• Time apportion of results of S in year of acquisition
• Deduction of post acquisition intra- group items as normal

Associates- Definition
An associate is an entity in which the investor has significant influence, but is not a
subsidiary.
Significant influence is the power to participate in the financing and operating policy
decisions of the entity, but not to control these policies.

Significant influence is assumed with a shareholding of 20% to 50%.

Key features of a parent-associate relationship

Evidence of significant influence by an investor:
 • Representation on board
• Participation in the policy making process
• Material transactions between investor and investee
• Potential voting rights

Principles of equity accounting

IAS 28 requires the use of equity method of accounting for investments in associates.
Consolidated SOFP will include:

100% income and expenses of the parent and subsidiary coy on a line by line basis

One line ‘share of profit of associates’ which includes group share of any associates profit
after tax.

It is included as a non-current asset investment

Cost of investment X

Share of post acquisition profitsX

Less: post-acquisition dividends

received (to avoid double counting) (X)

Less: PURP (P seller) (X)

Consolidated financial statements

An investment in an associate is accounted for in consolidated financial statements using

the equity method.

Equity method

IAS 28 states the following treatment:

Statement of financial position

Non-current assets

Investment in associates (Working) X

Working

Initial cost X

Add/less: post acquisition share of profits/losses (i.e. before

dividends) X

Less: post-acquisition dividends received (to avoid double counting) (X)

X_

Income statement

A's Profit for the period x Group % X

Shown before group profit before tax.

Points to note

– An associate is not a group company, therefore no cancellation of 'intragroup'

transactions should be performed.

However, IAS 28 states that the investor's share of unrealised profits and losses on
transactions between investor and associate should be eliminated in the same way as for
group accounts.

ACCOUNTING STANDARDS

IAS 10- EVENTS AFTER THE REPORTING PERIOD

IAS 37- PROVISIONS, CONTINGENT LIABILITIES AND ASSETS

IAS 18- REVENUE

IAS 10

Those material events both favourable and unfavourable, which occur between the
SOFP date and the date on which the financial statements are authorised for issue.

Adjusting- provide additional evidence of conditions existing at the reporting date and
affect the estimates that are part of the financial statement preparation process

Non-adjusting- events arising after the reporting date but which are indicative of
conditions that arose subsequent to the reporting date.

Adjusting Non-adjusting
Discovery of fraud/errors showing that Announcing plan to discontinue an
the financial statements are incorrect operation
Determination after reporting date of Major purchases of assets
cost of assets purchased/proceeds from
assets sold before reporting date

Receipt of information after the Destruction of assets after reporting date

reporting date indicating an asset was by fire or flood
impaired at reporting date

Bankruptcy of a customer after Commencing a court case arising out of

reporting date confirming year end debt events after the reporting date
is irrecoverable

Sale of inventories after reporting period Decline in the market value of investments
at price lower than cost
Settlement of court case after reporting Declaring dividends after the year end
period confirming entity had present
obligation at SOFP date

Adjust the financial Disclose by note

statements to reflect the event

Disclosure

By way of notes:

• Nature of the event

 • An estimate of the financial effect, or statement that such an estimate cannot be
made
• Date on which the financial statements were authorised for issue, who gave
authorisation
• Powers to amend the financial statements after issue

IAS 37

The complete standard is called provisions, contingent liabilities and assets.

• Purpose of the standard is to ensure that appropriate measurement and

recognition criteria are applied to provisions, contingent assets and liabilities.
• Also ensure that sufficient disclosure is made in the financial statements to enable
users to understand the provisions made

Provision
A provision is a liability of uncertain timing or amount of the future expenditure. It is made
where the following conditions are met:
- A present obligation (legal/constructive) exists as a result of past events
- There is a probable transfer of economic benefits
- A reliable estimate of the amount can be made.
A legal present obligation is an obligation that derives from-

-Terms of a contract; legislation; any other operation of law

A constructive obligation is one that derives from an entities actions where:

- The entity has in some way indicated that it will accept certain responsibilities
- The entity has created an expectation on the part of other parties that it will meet
those responsibilities.
E.g. A retail store has a policy of refunding purchases by dissatisfied customers, even
though it is under no legal obligation to do so. Its policy of making refunds is generally
known.

Accounting entries
Initially accounted for as the best estimate of probable outflow: Dr relevant expense a/c
Cr provision

Subsequent measurment

Movements in provisions should be reflected in the income statement.

Increase in provision: Dr Expense; Cr provision

Decrease in provision: Dr Provision; Cr expense

Contingent assets and liabilities

Contingent asset- a possible asset that arises from past events and whose existence will
only be confirmed by uncertain future events not wholly within the control of the
enterprise

Contingent liability- a possible obligation that arises from past events and whose
outcome is based on uncertain future events, or an obligation that is not recognised
because it is not probable, or cannot be measured reliably

The table below is a summary of how liabilities should be treated in the financial
statements

Accounting for contingent assets and liabilities

Disclosures

Key disclosures include:

• Movements in all classes of provisions during the period

• The nature of the provision and any uncertainties and assumptions used in
recognising and measuring it
• For contingent liabilities, the nature of the liability, uncertainties surrounding it, and
the possible financial effect.
IAS 18- Revenue
Revenue manipulation is one of the most common ways of creative accounting
Be clear when revenue can be recognised and ‘revenue’ is not the same as ‘gains’.

Revenue arises from a company’s ordinary trading activities while gains will include one
off’s like profit on disposal of property

Revenue definition
Concerned with the recognition of revenues arising from fairly common transactions:
• The sale of goods
• The rendering of services
• The use of others of assets of the entity yielding interest, royalties and dividends.
Generally revenue is recognised when the entity has transferred to the buyer the
significant risks and rewards of ownership and when the revenue can be measured
reliably.

Measurement
Revenue should be measured at the fair value of the consideration received/receivable

If revenue is deferred, it should be measured at present value

In a barter transaction, the revenue should be the fair value of the goods received.

Recognition
Revenue is recognised for the sale of goods when a number of criteria are met:
• The product or service has been provided to the buyer.
• The buyer has recognised his liability to pay for the goods or services provided.
• The buyer has indicated his willingness to hand over cash or other assets in
settlement of his liability.
• The monetary value of the goods or service has been established.
• it is probable that future economic benefits will flow to the entity and these benefits
can be measured reliably.
• The costs incurred or to be incurred in respect of the transaction can be measured
reliably
Revenue recognised for rendering of services is recognised according to the stage of
completion of transaction at SOFP date.

The following must be satisfied:

• Amount of revenue can be measured reliably

• Benefits from transactions are likely to flow to enterprise
• Stage of completion of work can be measured reliably
• Cost incurred or to be incurred for transaction can be reliably measured

Interest, royalties and dividends

Interest- recognise on a time proportion basis taking account of the yield on the asset

Royalties- recognise on an accrual basis in accordance with relevant agreement

Dividends- recognise when the shareholders right to receive payment has been
established

Disclosures

 Accounting policy for revenue recognition, including the methods used to

determine stage of completion of service transactions
 Amount of revenue recognised
 Amount if material arising from exchanges of goods and services

INTERPRETATION OF ACCOUNTS

Past periods- compare ratio calculated with past periods, it can tell if there has been
deterioration in performance. Useful to track ratios over time to see if possible to detect
trends

Similar businesses- consider performance in relation to that of other businesses operating

in the same industry. Ratio achieved by similar businesses during the same period.

Planned performance- ratios may be compared with the target that management
developed before the start of the period under review.
Problems
 Year end of competitors are different so trading conditions may not be identical
 Accounting policies may be different which will have a significant effect on
reported profits and asset values.
 Difficult to obtain financial statements of competitor business
Planned performance- this is the most valuable benchmark for managers to assess their
own business. Develop planned ratios for each aspect of their activities. These planned
levels of performance must be based on realistic assumptions if they are to be useful for
comparison purposes.

Purpose of interpretation of ratios

Financial ratios provide a quick and relatively simple means of assessing the financial
health of a business.

Users of FS can gain better understanding of significance of information in the financial

statements by comparing it with other relevant information.

RATIOS

Ratios can be grouped into broad categories which provide a useful basis for explaining
the nature of the financial ratios to be dealt with

Profitability- Provide an insight to the degree of success in creating wealth for their
owners. They express profit in relation to other key figures in the Financial statements.

Efficiency- measures the efficiency with which particular resources have been used within
the business.

Efficiency- also known as activity ratios

Ratios are grouped into broad categories which provide a useful basis for explaining the
nature of the financial ratios to be dealt with.

Profitability- They express profit in relation to other key figures in the FS

Liquidity- measures the ability of the firm in meeting its obligation when they are due.

Financial gearing- indicates:

Degree of risk attached to the company

Is concerned with a company’s long-term capital structure.

Investor ratios- concerned with assessing the returns and performance of shares held in a
particular business
KEY ACCOUNTING RATIOS

Profitability ratios

Gross profit margin= Gross profit x 100%

sales revenue

A measure of profitability of buying/producing and selling goods before any other

expenses are taken into account.

ROCE= PBIT

Capital employed

Is a fundamental measure of business performance.

Measures returns to all suppliers of long term finance. The higher, the better

Capital employed- equity- share capital, reserves, Non- current liabilities

ROCE compares inputs(capital invested) to outputs(operating profit).

ROCE is used by businesses in establishing targets for profitability. Compare ROCE with
prior year, target ROCE, other companies ROCE in same industry

Net asset turnover= Sales revenue = times pa

Capital employed (net assets)

Managements efficiency in generating revenue from the net assets at its disposal. Higher
better

Net profit margin= PBIT

Sales revenue

An indication of the quality of products or services supplied. (Higher quality= higher

margins)

Is change in Net profit margin in line with changes in Gross profit margin and sales
revenue?
Can very significantly between businesses, e.g, some supermarkets like EBEANO operate
on low prices hence low operating margins. This is done to stimulate sales and increase
operating profit generated.

Liquidity- amount of cash a coy can put its hands on quickly to settle its debts.

Current ratio- Current assets = 1

Current liabilities

Measures the adequacy of current assets to meet current liabilities as they fall due. Higher
the better.

Quick ratio = Current assets – Inventory = 1

Current liabilities

Represents a more stringent test of liquidity. Known as ‘acid test’ ratio. Normal range is 1:1
to 0.8:1

Liquid funds consist of cash, ST investment, fixed term deposits, trade receivables.

ome people say that 2:1 is the ideal current ratio but this does not take into account the
fact that different types of businesses require different current ratios e.g manufacturing
will have high current ratio due to inventory, FG,WIP and receivables, while a supermarket
will have lower ratio because inventories are fast moving inventories of finished goods.

If ratio too high, - slow inventory and idle cash which could be used else where

If the ratio is below 1, it is expected that the coy might be unable to pay its debts on time.

Acid test ratio- by eliminating inventory from current assets provides the acid test of
whether the company has sufficient liquid resources to settle its liabilities

Receivables = Trade receivables x 365 days

collection period Credit sales

Receivables collection period= average time it takes for a company’s customers to pay
what they owe. A collection period in excess of 30 days might be representative of poor
management of funds of a business.

However company’s must allow generous credit terms to win customers.

If increasing, may be a bad sign suggesting lack of proper credit control. Increasing
payables is a sign of lack of long term finance or poor management of current assets
resulting in bank overdraft

Payables payment period= Trade payables x 365days

Credit purchases

Inventory turnover period = Inventory x 365 days

Cost of sales

Company Trade receivables

Supermarket 6.4 days

Manufacturer 81.2 days

Sugar seller 29.3 days

Financial gearing-

Looks at level of gearing for the business.

Debt ratio= Total debts

Total assets ratio of 50% is ok

Gearing ratio = Total long term debt

SHE + Total long term debt

Ratio in excess of 50%, company is said to be highly geared. Lower gearing by boosting
shareholders capital.

Interest cover = PBIT

Interest payable

Ability of company to pay interest out of profits generated.

Leverage = SHE

SHE + LTD

Converse of gearing, i.e proportion of total assets financed by equity

Inter-relationships between ratios

ROCE can be subdivided into profit margin and asset turnover.

Profit margin x Asset turnover = ROCE

PBIT x Sales revenue = PBIT (profit before interest and taxes)

Sales revenue Capital employed CE (capital employed)

Profit margin gives an indication of the quality of products or services supplied

Asset turnover is how intensively the assets are worked.