SECRET SAUCE
(A2 LEVEL ACCOUNTING THEORY NOTES FOR 2020-2021)
OMAIR MASOOD
CEDAR COLLEGE (CLIFTON|PECHS)
PARTNERSHIP
What if there is no partnership agreement?
The partnership Act of 1890 will apply which states
No interest on capital or drawings
No Salaries
Profits to be shared equally ( Not in capital ratio)
Interest on Loan from partner ( if not stated) is taken at 5%.
What is a partnership change?
A partnership change occurs when there is a change in structure of the partnership .
The partnership is not dissolved it is only changed. i.e Admission of a new partner,
Retirement of an existing partner , or simply a change in existing profit sharing ratio.
Why do we have to treat for goodwill in a partnership change?
Any goodwill generated till date belongs to the old partners. So the goodwill
adjustment is done in such a way that old partners will benefit and the new partners
will loose out. This is because goodwill is kept in line with the profit sharing ratio .
The new partner ends up paying for goodwill and the old partner if he is leaving gets
paid for his goodwill. This way all partners are treated fairly.
How do we have to treat for goodwill in a partnership change?
There are two methods to treat goodwill
Method 1: Goodwill is kept in the books
In this method we create goodwill in the old profit sharing ratio in capital accounts
and leave it ( so that it can be shown in the balance sheet as a non current asset).
This method is rarely used and is not preffered because its not in line with the
Prudence and Money Measurement Concept.
Method 2: Goodwill is Created but then written off right away
In this method we create goodwill in the old profit sharing ratio in capital accounts but
then write it off in the new profit sharing ratio. This method is frequently used and
follows Prudence and Money Measurement Concept.
Note: If Question doesn’t specify clearly always use method 2
What if Goodwill is already recored on the balance and has to be adjusted?The
amount of goodwill on the balance sheet is already in capital accounts of the partner
so we only need to create the difference ( increase ) in the goodwill in old profit
sharing ratio ( and then write off the entire amount if required to write it off. Alternate
method would be to treat the change in goodwill in revalution account and then write i
off the full amount from the captial account.
What is the difference between revalution account and realization(dissoulition)
account?
Revalution account is made at the time of change in a partnership ( see above) . This
is done to change the values of asset to the current market value so that any gain or
loss that has arised before the change can be adjusted in capital of partners. When
making revalution account if only take the changes in assets ( the difference in
values) and close it off in the old profit sharing ratio
Realization account is made when the partnership business is dissolved or sold . The
aim of this account is to calculate the overall gain or loss upon closure of the
partnership business.In this we fisrt close the assets at net book value and compare
it with the amount realized upon sale . The difference ( overall gain or loss) is closed
off in the profit sharing ratio aswell.
What are the possible reasons for dissolution in a partnership?
•
•
•
•
•
•
Business is making losses and future prospects are not good.
Death/Retirement of a partner ( Specially in case of two partners in a
partnership)
Legal authorities have forced the business to close down
Dispute between the partners
Business is very illiquid and about to get bankrupt
Partners want to form a limited company.
COMPANY ACCOUNTS
RESERVES
The net assets of the company are represented with capital and reserves. While
Capital represents the claim that owners have because of the number of shares they
own, reserves represent the claim that owners have because of the wealth created
by the company over the years but not distributed to them. There are two main types
of reserves.
Revenue Reserves: The reserves which arise from profit (Trading activities of the
company) . These are transferred from the Appropriation Account. Examples include
General Reserve and Retained Profit (Profit and Loss) .Dividends can only be paid to
the amount of revenue reserves on the balance sheet. I.e. the maximum dividend
possible is the sum of both revenue reserves.
Capital Reserves:These are reserves which the company is required to set up by
law and cannot be distributed as dividends. They normally arise out of capital
transactions. These include Share Premium and Revaluation Reserve and also
Capital Redemption Reserve (See details of CRR)
Revaluation Reserve
This is created when the value of an asset is increased in the books due to a
permenant increase in market value. The amount of revaluation reserve is difference
between net book value at the time of revaluation and the market value. This is a
gain which cannot be transferred to the profit and loss account as it is still not
realized (earned) by the company. This reserve can be used in the future if the same
asset (on which the reserve was created) value goes down ( the loss can be written
off against this reserve). This can also be used for Bonus Issue
Share Premium
Share premium occurs when a company issues shares at a price above its nominal
(par) value. This excess of share price over nominal value is what is known as share
premium.
What are the uses of Share Premium?
•
Issue Bonus Shares
•
Write off Formation ( Preliminary Expenses)
•
Write off Goodwill
What are the different Types of Preference Shares?
•
Non Cumulative Preference Shares: In case company doesn’t have enough
profits these shareholders will get no dividend in the year and that amount of
dividend will never be given
•
Cumulative Preference Shares : : In case company doesn’t have enough
profits these shareholders will get no dividend in the year and that amount of
dividend will be carried forward to next year , when the company makes
enough profit the entire amount will be payable as dividend.
•
Participating Preference Shares: A participating preferred share gives the
holder the right to receive dividends equal to the normally specified rate that
preferred shareholders receive as well as an additional dividend based on
some predetermined condition ( like if profit exceeds a certain level)
•
Redeemable Preference Shares : These shares are temporary shares
which can “redeemed “(bought back ) by the company after a specified period
of time. Thery are recorded as non current liabilities and the dividends paid to
them are treated like interest ( finance cost)
ISSUE OF SHARES
Public Issue: This is normal issue of shares to general public. A company can issue
shares to public to raise more capital , this is done at the market price. Public issues
have higher cost of issue ( this means the company has to incur high expenses when
issuing the shares I.e. advertising and administration ). The main advantage of
issuing shares is that no interest has to be paid on it and the company only have to
provide a return when they actually make profits.
Rights Issue : A rights issue represents the offer of shares to the existing
shareholders in proportion to their existing holding at a lower price compared to the
market value.
Advantages of Rights Issue over Public issue
•
Rights issue are cheaper to administer and less risky way of raising capital
•
Shareholders will get some incentive as they will get shares at a lower price.
Disadvantages
•
Market price will fall
•
The company could have raised more funds through a public issue
Bonus Issue:
Is the issue of shares to existing shareholders for free .When the company is short of
cash and can’t give dividends so they give out shares for free to the ordinary
shareholders. Other reasons for bonus issue include.
•
To utilize the capital reserves
•
To increase confidence in the company’s future prospects as it is normally
taken as a signal of strength by the general public.
When doing bonus issue company will always use capital reserves first and then the
revenue reserves i.e.
We can use either of revaluation reserve or share premium first but if we don’t have
enough balance in both of these reserves then we will move to
•
General Reserve
•
Profit and Loss.
WHAT IS CONVERTIBLE DEBENTURE/CONVERTIBLE LOAN STOCK?
Special type of debenture which can be converted into shares at a specified date.
Upon conversion the debenture holder receives ordinary shares and he gives away
is debenture certificate. The shares are sold to them in return of debentures, so that’s
usually done at market price of share ( so share premium will be involved) . For
example
A company has convertible loan stock worth $60000. They decided to convert it into
shares by issuing 10 Ordinary shares of $1 each for every $15 of debenture. This
means company will issue 40000 shares to settle the debenture , each share which
is for $1 was sold for $1.5 .
Debit : Debenture 60000
Credit : Ordinary Shares 40000
Share premium 20000
PURCHASE AND SALE OF BUSINESS
Purchased Goodwill is calculated by the company which is buying the business . The
formula used is
PURCHASE CONSIDERATION ( PURCHASE PRICE) – FAIR VALUE OF NET
ASSETS ACQUIRED.
IF THE GOODWILL IS NEGATIVE IT IS RECORED AS A NEGATIVE ASSET IN
THE BALANCE SHEET i.e in brackets . It is called negative goodwill . We also use to
call it capital reserve.
The Business which is being sold will not calculate goodwill , infact it will calculate
gain or loss on realization (sale) , which will be done thorugh a realization account
Following Table is useful to summarize the differences in Sale and Purchase of
Business
Sale of Business
Purchase of Business
Assets are recorded at net book values
in realization for calculating gain or loss
Assets are included at revalued amount
(fair value) when calculating goodwill
Profit or Loss on disslution is shared by
partners in profit sharing ratio and
become part of capital
Goodwill is directly shown in the balance
sheet as an intangible asset. In brakets if
goodwill is negative
Shares given to seller are recorded at
market value (including premium) in his
capital account
Shares issued are recorded in the
financed by section of balance sheet ,
where we separate par value and share
premium
Include all asset and current liablities in
your realization account, irrespective of
take over or not ( excluding bank
account , only include if take over) .
Only include those assets and current
liablities which are taken over in the
calculation of goodwill.
Note: Bank Account will only be taken over if the question says clearly , or if it says
All assets and liablities were taken over , or the entire business was taken over. If
the seller still has to receive or make a payment from bank account , ( say for debtors
or creditors) and the question is silent about the bank account ,assume it was not
taken over.
STATEMENT OF CASHFLOWS
A cashflow statement is intended to disclose the information on actual movement of
cash in the business during the financial year. It helps to assess the liquidity of the
business and to judge the quality of profit earned by the business which can not to be
assessed from the Income statement ( Trading ,Profit and Loss account) and
Balance Sheet.
The Cashflow statement outlines the sources of cash received and specifies
activities on which the cash was spent. It explains why business has overdrawn from
the bank in a year although it has earned a good amount of profit.
The Cashflow statement is a bridge between the two balance sheets and it expalins
in details the changes took place during the year.
Why is Cashflow Statement important?
The statement of cash flows tells you how much cash went into and out of a
company during a specific time frame such as a quarter or a year. You may wonder
why there's a need for such a statement because it sounds very similar to the income
statement, which shows how much revenue came in and how many expenses went
out.
The difference lies in a complex concept called accrual accounting. Accrual
accounting requires companies to record revenues and expenses when transactions
occur, not when cash is exchanged. While that explanation seems simple enough,
it's a big mess in practice, and the statement of cash flows helps investors sort it out.
The statement of cash flows is very important to investors because it shows how
much actual cash a company has generated. The income statement, on the other
hand, often includes noncash revenues or expenses, which the statement of cash
flows excludes.
One of the most important traits you should seek in a potential investment is the
firm's ability to generate cash. Many companies have shown profits on the income
statement but stumbled later because of insufficient cash flows. A good look at the
statement of cash flows for those companies may have warned investors that rocky
times were ahead.
The Three Elements of the Statement of Cash Flows Because companies can
generate and use cash in several different ways, the statement of cash flows is
separated into three sections: cash flows from operating activities, from investing
activities, and from financing activities.
The cash flows from operating activities section shows how much cash the
company generated from its core business, as opposed to other activities such as
investing or borrowing. Investors should look closely at how much cash a firm
generates from its operating activities because it paints the best picture of how well
the business is producing cash that will ultimately benefit shareholders.
The cash flows from investing activities section shows the amount of cash firms
spent on investments. Investments are usually classified as either capital
expenditures--money spent on items such as new equipment or anything else
needed to keep the business running--or monetary investments such as the
purchase or sale of money market funds.
The cash flows from financing activities section includes any activities involved in
transactions with the company's owners or debtors. For example, cash proceeds
from new debt, or dividends paid to investors would be found in this section.
To summarize
The cashflow statement helps the shareholders, investors and others users in
assessing
*
Company’s ability to generate cash internally (operating activites) to meet its
obligations and to pay dividends
*
The causes of changes in liqudity (cash inflows and outflows)
*
Whether the business can generate to cash to service finance and pay taxes
and also maintain its fixed assets
*
How much the business is relied on long term finance
*
How much cash has been raised externally
*
Indication of future cash flows for capital investments
*
Reconciles profitability with liquidity
What is the Difference between Cash budget and Cashflow statements.?
Cashflow Statements
Based on Actual transactions
Based on Strict format
Published for external users ( Shareholders,
lenders, Future investors)
It is required by law to make cashflow
statements
Cash Budgets
Based on Future estimates
Prepated as per company’s policy
It is for managements internal use
No legal Requirement.
RATIOS (A2)
Note: ALL AS LEVEL RATIOS ARE ALSO IN A2 SYLLABUS
All of these ratios are calculated from the point of view of ordinary shareholders. Its
useful to understand the term Earnings .
What is Earning? ( Profit attributable to ordinary shareholders)
This is Profit After Interest , tax and preference share dividend. Basically whatever
goes to ordinary shareholders.
1. Earning Per Share
Earning/# of ordinary Shares
How much profit after tax and preference share dividends is attributable to each
ordinary share. Simply shows how much the company has earned for one ordinary
share, since all the earnings belong to ordinary shareholders. Investors regard EPS
as a measure of success of the company. Obviously the higher this number the more
money is made by the company. This ratio allows us to compare different companies
power to make money. The higher the EPS (with all else equal), the higher each
share should be worth. When we do our analysis we should look for a positive trend
of EPS in order to make sure the company is finding more ways to make more
money. Otherwise the company is not growing. The main problem with EPS is since
it is expressed on per share basis it becomes difficult to compare companies with
different amount of number of shares.
An important aspect of EPS that's often ignored is the capital that is required to
generate the earnings in the calculation. Two companies could generate the same
EPS number, but one could do so with less equity (investment) - that company would
be more efficient at using its capital to generate income and, all other things being
equal, would be a "better" company.
2. Dividend Per Share
Ordinary Dividend Paid /# of Ordinary Shares
This is calculated using dividends paid . Dividends are a form of profit distribution
to the shareholder. Having a growing dividend per share can be a sign that the
company’s management believes that the growth can be sustained. A high
Dividend per share also means the company has enough cash available to pay
for dividends.
3. Dividend Cover
EPS/DPS or Earnings/Ordinary Dividends Paid
This shows the relation of earning to dividends . How many times the dividend for
the year can be covered(paid) from this year’s earnings. A low cover indicates
future dividends are at risk if company’s profitability falls in the future( as they are
not retaining enough profits and are distributing the majority) .A high dividend
cover is an indication of safety of dividends in the future ,as the company has
retained enough profits. The long term investors look for high dividend cover
companies, because they believe if the company is retaining more profits then
they have more growth opportunities. If the ratio is under 1, the company is using
its profit from a previous year to pay this year's dividend. This ratio also shows
the dividend policy of the company , a high cover indicates a very conservative
approach where majority of the profits are invested back in the business.
4. Dividend Yield :
Ordinary Dividend Paid and Proposed/MPS * 100
per Share
where MPS is Market Price
This shows the dividends as a % of market price. This is used to calculate cash
return on investment. We take investment as market price because that is the
opportunity cost of holding a share. High dividend yield makes the share more
attractive.
5. Interest Cover
Operating Profit/Interest
Shows how many times the operating profit can cover for the interest expense. A
high ratio is desirable to this would mean company has more ability to handle its
interest charges and to more amount will be available to pay for dividends. A low
cover may turn a small profit into a loss due to the interest expense. Low cover
also makes it difficult for the company to raise more debts and loans as the
financial intuitions demand a minimum interest cover level.
6. Price to Earning Ratio
MPS/EPS
This relates market price to the Earning per share. High Ratio shows the investor
has more confidence in this company’s future to maintain its current level of
earning , that is why they are willing to pay more . The ratio should be compared
with the average ratio of the similar companies.
Some believe that the high ratio may mean that share price is overvalued and will
fall in future. But a growing PE ratio shows increase in the confidence level of
investors.
7. Gearing Ratio
Fixed Return Capital/Total Capital Employed * 100
This shows how much of the total capital employed ( total amount invested in the
business) is coming from external sources (not by ordinary shareholders) . The
amount of financing provided by long term liabilities and preference shareholders.
This is measure of risk because if a high proportion is coming from these sources
than majority of the profits will go as interest payments and preference dividends
( specially In the low profitability years), infact the interest expense has to be paid
even in case of losses. If a company is already highly geared then its difficult to raise
more loans (obviously). Gearing of more than 50% is considered high and risky.
Remember high gearing is not necessarily bad (but its risky) , it depends on risk
preference of the investor. A high geared company tends to grow faster because
they rely on debt and external financing, it can give amazing returns in good years
but in a bad year it can also go bankrupt.
8. Income Gearing
Interest/Operating profit *100
This shows how much% of operating profit has to go for interest
Its same as interest cover but calculated as a %.
9 . Net Asset Value Per Share ( Book value Per Share)
Ordinary Share Capital + All Reserves /# of Ordinary Shares
This is the value of one ordinary share according to the balance sheet. Remember
all reserves belong to ordinary shareholders. This indicates the amount of cash each
share will receive if the company is liquated at that date. Theoretically the book value
of one share should also be the market value , but market value tends to be higher
because
- Balance sheet does not include internally generated intangible assets
such as human capital and goodwill.
- Balance Sheet is historical and cant take into account future gains
- Speculations in stock market effects the share price.
10.RETURN ON EQUITY :
Shows how much return as a percentage of capital is earned by the company
Earnings/total ordinary shareholders funds *100
11.Net Working Assets to Revenue (Sales)
Net working assets
X100
= %
SALES
The net working assets are not liquid as cash. This calculation shows the proportion
of sales revenue that is tied up in the less liquid net current assets. A lower ratio is
better which means that if sales increase the net working assets will increase in a
lower rate as the company would desire to hold current assets in liquid form.
Note:Net working assets =Inventory + Trade Receivables – Trade payables
RATIOS(AS LEVEL)
PROFITABILITY
GROSS PROFIT MARGIN
(
Gross Profit x 100
Net Sales
)
While the gross profit is a dollar amount, the gross profit margin is expressed as a
percentage of net sales. The Gross Profit Margin illustrates the profit a company
makes after paying off its Cost of Goods sold. The Gross Profit Margin shows how
efficient the management is in using its labour and raw materials in the process of
production (In case of a trader, how efficient the management is in purchasing the
good). There are two key ways for you to improve your gross profit margin. First, you
can increase your process. Second, you can decrease the costs of the goods. Once you
calculate the gross profit margin of a firm, compare it with industry standards or with
the ratio of last year. For example, it does not make sense to compare the profit
margin of a software company (typically 90%) with that of an airline company (5%).
Reasons for this ratio to go UP (opposite for down)
1. Increase in selling price per unit
2. Decrease in purchase price per unit due to lower quality of goods or a different
supplier.
3. Decrease in purchase price per unit due to bulk (trade) discounts.
4. Extensive advertising raising sales volume (units) along with selling price.
5. Understatement of opening stock.
6. Overstatement of closing stock.
7. Decrease in carriage inwards/Duties (trading expenses)
8. Change in Sales Mix (maybe we are selling some new products which give a
higher margin).
NET PROFIT MARGIN
(Operating Profit x 100
Net Sales
)
Net profit margin tells you exactly how the management and operations of a business
are performing. Net Profit Margin compares the net profit of a firm with total sales
achieved. The main difference between GP Margin and NP Margin are the overhead
expenses (Expenses and loss). In some businesses Gross Margin is very high but Net
Margin is low due to high expenses, e.g. Software Company will have high Research
expenses.
Reasons for this ratio to go UP (opposite for down)
All the reasons for GP margin apply here. Additionally
1. Increase in cash discounts from suppliers
2. A decrease in overhead expenses
3. Increase in other incomes like gain on disposal, Rent Received etc.
Return on Capital Employed (ROCE)
This is the key profitability ratio since it calculates return on amount invested in the
business. If this ratio is high, this means more profitability (In exam if ROCE is
higher for any firm it is better than the other firm irrespective of GP and NP Margin).
This return is important as it can be compared to other businesses and potential
investment or even the Interest rate offered by the bank. If ROCE is lower than the
bank interest then the owner should shoot himself. This ratio can go up if profits
increase and capital employed remains the same. Also if Capital employed decreases,
this ratio might go up.
Operating Profit_
Capital Employed
x
100
Net Profit before Interest and Tax
Return on Total Assets
This shows how much profit is generated on total assets (Fixed and Current). The
ratio is considered and indicator of how effectively a company is using its assets to
generate profits.
Operating Profit_
Total Assets
x
100
Return on Shareholders’ Funds/Return on Net Assets/Return on
Owners capital
Since all the capital employed is not provided by the shareholders, this specifically
calculates the return to the shareholders (It’s almost the same thing as ROCE)
Net Profit after Tax
Shareholders Funds
x
100
O.S.C + P.S.C + RESERVES
NOTE:
Capital Employed = Fixed Assets + Current Assets – Current
Liabilities
OR
= Ordinary Share Capital + Preference Share
Capital + Reserves + Long-term Liabilities
LIQUIDITY AND FINANCIAL
As we know a firm has to have different liquidity. In other words they have to be able
to meet their day to day payments. It is no good having your money tied up or
invested so that you haven’t enough money to meet your bills! Current assets and
liabilities are an important part of this liquidity and so to measure the firms liquidity
situation we can work out a ratio. The current ratio is worked out by dividing the
current assets by the current liabilities.
CURRENT RATIO =
Current assets _
Current liabilities
The figure should always be above 1 or the form does not have enough assets to meet
its liabilities and is therefore technically insolvent. However, a figure close to 1 would
be a little close for a firm as they would only just be able to meet their liabilities and
so a figure of between 1.5 and 2 is generally considered being desirable. A figure of 2
means that they can meet their liabilities twice over and so is safe for them. If the
figure is any bigger than this then the firm may be tying too much of their money in a
form that is not earning them anything. If the current ratio is bigger than 2 they should
therefore perhaps consider investing some for a longer period to earn them more.
However, the current assets also include the firm’s stock. If the firm has a high level of stock, it may mean one of the two things, 1. Sales are booming and they’re producing a lot to keep up with demand.
2. They can’t sell all they’re producing and it’s piling up in the warehouse!
If the second of these is true then stock may not be a very useful current asset, and
even if they could sell it isn’t as liquid as cash in the bank, and so a better measure of
liquidity is the ACID TEST (or QUICK) RATIO. This excludes stock from the
current assets, but is otherwise the same as the current ratio.
ACID TEST RATIO =
Current assets – stock
Current liabilities
Ideally this figure should also be above 1 for the firm to be comfortable. That would
mean that they can meet all their liabilities without having to pay any of their stock.
This would make potential investors feel more comfortable about their liquidity. If the
figure is far below 1, they may begin to get worried about their firm’s ability to meet
its debts.
Rate of Stock Turnover
It shows the number of times, on average, that the business will sell its stock in a
given period of time. It basically gives an indication of how well the stock has been
managed. A high ratio is desirable because the quicker the stock is turned over, more
profit can be generated. A low ratio indicates that stocks are kept for a longer period
of time (which is not good).
Cost of Goods Sold
Average Stock
=
____ Times
Stock Days:
This is Rate of stock turnover in days. Lower the better.
Average Stock
Cost of Goods Sold
x 365 =
____ Days
Debtor Days:
Shows how long it takes on average to recover the money from debtors. Lower the
better.
Debtors
x 365 =
Credit Sales
____ Days
Creditor Days: (Creditor Payment Period)
Shows how long it takes on average to payback the creditors. Higher the better.
Creditors x 365 =
Credit Purchases
Working Capital Cycle:
____ Days
(Lower the better)
Stock Days + Debtor Days – Creditor Days
=
____ Days
Note:
Average Stock
=
Opening + Closing
2
IF Average cannot be calculated use Closing Figures as average.
Utilization Ratios (All higher the better)
Total Asset utilization (Total Asset Turnover)
Shows how much sales are being generated on Total Assets. Higher ratio indicates
better utilization of Total Assets.
Net Sales
=
____ Times
Total Assets
Fixed Asset Utilization (Fixed Asset Turnover)
Shows how much sales are being generated on Fixed Assets. Higher ratio indicates
better utilization of Fixed Assets.
Net Sales
=
____ Times
Fixed Assets
Working Capital Utilization (Working Capital Turnover)
Sows how much sales are being generated on Working Capital. Higher ratio indicates
better utilization of Working Capital.
Net Sales
=
____ Times
Working Capital
Advantages of Ratios
1.
2.
3.
4.
Shows a trend
Helps to compare a single firm over a two years (time – series)
Helps to compare to similar firms over a particular year.
Helps in making decisions
Disadvantages (Limitations):
1. A ratio on its own is isolated (We need to compare it with some figures)
2. Depends upon the reliability of the information from which ratios are
calculated.
3. Different industries will have different ideal ratios.
4. Different companies have different accounting policies. E.g. Method of
depreciation used.
5. Ratios do not take inflation into account.
6. Ratios can ever simplify a situation so can be misleading.
7. Outside influences can affect ratios e.g. world economy, trade cycles.
8. After calculating ratios we still have to analyze them in order to derive a
conclusion.
PUBLISHED FINAL ACCOUNTS
The shareholders are the owners of the public limitied company, but they are not
permitted to manage their company unless they qualify as a director. The
shareholders elect a Board of Directors and delegate the authority to them. As there
is a divorce between owenership and control , it is a legal requirement for all
companies to publish the financial statements for the use of shareholders. The
companies publish the accounts in form of an ANNUAL REPORT.
CONTENTS OF ANNUAL REPORT:
1 . Financial Statements ( Income Statement , Statement of Financial Position
(balance Sheet) and a Statement of Cashflows)
2. Accounting Policies (see below)
3. Explaintory notes to financial statements
4. Directors Report
5. Auditors Report
What are Accounting Policies ?
Accounting policies are the specific principles, bases, conventions, rules and
practices applied by an entity in preparing and presenting financial statements. In this
section companies show change in accounting policies over last year and the
reasoning behind the changes applied. ( SEE IAS8)
What are explanatory notes?
The published financial statement only show the headings like Sales , COGS ,
Operating expenses, Non current Assets on the face of the statement , all the
details are shown under footnotes to these Profit and Loss and Balance Sheet
NOTES TO PROFIT AND LOSS
1. Details of Sales (turnover)
2. Details of Interest and Finance Cost
3. Details of Cost of goods sold
4. Details of Taxation
5. Details of wages , specially of highly paid staff)
6. Directors Salary and other compensations ( emoluments and remuneration )
7. Auditors fees
NOTES TO BALANCE SHEET
1. Schedule of Fixed Asset
2. Details of revaluation
3. Treatment of Goodwill
4. Basis of Stock Valuation
5. Details of Share Capital
6. Analysis of Long term Liablities
What is Directors Report and what are the contents?
Directors report is a summary provided by the directors to the shareholders and other
stakeholders on the performance of a company for a particular year. What you
should realize is that the financial statements are just numbers and not everyone can
comrehend the numbers , A report from the director becomes absolutely important
for the shareholder if he wants to know his companys financail performance . It
includes
1. An overall business review
2. Main (operations ) activities carried on by the company
3. Particulars of events occuring after the balance sheet which effects the
company
4. Recommendation of dividends
5. Name of directors and their financial interst (stake) in the business
6. Health and safety arrangement details
7. Donations to political parties
8. Signifcant changes in Fixed Assets during the year
9. An indication of future plans of the business
10. Information about research and devlopment expenditure carried out by the
busienss.
What is An Auditors Report?Auditors are hired by the shareholder to provide
assurance on the data provided by the directors to the shareholders. They check the
validity of data provided in the annual report ,and give an independent opinion on
whether the financial statements provide a true and fair view of companys position.
They also make sure that the financial statements comply with the International
Accounting Standards (IAS see next pages).
Omair Masood
Cedar College
INTERNATIONAL ACCOUNTING STANDARDS
The International Accounting Standard Board (IASB) have set rules and regulation on how
certain accounting transactions should be recorded and presented by a company. In most of
the countires all companies are required to comply with these standards, and auditors make
sure that all public limited companies are following the standards.
The main purpose of Accounting standards is to reduce the range and variety in accounting
practices thorughout the world. It does not form uniform accounting basis but it does form
similar accounting bases. They restrict the oppurtunity of frauds and creative accounting
(window dressing) ,but they cannot prevent frauds. They also assist investors to understand
financial statements as the IASB issues notes and explanations of every accounting
standard.
You are suppose to remember standards with name and number . You are also required to
know details of a few standards.
International Accounting Standards
Users of financial statements
Financial statements are used by a variety of groups for a variety of reasons. The framework
surrounding IAS identifies the typical user groups of accounting statements. The table below identifies
the user groups (stakeholders) and gives likely reasons for the user groups to refer to financial
statements.
Main users
Reasons for use
Investors
• To assess past performance as a basis for future investment
Employees
• To assess performance as a basis of future wage and salary negotiations
• To assess performance as a basis for continuity of employment and job
security
Lenders
• To assess performance in relation to the security of their loan to the
company
Suppliers
• To assess performance in relation to receiving payment of their liability
Customers
• To assess performance in relation to the likelihood of continuity of
trading
Government
• To assess performance in relation to compliance with regulations and
assessment of taxation liabilities
Public
• To assess performance in relation to ethical trading
Qualitative characteristics
As shown above, financial statements are prepared for a variety of reasons. IAS sets out four
qualitative characteristics of financial statements that make them useful to users:
•
Understandability – the information is readily understandable by users
•
Relevance – the information influences the economic decisions of users
•
Reliability – the information is free from material error and bias
•
Comparability – the information enables comparisons over time to identify and evaluate trends.
Omair Masood
Cedar College
IAS 1- PRESENTATION OF FINANCIAL STATEMENTS.
A full set of financial statements include:
1. Statement of comprehensive income (Income statement)
2. Statement of financial position (balance sheet)
3. Statement of changes in equity
4. Statement of cashflows
5. Accounting policies and explanatory notes.
What are explanatory notes?
Financial statement notes are the supplemental notes that are included with the
published financial statements of a company. The notes are used to explain the
assumptions used to prepare the numbers in the financial statements, as well as the
accounting policies adopted by the company. They also show details of items not shown on
the face of financial statements for example only final figure of COGS is shown on the face
of income statement but the whole calculation can be disclosed as notes.
Financial statements are prepared for a variety of reasons. IAS sets out four qualitative
characteristics of financial statements that make them useful to users:
•
•
•
•
Understandability – the information is readily understandable by users
Relevance – the information influences the economic decisions of users
Reliability – the information is free from material error and bias
Comparability – the information enables comparisons over time to identify and
evaluate trends.
Accounting concepts The standard requires compliance with a series of accounting
concepts:
•
Going concern – the presumption is that the entity will not cease trading in the
foreseeable future. (This is generally taken to mean within the next 12 months).
•
Accrual basis of accounting – with the exception of the statement of cash flows, the
information is prepared under the accruals concept; income and expenditure are
matched to the same accounting period.
•
Consistency – the presentation and classification of items in the financial statements
is to be consistent from one period to the next.
•
Materiality and aggregation – classes of similar items are to be presented separately
in the financial statements. This would apply to a grouping such as current assets.
•
Offsetting – this is generally not permitted for both assets and liabilities, and income
and expenditure. For example it is not permitted to offset a bank overdraft with
another bank account not in overdraft.
Omair Masood
Cedar College
International Accounting Standards
Comparative
– opening
there isstock,
a requirement
toclosing
showstock,
the figures
from the
•• cost
of sales is the information
netted-off total of
purchases and
less purchases
returns
previous period for all the amounts shown in the financial statements. This is
• distribution
include,
for example,
delivery vehicle
r u n n i n g costs, driver’s wages,
designedcosts
to help
users
make relevant
comparisons.
warehouse costs
• administration costs include office costs, heat and light etc.
IAS 1 FORMAT FOR INCOME STATEMENT (STATEMENT OF COMPREHENSIVE INCOME)
Example statement of comprehensive income
XYZ Limited
Statement of comprehensive income for the year ended 31 December 2013
31 December 2013
$000
31 December 2012
$000
Revenue
100,000
80,000
Cost of Sales
(60,000)
(45,000)
Gross Profit
Distribution Costs
Administration Expenses
40,000
(8,000)
(11,000)
35,000
(7,000)
(10,000)
21,000
18,000
(3,000)
(2,000)
19,000
16,000
Profit/(Loss) from Operations
Finance Costs
International
Accounting Standards
Profit/(Loss) Before Tax
The statement of financial position
Taxation
(4,500)
(4,000)
IAS 1 specifies the minimum information which must be shown on the face of the statement of
financial
position.
It requires
entities totoseparate
out:
Profit/(Loss)
for the
year attributable
equity holders
14,500
12,000
• non-current assets – property, plant, equipment, plant and machinery, motor vehicles, intangible
assets, goodwill, etc.
Notes:
• current assets – inventories, trade receivables, cash and cash equivalents
• Other
comprehensive
income and
revaluation
gains can be shown after the profit or loss
Note:
comparative
is always
shown.
• current
liabilitiesinformation
– trade payables,
bank overdrafts
and taxation
attributable to equity holders.
• • non-current
liabilities
–
bank
loans
and
long-term
provisions
IAS 1 does not permit items to be described as ‘extraordinary items’. Any material items, for
• equity
– share
capital,
share premium,
reserves
retained
earnings.
example,
disposal
of investments
or property,
areand
to be
separately
disclosed, either in the
statement or by way of a note to it.
•
Note
the end is
point
of this statement.
previous of
statements,
is now a requirement to
retained earnings
the closing
figure fromUnlike
the statement
changes inthere
equity.
show various other information in:
IAS 1−does
not prescribe
the format
of the statement of financial position or the order in which
statement
of changes
in equity
information
is presented.
Forto
example,
non-current assets can be presented before current assets or
−
information
relating
dividends.
vice versa; current liabilities can be presented before non-current liabilities, then equity, or vice versa.
A net asset presentation (assets minus liabilities) is allowed. The long-term financing approach
used in the UK and elsewhere (fixed assets + current assets − short-term payables = long-term
debt plus equity) is also acceptable.
The1 example
below
shows
the way theOF
information
should
be presented.
Notice ON
that NEXT
the figure
for
IAS
FORMAT
FOR
STATEMENT
FINANCIAL
POSITION
(SHOWN
PAGE)
The layout in the example below is acceptable and familiar to teachers and learners. The alternative
layouts used in recent textbooks and by some companies may be a source of confusion. See
Appendix 2 for the common configuration/alternative that appears in some text books and company
reports.
Financial statements of a private limited company
Many private limited companies are changing to the IAS format used by a public limited company
8 – one which is traded on the stock exchange). However the traditional format of an income
(PLC
statement is given below, as this format is likely to continue to appear in textbooks and in the
accounts of private limited companies.
The income statement of a private limited company (a company which is not traded on the stock
exchange) follows the same format as for a sole trader, although interest on debentures and
directors’ remuneration may be included in the expenses in the profit and loss section.
The first section of the statement of financial position of a private limited company is similar to that of
Omair Masood
Cedar College
International Accounting Standards
Example statement of financial position
XYZ Limited
Statement of financial position at 31 December 2013
$000
Non-current Assets
Goodwill
Property, plant & equipment
31 December 2013
$000
31 December 2012
$000
7,700
8,000
100,000
92,100
107,700
100,100
Current Assets
Inventories
1,000
800
Trade and other receivables
5,000
4,000
500
300
6,500
5,100
Current Liabilities
Trade and other payables
1,200
1,000
Tax liabilities
3,500
4,000
4,700
5,000
Cash and cash equivalents
Net Current Assets
1,800
100
(5,000)
5,200
104,500
95,000
40,000
40,000
Share premium
2,000
2,000
General reserve
10,000
10,000
Retained earnings
52,500
43,000
104,500
95,000
Net Current Liabilities
Bank loan
Equity
Share capital
As mentioned above you can also make TOTAL ASSETS = EQUITY + LIABILITIES
11
Omair Masood
Cedar College
Along with financial statements. It is also required to make a Statement of Total recognized
Gains and Losses. This statement for our syllabus only includes two items.
Profit for the year after tax
Add gain on revaluation
Less loss on revaluation
Total recognized gains and losses
Xxx
Xxx
(xxx)
Xxx
IAS 1 also sets the following rules.
1.
Proposed dividends for ordinary shares should be shown as a note to account and
not deducted from profits ( obviously also not shown as a liablity in the balance
sheet)
2.
Redeemable preference shares are now treated just like debentures , they should
not be included in the equity of the company, they should be shown in the long term
liabilities. The dividends paid to them are now treated like interest (Finance Cost) in
the statement of comprehensive income ( income statement) . Non-redeemable
preference shares should be treated like equity and any dividends paid should be
adjusted from statement of changes in equity.
KEY POINTS OF THIS IAS
-What are financial statements
- characteristics of financial statements
- Important concepts to be followed
-formats of Income statement and SOFP (only main items are shown along with comparative
information from last year)
-statement of total recognized gains and losses
- treatment of proposed dividends
-treatment of redeemable and non-redeemable shares
Omair Masood
Cedar College
IAS 2 – INVENTORIES
TheInternational
term inventory
refers to the stock of goods which the business holds in a variety of
Accounting Standards
forms:
IAS 2: Inventories
• raw materials for use in a subsequent manufacturing process
• work in progress, partly-manufactured goods
The term inventory refers to the stock of goods which the business holds in a variety of forms:
• finished goods, completed goods ready for sale to customers
• • raw
materials
for use
in athe
subsequent
process
finished
goods
that
businessmanufacturing
has bought for
resale to customers.
• work in progress, partly-manufactured goods
finished goods,
completed
goods ready
for in
sale
The• principle
of inventory
valuation
set out
IASto2customers
is that inventories should be valued at
• finished goods that the business has bought for resale to customers.
the lower of cost and net realisable value.
The principle of inventory valuation set out in IAS 2 is that inventories should be valued at the lower
of
and net
realisable
Note cost
the exact
wording.
It isvalue.
the lower of cost and net realisable value, not the lower of cost
or Note
net realisable
value. It is the lower of cost and net realisable value, not the lower of cost or net
the exact wording.
realisable value.
The net realisable value is the estimated selling price in the normal course of business, less
The net realisable value is the estimated selling price in the normal course of business, less the
theestimated
estimated
cost
of completion
and
the estimated
costs necessary
to make
cost
of completion
and the
estimated
costs necessary
to make the
sale. the sale.
Note that stock is never valued at selling price or net realisable value when that price is greater than
Note
that stock is never valued at selling price or net realisable value when that price is
the cost.
greater than the cost.
Example of stock valuation (1)
The ABC Stationery Company bought 20 boxes of photocopier paper at $5 per box. Following a
flood in their stockroom 5 of the boxes were damaged. They were offered for sale at $3 per box. All
were unsold at the end of the company’s financial year.
At what price will they be valued in the annual accounts?
15 boxes will be valued at their cost of $5 per box, a total of $75.
5 boxes will be valued at $3 per box, a total of $15. The total stock value will be $90.
Omair Masood
Cedar College
International Accounting Standards
Example of stock valuation (2)
The Good Look Clothing Company carries a variety of stocks. At their year end they produce the
following data:
Item
Cost
Price
$
Net Realisable
Value
$
Selling
Price (when new)
$
New dresses
1,000
1,500
2,000
Children’s clothes
2,000
3,000
3,000
Bargain fashions
1,200
900
2,000
What will be the total stock value for the annual accounts?
$
New dresses
1,000
Children’s clothes
2,000
Bargain fashions
900
Total stock value
3,900
Note that the valuation of the Bargain Fashions is the lowest of the three choices. This means that
inventory valuation follows the prudence concept.
Inventory valuation methods
IAS 2 allows two different methods to be used for valuing inventory:
• First in, first out (FIFO). This assumes that the first items to be bought will be the first to be
used, although this may not match the physical distribution of the goods. Valuation of remaining
inventory will therefore always be the value of the most recently purchased items.
• Average cost (AVCO). Under this method a new average value (usually the weighted average
using the number of items bought) is calculated each time a new delivery of inventory is received.
IAS 2 does not allow for inventory to be valued using the last in, first out (LIFO) method.
Inventories which are similar in nature and use to the company will use the same valuation method.
Only where inventories are different in nature or use, can a different valuation method be used.
Once a suitable method of valuation has been adopted by a company then it should continue to use
that method unless there are good reasons why a change should be made. This is in line with the
consistency concept.
13
International Accounting Standards
International
Accountingfor
Standards
Closing inventories
a manufacturing
organisation
Omair Masood
Cedar College
A manufacturer
may hold
categories of inventory:
Closing
inventories
forthree
a manufacturing
organisation
International Accounting Standards
• manufacturer
raw materialsmay hold three categories of inventory:
A
Closing
inventories for a manufacturing organisation
• work in progress
• manufacturer
raw materials
A
may hold three categories of inventory:
• finished goods.
• work in progress
• raw materials
Valuing
raw
materials
finished
goods.
•• work
in progress
•Valuing
finishedraw
goods.
A comparison
is made between the cost of the raw materials (applying either FIFO or AVCO) and
materials
their realisable
value.
Valuing
raw materials
A comparison is made between the cost of the raw materials (applying either FIFO or AVCO) and
Valuing
work
in
progress
finished
goods
A
comparison
is made
between and
the cost
of the raw
materials (applying either FIFO or AVCO) and
their
realisable
value.
their realisable value.
IAS 2 requires
that
the valuation
of these goods
two items includes not only their raw or direct material
Valuing
work in
progress
and finished
Valuing
in progress
and
goods
content,work
but also
includes
anfinished
element
for direct labour, direct expenses and production overheads.
IAS
2
requires
that
the
valuation
of
these
two items includes not only their raw or direct material
IAS 2 requires that the valuation of these two items includes not only their raw or direct material
The
cost
of
these
two
items
therefore
consists
of:
content,but
butalso
also
includes
an element
for direct
direct expenses
and production
content,
includes
an element
for direct
labour,labour,
direct expenses
and production
overheads. overheads.
• direct
materials
The
costofof
these
items
therefore
consists
of:
The
cost
these
twotwo
items
therefore
consists
of:
• direct
direct labour
directmaterials
materials
direct
expenses
direct
labour
direct labour
production
overheads (costs to bring the product to its present location and condition)
direct
expenses
direct expenses
production
overheads
(costsmay
to bring
the producttotobring
its present
locationtoand
condition)location and
other overheads
which
be applicable
the product
its present
production
overheads (costs to bring the product to its present location and condition)
other
overheads which may be applicable to bring the product to its present location and
condition.
• condition.
other overheads which may be applicable to bring the product to its present location and
Thecondition.
cost of these two items excludes:
••
•••
••
•
••
•
•
The cost of these two items excludes:
• abnormal waste in the production process
cost of waste
theseintwo
excludes:
•The
abnormal
the items
production
process
storagecosts
costs
••• storage
abnormal waste in the production process
sellingcosts
costs
•• selling
• storage costs
•• administration
costs
not related
to production.
administration
costs
not related
to production.
• selling costs
• administration costs not related to production.
14
14
14
Omair Masood
Cedar College
International Accounting Standards
Example valuation of work in progress and finished goods
The XYZ Manufacturing Company manufactures wooden doors for the building trade. For the period
under review it manufactured and sold 10,000 doors. At the end of the trading period there were 1,000
completed doors ready for despatch to customers and 200 doors which were half-completed as
regards direct material, direct labour and production overheads.
Costs for the period under review were:
$
20,000
Direct material used
Direct labour
5,000
Production overheads
8,300
Non-production overheads
10,000
Total costs for the period
43,300
Calculate the value of work in progress and finished goods:
Total units sold
10,000
Finished goods units
1,000
Half-completed units (200 x 0.5)
Production for the period
Attributable costs
Cost per unit
100
11,100
$33,300
33,300 / 11,100 = $3
Value of work in progress:
200 x 0.5 x $3 = $300
Value of finished goods:
1,000 x 3 = $3,000
Notes:
• Overheads are excluded from the calculations.
• The value of finished goods ($3,000) will be compared with their net realisable value when
preparing the final accounts.
KEY POINT OF THIS IAS
-
lower of cost and NRV and how to apply it on inventory
Type of inventories (RM/WIP/FG)
Only FIFO AND AVCO are allowed. LIFO not allowed.
What cost to include and exclude in inventory valuation.
Valuation of Finished goods and WIP.
15
Omair Masood
Cedar College
International Accounting Standards
IAS
7- STATEMENT
IAS
7 StatementOFofCASHFLOWS
cash flows
IAS 7 covers the presentation of information about the historical changes in an entity’s cash and cash
equivalents in a statement of cash flows. The statement classifies cash flows during the period according
to operating, investing and financing activities.
This statement is required to be produced as part of a company’s financial statements. IAS 7 provides
guidelines for the format of the statement of cash flows. The statement is divided into three categories:
• operating activities – the main revenue-generating activities of the business, together with the
payment of interest and tax
• investing activities – the acquisition and disposal of long- term assets and other investing
activities
• financing activities – receipts from the issue of new shares, payments for the redemption
of shares and changes in long-term borrowings.
At the end of the statement, the net increase in cash and cash equivalents is shown, both at the start
and end of the period under review. For this purpose:
• Cash is defined as cash on hand and demand deposits.
• Cash equivalents are defined as short-term, highly liquid investments that can easily be converted
into cash. This is usually taken to mean money held in a term deposit account that can be
withdrawn within three months from the date of deposit.
• Bank overdrafts – usually repayable on demand – are included as part of the cash and cash
equivalents.
Format
ofOF
theTHIS
statement
KEY
POINTS
IAS
Operating activities
-
it gives the format of statement of cashflow
it defines cash equivalents as all cash at bank which can be accessed within 90 days
The cash flow from operating activities is calculated as:
• profit from operations (profit before deduction of tax and interest)
• add: depreciation charge for the year
• add: loss on sale of non- current assets (or deduct gain on sale of non- current assets)
• less: investment income
• add: decrease in inventories, decrease in receivables and increase in trade payables
or
deduct: increase in inventories, increase in receivables and decrease in trade payables
• less: interest paid
• less: taxes paid on income (usually corporation tax).
Investing activities
This is calculated by including:
• inflows from proceeds from sale of non-current assets, both tangible and intangible, together with
other long-term non-current assets
• outflows from cash used to purchase non-current assets, both tangible and intangible, together with
other long-term non-current assets
• interest received
• dividends received.
16
Omair Masood
Cedar College
IAS 8- ACCOUNTING POLICIES, CHANGES IN ACCOUNTING ESTIMATES AND
ERRORS.
This standard is designed to formalise accounting policies within an organisation. It contains
a number of key definitions and general comments.
Accounting policies These are defined as: ‘the specific principles, bases, conventions, rules
and practices applied by an entity in preparing and presenting financial statements’.
Accounting policies are selected by the directors of the entity . In selecting and applying
policies, the standard requires that:
•
•
Where an accounting policy is given in an accounting standard then that policy must
apply.
Where there is no accounting policy provided to give guidance then the directors of
the entity must use their judgement to give information that is relevant and reliable.
They must refer to any other standards or interpretations or to other standardsetting bodies to assist them
An entity must apply accounting policies consistently for similar transactions. Changes in
accounting policies can only occur:
•
•
if the change is required by a standard or interpretation or
if the change results in the financial statements providing more reliable and
relevant information.
Any changes adopted must be applied retrospectively to financial statements. This means
that the previous figure for equity and other figures in the income statement and statement
of financial position must be altered, subject to the practicalities of calculating the relevant
amounts.
An example of Accounting policy can be method of inventory valuation. Changing the
method from FIFO to AVCO would mean a change in accounting policy.
Accounting Estimates
The reasonable esitmates are needed to prepare financial statements, e.g to determine net
book value of assets, Provision for doubtful debts. Estimates must be revised when new
information becomes available which indicates a change in circumstances upon which the
estimates were formed. A change in Accounting estimate must be accounted for
Prospectively ( i.e the previous accounts are not required to be changed). Also note
depreciation method is an estimate and not an accounting policy
Accounting Errors: If errors from previous periods are discovered later then they should be
accounted for Retrospectively( (this means all the account balances from previous years
should be adjusted)
Omair Masood
Cedar College
KEY POINTS OF THIS IAS
-
Difference between policy and estimate.
Change in policy is retrospective but Change in estimate is prospective.
Correction of errors are always retrospective.
IAS 10- EVENTS AFTER THE REPORTING PERIOD
These are events, either favourable or unfavourable, that occur between the end of the
reporting period, and the date on which the financial statements are authorised for issue.
They may occur as a result of information which becomes available after the end of the
period, and therefore need to be disclosed in the financial statements.
The key is the point in time at which changes to the financial statements can be made. Once
the financial statements have been approved for issue by the board of directors they cannot
be altered. For example, the financial statements are prepared up to 31 December and are
approved for issue by the board of directors on 30 April in the following year. Between
these two dates, changes resulting from events after 31 December can be disclosed in the
financial statements.
The standard distinguishes between two types of events:
Adjusting events
An adjusting event is defined as an event after the reporting period that provides further
evidence of conditions that existed at the end of the reporting period. If such an event
would materially affect the financial statements, the financial statements should be
changed to reflect these conditions.
Examples of adjusting events include:
•
•
•
•
•
•
the settlement after the end of the reporting period of a court case that confirms
that a present obligation existed at the year end
the determination, after the reporting period of the purchase price or sale price of a
non-current asset bought or sold before the year end
inventories where the net realisable value falls below the cost price
assets where a valuation shows that impairment has occurred
trade receivables where a customer has become insolvent
the discovery of fraud or errors which show the financial statements to be incorrect.
Non-adjusting events
A non-adjusting event is defined as an event after the reporting period that is indicative of a
condition that arose after the end of the reporting period. No adjustment is made to the
financial statements for such events. If material, they are disclosed by way of notes to the
financial statements.
Examples of non-adjusting events include:
Omair Masood
Cedar College
•
•
••
•
•
••
•
major purchase of assets
International Accounting Standards
losses of production capacity caused by fire, floods or strike action by employees
If,
after the date of the
of financialof
position,
the reconstruction
directors determineofthat
business
announcement
or statement
commencement
a major
thethebusiness
intends to liquidate or cease trading and that there is no alternative to this course of action, then
changes in tax rates
the financial statements cannot be prepared on a going-concern basis.
entering into significant commitments or contingent liabilities
Entities
must disclose
the date
when
financial
statements
werereporting
authorised period
for issue and
commencing
litigation
based
onthe
events
arising
after the
who gave that authorisation. If anyone had the power to amend the financial statements after their
major share transactions.
authorisation then this fact must also be disclosed.
Examples of adjusting and non-adjusting events
ABC PLC has prepared its financial statements for the year ended 30 June 2014. During August 2014,
before the financial statements have been approved, the following issues arise:
1. The company are informed that a customer has been declared bankrupt owing ABC PLC $8,000.
The debt related to sales in January 2014.
2. The directors are told that an error in preparing the financial statements resulted in revenue being
understated by $50,000.
3. A fire at one of the company’s properties in July 2014 resulted in damage estimated at $125,000.
What action should the directors take in respect of these issues?
1. As the outstanding debt dated back to January 2014, before the end of the financial period, the
insolvency was evidence of a condition that existed at the date of the financial statements. It is thus an
adjusting event and the financial statements should be amended to write off the outstanding $8,000.
2. The error of understating $50,000 revenue relates back to the period ended 30 June 2014. It is thus
an adjusting event and revenue should be increased by $50,000.
3. The fire happened after the end of the financial period and is therefore not evidence of a condition
that existed at that date. This is a non-adjusting event. No adjustment is to be made in the financial
statements, but as the amount is material, the event should be disclosed in the notes to the accounts.
KEY POINTS OF THIS IAS
-
Financial statements are finalized after the year end
Adjusting events vs adjusting events. (definition)
Adjusting events are actually accounted for in the current year.
Non adjusting events (if material) are only disclosed via notes to accounts.
21
Omair Masood
Cedar College
IAS 16- PROPERTY, PLANT AND EQUIPMENT
This standard deals with the accounting treatment of the non-current assets of property, plant and
equipment. Property, plant and equipment is initially measured at its cost, and subsequently
measured using either a cost or revaluation model, and depreciated so that its depreciable amount is
allocated on a systematic basis over its useful life.
Key definitions:
•
Property, plant and equipment – tangible assets held for use in the production or supply of
goods and services, for rental to others and for administrative purposes, which are expected
to be used for more than a period of more than one year
•
Depreciation – the systematic allocation of the depreciable amount of an asset over its useful
life.
•
Depreciable amount – the cost or valuation of the asset, less any residual amount
•
Useful life – the length of time, or number of units of production, for which an asset is
expected to be used
•
Residual value – the net amount the entity expects to obtain for an asset at the end of its
useful life, after deducting the expected costs of disposal
Recognition of the asset in the financial statements
At what point does an entity recognise the asset? The standard states that an item of property, plant
and equipment is to be brought into the financial statements when:
•
it is probable that future economic benefits will flow to the entity
and
•
the cost of the asset can be reliably measured.
Costs which can be included in the statement of financial position when the
asset is purchased
The statement provides that the following can be included as part of the cost in the statement of
financial position:
•
•
•
•
•
•
•
the initial purchase price
any import duties, taxes directly attributable to bring the asset to its present location and
condition
the costs of site preparation
initial delivery and handling costs
installation and assembly costs
cost of testing the asset
professional fees (e.g. architects or legal fees).
The statement also provides guidance on which costs must be excluded as part of the cost in
the statement of financial position:
•
•
any general overhead costs
the start up costs of a new business or section of the business
Omair Masood
Cedar College
•
the costs of introducing a new product or service (e.g. advertising).
Valuation of the asset
Once the asset is acquired, the entity must adopt one of two models for its valuation:
•
Cost model – cost less accumulated depreciation.
•
Revaluation model – the asset is included (carried) at a revalued amount. This is taken as its
fair value less any subsequent depreciation and impairment losses. Revaluations are to be
made regularly to make sure that the carrying amount does not differ significantly from the fair
value of the asset at the date of the statement of financial position.
Rules of Revaluation
Guidance is also given on the frequency of the revaluations:
•
•
if changes are frequent, annual revaluations must be made
where changes are insignificant, revaluations can be made every three to five years.
If an asset is revalued then every asset in that class must be revalued. Thus, if one parcel of
land and buildings is revalued then all land and buildings must be revalued.
Any surplus on revaluation is transferred to the equity section of the statement of financial
position as part of the revaluation reserve. Any loss on revaluation is recognised as an
expense in the income statement ( unless that asset was revalued upwards before and we
have a revaluation reserve against it)
Omair Masood
Cedar College
This standard also requires companies to show a schedule
of non-current
for its
International
Accountingassets
Standards
property
plant and equipment. Format is as follows
Example schedule of non-current assets
DEF plc
Schedule of non-current assets at 31 December 2014
Premises
$000
Plant and
machinery
$000
Motor
vehicles
$000
Total
$000
Cost
At 1 January 2013
Revaluation
Additions
Disposals
At 31 December 2014
600
300
900
320
250
115
(85)
350
120
(90)
280
Depreciation
At 1 January 2013
Revaluation
Provided in the year
Disposals
At 31 December 2014
60
(60)
-
145
115
35
(15)
165
90
(30)
175
320
(60)
125
(45)
340
Net book value
At 31 December 2014
At 31 December 2013
900
540
185
175
105
135
1190
850
1170
300
235
(175)
1530
KEY POINT OF THIS IAS
-
Defines what can be counted as capital expenditure and revenue expenditure
Two types of model (Cost Vs Revaluation)
Key Definitions
Rules of revaluation.
Schedule of non-current assets.
25
Omair Masood
Cedar College
International Accounting Standards
InternationalAccounting
AccountingStandards
Standards
International
IAS3636:
Impairment of
assets
IAS
- IMPAIRMENT
OFassets
ASSETS
IAS 36:
Impairment of
IAS 36: Impairment of assets
This standard seeks to make sure that an entity’s assets are not carried at more than their recoverable
Thisstandard
standard
seeks
make
sure
that
entity’s
assets
carried
atismore
than
This
seeks
totomake
sure
that
anan
entity’s
assets
areare
notnot
carried
at more
their
recoverable
amount,
and to
define
how
the
recoverable
amount
is determined.
There
athan
series
oftheir
keyrecoverable
definitions:
amount,
amount
is determined.
There
is aisseries
of key
definitions:
amount,and
andtotodefine
definehow
howthe
therecoverable
recoverable
amount
is determined.
There
a series
of key
definitions:
• Impairment loss – the amount by which the carrying amount of an asset exceeds its recoverable
•• Impairment
which
thethe
carrying
amount
of an
asset
exceeds
its recoverable
Impairmentloss
loss––the
theamount
amountbyby
which
carrying
amount
of an
asset
exceeds
its recoverable
amount.
amount.
amount.
• Carrying amount – the amount at which the asset is recognised in the statement of financial
•• Carrying
amount
––the
atat
which
thethe
asset
is recognised
in the
statement
of financial
Carryingafter
amount
theamount
amount
which
asset
is
recognised
in the
statement
of financial
position,
deducting
accumulated
depreciation
and
accumulated
impairment
losses.
position,
after
deducting
accumulated
depreciation
and
accumulated
impairment
losses.
position,
after
deducting
accumulated
depreciation
and
accumulated
impairment
losses.
• Recoverable amount – the higher of the asset’s fair value less net selling price and its value in
•• Recoverable
of of
thethe
asset’s
fairfair
value
less
netnet
selling
price
andand
its value
in in
Recoverableamount
amount– –the
thehigher
higher
asset’s
value
less
selling
price
its value
use.
use.
use.
•• Fair
Fair value
value – theamount
amountforforwhich
which
an
asset
could
be
exchanged,
or
a liability
settled
between
anan
asset
could
bebe
exchanged,
or aor
liability
settled
between
• knowledgeable,
Fair value––the
thewilling
amount
for which
asset
could
exchanged,
a liability
settled
between
parties
in
an
arm’s
length
transaction.
The
standard
provides
guidance:
knowledgeable,
anan
arm’s
length
transaction.
TheThe
standard
provides
guidance:
knowledgeable,willing
willingparties
partiesinin
arm’s
length
transaction.
standard
provides
guidance:
–
The
best
evidence
of
fair
value
is
a
binding
sale
agreement
less
disposal
costs.
– The best evidence of fair value is a binding sale agreement less disposal costs.
– The best evidence of fair value is a binding sale agreement less disposal costs.
thereisisan
anactive
activemarket
marketasas
evidenced
buyers,
sellers
readily-available
prices,
–– IfIf there
evidenced
by by
buyers,
sellers
andand
readily-available
prices,
it is it is
– If there is an active market as evidenced by buyers, sellers and readily-available prices, it is
permissibletotouse
usethe
themarket
market
price
less
disposal
costs.
permissible
price
less
disposal
costs.
permissible to use the market price less disposal costs.
Wherethere
thereisisno
noactive
activemarket,
market,
entity
an estimate
based
on best
the best
information
– Where
thethe
entity
cancan
useuse
an estimate
based
on the
information
– Where there is no active market, the entity can use an estimate based on the best information
available
less
thethe
disposal
costs.
availableofofthe
theselling
sellingprice
price
less
disposal
costs.
available of the selling price less the disposal costs.
– Costs
costs
only,
forfor
example
legal
or removal
expenses.
Costsof
ofdisposal
disposalare
aredirect
direct
costs
only,
example
legal
or removal
expenses.
–
Costs
of
disposal
are
direct
costs
only,
for
example
legal
or
removal
expenses.
of of
thethe
estimated
future
cash
flows
expected
to betoderived
from from
an an
• Value
Value in
inuse
use––the
thepresent
presentvalue
value
estimated
future
cash
flows
expected
be derived
• asset.
Value in use
– the present value
of the
estimated
future
cash
flows expected
toshould
be derived
from an
using
discounted
cash
flowflow
techniques.
The The
entityentity
consider
asset. This
Thisisisusually
usuallycalculated
calculated
using
discounted
cash
techniques.
should
consider
asset. This is usually calculated using discounted cash flow techniques. The entity should consider
the
the following:
following:
the following:
–– estimated
thethe
asset
estimatedfuture
futurecash
cashflows
flowsfrom
from
asset
– estimated future cash flows from the asset
–– expectations
of
possible
variations,
either
in amount
or timing
of the
cashcash
flowsflows
expectations of possible variations, either
in amount
or timing
of future
the future
– expectations of possible variations, either in amount or timing of the future cash flows
– current interest rates
– current interest rates
– current interest rates
– the effect of uncertainty inherent in the asset.
– the effect of uncertainty inherent in the asset.
– the effect of uncertainty inherent in the asset.
Identifying an asset that may be impaired
Identifying an asset that may be impaired
Identifying
an asset
that
mayan
beentity
impaired
At
the end of each
reporting
period,
is required to assess whether there is any indication that
At
the end
of be
each
reporting
an entity
is required
to assess
whether
there is any indication that
an
may
impaired
(i.e.period,
its carrying
amount
may be higher
thanwhether
its recoverable
At asset
the end
of each
reporting
period,
an entity
is required
to assess
there isamount).
any indication that
an
asset
may
be
impaired
(i.e.
its
carrying
amount
may
be
higher
than
its
recoverable
amount).
Goodwill
tested for
impairment
annually.
an assetshould
may bebeimpaired
(i.e.
its carrying
amount may be higher than its recoverable amount).
Goodwill should be tested for impairment annually.
Goodwill should
be tested for impairment annually.
Indications
of impairment
Indications of impairment
Indications
of impairment
External
sources:
External sources:
•External
marketsources:
value declines
• market value declines
market value
declines
•• negative
changes
in technology, markets, economy or laws
•• increases
negative changes
in technology, markets, economy or laws
in interestinrates
• negative changes
technology, markets, economy or laws
••• net
increases
in
interest
rates
assets of
company
increases
in the
interest
rateshigher than market capitalisation.
•• net
higher than
than market
market capitalisation.
capitalisation.
net assets
assets of
of the
the company
company higher
Internal sources:
Internal
sources:
•Internal
obsolescence
sources:or physical damage
•• asset
obsolescence
or
is idle
obsolescence
or physical
physical damage
damage
•• worse
economic
performance than expected.
asset
asset is
is idle
idle
thatexpected.
the asset’s useful life, depreciation method, or residual value
indication
of impairment indicates
•An
than
• worse
worse economic
economic performance
performance than
expected.
may need to be reviewed and adjusted.
An
that the
the asset’s
asset’s useful
useful life,
life, depreciation
depreciationmethod,
method,or
orresidual
residualvalue
value
An indication
indication of
of impairment
impairment indicates
indicates that
may
need
to
be
reviewed
and
adjusted.
may need to be reviewed and adjusted.
26
26
26
whole, disclose:
Omair Masood
Cedar College
• the main classes of assets affected
• the main events and circumstances involved.
Example asset values in statement of financial position
An entity has three non-current assets in use at the date of its statement of financial position.
Details of their carrying values and recoverable amounts are set out below:
Asset
Carrying amount
1
2
3
$
30000
15000
20000
Fair value less costs
to sell
$
10000
12000
15000
Value in use
$
50000
14000
9000
In the statement of financial position they should be shown at the following values:
Asset
Value in statement of
financial position
$
1
30000
2
14000
3
15000
Reason
The carrying amount is less
than the recoverable
amount, its value in use.
The carrying amount is
greater than the
recoverable amount, the
highest of which is its value
in use.
The carrying amount is
greater than the
recoverable amount, the
highest of which is its fair
value less costs to sell.
KEY POINTS FOR THIS STANDARD
27
This standard seeks to ensure that non current assets on the balance sheet are not shown at
an overstated value (Including Goodwill). When Net book value ( reffered as Carrying
amount) is more then its recoverable amount , the asset is impaired. An impairment loss is
shown in the income statement as an expense.
What is recoverable amount?
This is the higher of the following two values
•
•
Current market value (Fair Value ) less cost to sell
Present value of future cashflows derived from the Asset ( Value in Use)
So if net book value is above the Recoverable amount , the asset value is reduced to its
recoverable Amount by recording an impairment loss as an expense.
Omair Masood
Cedar College
IAS 37- PROVISIONS, CONTINGENT LIABILITIES AND CONTINGENT ASSETS
The objective of the standard is to make sure that appropriate recognition criteria and
measurement bases are applied to provisions, contingent liabilities and contingent assets.
Enough information must be disclosed in the notes to the financial statements to enable
users to understand their nature, timing and amount. There are a series of key definitions:
•
Provision – a liability of uncertain timing or amount.
•
Liability – a present obligation as a result of past events, where settlement is
expected to result in an outflow of resources (payment)
•
Contingent liability – a possible obligation depending on whether some uncertain
future event occurs, or a present obligation, but payment is not probable or the
amount cannot be reliably measured.
•
Contingent asset – a possible asset that arises from past events and whose existence
will be confirmed only by the occurrence of one or more uncertain future events not
wholly within the control of the entity.
When can we recognize a provision?
Recognition of a provision or a contingent liability depends on the probability of liability
resulting. A provision must be recognised if:
•
•
•
a present obligation exists as a result of a past event
payment is probable (more likely than not) and
the amount can be reliably estimated.
An obligating event is an event that creates a legal or constructive obligation and,
therefore, results in an entity having no realistic alternative but to settle the obligation.
A possible obligation (a contingent liability) is disclosed, but not accrued. Where the
possibility of payment is remote, no accrual or disclosure is required.
Contingent asset
These should not be recognised in the financial statements, but should be disclosed where
an inflow of economic benefits is probable and the amount is material. Where the inflow of
economic benefits is possible or remote, there should be no recognition and no disclosure.
Omair Masood
Cedar College
Example of recognition of provision or contingent liability
A company manufactures shampoo. A customer has sued the company claiming that the
shampoo has caused burns to her head. The customer is claiming damages of $100,000.
Lawyers have advised the company that it is possible that the customer may win the legal
case.
As the outcome of the case is uncertain (i.e. a possible successful claim for damages), the
company is not certain to be liable, i.e. this is a contingent liability. In these circumstances,
the company should not make a provision, but should disclose details of the case in its notes
to the accounts.
If the lawyer was of the opinion that it was probable that they would lose the legal case,
provision for the damages should be made in the financial statements.
SUMMARY
Chances
Remote
Possible
Probable
%
0-10
10.01-49.99%
50%+
Contingent Liability
Ignore
Disclose in Notes
Make a provision
Contingent Asset
Ignore
Ignore
Disclose in Notes
KEY POINTS FOR THIS IAS
If there is a liability of uncertain timing or amount then it can either be a provision (if all
three criteria are met) or a contingent liability (if any one criteria is not met).
Provisions are recorded in the books as an expense and recorded as a liability (or a
reduction in asset) in the statement of financial position
Contingent Liabilities are not recorded and only disclosed if chances are not remote. No
need to even disclose if chances are remote.
Contingent Assets are not recorded at all and only disclosed if chances are probable.
(Prudence concept)
Omair Masood
Cedar College
IAS 38- INTANGIBLE ASSETS
This standard covers the accounting treatment for intangible assets.
An intangible asset is defined as an identifiable non-monetary asset without physical
substance. The three critical attributes of an intangible asset are:
•
•
•
must be identifiable
must be controlled by the entity
the entity must be able to obtain future economic benefits from the asset.
Intangible assets may be self-produced or purchased.
Examples of intangible assets
The following is not an exhaustive list, but gives some examples of intangible assets:
•
•
•
•
•
patented technology, for example computer software, databases, trade secrets.
trademarks
customer lists
marketing rights
franchise agreements.
Recognition (when can we record it)
The standard requires an entity to recognise an intangible asset, whether purchased or selfcreated (at cost) if:
•
it is probable that the future economic benefits attributable to the asset will flow to
the entity and
•
the cost of the asset can be reliably measured.
If an intangible asset does not meet both the definition of, and the criteria for,
recognition, IAS 38 requires the expenditure to be recognised as an expense when it
is incurred.
Specific cases
The standard details initial recognition criteria and accounting treatment for specific cases
as follows.
Research and development costs
•
•
Research costs – charge all to the income statement.
Development costs may be capitalised (as an intangible asset) only after the
technical and commercial feasibility of the asset for sale or use have been
Omair Masood
Cedar College
established. The entity must demonstrate how the asset will generate future economic
benefits.
Internally generated brands, customer lists etc.
These should not be recognised as assets.
Computer software
If purchased, this may be capitalised. If internally generated, whether for sale or for use, it
should be charged as an expense until technical and commercial feasibility has been
established.
Other types of cost
The following items must be charged to expenses when incurred, not classed as intangible
assets:
•
•
•
•
•
internally-generated goodwill
start-up costs
training costs
advertising and promotional costs
relocation costs.
Measurement subsequent to acquisition
Similarly to tangible non-current assets, an entity must choose either the cost model or the
revaluation model for each class of intangible asset.
Cost model
After initial recognition, intangible assets should be carried at cost less accumulated
amortisation (depreciation) and impairment losses.
Revaluation model
Intangible assets may be carried at a revalued amount (based on fair value) less any
subsequent amortisation and impairment losses, only if fair value can be determined by
reference to an active market. In the case of intangible assets, it is unlikely that such
markets will exist.
Classification based on useful life
Intangible assets are classified as having either an indefinite life or a finite life.
Omair Masood
Cedar College
Indefinite life
This is where there is no foreseeable limit to the period over which the asset is expected to
generate net cash inflows for the entity. An intangible asset with an indefinite useful life
should not be amortised.
Finite life
This is where there is a limited period of benefit to the entity. In these circumstances, the
cost less residual value should be amortised on a systematic basis over that life, reflecting
the pattern of benefits.
KEY POINTS OF THIS IAS
•
•
•
•
•
definition of intangibles and key attributes.
Examples of intangible.
When to record an intangible asset
Specific cases.
Finite life vs Infinite life.
BUDGETING
A budget is based on the objectives of a business and enables the manager to set
operational targets for the department and then to control operations by comparing
the actual results with those in the budgt.Please remember budgets are always short
term plans ( maximum one year) and they can never satisfy the long term needs.
ADVANTAGES :
•
Budgets formalize management plans. ( better planning)
•
Co-ordinate all functions of a business. ( better planning)
•
Gives a warning for future shortages of resources.
•
Increases management particiaption ( while preparing budgets) which gives
them a sense of commitement …> motivation
•
Budgeted results can be compared with actual results
•
Cash budgets are required by financial institutions when taking finance
( loans)
DISADVANTAGES:
•
•
•
•
Might cause de-motivation for workers if they feel budgted figures
are way too high to achieve
A budget will only emphaize on results and the real reasons (non
financial) will be ignored.
The budgeting process will also incur cost and time.
There is a need to revise the budget because circumstances will
change in every period.
What is a master budget?
A set final of accounts ( profit and loss and balance sheet) prepared using figures
from sales, purchases and cash budget.
TYPES OF BUDGETING
Incremental Budgeting: Incremental Budgeting uses a budget prepared
using a previous period’s budget or actual performance as a base, with
incremental amounts added for the new budget period. The allocation of
resources is based upon allocations from the previous period. This approach is
not recommended as it fails to take into account changing circumstances
Zero- Based Budgeting: is a technique of planning and decision-making which
reverses the working process of traditional budgeting. In traditional incremental
budgeting, departmental managers justify only increases over the previous year
budget and what has been already spent is automatically sanctioned. By
contrast, in zero-based budgeting, every department function is reviewed
comprehensively and all expenditures must be approved, rather than only
increases. No reference is made to the previous level of expenditure. Zero-based
budgeting requires the budget request be justified in complete detail by each
division manager starting from the zero-base. The zero-base is indifferent to
whether the total budget is increasing or decreasing
What is a principal budget factor?
Limiting factors, sometimes called principal budget factors are cicrumstances
which restricts the activiteis of a business. Examples include
•
Limited demand for a product
•
Shortage of material, which limits production
•
Shortage of labour,which also limits
production
•
Shortage of amount of money to be spent.
The importance of limiting factor is that they must be identified at the start of the
budgeting process. This is because all other budgets will be dependant on the
limit factor. For example, if the limiting factor is demand for the product (which is
usually the case), a sales budget must be prepared and all the other budgets will
than be prepared to fit in with the sales budget. But if the limiting factor is shortage
of material or labour then the production budget will be prepared first and the
sales budget will then be based on that.
What steps can be taken if the cash forecast highlights future cash shortages?
Please realize every action will have a disadvantage aswell. So the company
decides the best possible action with least effect .
What steps can be taken if the cash forecast highlights future cash shortages?
Please realize every action will have a disadvantage as well. So the company
decides the best possible action with least effect .
•
Delay capital expenditure for a later period
•
Delay payment of dividends
•
Search for short term borrowings
•
Issue shares
•
Control expenses
•
Encourage debtors to pay earlier
•
Sell Surplus fixed assets
•
Negotiate better credit terms with
suppliers
What is Flexible Budget and Fixed Budget? ( Done with Standard
Costing)
A flexible budget is a budget which is designed to change in accordance with the
LEVEL OF ACTIVITY actually produced. The budget is designed to change
appropriately with such fluctuation in units. Main purpose of this is to take effect
of VOLUME away from the budget so that we can compare it with actual
performance.
A fixed budget, the budget remains unchanged irrespective of the level of activity
actually attained. The fixed budget is prepared based only on one level of output.
Fixed budget approach helps to ensure that each department within the
organization always knows exactly how much they have to spend at the
beginning of the period and how much is remaining at any given point during the
budgetary period as the target is pre-set this may increase motivation
INVESTMENT APPRAISAL
Investment appraisal is a process of evaluating whether it is worthwhile to invest your
funds in a project. The projects can be of different nature and can be in both; the
private and the public sector. They can range from acquiring a new non-current
asset , replacement of an existing asset, introducing a new product, buying an
already established business or even buying a new player (for a sports club).
Different Accounting techniques are used to evaluate these projects. While
evaluating any project, an investor will look for profitability, liquidity and feasibility of
the project. Good companies should also take the social implications of the project
into account e.g. external costs like pollution.
Most commonly used techniques include Accounting Rate of Return (ARR), Payback
Period, Discounted Payback Period, Net present Value and the Internal Rate of
Return. ARR and payback period are non-discounted methods while others are
discounted techniques.
By discounting we mean, taking the “time value of
money” into account. The investment has to be made today but returns are coming in
the future. Future cash flows are discounted to present day values so that they can
be compared with the initial outlay on a realistic basis. To understand this consider
the following example
Assuming the interest rate is 10%. And I owe you $11000 but I will pay you in twelve
months’ time. You should be willing to accept $10000 from me today because you
can put that $10000 in the bank and after 12 months, it will automatically grow up to
$11000 (including the interest). So we can say that the present value of receiving
$11000 in one year’s time is $10000. Or simply the real worth of $11000 coming in
12months are equal to $10000 today.
As we know money coming in the future won’t be worth the same in today’s terms, so
we reduce the size of the cash-flow according to the discount factor (which will
always be available in CIE exam, may be not in my tests). Question might give you
full discount factor table with different percentages remember the discount factor you
have to use should be the cost of capital of the company.
So what the hell is Cost of Capital?
While explaining you concept of discounting in class I must have referred to cost of
capital being the inflation rate or sometimes the interest rate. But it is actually the rate
at which the company can borrow funds from debt and shareholders. For E.g. If a
project is financed through borrowing money from a bank loan at 8%, the cost of
capital for this project will be 8%. If it is partially financed by loan and shareholders
then an average percentage should be used (will be discussed in class during later
chapters).
What is the difference between Profit and Net Cash-flow?
Technically profit and cash-flow are very different concepts. When we calculate profit
we subtract all expenses (cash and non-cash) from our revenue (which can be on
cash or credit). Non-cash expenses might include depreciation and other provisions.
Cash-flow is calculated by simply subtracting all cash paid from total cash received.
It’s helpful to remember that while doing this chapter, we are making a lot of basic
assumptions. Firstly there are no credit sales; no other provisions except straight line
depreciation and all expenses are paid on time (no Owings or prepayments). If we
consider this then the only difference between profit and cash-flow is the depreciation
of asset, and in the last year Scrap value. While calculating profits we don’t take
scrap value into account (because profit is only calculated from revenue) but in cashflow calculation we got to include it. Following equation summarizes this concept
Profit = Cashflow – depreciation –Scrap Value (last year)
Note: ARR is the only method which takes profit into account. All other methods are
either based on Cash-flows or Discounted Cash-flows
KEYPOINTS TO REMEMBER
•
•
•
•
•
•
While solving any question, you have to take the incremental approach.
A lot of questions will give data in such a way that you can calculate
revenue/expenses without project and revenue/expenses with project.
In this situation always take the increase in values because we can
associate that directly to the project. Existing profits and cash flows are
ignored as being irrelevant because they will continue whether the new
project is undertaken or not.
Sunk Cost consists of expenditure that has already been incurred
before the new project has been considered. While appraising the new
project this should be ignored.
Some projects do not increase cash flows but reduce operating
expenses (Savings). While evaluating such projects we have to
evaluate how much money will be saved against the cost of the project.
Savings are treated as cash inflows.
If a project requires an increase in working capital this should be
treated as a cash outflow at the start of the project and as a cash inflow
in the last year of the project.
Unless stated in the question we assume that the initial cost will have
to be paid in year 0 (which means start of the project). All other cash
flows are assumed to occur at the end of the particular year. For
example it is assumed that all revenue of first year is received at the
end of the first year. (Similarly operating payments are also treated in
the same way). That Is why we write sales of first year as year 1
( which means after 12 months)
But if the question states that a particular operating expense is paid at
the start of the year this would have a significant impact on our
cashflows. If like let’s say rent has to be paid at the start of the year
then first years rent will be paid in year 0 and 2nd years rent will be paid
in year 1.
ADVANTAGES AND DISADVANTAGES OF ALL METHODS
Out of all the methods the best and most commonly used (and the criteria to decide
an investment) is the net present value method. If NPV is positive the project should
always be accepted unless there is another project with a higher NPV and funds are
limited.
1. ACCOUNTING RATE OF RETURN/AVERAGE RATE OF RETURN
(ARR)
ADVANTAGES
1. Focuses on Profitability
2. Management can compare the expected profitability with the present return
on capital employed of the existing business
3. Easy and simple to calculate and understand
DISADVANTAGES
1. It is based on profit which is subjective. Deprecation is a management
decisions and can be manipulated
2. Average Profit is not earned in any of the year
3. The time value of money is ignored
4. Ignores the risk factor as it doesn’t tell when the initial cost will be recovered
( ignores liquidity )
5. There is no common method to calculate average investment
2. PAYBACK PERIOD
ADVANTAGES
1. Based on Cash flows which is more accurate profits
2. Evaluates risk and it focuses on liquidity
3. Easy and Simple to calculate
DISADVANTAGES
1. The time value of money is ignored
2. Ignores cashflow occurring after the payback period is achieved
3. Ignores the timing of cashflow( two projects can have same payback but
with different timings of cashflow and can hence effect the liquidity)
Note: Discounted payback is very similar it’s just that it takes time value of money
into account.
3. NET PRESENT VALUE
ADVANTAGES
1. Considers time value of money
2. Based on cash flows
3. Consider all the cashflows of the project
4. It can directly be linked with shareholders wealth. A positive NPV of $50000
means the wealth of company will increase by $50000
DISADVANTAGES
1. Difficulty in estimating the discounting rate ( Cost of capital)
2. More complicated and doesn’t give a return in % form.
4. INTERNAL RATE OF RETURN (IRR)
ADVANTAGES
1. Considers time value of money
2. Based on cashflows
3. Indicates a return in % form.
DISADVANTAGES
1. More complicated than other methods
2. Ignores the size of investment
3. Is only estimated because we need spreadsheet to determine it accurately
4. Multiple IRR problem
How to compare two projects?
A lot of examination questions are designed in a way that we first have to evaluate
two or more projects using different investment appraisal techniques. The projects
are usually similar in nature and then based on our appraisal we have to eventually
recommend which project the company should go for. As discussed above the rule is
to maximize the net present value.
Following Example should be helpful:
Two projects X and Y have the following results after appraisal.
Project X (Cost
Project Y (Cost
$100000)
$100000)
Accounting Rate of Return
23%
26%
Payback Period
2 years 8 months
3 years
Net Present Value
$23000
$28000
From the above figures it can be seen that Project Y should be selected as it is
relatively more financially sound and feasible due to a higher NPV. NPV of $28000
indicates the amount earned after recovering the original cost and also catering for
time value of money. In simple words company’s wealth will increase by $28000 in
real terms if they invest in project Y as compared to Project X which only brings in
$23000.
However Project X is relatively more liquid, as the investment is recovered 4 months
earlier than Project Y. This means that risk involved is relatively less for Project X. If
the company will be really short of liquid funds in the future and is a risk-averse
company then they might consider Project X but since the difference is not that
significant, I think Project Y is still better.
Project Y is also more profitable than Project X according to ARR. This indicates only
an average during the life of the two projects we will earn more profits if we choose
project Y. ARR is not a very important determinant of choosing a project due to its
several disadvantages.
The company should also consider social implications of both the project. Will it
cause pollution? Will it create more jobs? Etc.
To conclude based on the numbers available. I would advise the company to invest
in Project Y
NOTE:
•
Usually when doing comparison projects are of similar nature, life and
similar investment cost. If size of the investment is different than
deciding purely on NPV will not be correct. You can use the following if
size of the investment is really different.
Calculate a ratio (known as profitability index)
NPV/ Initial Cost
The project giving highest answer should be most beneficial.
•
Usually all the methods (Payback/ARR/NPV) will suggest that one
project is superior to the other so it will be really easy to write about it.
(Unlike in the example above where Project X has a better payback).
Standard Costing
Standard cost is the amount the firm thinks a product or the operation of the process
for a period of time should cost, based upon certain assumed conditions. The
technique of using standard cost for the purpose of cost control is known as standard
costing. It is a system of cost accounting which is designed to find out how much
should be the cost of a product under the existing conditions. The actual cost can be
calculated only when the production is undertaken. The pre-determined cost is
compared with the actual cost and a VARIANCE between the two is calculated. This
enables the management to take necessary corrective measures.
Advantages:
*
Helps in prepration of budgets.
*
Activities which are responsible for variances are highlighted
*
Varianaces allow management by exception to be practiced. Management by
exception means that everybody is given a target to be aceivhed and
management need not supervice each and everything. The responsiblities
are fixed and everybody tries to achieve his/her targets.
*
As Standard cost is already calculated it helps in preparation of estimates for
the cost of new products and quoatations for orders.
*
Motivation increases as it a taget of effeciency .
*
Standards provide a benchmark against which actual cost can be compared.
*
Managers of deparment with favourable varainces can be rewarded.
*
Increases workers participation.
Disadvantages:
*
There is cost involved in establshing and mantaing a standard costing system
*
There be may be reluctance from workforce to establish the system
*
Results in increase in admin work
*
Can de motivate ( if standards are not met constantly)
TYPES OF STANDARDS:
Standard here means expectation from your workforce.
Basic Standards:
These allow for a low level of effeciency . Workforce is not expected to be very
good and low standards are kept which will allow for wastage. Basic standards are
set at the intial time the company has started, as the workforce gets more trained the
company will move towards more strict standards.
Attainable Standards:
These are relatively more strict than the basic standards but do allow for some
wastage and recognizes that not all hours worked are productive.
Ideal Standards:
are standards that can only be met under ideal conditions. They allow for no
wastage or no idle time .
Causes Of Variances.
Direct Material Usage Varaince
Favorable
Better Quality Material
Efficient Workers
Better Machinery
Unfavorable (adverse)
Poor Quality
Ineffecient Workers
Poor Machinery/More spoilage/ Theft of
material
Direct Material Price Variance
Favorable
Fall in Price (Deflation)
Supplier charging lower price due to less
demand of material
Use of different type of material
Buying in bulk (trade discount)
Favourable change in currency ( in case of
imported material)
Unfavorable (Adverse)
Inflation
Supplier charging higher price due to shortage
Use of different type of material
Buying less (loss of discount)
Unfavorable change is currency ( in case of
imported material)
Direct Labor Effeciency Varaince
Use of higher or lower skilled labor
Poor or good machinery
Poor or good working methods
Poor or good morale
Poor or good quality control / Training
Direct Labor Rate Variance (opposite for unfavorable variances)
Use of higher lower skilled labor
Wage inflation
Minimum Wage requirement by government
Overtime Conditions
Sales Price Variance
Sales Volume Varaince
Change in price for bulk cosumers
Change in marketing strategy
Price redution (summer sale)
Change in consumer taste
Price increse ( new models)
Competition within the sector
What is the link between Material usage and Labor Effeciency Varaince?
These varainces generally go in same direction , if one is favourable other one is
also favourable ( not every time but generally) . The reason behind this is that if we
use better quality material it wil give a favourable usage varaince , now since better
quality material has less spoilage and is much easier to handle this will also save on
the time consumed by labor ( hence a reduction in actual labor hours worked) which
will lead to a favourable labor effeciency varaince. The opposite Is also true if we use
relatively poor quality material.
SENSIVITY ANALYSIS
A technique used to determine how different values of an independent variable will
impact a particular dependent variable under a given set of assumptions. This
technique is used within specific boundaries that will depend on one or more input
variables, such as the effect that changes in interest rates will have on a bond's price.
Sensitivity analysis is a way to predict the outcome of a decision if a situation turns
out to be different compared to the key prediction(s). It is used in
Breakeven Analysis
Calculation of Selling price
Investment Appraisal
Budgeting and Standard Costing
Some important Formules:
Sensitivity Applied to Marginal Costing
(a) Sensitivity of Selling Price :
(b) Sensitivity of Fixed Cost :
(c) Sensitivity of Variable Cost :
(d) Sensitivity of Volume
Profit /Sales *100
Profit /Fixed Cost *100
Profit/Variable Cost *100
Margin of safety (Units)/Total Units * 100
Sensitivity Applied to Investment Appraisal
(a) Sensitivity of Selling Price :
NPV/Present Value of Sales * 100
(b) Sensitivity of Intial Cost :
NPV/Intial Cost *100
MANUFACUTURING ACCOUNTS
COST OF PRODUCTION = PRIMECOST +FACTORY OVERHEADS
Goods are transferred from factory to warehouse at a factory markup. Inventory of
finished goods are also kept at marked up values . The amount of profit included in
these items has to be adjusted at the end of the income statement.
Net profit from trading
Add Factory Profit
Add opening URP
Less closing URP
If nothing is specified in the question then assume Inventories of finished goods are at
marked up price ( they include profit).
The amount of profit in opening inventory is Opening Unrealized profit and in closing
is called Closing unrealized profit.
If breakeven for factory is required then the transfer value should be considered as
selling price.
NON-PROFIT ORGANIZATION (CLUBS
AND SOCITIES)
The non-profit organization is with a view of providing services to its members. The
aim is not to make profits out of trading activities, but to increase to welfare of
members through social interaction and other activities. A club is owned by all the
members collectively and since there is no single owner, there are no DRAWINGS.
TERMINOLOGY DIFFERENCE
Non-profit organizations
Receipts and Payments Account
Income and Expenditure Account
Surplus
Deficit
Accumulated Funds
Normal trading Businesses
Bank Account
Trading, Profit and Loss Account
Profit
Loss
Capital
Why is a Receipts and Payments Account unsatisfactory for the members?
The receipts and Payments account does not provide information to the members
relating to
1. Assets owned by the club
2. Liabilities owed by the club
3. Surplus or Deficit
4. Depreciation of fixed assets
5. Performance of the club
6. Financial position of the club.
In order to make the income and expenditure account, you will need to determine the
incomes separately. Incomes may include:
-­‐ Refreshment Profit/Bar profit (make a separate account to calculate net profit
from this)
-­‐ Annual subscription (separate subscription account for this)
-­‐ Gain on disposal.
-­‐ Interest on deposit account or investment account.
-­‐ Profits from different events (say Dinner dance)
-­‐ Life Subscription (don’t mix this with Annual Subscription)
-­‐ Donations (only day to day)
Check debit side of Receipts and Payments account for anything else.
What is the difference between receipts and payments account and Income and
Expenditure account?
Receipts and Payment account
It shows balance of bank at start and end
It records money coming in and going out
It considers all type of money coming
including capital receipts, e.g. Long term
donations and all type of money going out,
e.g. Purchase of fixed asset
It is an alternative name for cashbook
Income and Expenditure account
It shows Surplus of Deficit for the year
It records Incomes and expenses incurred
It considers only revenue incomes and
expenditure.
It is an alternative name for profit and Loss
What is a donation and what are two accounting treatments for it?
An amount received by a club which the club does not have to pay back. This
includes donations, gifts, legacy and grants.
If donation is for a day to day expenditure or will remain with the club only for a
short period then it should be treated as an income in the income and expenditure
account.
If donation is for purpose of capital expenditure on long term assets, then it is shown
as a special fund in the balance sheet. (Financed by section added it to accumulated
funds).
What is life subscription (Life membership or admission fees)?
All of these are treated in the same way.
The club receives money for subscription for the entire life of the member. This is put
in a separate life membership account. Every year an amount of it is transferred to the
income and expenditure account (this will be given in the question), e.g. the amount
of money received from this life membership scheme is $300 and club decides to
transfer 20% every year. This would mean that $60 (20% of $300) is transferred to
income and expenditure account and the remainder $240 should go to the balance
sheet as a long term liability. If the life membership fund already has a balance, let’s
say $2 000 and we have received $500 during the year and club transfers 10% year.
This would mean we would show 250 (10% of 2 500) as an income and the remainder
2 250 (2 500 – 250) as a long term liability.
ACCOUNTING FOR CONSIGNMENTS
What is a consignment?
A business may want to expand its trading activities. For this purpose, it may
introduce its product to the consumers of other localities, like other cities or countries.
However, it may not be feasible at the initial stage to open sale terminals/branches at
such places. Therefore the business may negotiate and arrange sale of goods
through local businesses/retailers for a commission. This arrangement is known as a
“consignment”. The business which sends the goods is called a “consignor´ and
the agent whom goods are sent on sale or return basis is known as a “consignee”.
Accounting for consignment
A consignment account is made by the consignor to determine profit or loss .
Debit side is used to record expenses and credit side is used to record incomes
(Difference being the profit or loss)
The consignor will also make an account for Consignee. This is like a trade debtor
account . At the end of the contract if the payment is received this account is closed
via bank ( else you can bring down the balance)
The consignee will make an opposite account for the consignor .
Valuation of unsold goods
If there are some units unsold then we have to value them and record as Bal c/d
( credit side ) in the consignment account . This value should include the following
cost:
1.Original Cost of the goods
2. Any expenses paid by the consignor to dispatch goods to consignee.
3. Any expenses paid by the consignee to receive the goods and turn them into a
salebale condition.
Please note expenses like marketing , selling cost ,commission
included in the inventory
should not be
JOINT VENTURES
What is a joint venture?
A joint venture is a temporary partnership. It is formed for a particular purpose and it
is terminated on completion of a job or a venture for which it is formed.
For example:
1.
A joint venture may be formed between two individuals for construction of
residential apartments. One may have expertise in construction work and the
other one may provide the required finance.
2.
A joint venture may be formed between a construction company and an
architect firm for construction of a bridge or a housing society.
Features of a joint venture:
1.
2.
3.
4.
5.
6.
7.
8.
It is a particular partnership.
It does not entail continuing features after completion of the task.
The business is dissolved after completion of the venture.
It applies cash accounting concept rather than going concern concept.
Calculation of incomes is relatively simple.
All the assets are timely received in cash and all the liabilities are paid in cash.
Profit is determined as the difference between cash received and cash paid.
It does not use a business name.
Bookkeeping methods for a joint venture:
1.
No separate books are kept:
In a small joint venture which may expect to last for a short time period, no
separate books are kept. Each party records only those transactions with
which it may concern.
2
Separate books are kept: ( Not in syllabus)
For a large-scale joint venture which may expect to last for a longer period a
separate set of books are kept. In such cases the calculation of profit is not
difficult. It is similar to preparing the financial statement for a firm.
NO SEPARATE BOOKS ARE KEPT
In this method accounting is done in the existing books of parties involved in the
venture ( 2 or more). For example if Harold and Kumar enter into a Joint Venture then
following accounts will be made.
In the books of Harold : Joint Venture with Kumar Account
In the books of Kumar : Joint Venture with Harold Account.
Both parties will record Payments on the debit side and receipts on the credit side.
Once all transactions are recorded , both parties will share the respective accounts
with each other and a memorandum joint venture account will be prepared ( which is
simply a merger of both accounts ). The main purpose of this account is to calculate
the profit or loss from the venture . This profit is then divided in the profit sharing
ratio and transferred to individual joint venture accounts ( Profit on the debit side and
loss on the credit side) .
The trick to find out if answer is correct or not is that the individual joint venture
account balances will add up to zero.
ACTIVITY BASED COSTING
Product costing requires an accurate measurement of the resources consumed to
manufacture a product. If a product is undercharged it may result into a loss to the
business. Contrary to that if a customer is overcharged, there are ample chances
that the business may not be able to compete and lose a customer.
The conventional absorption costing method absorbs support overheads simply
on production volume measured in terms of labour hours worked or number of units
produced. In case the proportion of support overheads is quite low in total cost of a
product and the manufacturing process is labour intensive, as a result, the direct
costs would have been much higher than indirect costs and it may have an
insignificant impact on realistic product pricing.
However, the modern manufacturing process has become more machine intensive
and as a result the proportion of production overheads have increased as compared
to direct costs, therefore it is important that an accurate estimate is made for the
production overheads per unit.
The activity based costing (ABC) adopts more realistic approach to charge
production overheads to determine the product cost. It charges overheads on the
basis of benefits received from a particular overheads. It considers the relationship
between the overheads costs and the activity which causes incurring of such costs,
known as cost drivers.
The examples of transactions-based cost drivers are given below:
Support department (Cost centre)
1. Production scheduling
Possible cost driver
Number of production runs
2. Set-up costs
Number of machine set-ups
3. Store department
Number of store requisitions
4. Purchasing department
Number of purchase orders
5. Finished goods handling
Number of orders delivered
6. Canteen
Number of employees
7. Power generation
Number of kilo-watts consumed
Steps to calculate cost of production using ABC
There are following five basic steps:
1. Classify production overheads into activities according to how they are driven.
2. Identify the cost driver for each activity, which causes these activities to incur the
costs.
3. Calculate an overheads absorption rate (OAR) for each activity.
4. Absorb the activity costs into the product based on the benefits received by the
production process.
5. Calculate the total cost of the product.
Uses of Activity Based Costing
1. It is used to calculate a more accurate and realistic cost of a product.
2. It is used in an organisation where production overheads form a significant
portion of total cost of production.
3. It gives a better insight to consider what factors drive overheads costs.
4. It recognises that all overhead costs are not related to production and sales
volume.
5. It is used to control overhead costs by managing cost drivers.
6. It is used to apply on all the overhead costs not only the production overheads.
7. It is used just as easily as it is used in product costing.
Limitations of Activity Based Costing
1. It has limited benefit if the overhead costs are a small proportion of the total costs.
2. The choice of both activities and cost drivers might be inappropriate.
3. It is more complex method of calculating the cost of a product.
AUDITING AND STEWARDSHIP OF LIMITIED COMPANIES
Difference between Shareholders and Directors?
Shareholders provide the capital of limited companies by the purchase of shares. In the case
of public limited companies there are often many thousands of shareholders. Clearly, all
these shareholders cannot run the business on a day-to-day basis, so it is the responsibility
of shareholders to appoint directors to run and manage the business on their behalf. These
directors can be within the shareholders or external.
The directors of a limited company are responsible for the preparation of annual financial
statements that are then used by shareholders to assess the performance of the company
and the directors whom they have appointed. The directors must ensure that the provisions
of the Companies Act 1985 are implemented. Directors are paid emoluments(salaries) as
their reward for running the business.
‘Divorce of ownership and control’ is the term often used to describe the relationship
between shareholders and directors because although shareholders are the owners of a
company, it is the directors who control the day-to-day affairs of the business.
Stewardship is the responsibility which directors have for the management of resources
within a business on behalf of the shareholders (please remember this definition)
Responsibilities of Directors
•
•
•
•
•
•
Keep proper accounting records that allow financial statements to be prepared in
accordance with relevant companies’ legislation.
Safeguard business assets
Directors must avoid any situation which him/her in direct conflict with the interest
of the company.
Select the accounting policies to be applied to the financial statements
Report on the state of the company’s affairs
Ensure that the financial statements are signed by two members of the board of
directors.
Directors are required to make a report at the end of each year
What is Directors Report and what are the contents?
Directors report is a summary provided by the directors to the shareholders and other
stakeholders on the performance of a company for a particular year. What you should
realize is that the financial statements are just numbers and not everyone can comrehend
the numbers , A report from the director becomes absolutely important for the shareholder
if he wants to know his company’s financal performance . It includes
1.
An overall business review
2.
Main (operations ) activities carried on by the company
3.
Particulars of events occuring after the balance sheet which effects the company
4.
Recommendation of dividends
5.
Name of directors and their financial interst (stake) in the business
6.
Health and safety arrangement details
7.
Donations to political parties
8.
Signifcant changes in Fixed Assets during the year
9.
An indication of future plans of the business
10.
Information about research and devlopment expenditure carried out by the
busienss.
If the directors are responsible for keeping financial records and the preparation of the
annual financial statements, how can shareholders be guaranteed that the records are
prepared in an objective way?
Shareholders appoint a team of professionally qualified accountants (external auditors) to
check and verify the financial statements and the transactions that led to their preparation.
So to summarize
Shareholders who are owners of the company, they appoint directors(managers) to run
the company and external auditors to keep a check on directors.
What is Audit?
An official inspection of an organization’s account typically by an independent body.
In connection with a limited company there are two types of auditor:
1. Internal auditor
The internal auditor is an employee of the company, appointed by the directors. Their main
role is to help ‘add value’ to the company and help the organisation achieve its strategic
objectives. They are thus part of the day-to-day management team of the business. Their
key roles are therefore:
• Evaluate and assess the control systems inplace within the company
• Evaluate information security and risk within the company
• Consider and test the anti-fraud measures in place in the company
• Overall help to ensure that the company meets its strategic and ethical objectives.
Remember Internal audit is not a legal requirement and its an option for directors to
appoint an internal auditor or not. The main audit which we have to consider in the External
Audit which is a legal requirement. If in exam they only mention “audit” then they are
talking about external audit
2. External auditor
The external auditor is not an employee of the company. They are independent, usually
large, firms of accountants. They are appointed by the shareholders to ensure that the
financial statements prepared by the directors are a true and fair view of the state of
financial affairs of the company. The auditors examine the financial records and systems in
an honest and forthright manner and prepare an audit report. The auditor’s report is
presented to the shareholders at the annual general meeting. The shareholders are unable
to inspect the company’s books of account, indeed they may well lack the technical
knowledge to do so. However, they are, along with the debenture holders, entitled to
receive copies of the annual accounts. It is important that shareholders and debenture
holders can be sure that the directors can be trusted to conduct the company’s business
well and that the financial statements are reliable.
Duties of External Auditor
The shareholders appoint auditors to report at each annual general meeting whether:
i.
ii.
iii.
iv.
v.
proper books of account have been kept.
the annual financial statements are in agreement with the books of account.
in the auditor’s opinion,the statement of financial position gives a true and fair view
of the position of the company at the end of the financial year, and the income
statement gives a true and fair view of the profit or loss for the period covered by
the account.
the accounts have been prepared in accordance with the Companies Act and all
current, relevant International accounting standards.
the information given in the directors report is consistent with the accounts.
The auditor’s responsibility extends to reporting on the directors’ and any strategic report
and stating whether the statements in it are consistent with the financial statements. They
must also report whether, in their opinion, the report contains misleading statements.
Auditors must be qualified accountants and independent of the company’s directors and
their associates. They report to the shareholders and not to the directors; as a result,
auditors enjoy protection from wrongful dismissal from office by the directors.
What is True and Fair View?
The overall objectives of a set of financial statements is that they provide a true and fair
view of the profit or loss of the company for the year, and that the statement of financial
position likewise gives a true and fair view of the state of affairs of the company at the end
of the financial year. The word true may be explained in simple terms as meaning that, if
financial statements indicate that a transaction has taken place, then it has actually taken
place. If a statement of financial position records the existence of an asset, then the
company has that asset. The word fair implies that transactions, or assets, are shown in
accordance with accepted accounting rules of cost or valuation.
The Audit Report
The auditor’s report has three main sections:
1. Responsibilities of directors and auditors
a) Directors are responsible for preparing the financial statements.
b) Auditors are responsible for forming an opinion on the financial statements
2. Basis of opinion – the framework of auditing standards within which the audit was
conducted, other assessments and the way in which the audit was planned and
performed. If the auditor fails to obtain information and explanations necessary to
support his audit then this must be reported. Any deviation from the necessary
disclosure requirements must be identified.
3. Opinion – the auditor’s view of the company’s financial statements.
The Audit opinion can be of 3 types
Unqualified Opinion: An unqualified opinion is given if the financial statements are
presumed to be free from any error or misstatements ( CLEAN REPORT)
Qualified Opinion: A qualified opinion is given when a company’s financial statements are
not in accordance with Accounting standards or show errors and misstatements.
Disclaimer of Opinion: In the event the auditor is unable to complete the audit due to
absence of financial records or insufficient corporation from management, the auditor
issues a disclaimer of opinion.
Which documents must be Audited by the external auditor?
The main statements that have to be audited are:
o
o
o
o
o
the income statement
the statement of financial position
statement of cash flows
statement of total recognised gains and losses
accounting policies and notes to the accounts
IMPORTANCE OF AUDIT OPINION
If audit opinion is qualified which means auditor is saying that the financial statements
have errors and misstatements. This will have an adverse effect on company and its
directors and shareholders will not trust the financial statements. The share price might also
get adversely effected.
If audit opinion is unqualified which means auditor is saying that the financial statements
are free from errors and any misstatements then it helps in building the trust and will
effect the company in a positive way.
Computerized Accounting Systems.
The business world is becoming increasingly competitive with each passing year and
changing at a pace never before seen. Businesses today are competing in a global
economy and to cope with these pressures managers need to take full advantageof all
aspects of information technology. It has been said that ‘information is one of the
most important resources’ that managers have. This information includes records of
the activities of all stakeholders – customers, suppliers and staff – and how the
business deals with them through its activities that involve inventory, payroll, etc.
Customers and suppliers expect a business to be efficient. Managers need to react to
stakeholder requirements quickly and efficiently, so reaction time is of the essence.
Information technology (IT) makes relevant and detailed data available at the click of
a mouse.
Nearly all managers of businesses that use a double-entry system of recording
financial transactions will use a computer in some, if not all, parts of their business.
As the use of computers has increased in all kinds and sizes of business, the use of
handwritten entries in the accounting system has steadily decreased; paper documents
have given way to onscreen documents and computer printouts.
The underlying system of accounting remains unaltered but the speed at which
information is processed and made available to users has greatly increased. In any
accounting system all transactions have a ‘knock on effect’; all transactions are
interrelated and interdependent and an efficient computerised accounting system will
provide useful feedback to management and staff.
A good IT system of computerised accounting will allow all levels of management to:
◦
●
create plans ◦
●
put those plans into practice ◦
●
control activities ◦
● evaluate outcomes so that adjustments to the business can be made
and any errors can be rectified quickly. A computerised accounting system provides managers with instant and up-to-date
reliable information in real time that can be used to plan and control the business,
allowing prompt decision making. Information obtained from the computerised
accounting system can be used to help guide and control business policy.
Advantages of introducing a computerised accounting
system
◦
● Speed: Data entry into the system can be carried out much more
quickly than if done manually. One entry can be processed into a multitude of
different areas. For example one entry can be made that will simultaneously
update a customer’s account, sales account in the general (nominal) ledger and
inventory records. ◦
Accuracy: Provided that the original entry is correct there are fewer
areas where an error can be made since only one entry is necessary to provide
the data that is replicated throughout the system. ◦
● Automatic document production: Fast and accurate invoices and
credit notes are produced and processed in the appropriate sections of the
system. ◦
Availability of information: Accounting records are automatically
updated once information is keyed in. This information is then readily
available to anyone within the organisation who requires it. ◦
● Taxation returns: Information required by tax authorities is
available at the touch of a button. ◦
● Legibility: Data are always legible, whether shown on screen or as a
printout. This reduces the possibility of errors caused by poor handwriting. ◦
● Efficiency: Time saved may mean that staff resources can be put to
better use in other areas of the business. ◦
● Staff motivation: Since staff require training to acquire the
necessary skills to use a computerised accounting system, their career and
promotion prospects are en- hanced, both within their current role and for
future employment. Some staff may benefit from increased responsibility, job
satisfaction and pay. ●
●
Disadvantages of introducing a computerised accounting
system Hardware costs: The initial costs of installing a computerised accounting
system can be expensive. Once the decision has been made to install a system,
the hardware will inevitably need to be updated and replaced on a regular
basis, leading to further costs. ●
Software costs: Accounting software needs to be kept up to date.
Investment in software therefore requires a long-term financial commitment. ●
Staff training: Staff will need training to use the software and training
updates each time the system is modified. ●
Opposition from staff: Some staff may feel demotivated at the prospect of
using a computerised system. Other members of staff may fear that the
introduction of a new system will lead to staff redundancies, which could
include them. Changing to a computerised system can cause disruption in the
workplace and changes to existing working practices may make staff feel
uneasy. ●
Inputting errors: Staff can become complacent because inputting into the
system becomes more repetitive and therefore they may lose concentration
which can lead to input errors. ●
Damage to health: There are many cases of reported health hazards to staff
working long hours at a computer terminal. The health issues range from
repetitive strain injuries through to backache and headaches. ●
● Back-up requirements: All work entered into the computerised
accounting system must be backed up regularly in case there is a failure of the
system. Much workhas to be printed out on paper as a back-up, so hard copies
might require further expenditure on secure storage facilities. ● Security breaches: There is always a danger that computer hackers
might try to breach the security of the accounting system while others may try
to gain access to hard copy. Some might argue that a computerised system
makes staff fraud simpler to achieve. A computer system that communicates
with outside agencies such as customers, suppliers and government agencies
means there is always the danger of infection from software viruses. Robust
anti-virus protection and firewalls will need to be put in place to protect
sensitive and important data. Moving from a manual to a computerised system
When a computerised accounting system is first installed great care must be taken
to ensure that the transition from manual records to computer records is
smooth and accurate. The opening entries in the computerised system should
be double checked by different members of staff. The check can take the form
of, say, a manually prepared control account which is then compared with a
printout; clearly the two should match. Similarly, a manually prepared trial
balance can be compared to a trial balance extracted from the computer. A
system of protective devices (firewalls, virus protection, etc.) must also be
introduced into the system. Each member of staff should have a unique
password allowing access to their area(s) of responsibility within the system.