Financial Accounting
FFA/FA
Integrated Course Notes
For exams from 1st September 2019
to 31st August 2020
ISBN: 9781509780617
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FFA/FA Financial Accounting
Study Programme
Taught Phase Study Programme
Page
Introduction to the exam and the course ................................................................................................................. 4
Skills bank ............................................................................................................................................................. 13
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
Introduction to accounting ............................................................................................................................ 45
The regulatory framework............................................................................................................................. 55
The qualitative characteristics of financial information ................................................................................. 63
Sources, records and books of prime entry.................................................................................................. 73
Ledger accounts and double entry ............................................................................................................... 87
From trial balance to financial statements .................................................................................................... 97
Inventory..................................................................................................................................................... 111
Tangible non-current assets....................................................................................................................... 125
Intangible non-current assets ..................................................................................................................... 149
Accruals and prepayments......................................................................................................................... 157
Provisions and contingencies..................................................................................................................... 175
Irrecoverable debts and allowances ........................................................................................................... 185
Sales tax..................................................................................................................................................... 199
Control accounts ........................................................................................................................................ 209
Bank reconciliations.................................................................................................................................... 233
Correction of errors..................................................................................................................................... 243
Incomplete records..................................................................................................................................... 253
Preparation of financial statements for sole traders ................................................................................... 265
Introduction to company accounting........................................................................................................... 273
Preparation of financial statements for companies..................................................................................... 293
Events after the reporting period ................................................................................................................ 315
Statements of cash flows............................................................................................................................ 319
Introduction to consolidated financial statements....................................................................................... 335
The consolidated statement of financial position........................................................................................ 353
The consolidated statement of profit or loss............................................................................................... 377
Interpretation of financial statements ......................................................................................................... 391
Appendix A: Overview summaries.............................................................................................................. 409
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INTRODUCTION
Introduction to FFA/FA Financial Accounting
The ACCA FA Financial Accounting exam and the Foundations in Accountancy FFA Financial Accounting exam
are effectively one and the same. They have an identical syllabus and students sitting either qualification will sit
an identical exam. All references to FFA/FA within these Course Notes relate to the Financial Accounting
syllabus and exam regardless as to whether you are sitting the Foundations in Accountancy FFA Financial
Accounting exam or the ACCA FA Financial Accounting exam.
Overall aim of the syllabus
To develop knowledge and understanding of the underlying principles and concepts relating to financial
accounting and technical proficiency in the use of double-entry accounting techniques including the preparation
of basic financial statements.
The syllabus
The broad syllabus headings are:
A
B
C
D
E
F
G
H
The context and purpose of financial reporting
The qualitative characteristics of financial information
The use of double entry and accounting systems
Recording transactions and events
Preparing a trial balance
Preparing basic financial statements
Preparing simple consolidated financial statements
Interpretation of financial statements
Main capabilities
On successful completion of this exam, candidates should be able to:








Explain the context and purpose of financial reporting
Define the qualitative characteristics of financial information
Demonstrate the use of double entry and accounting systems
Record transactions and events
Prepare a trial balance (including identifying and correcting errors)
Prepare basic financial statements for incorporated and unincorporated entities
Prepare simple consolidated financial statements
Interpret financial statements
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INTRODUCTION
Links with other exams
SBR
ACCA
FR
FIA
FFA
FA
FA2
FA1
This exam is the final exam in the financial accounting pillar of the Foundations in Accountancy qualification and
the first exam in the financial accounting pillar of the ACCA qualification.
The exam
The syllabus is assessed by a two-hour computer-based examination.
Questions will assess all parts of the syllabus and will test knowledge and some comprehension or application of
this knowledge.
The examination will consist of two sections. Section A will contain 35 two-mark objective test questions. Section
B will contain two 15-mark multi-task questions, testing consolidations and accounts preparation. The
consolidation question could include a small amount of interpretation and the accounts preparation question
could be set in the context of a sole trader or a limited company.
Format of the Exam
Marks
Section A: 35 objective test questions (2 marks each)
70
Section B: 2 multi-task questions (15 marks each)
30
100
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INTRODUCTION
Study Programme Aims
Achieving the FFA/FA Study Guide Outcomes
A
The context and purpose of financial reporting
A1 The scope and purpose of financial statements for external reporting
Chapter 1
A2 Users' and stakeholders' needs
Chapter 1
A3 The main elements of financial reports
Chapter 1
A4 The regulatory framework
Chapter 2
A5 Duties and responsibilities of those charged with governance
Chapter 1
B
The qualitative characteristics of financial information
B1 The qualitative characteristics of financial information
C
Chapter 3
The use of double entry and accounting systems
C1 Double entry bookkeeping principles including the maintenance of accounting records
Chapters 4 & 5
C2 Ledger accounts, books of prime entry and journals
Chapters 4 & 5
D
Recording transactions and events
D1 Sales and purchases
Chapters 4, 5, 7 &
14
D2 Cash
Chapters 4 & 5
D3 Inventory
Chapter 8
D4 Tangible non-current assets
Chapter 9
D5 Depreciation
Chapter 9
D6 Intangible non-current assets and amortisation
Chapter 10
D7 Accruals and prepayments
Chapter 11
D8 Receivables and payables
Chapter 12
D9 Provisions and contingencies
Chapter 13
D10 Capital structure and finance costs
Chapters 19 & 20
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INTRODUCTION
E
Preparing a trial balance
E1
Trial balance
Chapter 6
E2
Correction of errors
Chapter 16
E3
Control accounts and reconciliations
Chapter 14
E4
Bank reconciliations
Chapter 15
E5
Suspense accounts
Chapter 16
F
Preparing basic financial statements
F1
Statements of financial position
Chapters 17 & 20
F2
Statements of profit or loss and other comprehensive income
Chapters 17 & 20
F3
Disclosure notes
Chapter 20
F4
Events after the reporting period
Chapter 21
F5
Statements of cash flows (excluding partnerships)
Chapter 22
F6
Incomplete records
Chapter 18
G
Preparing simple consolidated financial statements
G1 Subsidiaries
Chapters 23 - 25
G2 Associates
Chapter 23
H
Interpretation of financial statements
H1 Importance and purpose of analysis of financial statements
Chapter 26
H2 Ratios
Chapter 26
H3 Analysis of financial statements
Chapter 26
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INTRODUCTION
Analysis of the Specimen Exam
Please note that past exams will not be published. The analysis of the Specimen Exam should therefore be used
as a guide to both the areas that will be examined and the mix between narrative and computational questions.
Computational
Narrative
Section A – 35  2 mark questions (70 marks)
The context and purpose of financial reporting
The scope and purpose of financial statements for external reporting
4
Users' and stakeholders' needs
The main elements of financial reports
The regulatory framework
Duties and responsibilities of those charged with governance
The qualitative characteristics of financial information
The qualitative characteristics of financial information
2
The use of double entry and accounting systems
Double entry bookkeeping principles including the maintenance of accounting records
Ledger accounts, books of prime entry and journals
Recording transactions and events
Sales and purchases
2
Cash
2
Inventory
2
Tangible non-current assets and depreciation
2
6
Intangible non-current assets and amortisation
2
Accruals and prepayments
6
Receivables and payables
2
Provisions and contingencies
2
Capital structure and finance costs
2
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Narrative
Computational
INTRODUCTION
4
2
Preparing a trial balance
Trial balance
Correction of errors
Control accounts and reconciliations
6
Bank reconciliations
2
Suspense accounts
2
Preparing basic financial statements
Statements of financial position
4
Statements of profit or loss and other comprehensive income
Disclosure notes
2
Events after the reporting period
2
Statements of cash flows (excluding partnerships)
2
Incomplete records
4
Preparing simple consolidated financial statements
Subsidiaries
Associates
Interpretation of financial statements
Importance and purpose of analysis of financial statements
2
Ratios
2
2
36
34
Analysis of financial statements
Total number of marks
9
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INTRODUCTION
Computational
Narrative
Section A – 2  15 mark questions (30 marks)
The context and purpose of financial reporting
The scope and purpose of financial statements for external reporting
Users' and stakeholders' needs
The main elements of financial reports
The regulatory framework
Duties and responsibilities of those charged with governance
The qualitative characteristics of financial information
The qualitative characteristics of financial information
The use of double entry and accounting systems
Double entry bookkeeping principles including the maintenance of accounting records
Ledger accounts, books of prime entry and journals
Recording transactions and events
Sales and purchases
Cash
Inventory
1.5
3
2
Accruals and prepayments
1
0.5
Receivables and payables
2
1
Tangible non-current assets and depreciation
Intangible non-current assets and amortisation
Provisions and contingencies
Capital structure and finance costs
10
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Computational
Narrative
INTRODUCTION
Preparing a trial balance
Trial balance
Correction of errors
Control accounts and reconciliations
Bank reconciliations
Suspense accounts
Preparing basic financial statements
4
Statements of financial position
Statements of profit or loss and other comprehensive income
Disclosure notes
Events after the reporting period
Statements of cash flows (excluding partnerships)
Incomplete records
Preparing simple consolidated financial statements
Subsidiaries
4
11
14
16
Associates
Interpretation of financial statements
Importance and purpose of analysis of financial statements
Ratios
Analysis of financial statements
Total number of marks
11
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INTRODUCTION
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Skills bank
This section explains and demonstrates the key skills
required to enable you to maximise your chance of
exam success. Knowledge of the syllabus is insufficient
on its own. Through question practice you will develop a
set of skills that will enable you to pass this exam.
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Key skills required to pass
Our analysis of the examining team's comments on past exams, together with our experience of preparing
students for this type of exam, suggests that to pass this exam you will need to develop a number of key skills.
1 Learning and
understanding
the syllabus
content
4 Tackling multi-task
questions
2 Time management
3 Tackling objective
test questions
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Skill 1 – Learning and understanding the syllabus content
1 What do I need to know to attempt the exam?
This exam has a broad syllabus that will be tested in Section A by 35 objective test questions worth 2 marks
each (including multiple choice questions and other means such as data entry type questions) and in Section B
by 2 multi-task questions worth 15 marks each (on consolidations and accounts preparation). As all the questions
are compulsory you need a broad and yet quite detailed knowledge of the syllabus as well as an understanding
of a variety of calculations to apply the theory.
The type of knowledge that you have to acquire includes the following:
Practical application – eg preparing financial statements (for an individual company or a group); calculation of
numbers to be included in the financial statements; identifying errors and correcting them; producing figures to go
into a statement of cash flows; ratio calculation and interpretation.
Theoretical knowledge – eg how accounts fit together and their key components; the purpose and roles of the
regulatory bodies; the underlying concepts and assumptions that govern accounts preparation.
In this section we will look at approaches that you can take to help you learn the key elements of the knowledge
in the syllabus.
2 Practical application
Practical application requires you to do two main things:
1.
2.
Understand the principles behind a topic and be able to explain them; and
Apply your understanding to generate financial statements or figures that may be included in a set of
accounts.
In this way you should be in a good position to answer most questions. They will either ask you to calculate a
number from some information provided, or to use the numerical information provided to demonstrate your
knowledge of the topic in some way. You should ensure that you read the requirement carefully for these
questions; further tips on question approach will be covered under skills 3 and 4.
Principles:
For example, in the Specimen Exam, Q28 asks:
Gareth, a sales tax registered trader, purchased a computer for use
in his business. The invoice for the computer showed the following
costs related to the purchase.
$
Computer
890
Additional memory
95
Delivery
10
Installation
20
Maintenance (one year)
25
1,040
182
Principles
Sales tax (17.5%)
1,222
Total
How much should Gareth capitalise as a non-current asset in
relation to the purchase?
$
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Note that to find the correct figure you need to understand both the principle behind what can be included in the
cost of a non-current asset and what effect the sales tax may have on the cost of the asset to be included in the
accounts.
Application:
Another question type is Q18 from the Specimen Exam:
The total of the list of balances in Valley's payables ledger was
$438,900 at 30 June 20X6. This balance did not agree with Valley's
payables ledger control account balance. The following errors were
discovered:
(1)
A contra entry of $980 was recorded in the payables ledger
control account, but not in the payables ledger
(2)
The total of the purchase returns daybook was undercast by
$1,000
(3)
An invoice for $4,344 was posted to the supplier's account as
$4,434
Application
What amount should Valley report in its statement of financial
position as accounts payable at 30 June 20X6?
A
$436,830
B
$438,010
C
$439,790
D
$437,830
This question requires you to have a good understanding of how to account for credit purchase transactions and
the way control accounts work in order to be able to answer it.
Therefore you need to ensure that you understand the context of the principles of what you are learning and are
able to apply them to numerical examples. To do this you should consider:
Detail – for practical application of the topics covered in the syllabus, you must know the rules for each area and
understand where they have been derived from. By reviewing the overview at the beginning and the summary at
the end of the relevant chapter in your course notes before attempting questions, you should be able to pick up
the key points.
Application – this is where question practice is key. The more practice you have in working through the
questions, the more confident you will become on using and applying the theory.
3 Theory
You will also have to answer narrative questions about theory.
You can expect questions about:
1.
Fact – eg what are the rules and requirements of the accounting standards? What are the similarities
and differences between sole traders, partnerships and companies?
2.
Application – eg how are the accounting concepts applied to different areas of the syllabus?
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Fact:
Q2 from the Specimen Exam illustrates how knowledge of a fact might be tested:
Fact
Which of the following explains the imprest system of operating
petty cash?
A
Regular equal amounts of cash are transferred into petty cash
at intervals
B
The exact amount of expenditure is reimbursed at intervals to
maintain a fixed float
C
Weekly expenditure cannot exceed a set amount
D
All expenditure out of the petty cash must be properly
authorised
This question is testing you on a specific fact – here you need to know what an imprest system is. You need to
make sure you have a good breadth of knowledge of the FA syllabus.
Application:
Q1 from the Specimen Exam is a good example of how you might have to apply your knowledge in a practical
situation:
Application
Which of the following calculates a sole trader's net profit for a
period?
A
Closing net assets + drawings + capital introduced – opening
net assets
B
Closing net assets + drawings – capital introduced – opening
net assets
C
Closing net assets – drawings – capital introduced – opening
net assets
D
Closing net assets – drawings + capital introduced – opening
net assets
This type of question is about applying the theory to a theoretical situation. This can seem tricky if there are no
numbers involved – the key here is to think of some simple numbers for opening net assets, capital introduced,
net profit and drawings and then rearrange the equation to identify the correct answer. For example:
$
2,000
1,500
800
(240)
4,060
Opening net assets
Capital introduced
Net profit
Drawings
Closing net assets
We therefore have:
Closing net assets = opening net assets + capital introduced + net profit – drawings
Rearranging this gives:
Net profit = Closing net assets + drawings – capital introduced – opening net assets
Check this using your numbers:
800 = 4,060 + 240 – 1,500 – 2,000 
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There are various ways to build up this level of knowledge. Here are some suggestions:
Read Passcards
regularly
Get a colleague or
friend to set you
quizzes
Practise as many
questions as possible
Produce a list of your
common mistakes and
review it before doing
question practice!
Use annotated
overviews as
summaries from each
chapter (or annotate
your own)
Skills practice
Learn the content of the syllabus actively by:
1.
Reviewing the annotated overviews for each chapter – these are available in Appendix A of
the Course Notes
2.
Practising as many questions as possible, moving from using your notes to completing them
without any help
3.
Using the study text/pre-recorded lectures in your learning plan to help only on areas you're
struggling with and to fill in gaps in your background knowledge
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Skill 2 – Time management
It is important that you use your time wisely in the exam to gain maximum marks.
Time management

What you SHOULD NOT do
Panic! You have two hours to answer 35 objective test questions (worth 2 marks each) in Section A and 2 multitask questions (worth 15 marks each) in Section B. This equates to 1.2 minutes a mark. This means that you
have approximately 2.4 minutes to answer each objective test question and 18 minutes to answer each multitask question. In total, you should complete Section A in 84 minutes and Section B in 36 minutes. For many
questions you will get the answer straight away and so you are likely to have a bit more time to think about some
of the others. Therefore don't worry about your timing on each individual question, just keep track over a few (eg
5).

What you SHOULD do
It is important to start the exam positively.
Firstly:
Make a note of the finishing time for each of Sections A and B
Section A (35 objective test questions) should take approximately 84 minutes. Make a note of what time you
should finish Section A at.
Section B (2 multi-task questions) should take approximately 36 minutes. Make a note of what time you should
finish Section A at and more specifically the finishing time for each of the 2 multi-task questions.
Secondly:
Work through questions systematically
Start at Question 1 and begin answering from there working through questions in order.
If you find a question that you don't know the answer to and want to come back to it later then put an answer in
for the moment, make a note of it and go onto the next question.
Try not to jump around questions otherwise you may leave some unanswered by the end.
Then:
Check your answers before the end of the exam
Having answered all of the questions you should look through your answers to make sure:
1.
2.
You are happy with the options selected; and
You have answered all questions
If you have taken this logical and systematic approach you should have given yourself the best chance of doing
well in the exam.
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Practical advice for computer based exams
STEP
1
Before the exam
Make sure that you are registered with ACCA and that your exam centre has your exam
booking. This is important because you cannot sit the exam if you are not a registered student
and you need your student card as identification on the day of your exam.
Practise at least one mock exam using the computer so that you are familiar with navigating
through questions and not being able to annotate the question paper.
STEP
2
At the beginning of the exam
You want to make the start of the exam as stress-free as possible so make sure that you have
the following available:



STEP
3
STEP
4
Photo identification and your student number – your ACCA student card is ideal for this
Paper supplied by your exam centre, pens and a calculator
Details of which exam you are planning to sit
Starting the exam
To start the exam you will need to do the following:

Login – enter your ACCA student number and your date of birth – make sure that you
have both to hand.

Select the exam – the system will ask you which exam you want to do and then you
<Confirm> that selection.

Instructions – the next three screens are instructions – read these carefully so that you
know what you have to do to complete the exam.

Launch the exam – please don't click this screen until you have been advised to by your
invigilator and you are ready because this starts the exam and starts the timer.
Answering the questions
The exam will start at question 1. You can progress through the questions by clicking <Next> but
you can also go back by clicking <Previous>. When you answer the questions you must follow
the following procedure:

Enter your answer.

Click on <Submit> – you must do this otherwise as soon as you click <Next> to move to
the next question your entry will be lost and you will have to re-enter.

If you click <Next> and have not submitted your answer to a question then you will get a
reminder – clicking <OK> on the reminder does not submit your answer – you must go
back and re-enter your answer and then <Submit>.

If you are unsure of an answer then just put an answer in for now, make a note of it, and
revisit it later.
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You can see that it is very important to submit your answers as you go and to keep track of what you have done.
It is probably a good idea therefore to use your pad of paper to do two things:
1. Make any notes you want to help you answer the questions; and
2. Keep a record of the status of each question.
For example:
Question
Status
1

2
?
3

4
X
Where

means that the question has been answered and I am reasonably confident of the answer.
?
means that the question has been answered but I want to check the answer.
X
means that the question has not been answered and I need to go back to it.
It would be most efficient to set this up at the beginning of the exam. In this way you will have a tally of which
questions really need to be checked over at the end of the exam and it reduces the chances that you will leave a
question unanswered.
STEP
5
At the end of the exam time
At the end of the exam you should check your answers and ensure that you have submitted an
answer for every question as well as double checking any answers you were not sure of.
You have two ways of navigating the questions:
1.
Clicking <Previous> to work back through the questions one by one; or
2.
Using the drop down menu which shows all the Questions 1-37 (Questions 1 to 35 being
the objective test questions in Section A; Questions 36 and 37 being the two multi-task
questions) indicating whether an answer has been submitted or not; clicking on the
question number will take you directly to that question
Remember that if you choose to change a previously submitted answer you must
<Submit> the new one otherwise your original answer will be retained instead!
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STEP
6
Closing your exam session
Once you are satisfied that you are happy with your answers, if you have time left in the exam
then you have a couple of options to finish your exam session (subject to any advice you get
from the invigilators in your exam centre).
1.
Let the time on the on-screen clock run down to zero and the exam session will end
automatically; or
2.
Click <Exit> – you will be asked to <Confirm> this so you cannot accidentally end your
session early.
In either case, the next thing you will see will be the Results Screen that shows your mark and
whether you have passed or not.
It is important that you don't <Exit> at this stage since you have no proof of your result!
Your invigilator will ask you to <Print> two copies and will instruct you to <Exit> once these
have been printed off.
You have now finished your exam.
Final tips on timing

Make use of the paper to make notes or to work out the answers to questions.

If you find a particularly difficult question or a long calculation, move on and come back to it later in the
remaining time – it is important that you do not run out of time leaving easier questions later in the
exam unanswered.

Keep an eye on the clock so that you can pace yourself – you will be given a 15 minute warning
15 minutes prior to the end of the 2 hour exam session.

Be well prepared for the exam day so that you can concentrate on doing the exam rather than the
administration around it.

Get to your exam venue in plenty of time so that you are relaxed when you get into the exam room.
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Skill 3 – Tackling objective test questions
Technique for multiple choice questions
These are questions where one of the four options is correct.
Narrative questions
1 What to do if you know the answer to the question
If you know the answer to a narrative question you should:
1.
Read the requirement
2.
Locate the correct answer
3.
Check the other answers
4.
Read the requirement again to ensure you're answering the correct question
5.
Confirm that you have the correct answer
This systematic check will ensure that you do not throw away marks when you really do know the answer.
2 What to do if more than one answer appears plausible
Sometimes more than one option can seem to answer the question. In this case you have to firstly ensure you've
read the requirement carefully, as questions may be phrased in ways that are not what you're expecting. If you
still identify more than one likely option, select the 'most correct' answer. The approach adopted above is useful
here too but this time you have to think through the alternatives a bit more.
For example, Q12 on the Specimen Exam asks:
Which of the following statements is TRUE?
A
Ratios based on historical data can predict the future performance of
an entity
B
An entity's management will not assess an entity's performance using
financial ratios
C
The analysis of financial statements using ratios provides useful
information when compared with previous performance or industry
averages
D
The interpretation of an entity's financial statements using ratios
is only useful for potential investors
This is testing your understanding of interpretation of financial statements. At first sight, it may be tricky to identify
the correct answer as each option is quite long and there seems to be more than one plausible answer.
Here are some steps to follow:
STEP
1
Read the requirement carefully
Here we need to select the statement which is 'true' and because of the verb 'is', only one
statement can be true. In another question, we might be asked which statement is 'false' and
the verb 'are' could have been used, implying that we need to select more than one option.
Therefore it is crucial to analyse the requirement carefully before looking at the answer.
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STEP
2
STEP
3
STEP
4
Read each option carefully and eliminate any obviously wrong answers
Firstly, identify any answers that are immediately wrong. In this question, the key thing to think
about is who ratios are prepared for and what their purpose. Statement (2) is clearly incorrect
because one of the key purposes of ratio analysis is to assess an entity's performance. Equally
statement (4) is incorrect because there are many users of financial statements so ratio analysis
is not only useful to investors, it is useful to all users.
Assess the remaining answers
We now need to consider which of statement (1) and statement (3) is correct. If we consider
statement (1) first, ratios based on historical data are used to assess past performance and
are not necessarily indicative of what might happen in the future – future performance would be
better assessed using forecast rather than historical data. Therefore statement (1) is incorrect.
This leaves use with statement (3) - to be useful, ratios must be compared to other ratios (eg
prior years, industry average) which makes this statement correct.
Read the question again…
Finally, we should re-read the requirement before submitting the question to ensure we are
answering the correct question. The question could easily have asked: 'Which of the following
statements is incorrect' which would have led us to a different answer!
This systematic approach helps you to break a question down and work through to find the correct answer
logically.
Numerical questions
In the exam, you will be asked to calculate numbers based on some information provided. If it is a multiple choice
question rather than a data entry question, the temptation may be to look at the options first, and then 'fit' your
calculations to the one you think is most likely. This could lead you to answering the question incorrectly,
especially if you have not read the requirement carefully.
For example, it would be easy to pick up the wrong answer in Q29 of the Specimen Exam:
The following bank reconciliation statement has been prepared by a trainee
accountant.
$
Overdraft per bank statement
Less: Unpresented cheques
3,860
9,160
5,300
Add: Outstanding lodgements
16,690
Cast at bank
21,990
What should be the correct balance per the cash book?
A
$21,990 balance at bank as stated
B
$11,390 balance at bank
C
$3,670 balance at bank
D
$3,670 overdrawn
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Because unpresented cheques are normally deducted and outstanding lodgements are normally added, it would
be easy to conclude that the above bank reconciliation is correct. This would make us pick the first option without
performing our own independent check. However, on more careful reading, we can see it has been prepared by
a trainee accountant and so might well contain errors. We need to look at the wording and the signs very
carefully – because the opening balance per the bank statement is an overdraft, it should be in brackets.
Unpresented cheques should also be in brackets (increasing the overdraft) and outstanding lodgements should
be positive (reducing the overdraft), leaving us with a correct positive balance per the cash book of $3,670
(option (3)).
STEP
1
Read the requirement carefully
With numerical questions it is really important to first understand what the question is asking,
since you can easily either do too much work and waste time working out calculations that aren't
required, or answer the question you want to answer, and not the question that is actually being
asked!
Here it would be easy to miss that the bank reconciliation had been prepared by a trainee
accountant and was therefore likely to contain errors. Students who had missed this would have
picked the first option.
STEP
2
Think about which proforma or formula may be relevant
Think whether a proforma or formula may be necessary to help you calculate your answer.
Here the bank reconciliation proforma is relevant.
STEP
3
Calculate your answer from scratch (writing out your workings)
Once you're certain what the question is asking, you should calculate your answer from scratch
using the relevant proforma or formula where applicable. Write down your workings – you
will be less likely to make a mistake then and also, if you find that your answer does not match
one of the options, you can come back and check your workings for errors.
Ignore the options given, as you may arrive at an answer that matches an option but is not
what is required by the question.
Again, the first option is very enticing as it stands out as an easy choice.
STEP
4
Match your answer
Once you've calculated your answer (using proforma or formula where relevant), match it to the
options. If you've worked carefully and answered the question, the matching option will be
available. If no option matches your calculation, re-read the requirement to ensure you've
understood what you have to do. In this situation it helps if you write down your calculations so
that you can go back and check each individual number for errors. If you still can't find the
answer, you may want to guess the answer, make a note of the question number and return to it
at the end when you can judge how much of the time remaining you can spend on it.
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What to do if you still don't know the answer (numerical and narrative questions)…
If you have been through the above 4 steps and can't identify a preferred answer then you have to guess!

What you SHOULD NOT do
Two main things to avoid:
1.
Waste excessive time – time spent dithering over a single question could leave you with insufficient time
for the rest of the exam.
2.
Not answering – this is a common yet serious error – even if you make a wild guess you start with a 25%
chance of success. Your chance of getting the 2 marks if you don't offer an answer is zero!

What you SHOULD do
Having used the step by step approaches above to narrow down your possible answers, go with the one that
feels right. And move on.
If you have a flash of inspiration later in the exam go back and revisit it – but only if you are sure.
Technique for other types of question in computer based exam
1 Data entry
You may be asked to calculate a numerical figure which you then have to enter into a box in the exam. The only
permitted characters for numerical answers are:

Numbers

One full stop as a decimal point if required

One minus symbol at the front of the figure if the answer is negative.
For example: -10234.35
No other characters, including commas, are accepted.
Be very careful to follow these strict rules otherwise there is a risk that an otherwise correct answer might be
marked incorrect, if for example you insert a comma to denote thousands.
For these questions you can use steps 1 to 3 above in How to Approach Numerical Questions.
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This can be illustrated with the Specimen Exam Q4:
Annie is a sole trader who does not keep full accounting records. The
following details relate to her transactions with credit customers and
suppliers for the year ended 30 June 20X6.
$
Trade receivables, 1 July 20X5
130,000
Trade payables, 1 July 20X5
60,000
Cash received from customers
686,400
Cash paid to suppliers
302,800
Discounts received
2,960
Contra between payables and receivables ledger
2,000
Trade receivables, 30 June 20X6
181,000
Trade payables, 30 June 20X6
84,000
What figure should appear in Annie's statement of profit or loss for the
year ended 30 June 20X6 for purchases?
$
STEP
1
Read the requirement carefully
STEP
2
Think about which proforma or formula may be relevant
STEP
3
Calculate your answer from scratch (writing out your workings)
Here the question asks for the 'purchases' figure to appear in the statement of profit or loss.
This question also gives you the information to find the sales figure but having read the
requirement, you now know that you should only focus on items relevant to purchases.
Here the relevant proforma is the trade payables T account.
Set up a trade payables T account on a piece of paper and work down the question line by line
extracting the balances which are relevant to trade payables being very careful to put them on
the correct side of your T account. Remember that credits increase liabilities and debits
decrease liabilities. For a liability account like this one, the balance brought down should be on
the right and the balance carried down should be on the left.
Once you've posted all the relevant numbers, fill in the total of whichever side adds to the higher
number (should be the debit side) and find the missing figure on the other side (should be on the
credit side as purchases increase payables) which will represent purchases.
STEP
4
Enter your answer
Type your answer into the box, making sure that you do not include $ or commas.
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2 Select more than one option
These questions are very similar to narrative multiple choice questions and the approach required is effectively
the same.
Using Q5 from the Specimen Exam:
Which TWO of the following errors would cause the total of the debit
column and the total of the credit column of a trial balance not to agree?
A
A cheque received from a customer was credited to cash and correctly
recognised in receivables
B
A transposition error was made when entering a sales invoice into the
sales day book
C
A purchase of non-current assets was omitted from the accounting
records
D
Rent received was included in the trial balance as a debit balance
STEP
1
STEP
2
Read the requirement carefully
Here we need to select two errors which would cause the trial balance not to balance. We are
therefore looking for one sided entries or entries of different amounts.
Read each option carefully and eliminate any obviously wrong answers
Here option 2 is incorrect because the double entry is posted from the total of the sales day book
and as an invoice was entered incorrectly, the total would be wrong but the same amount would
be debited to trade receivables and credited to revenue therefore the trial balance would still
balance.
Option 3 is also incorrect because no debit or credit has been entered for the purchase of noncurrent assets. This means that the trial balance would still balance.
STEP
3
Assess the remaining answers
By process of elimination options 1 and 4 must be correct. Option 1 is correct because the
cheque received has been credited to cash and correctly recognised in receivables ie credited to
receivables – this means that two credits have been posted and no debit, causing the trial
balance not to balance.
Option 4 is correct because rent received is income and income is a credit balance but it has
incorrectly been listed as a debit balance in the trial balance. Again this would cause the trial
balance not to balance.
STEP
4
Read the question again…
Finally, we should re-read the requirement before submitting the question to ensure we are
answering the correct question. We need to make sure that we tick on the two options that
would cause the trial balance not to balance (options 1 and 4).
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3 'True or false'/'yes or no'
Some questions required you to enter an answer by each statement – either 'true or false' or 'yes or no'.
The approach is very similar to the above approach but you just need to enter an answer for each of the
statements in the question. Effectively you need to merge steps 2 and 3 as illustrated by Q9 from the Specimen
Exam:
Are the following statements true or false?
True
False
A statement of cash flows prepared using the direct
method produces a different figure to net cash from
operating activities from that produced if the
indirect method is used
Rights issues of shares do not feature in a
statement of cash flows
A surplus on revaluation of a non-current asset
will not appear as an item in a statement of cash
flows
A profit on the sale of a non-current asset will
appear as an item under cash flows from investing
activities in a statement of cash flows
STEP
1
Read the requirement carefully
STEP
2
Read each option carefully and select your answer for each statement
Here for each statement relating to the statement of cash flow, we need to identify whether it is
true or false. To answer this question well, you need to know the proforma for the statement of
cash flow.
Statement 1 is false because both the direct method and indirect method will produce the same
net cash flow from operating activities.
Statement 2 is false because a rights issue is a share issue at below market value but cash will
still be received and recorded in the financing section of the cash flow.
Statement 3 is true because the double entry for a revaluation is to increase the non-current
asset and record the revaluation gain in other comprehensive income so there is no cash effect.
Statement 4 is false because the proceeds not the profit on disposal should be recorded in
investing activities (the profit on disposal is removed as an adjustment in the operating activities
section under the indirect method).
STEP
3
Read the question again…
Finally, we should re-read the requirement before submitting the question to ensure we are
answering the correct question. We need to make sure that we have selected true or false for
each of the four statements.
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Skills practice
1.
Practise keeping track of the questions you have answered when doing questions from the
Practice and Revision Kit.
2.
Always check your answers through (if you would have time in the exam) before looking at
the solutions in the back of the book.
3.
Practise as many objective test questions as possible.
4.
If you don't know the answer to a question – don't just go to the answer at the back or just
guess – use the step by step approach described above.
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Skill 4 – Tackling multi-task questions
In Section B of the exam, there will be two 15 mark multi-task questions on the following two areas:

Consolidation (this could include a small amount on interpretation); and

Accounts preparation (this could be set in the context of a sole trader or a limited company and could
include a statement of cash flow).
The technique required for each of these questions differs slightly.
1 Consolidation
Consolidated statement of profit or loss and other comprehensive income
The technique required here is best illustrated using Q36 from Section B of the Specimen Exam:
Keswick Co acquired 80% of the share capital of Derwent Co on 1 June 20X5.
The summarised draft statements of profit or loss for Kewswick Co and
Derwent Co for the year end of 31 May 20X6 are shown below:
Keswick Co
Derwent Co
$'000
$'000
Revenue
8,400
3,200
Less: Cost of sales
4,600
1,700
Gross profit
3,800
1,500
Less: Distribution costs
1,500
510
700
450
1,600
540
600
140
1,000
400
Administrative costs
Profit before tax
Less: Tax
Profit of the year
During the year Keswick Co sold goods costing $1,000,000 to Derwent Co for
$1,500,000. At 31 May 20X6, 30% of these goods remained in Derwent Co's
inventory.
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Task 1
0 of 11 marks
Use the information above to complete the following financial statement:
$'000
Revenue
Less: Cost of sales
Gross profit
Less: Distribution costs
Administrative costs
Profit before tax
Less: Tax
Profit of the year
Attributable to:
Equity owners of Keswick Co
Non-controlling interest
Task 2
0 of 4 marks
Does each of the following factors illustrate the existence of a parent –
subsidiary relationship?
Yes
No
50% of all shares and debt being held by an investor
100% of the equity shares being held by an investor
Non-controlling interest
Control
Significant influence
Greater than 50% of preference shares and debt being
held by an investor
Greater than 50% of the preference shares being held
by an investor
Greater than 50% of the equity shares being held by
an investor
Here we will focus on the skills required to answer Task 1 because Task 2 is essentially identical to an objective
test question ('true or false'/'yes or no') so to answer Task 2, you need to apply Skill 3 above.
These are the steps required to answer Task 1:
STEP
1
Read the requirement and work out time
Here Task 1 requires us to complete the consolidated statement of profit or loss for the Keswick
Co group. Based on 1.2 minutes a mark, we have 13 minutes to complete it.
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STEP
2
Draw up the group structure
On a piece of paper, draw up the group structure noting:

% owned (here 80%)

Date of acquisition (1 June 20X5)

Pre-acquisition reserves if given (not given here)
Try and identify the year end from the question to ascertain whether there has been a mid-year
acquisition. Here the year end of 31 May 20X6 is given in the opening paragraph so the
subsidiary was acquired at the start of the year (no pro-rating will be required).
STEP
3
Identify any consolidation adjustments required
Here, as a result of the intragroup trading, two adjustments are required:
1.
Cancel intragroup revenue and cost of sales of $1.5m
2.
Cancel unrealised profit on goods left in inventory at the year end by increasing cost of
sales by $150,000 (30% x [$1.5m - $1m]
Make a note of these on a piece of paper.
STEP
4
Complete the consolidation
Make sure you complete any blank box (whether it relates to words or numbers). Where there is
a dropdown option, select the correct answer. Where there is no dropdown option, calculate the
required number then enter your answer (being careful here to show your answer in thousands
and not to use any commas).
The technique when working down your consolidation is to:

Add the parent and 100% of the subsidiary's income and expenses line by line,
remembering to post your consolidation adjustments from Step 3 (if it had been a
consolidated statement of financial position you would do the same for assets and
liabilities)

Complete any workings required (here, non-controlling interest [NCI] is calculated as
the subsidiary's profit for the year multiplied by the NCI percentage of 20%)
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Consolidated statement of financial position
There was no consolidated statement of financial position in the Specimen Exam. However, this is one in the
bank of extra multi-task questions provided by ACCA:
Background
On 1 January 20X3 Gasta Co acquired 75% of the share capital of Erica Co
for $1,380,000. The retained earnings of Erica Co at that date were
$480,000. Erica Co's share capital has remained unchanged since the
acquisition.
The following draft statements of financial position for the two companies
have been prepared at 31 December 20X9.
Gasta Co
Erica Co
$'000
$'000
Investment in Erica Co
1,380
0
Other assets
4,500
2,400
Total assets
5,880
2,400
Equity share capital
2,000
1,000
Retained earnings
2,040
660
4,040
1,660
Liabilities
1,840
740
Total equity and liabilities
5,880
2,400
The non-controlling interest (NCI) was valued at $450,000 as at 1 January
20X3.
Task 1
0 of 4.5 marks
Complete the following to determine the goodwill arising on acquisition.
Caption
$'000
Value of investment at acquisition
Investment in Erica Co held by Gasta Co
Total value of investment at acquisition (A)
Fair value of Erica Co's net assets at acquisition
Equity share capital
Total fair value of Erica Co's net assets at acquisition
(B)
Goodwill at acquisition expressed as a formula
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Task 2
0 of 3 marks
Are each of the following statements relating to consolidation correct?
Yes
No
The process of consolidation results in a
single separate legal entity
Goodwill is recalculated using the most
recent fair values at each reporting
period and
NCI will always feature within the
consolidated financial statements
Task 3
0 of 1.5 marks
Select the formula which correctly calculates NCI as at 31 December 20X9,
in accordance with IFRS 10 Consolidated Financial Statements.
A
Fair value of NCI at acquisition + 25% of post acquisition profits
B
25% of net assets at 31 December 20X9
C
Fair value of NCI at acquisition + 25% of retained earnings as at 31
December 20X9
Task 4
0 of 6 marks
Calculate the following figures which will be reported in Gasta's
consolidated statement of financial position as at 31 December 20X9.
$'000
Investment
Other assets
Share capital
Retained earnings
Liabilities
As this question contains more tasks that the consolidated statement of profit or loss question above, you need
to think of it as a series of numerical objective test questions and follow the approach adopted in Skill 3 for data
entry objective test questions.
You should approach each task one at a time as if each one were a separate question. The same basic
technique can be applied to each task:
STEP
1
Read the requirement carefully
Read the requirement before reading the information in the scenario. The requirement is always
given in bold.
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STEP
2
Think about which proforma or formula may be relevant
First you need to draw up the group structure:
 % owned (here 75%)
 Date of acquisition (1 January 20X3)
 Pre-acquisition reserves if given ($480,000).
In Task 1, you will need the proforma for goodwill:
Fair value of consideration
Fair value of non-controlling interest
Less:
–
–
–
–
–
X
X
Fair value of net assets at acquisition
Share capital
Share premium
Retained earnings at acquisition
Other reserves at acquisition
Fair value adjustments at acquisition
X
X
X
X
X
(X)
X
As Task 2, is written, there is no proforma. You need to read each statement carefully thinking
about whether it is true or not.
In Task 3, you need the proforma for non-controlling interest:
X
X
X
NCI at acquisition (from goodwill working)
NCI share of post acq'n reserves (from reserves working  NCI %)
In Task 4, remember that the investment cancels on consolidation. For the assets and liabilities,
you will need to together the parent and 100% of the subsidiary. For retained earnings, you wll
need the retained earnings working:
Per question
Provision for unrealised profit (seller's column)
Pre-acquisition retained earnings
Group share of post acq'n ret'd earnings:
Subsidiary (A  %)
Parent
X
(X)
Subsidiary
X
(X)
(X)
A
X
X
STEP
3
Calculate your answer from scratch (writing out your workings)
STEP
4
Enter your answer
On a piece of paper, using the proformas above, work out your answers a task at a time.
For each task, having completed the relevant working (if applicable), enter your answer. If there
is a dropdown menu, select the correct option. If it is a 'yes/no' question, click on the correct
answer. If there is no dropdown menu, type in your answer, remembering that it it's a number,
there should be no $ or comma.
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2 Accounts preparation
Statement of financial position (SOFP) and statement of profit or loss and other
comprehensive income (SPLOCI)
Your approach to these questions needs to remain flexible as the tasks, requirements and content will vary from
sitting to sitting.
To succeed in this type of question, you must know:

The proformas for a statement of financial position and statement of profit or loss (and other
comprehensive income)

The calculations and journals required for year end adjustments
The specific technique required is best illustrated with the second question from Section B of the Specimen Exam:
Background
Malright, a limited liability company, has an accounting year end of 31
October. The accountant is preparing the financial statements as at 31
October 20X7. A trial balance has been prepared.
Task 1
0 of 4 marks
Do each of the following items belong on the statement of financial
position (SOFP) as at 31 October 20X7?
Buildings at cost
Dr
CR
$'000
$'000
740
Buildings accumulated
depreciation at 1 November 20X6
Plant at cost
60
220
Plant accumulated depreciation at
1 November 20X6
110
Bank balance
70
Revenue
1,800
Net purchases
1,140
Inventory at 1 November 20X6
160
Cash
20
Trade payables
250
Trade receivables
320
Administrative expenses
325
Allowance for receivables at 1
November 20X6
10
Retained earnings at 1 November
20X6
130
Equity shares, $1
415
Share premium account
80
2,925
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2,925
Belongs on
SOFP as at 31
October 20X7
SKILLS BANK
Task 2
0 of 3 marks
The allowance for receivables is to be increased to 5% of trade
receivables. The allowance for receivables is treated as an administrative
expense.
The year end journal for allowance for receivables is given below. Prepare
the double entry by selecting the correct option for each row.
Trade receivable
Administrative expenses
Allowance for receivables
Revenue
Complete the following:
The amount included in the statement of profit or loss after the allowance
is increased to 5% of trade receivables is $
'000.
Task 3
0 of 5 marks
Plant is depreciated at 20% per annum using the reducing balance method
and buildings are depreciated at 5% per annum on their original cost.
Depreciation is treated as a cost of sales expense.
The year end journal for buildings and plant depreciation is given below.
Using the information above, prepare the double entry by selecting the
correct option for each row.
Administrative expenses
Cost of sales
Buildings cost
Plant cost
Buildings accumulated depreciation
Plant accumulated depreciation
Calculate the depreciation charge for the below for the year ended 31
October 20X7. Use the information above to help you.
Buildings
$
'000
Plant
$
'000
Task 4
0 of 1.5 marks
Closing inventory has been counted and is valued at $75,000.
Ignoring the depreciation charge calculated earlier, what is the cost of
sales for the year?
$
'000
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Task 5
0 of 1.5 marks
An invoice of $15,000 for energy costs relating to the quarter ended 30
November 20X7 was received on 2 December 20X7. Energy costs are included
in administrative expenses.
Complete the following statements:
The double entry to post the year end adjustment for energy costs is:
Dr
Cr
The amount to be posted within the year end adjustment double entry above
is $
'000.
As there are quite a few tasks involved here, the best way to think if this is as 5 objective test questions rather
than 1 long 15 mark question.
You should approach each task one at a time. However, the general approach for each of these tasks is the
same as for data entry objective test questions (Skill 3):
STEP
1
Read the requirement carefully
STEP
2
Think about which proforma or formula may be relevant
Read the requirement before reading the information in the scenario. The requirement is always
given in bold.
In Task 1, you need to be thinking of your statement of financial position proforma (assets,
liabilities, equity). Also watch out for dates – any figures with the start of the year date
(1 November 20X6) will not live in the statement of financial position as it is prepared at the year
end date (31 October 20X7).
In Task 2, you will need the following proforma for the allowance for receivables (the journal being
prepared from the movement):
Allowance b/d (given in Task 1)
Movement (balancing figure)
Allowance c/d (calculate)
X
X
X
In Task 3, you need to think about the formula for depreciation.
 Reducing balance method = Depreciation rate (%) x net book value
 Straight line method = [(Cost – residual value)/useful life] or [(cost – residual value) x %]
In Task 4, you need the formula for cost of sales:
Opening inventory
Purchases
Closing inventory
X
X
(X)
X
In Task 5, there is no formula but you need to note the year end (31 October 20X7), when the bill
was received ie after the year end (2 December 20X7), how many months of the bill relate to the
current year and therefore how much of it should be accrued for.
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For all of the tasks requiring journals, to help you work out which account to debit and which to
credit, think of DEAD CLIC:
Debits
(increase)
Credits
(increase)
Expenses
Liabilities
Assets
Income
Drawings/dividends
Capital
(and credits will decrease these)
(and debits will decrease these)
STEP
3
Calculate your answer from scratch (writing out your workings)
STEP
4
Enter your answer
Fill in your proformas/formulae above and generate any required journal(s).
If there is a dropdown menu, select the correct answer. If there is no dropdown menu, type in
your answer, remembering that if it's a number, there should be no $ or comma.
Statement of cash flow
There was no statement of cash flow question in the Pilot Exam. However, one was included in the extra bank of
multi-task questions provided by ACCA:
The following information relates to Geofrost, a limited liability
company, for the year ended 31 October 20X7.
Extracts from the statement of profit or loss for the year ended
31 October 20X7
$'000
Profit before tax
15,000
Less tax
4,350
Profit for the year
10,650
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Statement of financial position as at 31 October
20X7
20X6
$'000
$'000
44,282
26,574
Inventory
3,560
9,635
Receivables
6,405
4,542
Cash
2,045
1,063
12,010
15,240
56,292
41,814
Ordinary share capital
19,365
17,496
Retained earnings
17,115
6,465
36,480
23,961
8,000
10,300
Bank overdraft
1,230
429
Trade payables
7,562
4,364
Taxation
3,020
2,760
11,812
7,553
56,292
41,814
Assets
Non-current assets
Current assets
Total assets
Equity and liabilities
Capital and reserves
Non-current liabilities
Loan
Current liabilities
Total equity and liabilities
Additional information:
(1)
Depreciation expense for the year was $4,658,000
(2)
Assets with a carrying value of $1,974,000 were disposed of at a
profit of $720,000
Complete the statement of cash flows for the year ended 31 October 20X7
for Geofrost.
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SKILLS BANK
Statement of cash flows for the year ended 31 October 20X7
Cash flows from operating activities
$'000
Adjustments:
Depreciation
Profit on disposal of non-current
assets
Inventory
Receivables
Payables
Tax paid
Net cash from operating activities
Cash flows from investing activities
Payments to acquire non-current assets
Proceeds from sale of non-current assets
Net cash from investing activities
Cash flows from financing activities
Proceeds from issue of share capital
Repayment of loans
Net cash from financing activities
Net movement in cash and cash equivalents
Cash and cash equivalents at beginning of
period
Cash and cash equivalents at end of period
The technique required here is as follows:
STEP
1
Read the requirement carefully
STEP
2
Read through the scenario to identify which workings you think you might
need
Here we are required to complete the statement of cash flows of Geofrost for the year ended
31 October 20X7.
The general rule is that if an item lives in both the statement of financial position (SOFP) and the
statement of profit or loss (SPL), you need a working.
Here, you need a working for property, plant and equipment because it lives in both the SOFP and
the SPL (depreciation). You will also need a working for the profit on disposal of the assets to find
the sales proceeds to post to the statement of cash flows. Finally we can see that tax lives in both
the SOFP and SPL so it needs a working.
Set up your workings on a piece of paper.
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SKILLS BANK
STEP
3
Work down the cash flow proforma, filling it in, completing a working first
where necessary
Work down your proforma line by line, filling in the blank boxes by either:

Selecting an option from the dropdown menu; or

Typing in the relevant number (remember to exclude $ and commas and rounding your
answer in thousands).
Where a working is required (see Step 2 above), you must complete the working on paper,
finding the figure for entry into the cash flow as a balancing figure before selecting/entering the
answer.
Think carefully whether each number represents a cash inflow or outflow.
STEP
4
Enter your answer
If there is a dropdown menu, select the correct answer. If there is no dropdown menu, type in
your answer, remembering that it it's a number, there should be no $ or comma.
Skills practice
1.
Practice all the multi-task questions from the Specimen Exam and the Extra Bank of MTQs
and as many as possible from the Practice and Revision Kit making sure you attempt a good
spread across the syllabus areas (ie groups – consolidated SOFP and SPL; accounts
preparation – SOFP, SPL and cash flow).
2.
Adopt the steps recommended above, remembering where there are many tasks, to treat
them as a group of objective test questions but being careful not to overrun on time.
3.
Rework any questions that you struggle with.
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Introduction
to accounting
Syllabus Guide Detailed Outcomes
Having studied this chapter you will be able to:

Define financial reporting and understand the nature, principles and scope of financial reporting.

Identify and define the different business entities of: sole trader, partnership and limited liability company and
recognise the legal differences between them.

Identify the advantages and disadvantages of operating as each of the three types of business entity.

Identify the users of financial statements and state and differentiate between their information needs.

Understand and identify the purpose of each of the main financial statements.

Define and identify assets, liabilities, equity, revenue and expenses.

Explain what is meant by governance specifically in the context of the preparation of financial statements.

Describe the duties and responsibilities of directors and other parties covering the preparation of financial
statements.
Exam Context
This chapter introduces the subject of accounting. Questions on this area will most likely focus on the different
characteristics of the three types of business entity: sole trader, partnership and limited liability company.
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1: INTRODUCTION TO ACCOUNTING
Overview
Statement of profit or
loss
Statement of financial
position
Financial statements
Governance
Users of financial
information
Introduction
to accounting
Types of business entities
Sole trader
Partnership
Concept of separate entity
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Limited liability
company
1: INTRODUCTION TO ACCOUNTING
1
Accounting
Definition
1.1
Accounting is a way of recording, analysing and summarising transactions of a business.
2
Proforma financial statements
Statement of profit or loss – sole trader
2.1
STATEMENT OF PROFIT OR LOSS FOR THE YEAR ENDED 31 DECEMBER 20X7:
$
Sales
Less:
Cost of sales
Opening inventories
Purchases
Carriage inwards
40,000
110,000
20,000
170,000
(50,000)
Closing inventories
(120,000)
80,000
5,000
3,000
88,000
Gross profit
Sundry income
Discounts receivable
Less:
$
200,000
Expenses
Rent
Carriage outwards
Telephone
Electricity
Wages and salaries
Depreciation
Bad and doubtful debts
Motor expenses
Insurance
11,000
4,000
1,000
2,000
9,000
7,000
3,000
5,000
1,000
(43,000)
45,000
Profit for the year
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1: INTRODUCTION TO ACCOUNTING
Statement of financial position – sole trader
2.2
STATEMENT OF FINANCIAL POSITION AS AT 31 DECEMBER 20X7:
$
Assets
Non-current assets
Land and buildings
Office equipment
Motor vehicles
Furniture and fixtures
$
100,000
50,000
30,000
20,000
200,000
Current assets
Inventories
Trade receivables
Less: allowance for receivables
50,000
30,000
(2,000)
28,000
5,000
7,000
90,000
290,000
Prepayments
Cash in hand and at bank
Total assets
Capital and liabilities
Capital
Capital
Profit
Less: drawings
170,000
45,000
(25,000)
190,000
Non-current liabilities
Bank loans
40,000
Current liabilities
Bank overdraft
Trade payables
Accruals
16,000
40,000
4,000
60,000
290,000
Total capital and liabilities
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1: INTRODUCTION TO ACCOUNTING
3
Users of financial information
Lecture example 1
Idea generation
Required
What information would these users of financial information be interested in?
Solution
(a)
Investors
(b)
Employees
(c)
Lenders
(d)
Suppliers
(e)
Customers
(f)
Governments and their agencies
(g)
Public
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1: INTRODUCTION TO ACCOUNTING
4
Accounting records
4.1
In order to be able to produce a statement of profit or loss and a statement of financial
position a business needs to keep a record of all its transactions.
4.2
This process is called bookkeeping.
4.3
Accounting records should be complete, accurate and valid if the information produced is
to be useful for the users of financial information.
4.4
The mechanics of bookkeeping and the accounting records a business should keep will be
covered in Chapters 4, 5 and 6.
5
Types of business entities
5.1
Businesses fall into three main types:
(a)
(b)
(c)
Sole trader
Partnership
Limited liability company
The sole trader is the simplest of these forms.
6
The concept of business entity (separate entity)
6.1
A business is considered to be a separate entity from its owner and so the personal
transactions of the owner should never be mixed with the business transactions.
6.2
When considering a limited liability company this distinction is laid down in law – the
company has a separate legal identity.
6.3
In preparing accounts, any type of business is treated as being a separate entity from its
owner(s).
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Additional Notes
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1: INTRODUCTION TO ACCOUNTING
7
Governance
Definition
7.1
Governance, or corporate governance, is the process by which businesses are directed
and controlled.
7.2
Governance is relevant to all businesses but is a bigger issue for businesses which are
structured as a limited liability company.
7.3
This is due to the fact that in a sole trader's business, the owner is also the manager and
therefore knows all the day-to-day goings on of the business.
7.4
In a limited liability company, however, the business is owned by the shareholders, but run
on a day-to-day basis by the board of directors.
Owners =
Managers =
Shareholders
Board of Directors
7.5
The separation of ownership and control means that there is a risk that the directors may
choose to act in their own personal interests, rather than in the best interests of the
shareholders.
7.6
This has been illustrated many times in recent years as the world has suffered from several
high profile corporate scandals, for example Robert Maxwell.
7.7
Directors are appointed by the shareholders and are collectively referred to as the Board of
Directors.
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1: INTRODUCTION TO ACCOUNTING
Duties and responsibilities of directors for the financial statements
7.8
7.9
The directors' responsibilities in relation to the financial statements include:
(a)
Keeping proper accounting records
(b)
Preparing financial statements for each financial year, in accordance with the
applicable financial reporting framework, which present fairly the activities of the
business
(c)
Establishing a system of internal controls which will ensure the financial statements
are free from material misstatement, whether due to fraud or error
(d)
The prevention and detection of fraud and error
(e)
Filing the business' financial statements and other returns with the relevant authority
on a timely basis
In order to give the shareholders assurance that the directors have carried out their
responsibilities, companies are often required to have their financial statements audited.
7.10 The auditor will carry out testing on the financial statements and offer an opinion as to
whether the financial statements comply with the applicable financial reporting framework
and present fairly the activities of the business.
Appoint
independent
Auditor
Adds credibility
Measure
performance
Financial
Statements
Appoint
Shareholders
Own
Company
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Prepare
Management
Manage
1: INTRODUCTION TO ACCOUNTING
8
Chapter summary
Section Topic
Summary
1
Accounting
Accounting is a way of recording, analysing and
summarising a business' transactions.
2
Proforma financial
statements
Companies must follow a prescribed format when
producing their financial statements, there is
however no set format for a sole trader's statement
of profit or loss and statement of financial position.
3
Users of financial
information
Financial statements are used by a wide variety of
users, each with different information needs.
Satisfying the investors' needs will mean that the
majority of other users' needs are also met.
4
Accounting records
All businesses must keep sufficient accounting
records in order to be able to produce accurate
information about the entity's activities.
5
Types of business
entities
There are three main types of businesses. For sole
traders and partnerships the owners have
unlimited liability and bear all the risks and reap all
the rewards of being in business. For a limited
liability company the shareholders' liability is
limited to the extent of their investment.
6
The concept of
business entity
The business entity concept states that a business
is a separate entity from its owners.
7
Governance
Corporate governance is the process by which
businesses are directed and controlled by those
responsible for running the business.
END OF CHAPTER
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The regulatory framework
Syllabus Guide Detailed Outcomes
Having studied this chapter you will be able to:

Understand the role of the regulatory system including the roles of the
–
–
–
–

International Financial Reporting Standards Foundation (IFRSF)
International Accounting Standards Board (IASB)
International Financial Reporting Standards Advisory Council (IFRS AC)
International Financial Reporting Standards Interpretations Committee (IFRS IC)
Understand the role of International Financial Reporting Standards (IFRS)
Exam Context
Questions on this chapter are likely to be knowledge based and focus on the role of each of the bodies within the
regulatory framework.
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2: THE REGULATORY FRAMEWORK
Overview
Regulatory
framework
IFRSF
IFRS AC
IASB
Issue IFRS
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IFRS IC
2: THE REGULATORY FRAMEWORK
1
Introduction
1.1
Financial statements are produced by an entity's managers in order to show its owners how
the entity has performed over a period of time.
1.2
Company financial statements particularly need to show a true and fair view.
This means a system of regulation is necessary to ensure that financial statements are
produced to a high standard and are comparable across different companies.
2
Regulatory system
2.1
IFRS
Foundation
(IFRSF)
(22 Trustees)
IFRS Advisory Council
(IFRS AC)
Key:
International Accounting
Standards Board
(IASB)
IFRS
Interpretations Committee
(IFRS IC)
Appoints
Reports to
Advises
International Financial Reporting Standards Foundation (IFRSF)
2.2
The IFRSF is a not-for-profit private organisation working in the public interest.
Its Trustees appoint members to the IASB, IFRS IC and IFRS AC. They also oversee the
regulatory system and raise the finance necessary to support it.
It has no involvement in the standard setting process.
International Accounting Standards Board (IASB)
2.3
The IASB's principal aim is to develop a single set of high quality accounting standards:
International Financial Reporting Standards (IFRS).
It also liaises with national accounting standard setters (for example the UK's ASB) to
achieve convergence in accounting standards around the world.
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2: THE REGULATORY FRAMEWORK
International Financial Reporting Standards Interpretations Committee
(IFRS IC)
2.4
The IFRS IC issues guidance on both how to apply existing IFRSs in company financial
statements and how to account for new financial reporting issues where no IFRS exists. It
reports to the IASB.
International Financial Reporting Standards Advisory Council (IFRS AC)
2.5
The IFRS AC's principal role is to advise the IASB on a range of issues which include:


The IASB's agenda and timetable for developing IFRSs
Advising the IASB of areas that may need to be considered by IFRS IC
3
The role of International Financial Reporting
Standards (IFRSs)
3.1
IFRSs provide guidance as to how transactions and events should be:




Recognised – when and where recorded?
Measured – what amount?
Presented – what heading?
Disclosed – what information should be shown in the notes to the accounts?
in a set of financial statements.
For example: IAS 2: Inventory states at what amount a company should value its inventory
and also requires that the financial statements breakdown the inventory figure between its
components such as raw materials, work in progress and finished goods.
3.2
If a company follows the relevant accounting standards its financial statements should show
a true and fair view.
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2: THE REGULATORY FRAMEWORK
Lecture example 1
Exam standard question for 2 marks
What is the role of the International Financial Reporting Standards Foundation?
A
To appoint members of the IASB
B
To advise the IASB on new accounting standards they should consider issuing
C
To give guidance to businesses regarding to how to apply accounting standards in their
financial statements
D
To issue International Financial Reporting Standards
Solution
Lecture example 2
Exam standard question for 2 marks
Which of the following bodies is involved is trying to achieve convergence of global
accounting standards?
A
B
C
D
The IASB
The IFRS IC
The IFRSF
The IFRS AC
Solution
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2: THE REGULATORY FRAMEWORK
Lecture example 3
Exam standard question for 2 marks
Accounting standards are prepared by:
A
The IASB
B
The IFRS Foundation
C
The IAASB
D
The accounting bodies of each country
Solution
Lecture example 4
Exam standard question for 2 marks
Which of the following best describes the role of the International Financial Reporting
Standards Interpretations Committee?
A
Issues International Financial Reporting Standards
B
Provides advice on the development of standards
C
Interprets International Financial Reporting Standards
D
Investigates listed companies to ensure they comply with International Financial Reporting
Standards
Solution
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Lecture example 5
Exam standard question for 2 marks
Are the following statements in relation to IFRSs true or false (tick the correct answer)?
True
To achieve fair presentation in financial statements, IFRSs must be
applied
IFRSs are primarily designed for non-for-profit entities
IFRSs are designed to apply to general purpose financial statements
IFRSs set out recognition, measurement, presentation and disclosure
requirements for transactions and events
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False
2: THE REGULATORY FRAMEWORK
4
Chapter summary
Section Topic
Summary
1
Introduction
Financial statements are relied on by many different
user groups to make economic decisions. A system
of regulation is therefore necessary to ensure that
the information produced is of a high standard.
2
Regulatory system
The IFRSF appoints members to the IASB, IFRS IC
and IFRS AC.
The IASB issues International Financial Reporting
Standards.
The IFRS IC issues guidance on how to apply
accounting standards.
The IFRS AC advises the IASB on its agenda.
3
International financial reporting standards give
guidance as to how transactions should be
recognised, measured, presented and disclosed in
the financial statements.
The role of
international financial
reporting standards
END OF CHAPTER
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The qualitative
characteristics of
financial information
Syllabus Guide Detailed Outcomes
Having studied this chapter you will be able to:


Define, understand and apply qualitative characteristics.
Define, understand and apply accounting concepts.
Exam Context
Questions on this chapter are likely to test your understanding of the qualitative characteristics of information. For
example, you may be required to identify the factors that make information relevant.
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3: THE QUALITATIVE CHARACTERISTICS OF FINANCIAL INFORMATION
Overview
The qualitative characteristics of
financial information
The IASB's conceptual framework
The objective of
general purpose
financial reporting
Other accounting concepts
Financial statements
and the reporting entity
Qualitative
characteristics of
useful information
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Elements of financial
statements
3: THE QUALITATIVE CHARACTERISTICS OF FINANCIAL INFORMATION
1
Introduction
1.1
As noted in Chapter 2 financial statements should show a true and fair view of, or present
fairly, the entity's activities. They are produced to provide information to the entity's owners.
1.2
In order for this information to be useful it must possess certain characteristics.
2
The IASB's conceptual framework
Conceptual framework
2.1
The IASB's Conceptual Framework for Financial Reporting is not an accounting standard.
2.2
It is a set of principles which underpin the foundations of financial accounting.
2.3
Whenever a new accounting standard is issued it will be based on the principles of the
Conceptual Framework. Furthermore, its principles should be applied to account for any
item where no accounting standard exists.
2.4
The Conceptual Framework is divided into eight chapters:
Chapter 1
The objective of general purpose financial reporting *
Chapter 2
Qualitative characteristics of useful financial information*
Chapter 3
Financial statements and the reporting entity *
Chapter 4
The elements of the financial statements *
Chapter 5
Recognition and derecognition
Chapter 6
Measurement
Chapter 7
Presentation and disclosure
Chapter 8
Concepts of capital and capital maintenance
* only these chapters are examinable at this level
The objective of general purpose financial reporting
2.5
To provide information about the reporting entity that is useful to existing and potential
investors, lenders and other creditors in making decisions about providing resources to
the entity. Those decisions involve buying, selling or holding equity and debt instruments,
providing or settling loans and other forms of credit or exercising rights to vote on or
otherwise influence management's actions that affect the use of the entity's economic
resources.
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3: THE QUALITATIVE CHARACTERISTICS OF FINANCIAL INFORMATION
2.6
Information should be provided about:
Economic resources
and claims
2.7
Changes in resources
and claims
To help assess entity's:
Resulting from:

Liquidity and solvency


Need for additional
financing
Financial performance
(reflected by accrual
accounting – see below)

Likelihood of success in
obtaining additional
financing

Other events or
transactions (eg issuing
debt or equity)
Accrual accounting depicts the effects of transactions and other events and circumstances
on a reporting entity's economic resources and claims in the periods in which those
effects occur, even if the resulting cash receipts and payments occur in a different period.
Lecture example 1
Exam standard question for 2 marks
Which of the following statements best describes the primary purpose of the statement of
profit or loss?
A
B
C
D
To report on the financial position of an entity at the year end
To record the cash inflows and outflows in the year
To list the entity's assets, liabilities and equity at the year end
To record the entity's financial performance for the year
Solution
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3: THE QUALITATIVE CHARACTERISTICS OF FINANCIAL INFORMATION
Fundamental qualitative characteristics of financial information
2.8
Relevance
Faithful
representation

Capable of making a
difference to decisions
made by users

Predictive value,
confirmatory value or both
Three characteristics:

Complete

Neutral

Free from error
Materiality
Materiality is an important part of considering relevance
2.9
Information is material if omitting it or misstating it could influence the decisions that the
primary users' of the general purpose financial reports make on the basis of those reports. It
is an entity-specific aspect of relevance based on the nature or magnitude, or both, of the
items to which information relates in the context of the entity's financial report.
Prudence
Prudence is a component of neutrality
2.10 Prudence was introduced in the revised Conceptual Framework. It is described as 'the
exercise of caution when making judgements under conditions of uncertainty. The exercise
of prudence means that assets and income are not overstated and liabilities and expenses
are not understated'
Enhancing qualitative characteristics of financial information
2.11
Comparability
Verifiability

For same entity over different
periods

Different observers could
reach consensus

Between different entities

Can be direct (eg counting
cash) or indirect (eg checking
inputs and recalculating
outputs)
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Timeliness

Understandability
Available to decision
makers in time to
influence their decisions

Classify, characterise and
present information clearly
and concisely

Assume users have
reasonable knowledge
Lecture example 2
Exam standard question for 2 marks
The IASB's Conceptual Framework for Financial Reporting identifies characteristics which make
financial information faithfully represent what it purports to represent.
Which of the following are examples of those characteristics?
(1)
(2)
(3)
(4)
Neutrality
Accruals
Freedom from error
Going concern
A
B
C
D
1 and 2
1 and 3
2 and 3
2 and 4
Solution
Financial statements and the reporting entity
2.12 Going concern
The financial statements are normally prepared on the assumption that an entity is a going
concern and will continue in operation for the foreseeable future.
If this is not appropriate, then additional disclosure about the basis of preparation must be
made in the financial statements.
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The elements of the financial statements
2.13 The elements of financial statements
The five elements of financial statements and their definitions are listed below.
Asset
An asset is a present economic resource controlled by the entity as a result of past
events. An economic resource is a right that has the potential to produce economic
benefits.
Liability
A liability is a present obligation of the entity to transfer an economic resource as a
result of past events.
Equity
The residual interest in the assets of an entity after deducting all its liabilities, so
EQUITY = NET ASSETS = ASSETS – LIABILITIES = SHARE CAPITAL + RESERVES
Income
Income is increases in assets, or decreases in liabilities, that result in increases in
equity, other than those relating to contributions from holders of equity claims.
The definition of income encompasses both revenue (which arises in the course of ordinary
activities of the entity) and gains (other items meeting the definition of income).
Expenses
Expenses are decreases in assets, or increases in liabilities, that result in decreases in
equity, other than those relating to distributions to holders of equity claims.
3
Other accounting concepts
Substance over form
Substance over form is not included in the Conceptual Framework but is an important accounting
concept.
3.1
Transactions and events should be accounted for and presented in accordance with their
economic reality (substance) and not merely their legal form.
For example, if an entity sells an asset and the documentation transfers legal title but an
agreement allows the selling entity to continue to use the asset, in substance, a sale has not
taken place.
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Business entity concept
3.2
This is the concept that was covered in Chapter 1 where a business is considered to be a
separate entity from its owner and so the personal transactions of the owner should never
be mixed with the business transactions.
Accrual accounting
3.3
This is the concept of recording transactions and events in the period in which they occur
which is covered in more detail in Section 2.7 above.
Fair presentation
3.4
According to IAS 1 Presentation of Financial Statements fair presentation required the
faithful representation of the effects of transactions, other events and conditions in
accordance with the definitions and recognition criteria for assets, liabilities, income and
expenses set out in the Conceptual Framework.
3.5
The application of IFRS Standards, with additional disclosure where necessary, is
presume to result in financial statements that achieve a fair presentation.
Consistency
3.6
Consistency refers to the use of the same methods for the same items, either from
period to period within a reporting entity or in a single period across entities.
Consistency helps to achieve the goal of comparability but is not the same as comparability.
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4
Chapter summary
Section Topic
Summary
1
Introduction
Financial statements should present fairly the activities
of an entity for a particular period.
2
The IASB's Conceptual
Framework for
Financial Reporting
The Conceptual Framework provides a set of
principles on which financial accounting is based.
The objective of financial statements to provide
information about the reporting entity that is useful to
existing and potential investors, lenders and other
creditors in making economic decisions.
Accrual accounting depicts the effects of transactions
and other events and circumstances on a reporting
entity's economic resources and claims in the periods
in which those effects occur, even if the resulting
cash receipts and payments occur in a different period.
The going concern basis assumes that the entity will
continue in operation for the foreseeable future.
In order for the information in the financial statements to
be useful it should posses the qualitative
characteristics of relevance, faithful representation,
comparability, verifiability, timeliness and
understandability.
The five elements of financial statements (assets,
liabilities, equity, income and expenses) are defined by
the Conceptual Framework.
3
Other accounting
concepts
Substance over form requires accounting for an item
in accordance with its economic reality rather than its
legal form.
The business entity concept requires personal and
business transactions to be kept separate.
Application of IFRS Standards results in fair
presentation.
Consistency refers to use of the same methods for
the same items.
Going concern and accruals are covered by the
Conceptual Framework above.
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3: THE QUALITATIVE CHARACTERISTICS OF FINANCIAL INFORMATION
END OF CHAPTER
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Sources, records and
books of prime entry
Syllabus Guide Detailed Outcomes
Having studied Chapters 4 and 5 you will be able to:

Identify and explain the function of the main data sources in an accounting system.

Understand how the accounting system contributes to providing useful accounting information and complies
with organisational policies and deadlines.

Outline the contents and purpose of different types of business documentation, including: quotation, sales order,
purchase order, goods received note, goods despatched note, invoice, statement, credit note, debit note,
remittance advice, receipt.

Identify the main types of business transactions, for example, sales, purchases, payments and receipts.

Understand and apply the concept of double entry accounting and the duality concept.

Identify the main types of ledger account and books of prime entry, and understand their nature and function.

Understand and illustrate the uses of journals and the posting of journal entries into ledger accounts.

Identify correct journals from given narrative.

Illustrate how to balance and close a ledger account.

Record sale, purchase and cash transactions in ledger accounts.

Understand the need for a record of petty cash transactions.
Exam Context
Questions are unlikely to feature solely on this chapter; however, you should have a good understanding of what
constitutes an asset, liability, capital, income and expense. You should also be aware of the principal contents of each
book of prime entry and the purpose of the memorandum ledgers.
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4: SOURCES, RECORDS AND BOOKS OF PRIME ENTRY
Overview
Statement of profit or loss
Statement of financial
position
Types of business
documentation
Sources, records and
books of prime entry
Books of prime entry
Cash book
Sales day
book
Memorandum ledgers
Purchase day
book
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Petty cash
book
Journal book
4: SOURCES, RECORDS AND BOOKS OF PRIME ENTRY
1
Statement of financial position
1.1
An individual could prepare a list of everything they own and everything they owe.
Lecture example 1
Idea generation
Required
List out everything you own and owe.
Solution
(a)
Own
(b)
Owe
1.2
For a business, this list is formalised as a statement of financial position and show the
entity's assets and liabilities.
(a)
Asset: is a present economic resource controlled by the entity as a result of past
events. An economic resource is a right that has the potential to produce
economic benefits.
(b)
Liability: is a present obligation of the entity to transfer an economic resource as
a result of past events.
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Proforma statement of financial position – sole trader
1.3
STATEMENT OF FINANCIAL POSITION AS AT 31 DECEMBER 20X7:
$
Assets
Non-current assets
Land and buildings
Office equipment
Motor vehicles
Furniture and fixtures
Current assets
Inventories
Trade receivables
Less: allowance for receivables
$
100,000
50,000
30,000
20,000
200,000
50,000
30,000
(2,000)
28,000
5,000
7,000
90,000
290,000
Prepayments
Cash in hand and at bank
Total assets
Capital and liabilities
Capital
Capital
Profit
Less: drawings
170,000
45,000
(25,000)
190,000
Non-current liabilities
Bank loans
40,000
Current liabilities
Bank overdraft
Trade payables
Accruals
16,000
40,000
4,000
60,000
290,000
Total capital and liabilities
Key features
1.4
(a)
Always headed as at, for the date of the statement of financial position.
(b)
Non-current assets – assets held and used in the business over the long-term (ie
more than one year).
(c)
Current assets – not non-current assets! Conventionally listed in increasing order of
liquidity (ie closeness of assets to cash).
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4: SOURCES, RECORDS AND BOOKS OF PRIME ENTRY
(d)
Capital – what the business owes the proprietor/owner. In this case the sole trader
owns all of the business, ie its total net worth.

(e)
CAPITAL =
=
ASSETS – LIABILITIES
NET ASSETS
Don't include a caption (item heading) if there isn't a value for it.
The statement of financial position is a snapshot of the business at one point in
time.
2
Statement of profit or loss
Profit – example
2.1
Suppose a business buys three books for $10 each. Then it sells them for $15 each:
$
Sales
45 Income
Cost of sales
(30) Expenditure
Gross profit
15
Profit is the excess of total income over total expenditure.
Note: The business may have other expenses such as rent, telephone bills, etc. to take off
before the 'true' profit is shown.
Proforma statement of profit or loss – sole trader
2.2
STATEMENT OF PROFIT OR LOSS FOR THE YEAR ENDED 31 DECEMBER 20X7:
$
$
Sales
200,000
Less:
Cost of sales
Opening inventories
40,000
Purchases
110,000
Carriage inwards
20,000
170,000
Closing inventories
(50,000)
(120,000)
Gross profit
80,000
Sundry income
5,000
Discounts receivable
3,000
88,000
Less:
Expenses
Rent
11,000
Carriage outwards
4,000
Telephone
1,000
Electricity
2,000
Wages and salaries
9,000
Depreciation
7,000
Bad and doubtful debts
3,000
Motor expenses
5,000
Insurance
1,000
(43,000)
Profit for the year
45,000
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Key features
2.3
(a)
Headed up with the period for which the income and expenses are being included.
(b)
The top part
Sales
Cost of sales
Gross profit
X
(X)
X
is called the trading account as it records just the trading activities (buying and
selling) of the business.
(c)
Sundry income includes items like bank account interest.
(d)
Do not include nil value captions.
The statement of profit or loss is a summary of the business' performance over a
period of time – think of it as a DVD!
3
Relationship between the statement of financial
position and the statement of profit or loss
3.1
Statement of financial position – shows the worth of business at a point in time.
Statement of profit or loss – shows the trading activities over a period of time (financial
performance).
3.2
The accounting period is the period for which the statement of profit or loss was prepared.
This is usually a year.
3.3
Therefore, there will be a statement of financial position at the beginning of the year (prior
year end) and at the end of the accounting period.
The statement of profit or loss is for the intervening period.
Statement of profit or loss for the year ended 31.12.X7
Statement
of financial
position
as at
31.12.X7
Statement
of financial
position
as at
31.12.X6
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4
From business transactions to financial statements
4.1
A business will enter into a number and variety of transactions during an accounting period:
CASH TRANSACTIONS
Sales
Purchases
Wages
Stationery
Acquisition
of non-current
assets
CREDIT TRANSACTIONS
Sales
Purchases
Ultimately all of these transactions must be summarised in the business' financial
statements (ie the statement of financial position and statement of profit or loss).
4.2
This is achieved by having accounting records to record each stage of the process:
Assorted transactions
(eg invoices)
Categorised
(in Books of Prime Entry)
Summarised
(eg nominal ledger, trial balance)
FINANCIAL STATEMENTS
(eg Statement of Financial Position and Statement of Profit or Loss)
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5
Types of business documentation
5.1
Each transaction is recorded on the relevant business document. Typically there are six
stages to a sale or purchase and at each stage a document is generated:
Stage Process
1
Sale:
Purchase:
Name of document
Name of document
Quotation is requested for Quotation
goods/services
Quotation
(goods or service, price,
terms and conditions)
5.2
2
Order is placed
Sales order
Purchase order
3
Goods are despatched
and signed for on receipt
Goods despatched note
(confirmation that goods
sent out to customer)
Goods received note
(confirmation that
goods received from
supplier)
4
Payment requested
Sales invoice
Purchase invoice
5
Goods may be returned
to vendor
Credit note (negative
invoice)
Debit note (request to
supplier for credit
note)
6
Payment
Receipt (confirmation
that receipt received)
Remittance advice
note (detailing which
invoices are being
paid and which credit
notes offset)
Statements are also usually sent out monthly by a supplier to a customer listing the
transactions on the customer's account, including all invoices and credit notes issues and all
payments received from the customer. The statement is useful as it allows the customer to
reconcile the amount that they believe they owe the supplier to the amount the supplier
believes they are owed.
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4: SOURCES, RECORDS AND BOOKS OF PRIME ENTRY
6
Books of prime entry
6.1
The business' transactions are categorised with other similar transactions in the books of
prime entry.
6.2
Books of prime entry
Cash book
Receipts
Sales day
book
Purchase day
book
Petty cash
book
Journal book
Payments
Cash transactions
Small cash
Credit purchases transactions
Credit sales
Adjustments
and errors
Note: Some businesses have two extra books of prime entry:

Sales returns day book – for returns of goods from credit customers

Purchase returns day book – for returns of goods to credit suppliers.
Cash book
6.3
(a)
Records receipts and payments into and out of the bank.
(b)
For exam purposes often assumed to be two books, one for receipts, one for
payments.
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4: SOURCES, RECORDS AND BOOKS OF PRIME ENTRY
Cash book (receipts)
6.4
Example:
Date
Narrative
Total
$
Capital
$
2.1.X7
F. Bloggs
4,000
4,000
5.1.X7
J. Spalding
200
6.1.X7
J. Smith
500
Sales
$
Receivables
$
200
500
4,700
4,000
total cash
received
500
200
reason why cash was
received
Cash book (payments)
6.5
Example:
Date
Narrative
6.1.X7
Manley &
Co.
6.1.X7
Petty Cash
8.1.X7
Digby Co
Total
$
Purchases
$
Van
$
350
Rent
$
Payables
$
Petty cash
$
350
50
1,000
50
1,000
1,400
1,000
350
50
reason why payment
was made
total cash
payment
Sales day book
6.6
Lists all sales made on credit, ie each individual invoice raised.
6.7
Example:
Date
Customer
$
3.1.X7
J. Spalding
200
5.1.X7
G. McGregor
400
8.1.X7
J. Spalding
14.1.X7
G. McGregor
400
300
TOTAL
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1,300
Drawings
$
4: SOURCES, RECORDS AND BOOKS OF PRIME ENTRY
Purchase day book
6.8
Lists all purchases made on credit, ie each individual invoice received.
6.9
Example:
Date
Supplier
$
1.1.X7
Tewson Co.
400
4.1.X7
Manley & Co.
350
16.1.X7
Manley & Co.
200
TOTAL
950
Petty cash book
6.10 (a)
(b)
Records the movement of physical cash (kept on the premises) in and out of the
petty cash tin.
Used for small incidental expenses.
6.11 Example:
Receipts
Payments
Date
Narrative
Total
$
6.1.X7
Cheque
cashed
50
Date
Narrative
Total
$
7.1.X7
City
Stationers
10
8.1.X7
F. Bloggs
2
Stationery
$
Travel
$
10
2
Metro fare
12
10
2
Controlling petty cash – the imprest system
An imprest system acts as an accounting control by having a set amount of petty cash.
6.12 (a)
(b)
(c)
(d)
(e)
Pre-set limit, say $50.
Voucher filled in when money is taken out to pay expenses.
At any time, vouchers + cash = pre-set limit.
At the end of the week/month, the petty cash book is filled in from the vouchers.
The amount needed to bring the balance back up to the pre-set limit = money spent.
Journal book
6.13 Certain transactions do not 'fit' in the main books, for example:
(a)
(b)
period end adjustments
correction of errors
The journal book lists these sundry transactions.
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4: SOURCES, RECORDS AND BOOKS OF PRIME ENTRY
7
Memorandum ledgers
Purpose
7.1
To know how much is owed by a particular customer or to a certain supplier at a point in
time.
For example, the sales day book shows the sales made on credit to all customers and the
cash book receipts shows the cash received from all sources.
J. Spalding owes the business $400 but this cannot be seen from the books of prime entry
without trawling back through the detailed information.
A separate memorandum ledger is kept to show this information.
7.2
There are two types of memorandum ledgers kept by the business:
(a)
(b)
7.3
Receivables ledger – showing how much is owed by each individual customer.
Payables ledger – showing how much is owed to each individual supplier.
The entries in these ledgers are made by rearranging the information in the day books into
individual customer and supplier accounts.
Receivables ledger
7.4
Example:
J. Spalding (Customer)
Sales
$
Date
Narrative
3.1.X7
Invoice 1032
5.1.X7
Cash received
8.1.X7
Invoice 1101
Cash
$
200
Total
$
200
200
400
–
400
G. McGregor (Customer)
Sales
$
Cash
$
Date
Narrative
5.1.X7
Invoice 1033
400
400
14.1.X7
Invoice 1129
300
700
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Total
$
4: SOURCES, RECORDS AND BOOKS OF PRIME ENTRY
Payables ledger
7.5
Example:
Tewson Co. (Supplier)
Cash
$
Date
1.1.X7
Invoice A112
Purchases
$
Total
$
400
400
Purchases
$
Total
$
Manley & Co. (Supplier)
Cash
$
Date
4.1.X7
Invoice 063
6.1.X7
Cash book
16.1.X7
Invoice 097
350
350
–
200
Lecture example 2
350
200
Exam standard question for 2 marks
Which of the following statements about the accounting system are corrrect?
(1)
It provides useful accounting information and helps comply with organisation policies and
deadlines
(2)
The sales day book shows amounts owed by individual customers and the purchase day
books shows amounts owed to individual suppliers
(3)
Transactions are categorised in the books of prime entry, summarised in the nominal ledger
and extracted from the trial balance to produce financial statements
(4)
Entities do not need accounting systems to prepare their annual financial statements
A
B
C
D
1 and 3
2 and 4
1, 2 and 3
1, 2, 3 and 4
Solution
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8
Chapter summary
Section Topic
Summary
1
Statement of financial
position
The statement of financial position shows the assets
and liabilities of a business at a particular point in
time.
2
Statement of profit or
loss
The statement of profit or loss shows its
performance over a period.
3
The relationship
between the statement
of financial position
and the statement of
profit or loss
The statement of profit or loss largely explains the
movement between the business' assets and
liabilities at the beginning of the year and at the end of
the year.
4
From business
transactions to
financial statements
5
Types of business
documentation
A business will enter many transactions during the
year. All of these need to be recorded and
summarised to produce the entity's financial
statements.
Quotation, sales/purchase order, goods
received/dispatched note, invoice, credit/debit note,
receipt/remittance advice.
6
Books of prime entry
The business' transactions must first be categorised
into the books of prime entry. The cash book
records money paid in to and out of the bank account;
the sales day book records credit sales; the purchase
day book records credit purchases; the petty cash
book records transactions made in petty cash and the
journal book is used to correct errors and make other
adjustments such as accruals and prepayments. The
totals on these books are then summarised in the
nominal ledger.
7
Memorandum ledgers
There are two memorandum ledgers: the receivables
ledger and the payables ledger. The receivables
ledger shows how much the business is owed by
each individual customer at a point in time and the
payables ledger show how much it owes to each
individual supplier at any point in time.
END OF CHAPTER
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Ledger accounts
and double entry
Syllabus Guide Detailed Outcomes
Having studied Chapters 4 and 5 you will be able to:

Identify and explain the function of the main data sources in an accounting system.

Understand how the accounting system contributes to providing useful accounting information and complies
with organisational policies and deadlines.

Outline the contents and purpose of different types of business documentation, including: quotation, sales order,
purchase order, goods received note, goods despatched note, invoice, statement, credit note, debit note,
remittance advice, receipt.

Identify the main types of business transactions, for example, sales, purchases, payments and receipts.

Understand and apply the concept of double entry accounting and the duality concept.

Identify the main types of ledger account and books of prime entry, and understand their nature and function.

Understand and illustrate the uses of journals and the posting of journal entries into ledger accounts.

Identify correct journals from given narrative.

Illustrate how to balance and close a ledger account.

Record sale, purchase and cash transactions in ledger accounts.

Understand the need for a record of petty cash transactions.
Exam Context
Your understanding of double entry will be crucial to passing the exam. For example, a question may ask you to derive
the statement of profit or loss expense for electricity where amounts need to be accrued at the year end. You will only
get this right if you understand the double entry for recording expenses and accruals. An objective test question could
also describe a transaction and ask you to identify the correct double entry to record this. Part of the accounts
preparation multi-task question could ask you to select which accounts to debit and credit and to calculate the required
amount for the journal entry.
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5: LEDGER ACCOUNTS AND DOUBLE ENTRY
Overview
Ledger accounts
and double entry
Double entry
Ledger accounts
Debit
Balancing off
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Credit
5: LEDGER ACCOUNTS AND DOUBLE ENTRY
1
Introduction
1.1
This chapter is designed to enable you to explain the principles of double entry and apply
these principles to the preparation of accounting records within the nominal/general ledger.
1.2
In Chapter 4 we saw how transactions were categorised in books of prime entry, the next
step is to summarise the information in a format nearer to that of the final financial
statements.
The nominal ledger
1.3
(a)
Each item in the statement of financial position or statement of profit or loss will have
an 'account' (which might be a page in a book or a record on a computer).
(b)
All the accounts are collected together in the nominal ledger.
(c)
The books of prime entry are totalled up and two entries will be made in these
accounts with each of these totals – this is called double entry.
The dual effect
1.4
The method used stems from the fact that every transaction affects two things, for example:
(a)
A sole trader pays $6,000 in the business bank account:
Cash increases by $6,000
Capital increases by $6,000
(b)
A sole trader purchases on credit some goods for sale for $400:
Purchases increase by $400
Trade payables increase by $400
(c)
A sole trader sells some of those goods for cash of $150:
Cash increases by $150
Sales increase by $150
(d)
A sole trader pays his rent with cash for $100:
Rent expenses increase by $100
Cash decreases by $100
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2
Ledger accounts (T-accounts)
2.1
Debit
CAPITAL
Credit
$
$
Decrease Capital
Increase Capital
We make two entries from each total extracted from the books of prime entry, and call one a
Debit (Dr), and the other one a Credit (Cr).
TOTAL DEBITS = TOTAL CREDITS
Principles of double entry bookkeeping
2.2
The cash account is a good starting point:
Dr
CASH
Cr
$
CASH IN = DEBIT
$
CASH OUT = CREDIT
General rules
2.3
(a)
DEBIT entry represents:
(i)
(ii)
(iii)
(b)
An increase in an asset;
A decrease in a liability; or
An item of expense.
CREDIT entry represents:
(i)
(ii)
(iii)
An increase in a liability;
A decrease in an asset; or
An item of income.
This can be remembered as follows
Debits
(increase)
Credits
(increase)
Expenses
Liabilities
Assets
Income
Drawings
Capital
(and credits will decrease these)
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(and debits will decrease these)
5: LEDGER ACCOUNTS AND DOUBLE ENTRY
Lecture example 1
Preparation question
Required
What is the double entry for each of the following?
Explain each entry in terms of the general rules above.
Solution
Transaction
Debit
(a)
Sales for cash.
(b)
Sales on credit.
(c)
Purchase for cash.
(d)
Purchase on credit.
(e)
Pay electricity bill.
(f)
Receive cash from a credit customer.
(g)
Pay cash to a credit supplier.
(h)
Borrow money from the bank.
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Credit
5: LEDGER ACCOUNTS AND DOUBLE ENTRY
Lecture example 2
Technique demonstration
Douglas
Douglas had the following transactions during January:
(1)
(2)
(3)
(4)
(5)
(6)
(7)
(8)
Introduced $5,000 cash as capital
Purchased goods on credit from Richard, worth $2,000
Paid rent for one month, $500
Paid electricity for one month, $200
Purchased car for cash, $1,000
Sold half of the goods on credit to Tish for $1,750
Drew $300 for his own expenses
Sold goods for cash, $2,100
Required
Post transactions (1) to (8) to the relevant ledger accounts.
Solution
Cash
$
$
Capital
$
$
Trade payables
$
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$
5: LEDGER ACCOUNTS AND DOUBLE ENTRY
Purchases
$
$
Rent
$
$
Electricity
$
$
Car
$
$
Drawings
$
$
Trade receivables
$
$
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5: LEDGER ACCOUNTS AND DOUBLE ENTRY
Sales
$
$
3
Flow of information
3.1
In Lecture example 2 the original transactions were posted to the ledger accounts. A
business would firstly categorise this information in the books of prime entry. The totals
from the books of prime entry are then posted to the nominal ledger using double entry.
3.2
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4
Balancing off the ledger accounts
4.1
The totals from the books of prime entry may be posted to the nominal ledger each month. A
business will want to know the balance on each account. This is done by 'balancing off' each
account.
Lecture example 3
Technique demonstration
The following information has been posted to the cash account below.
Required
Balance off the cash account to determine the amount of cash held at the end of January.
Solution
Dr
Cash
2/1 Sales
10/1 Sales
$
500
500
Cr
1/1 Purchases
25/1 Telephone
$
300
50
Steps
4.2
(1)
Add the debit and credit sides separately.
(2)
Fill in the higher of the two totals on both sides.
(3)
Literally 'balance' the account (what number do we need and on which side to make
the two sides equal?) – balance c/d.
(4)
Complete the 'double entry' – balance b/d on opposite side.
Lecture example 4
Technique demonstration
Douglas
Refer to Lecture example 2.
Required
Balance off the ledger accounts for Douglas
Solution
Complete in the solution space for Lecture example 2.
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5
Chapter summary
Section Topic
Summary
1
In Chapter 4 the totals on the books of prime entry were
summarised in the nominal ledger. These amounts are
posted to the nominal ledger using double entry.
Introduction
The principles of double entry work on the basis that for
each debit entry there must be a credit entry. This is
also known as the dual effect.
2
Ledger accounts
A debit entry increases assets, expenses and drawings
and a credit entry increases liabilities, income and
capital – this can be remembered as DEAD CLIC.
3
Flow of information
A business' transactions are categorised in the books of
prime entry and the totals are then posted to the
nominal ledger. A trial balance (Chapter 6) can then be
extracted from the balances on the nominal ledger
accounts and the statement of financial position and
statement of profit or loss produced.
4
Balancing off the
ledger accounts
At the end of each period the nominal ledger accounts
(T-accounts) are 'balanced off' to determine the closing
balance on each account.
END OF CHAPTER
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From trial balance to
financial statements
Syllabus Guide Detailed Outcomes
Having studied this chapter you will be able to:





Identify the purpose of a trial balance.
Extract ledger balances into a trial balance.
Prepare extracts of an opening trial balance.
Identify and understand the limitations of a trial balance.
Understand and apply the accounting equation.
Exam Context
Questions on this chapter may require you to derive missing figures (for example, profit for the period) using the
accounting equation, identify the correct double entry to record transactions such as drawings or determine whether
balances in a trial balance should be reported in the statement of financial position or the statement of profit or loss.
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Overview
Trial balance
From trial balance
to financial statements
Statement of profit or loss
Statement of financial
position
Accounting equation
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1
Introduction
1.1
We saw in Chapters 4 and 5 that:

Transactions are categorised in the books of prime entry;

The totals are then posted to the ledger accounts in the nominal ledger using double
entry; and

The ledger accounts are then balanced off and the balances brought down.
2
The trial balance
2.1
The trial balance consists of a list of the balances brought down on each ledger account,
separated in to debits and credits as below.
Example
2.2
Miss Smith – Trial Balance at as 31 December 20X7:
Account
Debit
$
Cash
720
Capital
500
Sales
2,200
Purchases
1,100
Furniture
500
Electricity
120
Telephone
60
Drawings
Total
2.3
Credit
$
200
2,700
The trial balance should balance, ie
Total debits = Total credits
If the trial balance doesn't balance then an error must have occurred.
The correction of errors is covered later in the course.
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6: FROM TRIAL BALANCE TO FINANCIAL STATEMENTS
Lecture example 1
Technique demonstration
Douglas
Refer to Lecture example 2 in Chapter 5 where the ledger accounts were balanced off.
Using the ledger accounts for Douglas, prepare the trial balance as at the end of January.
Solution
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3
The statement of profit or loss
3.1
The statement of profit or loss is part of the double entry system and can be shown as a
T-account.
Completing the statement of profit or loss
3.2
The balances on all the income and expenditure T-accounts are transferred to the statement
of profit or loss.
3.3
The income and expenditure accounts have now been closed out and a new account will be
created for each income and expenditure item next year.
Lecture example 2
Technique demonstration
Douglas
Refer to Lecture example 1.
Required
Prepare an statement of profit or loss in ledger account form.
Solution
Statement of profit or loss a/c
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4
The statement of financial position
Completing the statement of financial position
4.1
Statement of financial position:
(a)
(b)
(c)
4.2
Lists all ledger accounts with balances remaining;
Ie all assets and liabilities;
Is not part of double entry system so these balances are not transferred out.
At end of period, clear balances on the statement of profit or loss and drawings to capital
account.
Lecture example 3
Technique demonstration
Douglas
Refer to Lecture example 1 and Lecture example 2.
Required
Draw up a statement of profit or loss for the period and a statement of financial position at the end
of January.
Solution
DOUGLAS
STATEMENT OF PROFIT OR LOSS FOR THE MONTH OF JANUARY
$
Sales
Less cost of sales:
Purchases
Gross profit
Less expenses:
Rent
Electricity
Net profit
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$
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DOUGLAS
STATEMENT OF FINANCIAL POSITION AS AT 31 JANUARY
Non-current assets
$
$
$
$
Motor vehicle
Current assets
Trade receivables
Cash
Proprietor's interest
Capital introduced on 1 January
Profit for the year
Less: drawings
Balance 31 January
Current liabilities
Trade payables
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Lecture example 4
Technique demonstration
Douglas
Refer to Lecture example 3.
Required
Transfer the profit and drawings to the capital account.
Solution
Drawings
4.3
Drawings are amounts being taken out of a business by its owner. Drawings are generally in
the form of cash, but an owner may also take inventory out of the business. Drawings of
inventories are recorded at the cost of the inventories not the sales price.
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5
The accounting equation
5.1
The accounting equation expresses the statement of financial position as an equation.
5.2
At its most simple:
DEBITS
(assets)
=
CREDITS
Different types of credits
PROFIT
(less drawings)
CAPITAL
LIABILITIES
Proprietor's interest
5.3
This can be summarised as:
Assets = Capital + Profit – Drawings + Liabilities
And can be rearranged as:
Assets – Liabilities = Capital + Profit – Drawings
Lecture example 5
Technique demonstration
Douglas
Refer to Lecture example 3.
Required
Prepare the accounting equation for Douglas.
Solution
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6
Additional question practice
Lecture example 6
Technique demonstration
Joan
Joan, a second hand bookseller, has been in business for two months. In this time she:
(1)
Paid in cash $5,000 as capital
(2)
Took the lease of a stall and paid two months' rent. The annual rental was $1,200
(3)
Purchased, on credit from J Fox, books at cost of $825
(4)
Spent $420 cash on the purchase of other books from W Smith
(5)
Paid an odd-job man $75 to paint the exterior of the stall and repair a broken lock
(6)
Put an advertisement in the local paper at a cost of $10
(7)
Sold three volumes containing The Complete Works of Shakespeare to an American for $60
cash
(8)
Sold six similar sets on credit to a local school for $300
(9)
Paid J Fox $525 on account for the amount due to him
(10) Received $200 from the school
(11) Purchased cleaning materials at a cost of $10 and paid a char lady $30
(12) Took $100 from the business to pay for her own personal expenses
(13) Made other cash sales during the two months of $1,500
(14) All books had been sold by the end of two months
Required
(a)
(b)
(c)
Write up the relevant ledger accounts for these transactions.
Balance off all of the ledger accounts.
Prepare a trial balance, a statement of profit or loss and a statement of financial position.
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Solution
Bank (SOFP)
$
$
Capital (SOFP)
$
$
Rent (SPL)
$
$
Trade payables (SOFP)
$
$
Purchases (SPL)
$
$
Repairs (SPL)
$
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$
6: FROM TRIAL BALANCE TO FINANCIAL STATEMENTS
Advertising (SPL)
$
$
Sales (SPL)
$
$
Trade receivables (SOFP)
$
$
Cleaning materials (SPL)
$
$
Cleaning (SPL)
$
$
Drawings (SOFP)
$
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$
6: FROM TRIAL BALANCE TO FINANCIAL STATEMENTS
Trial Balance
Debit
$
Credit
$
Bank
Capital
Rent
Trade payables
Purchases
Repairs
Advertising
Sales
Trade receivables
Cleaning materials
Cleaning
Drawings
JOAN
STATEMENT OF PROFIT OR LOSS FOR THE TWO MONTHS ENDED …
$
$
Sales
Purchases
Gross profit
Rent
Repairs
Advertising
Cleaning (10 + 30)
Profit for the year
JOAN
STATEMENT OF FINANCIAL POSITION AS AT ...
$
Current Assets
Trade receivables
Bank
Proprietor's Interest
Capital
Profit
Less: drawings
Current Liabilities
Trade payables
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7
Chapter summary
Section Topic
Summary
1
Introduction
Once a business' transactions have been categorised
in the books of prime entry and summarised in the
nominal ledger accounts the next step is to extract a
trial balance.
2
The trial balance
The trial balance consists of a list of the balances
brought down on each ledger account.
3
The statement of profit
or loss
The balances on all of the income and expenditure
ledger accounts are transferred to the statement of
profit or loss along with any adjustments that will affect
profit.
4
The statement of
financial position
The statement of financial position lists out the
balances on all of the asset and liability ledger
accounts.
5
The accounting
equation
The accounting equation expresses the statement of
financial position as an equation:
Assets = capital + profit – drawings + payables
6
Additional question
practice
The key to success on accounts preparation is question
practice.
END OF CHAPTER
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Inventory
Syllabus Guide Detailed Outcomes
Having studied this chapter you will be able to:









Recognise the need for adjustments for inventory in preparing financial statements.
Record opening and closing inventory.
Identify the alternative methods of valuing inventory.
Understand and apply the IASB requirements for valuing inventories.
Recognise which costs should be included in valuing inventories.
Understand the use of continuous and period end inventory records.
Calculate the value of closing inventory using 'first in, first out' and 'average cost'.
Understand the impact of accounting concepts on the valuation of inventory.
Identify the impact of inventory valuation methods on profit and on assets.
Exam Context
Accounting for inventories and inventory valuation is a basic principle that affects any business. Examination questions
are likely to test your understanding of the terms cost and net realisable value. You should also expect calculations on
this area and be able to make adjustments for both opening and closing inventory.
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Overview
Accounting adjustments
Inventory
Valuation
Effects on profit and
assets
Net realisable value (NRV)
Cost
Methods of estimating cost
FIFO
AVCO
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1
Introduction
1.1
For some businesses, for example manufacturing entities, inventory can be a significant
figure.
1.2
It impacts the financial statement in two ways:
1.3
(a)
Statement of financial position:
a potentially large balance within current assets
(b)
Statement of profit or loss:
opening and closing inventory have a direct
impact on cost of sales and therefore profits
Businesses must therefore ensure that their financial statements account for inventory
accurately in terms of:
(a)
(b)
The accounting adjustment
Its valuation
2
Accounting adjustment
2.1
Inventory is generally accounted for as a year end adjustment via a journal entry.
2.2
Opening inventory
The trial balance produced by the entity at the end of the year will show an inventory figure.
This amount generally relates to the opening inventory – ie the goods held by the business
at the beginning of the year.
Such goods will have been sold during the year. They are no longer an asset of the entity
but will form part of the costs that should be matched against sales revenue when
determining profit.
The accounting entry is:
Dr
Cr
2.3
Cost of sales (SPL)
Inventories (SOFP)
Closing inventory
The goods held by the business at the end of the year must be included as an asset in the
statement of financial position and as a deduction within cost of sales in the statement of
profit or loss.
The accounting entry is:
Dr
Cr
Inventories (SOFP)
Cost of sales (SPL)
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Illustration
Eddie has a business selling phones. At the beginning of the month, he had 7 phones in
inventory which had cost $20 each. During the month, the price of phones has remained the
same so Eddie buys a further 50 phones for $20 each, and sells 35 for $30 each.
His trading account would show the following:
$
Sales
Cost of sales
Opening inventories
Purchases
Less: closing inventories
$
1,050
140
1,000
(440)
(700)
Gross profit
350
The trading account shows a profit of $350 which relates to 35 phones sold at a profit of
$10 per phone ($30 sales price - $20 purchase price)
2.4
The inventories figure comprises two elements:
QUANTITY  VALUATION
Quantity:
normally ascertained by inventory count at end of accounting period or
by continuous inventory records.
Valuation:
much more subjective, so guidance is provided in IAS 2.
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2.5
Inventory overview
Inventory
=
Quantity
Continuous
inventory records
x
Inventory
count
All costs to get
item to current
location in
current condition
Actual cost
Valuation
Lower of
Cost
and
NRV
Selling price
Less: completion costs
Less: selling costs
Deemed cost
FIFO
3
Valuation
3.1
The basic rule per IAS 2 Inventories is:
Average
Cost
'Inventories should be measured at the lower of cost and net realisable value (NRV).'
3.2
This is an example of prudence in presenting financial information.
(a)
If inventory is expected to be sold at a profit:
(i)
(ii)
(b)
Value at cost
Do not anticipate profit
If inventory is expected to be sold at a loss:
(i)
(ii)
Value at net realisable value
Do provide for the future loss
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$
X
(X)
(X)
X
7: INVENTORY
4
Cost
4.1
The cost of an item of inventory includes:
For example:

Purchase price

Import duties
Cost of purchase
But not:

Sales tax

Trade discounts
Relating to productions:

Direct labour

Direct/variable overheads

An allocation of fixed
overheads (based on
normal level of activity)
Costs of conversion
Other costs incurred in bringing
the inventories to their present
location and condition
For example:

Carriage inwards
Lecture example 1
Exam standard question worth 2 marks
According to IAS 2 Inventories, which of the following should not be included in
determining the cost of the inventories of an entity?
(1)
(2)
(3)
(4)
Labour costs
Transport costs to deliver goods to customers
Administrative overheads
Depreciation on factory machine
A
B
C
D
All four items
1 only
2 and 3 only
2, 3, and 4 only
Solution
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5
Net realisable value (NRV)
5.1
The net realisable value of an item is essentially its net selling proceeds after all costs have
been deducted.
5.2
It is calculated as:
$
X
(X)
(X)
X
Estimated selling price
Less: estimated costs of completion
Less: estimated selling and distribution costs
Lecture example 2
Preparation question
Jessie is trying to value her inventory. She has the following information available:
$
35
20
12
1
Selling price
Costs incurred to date
Cost of work to complete item
Selling costs per item
Required
What is the net realisable value of Jessie's inventory?
Workings
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$
7: INVENTORY
No netting off
5.3
The IAS 2 rule 'lower of cost and net realisable value' should be applied as far as
possible on an item by item (or line by line) basis.
Illustration
5.4
Suppose an entity has four items of inventories on hand at the year end. Their costs and
NRVs are as follows:
Inventory item
Cost
$
27
14
43
29
113
1
2
3
4
NRV
$
32
8
55
40
135
Lower of cost
and NRV
$
27
8
43
29
107
It would be incorrect to compare total cost of $113 with total NRV of $135 and state
inventories as $113.
A loss on item 2 of $6 can be foreseen and should therefore be recognised.
The comparison should be made for each item of inventory and thus a value of $107 would
be attributed to inventories.
This would be accounted for by the journal entry:
Dr
Cr
6
$
107
Inventories (SOFP)
Cost of sales (SPL)
$
107
Theoretical methods of estimating cost
Issue
6.1
6.2
If various batches of inventories have been purchased at different times during the year and
at different prices, it may be impossible to determine precisely which items are still held at
the year end and therefore what the actual purchase cost of the goods was. IAS 2 therefore
allows an entity to approximate the cost of its inventories. There are two methods
examinable:


First in, first out (FIFO)
Average cost
(a)
FIFO
Under FIFO it is assumed that:
(i)
(ii)
First goods purchased/produced will be the first to be sold
Remaining inventories are the from the most recent purchases/production
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(b)
Average Cost (AVCO)
There are two average costs available:
(i)
Periodic (or Simple) average cost
The cost of all purchases/production during the year is divided by the total
number of units purchased.
(ii)
Weighted average cost
The weighted average of the cost of similar items is recalculated each time a
new item is purchased/produced during the period (IAS 2 requires the weighted
average to be used).
Lecture example 3
Preparation question
On 1 January 20X7 a company held 200 units of finished goods valued at $10 each. During
January the following transactions took place.
Date
Units purchased
Cost per unit
10 January
300
$10.85
20 January
350
$11.50
25 January
250
$13.00
Sales during January were as follows:
Date
Units sold
Sales price per unit
14 January
280
$18.00
21 January
400
$18.00
28 January
80
$18.00
Required
Determine the valuation of closing inventories and cost of sales using:
(a)
(b)
FIFO
Weighted average cost
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Solution
(a)
Closing inventories (FIFO)
Purchases
10.1.X7
20.1.X7
1.1.X7
25.1.X7
Sales
Cost of sales (FIFO)
(b)
Closing inventories and cost of sales (AVCO)
Units
1.1.X7
b/f
10.1.X7
Purchase
14.1.X7
Sale
20.1.X7
Purchase
21.1.X7
Sale
25.1.X7
Purchase
28.1.X7
Sale
Cost
$
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Average
Unit Cost
$
Total
Cost
$
Cost of
Sales
$
7: INVENTORY
Workings
Advantages and disadvantages
6.3
FIFO:
more 'realistic' value on statement of financial position.
Average cost: can be complex as weighted average is required by IAS 2.
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7
Valuation effects on profit and assets
7.1
All of the inventory valuation methods affect profits and assets. Using the FIFO, and
average cost examples above, this can be illustrated in the extracts from the financial
statements below:
STATEMENT OF PROFIT OR LOSS (extract):
FIFO
$
Sales (760  $18)
Cost of sales
Opening inventories
Purchases
Closing inventories
$
13,680
2,000
10,530
(4,285)
Weighted average
$
$
13,680
2,000
10,530
(4,160)
8,245
5,435
Gross profit
8,370
5,310
STATEMENT OF FINANCIAL POSITION (extract):
FIFO
$
Current assets
Inventories
7.2
Weighted average
$
4,285
4,160
The only figure that varies is the closing inventories. This results in profit and current assets
being higher by $125 under the FIFO method in this example.
This re-emphasises the significance of inventory valuation in the preparation of financial
statements.
Effects in times of changing prices
7.3
In the above example, the purchase price of inventories was rising during the period. Notice
that when prices are rising:
FIFO will tend to give higher inventory values and higher profits.
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8
Chapter summary
Section
Topic
Summary
1
Introduction
Inventories can be a significant figure in an entity's
accounts and will impact both the profit figure and the
net asset position. It is important therefore that it is
recorded correctly.
2
Accounting adjustment
The statement of profit or loss matches the sales
revenue earned in a period with the cost of sales
incurred to generate that revenue. There are therefore
two inventory adjustments: the opening inventory
adjustment and the closing inventory adjustment.
3
Valuation
Inventories should be valued at the lower of cost and
net realisable value.
4
Cost
The cost of inventory includes the cost of purchase,
costs of conversion and any other costs necessary
to bring the inventory to its present location and
condition.
5
Net realisable value
(NRV)
Net realisable value is the estimated selling price less
the costs to completion and any selling and
distribution costs.
6
Theoretical methods of
estimating cost
Methods available to estimate the cost of inventories
are first in, first out (FIFO) and average cost. Under
FIFO the inventories held at the year end are the most
recent purchases but under average cost the cost of all
inventories purchased during the year is weighted to
produce an average figure.
7
Valuation effects on
profit and assets
In times of rising prices, using FIFO will mean the
financial statements show higher inventory values and
higher profits.
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Tangible non-current
assets
Syllabus Guide Detailed Outcomes
Having studied this chapter you will be able to:

Define non-current assets and recognise the difference between current and non-current assets.

Explain the difference between capital and revenue items and classify expenditure accordingly.

Prepare ledger entries to record the acquisition, disposal, depreciation and accumulated depreciation of
non-current assets.

Calculate and record profits or losses on disposal of non-current assets in the statement of profit or loss including
part exchange transactions.

Record the revaluation of a non-current asset and calculate its subsequent depreciation and profit or loss on
disposal.

Explain the purpose and function of an asset register.

Understand and explain the purpose of depreciation.

Calculate the charge for depreciation using the straight line and reducing balance methods, identifying when
each is appropriate.

Calculate the adjustments to depreciation necessary if changes are made in the estimated useful life and/or
residual value of a non-current asset.

Record depreciation in the statement of profit or loss and statement of financial position.
Exam Context
Tangible non-current assets and depreciation are an important part of the syllabus and you should expect several
objective test questions on this area. It could also feature as part of the accounts preparation multi-task question in
Section B of the exam. Questions are likely to focus on areas such as calculating depreciation and asset values (both on
assets held at historic cost and revalued amounts), profits or losses on disposal of assets and the components that can
be included in the cost of a non-current asset.
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Overview
Capital versus revenue
expenditure
Cost
Tangible non-current
assets
Revaluations
Depreciation
Straight line
method
Reducing balance
depreciation
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Disposals
8: TANGIBLE NON-CURRENT ASSETS
1
Introduction
1.1
The purchase of a non-current asset is often a significant cost to a business which will have
a large impact on its financial statements.
1.2
It is important therefore that this expenditure is accounted for appropriately.
1.3
Data about each non-current asset is recorded in an asset register. This asset register is
used as an internal check on the accuracy of the nominal ledger (in relation to non-current
assets). It is separate from the nominal ledger and contains much more detail (eg purchase
date, cost, location, serial number, description).
2
Non-current assets
Definition
2.1
Non-current assets are assets which are intended to be used by the business on a
continuing basis and include both tangible and intangible assets.
Intangible non-current assets are covered later in the course.
2.2
A business should classify an asset as current when:




It expects to realise, sell or consume the asset in its normal operating cycle;
It holds the asset primarily for the purpose of trading;
It expects to realise the asset within twelve months after the reporting period; or
The asset is cash or a cash equivalent.
All other assets should be classified as non-current.
2.3
The accounting treatment of tangible non-current assets is covered by IAS 16 Property,
Plant and equipment.
Tangible non-current assets are defined as those which:
(a)
Are held for use in the production or supply of goods or services or for administrative
purposes; and
(b)
Are expected to be used during more than one period.
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Lecture example 1
Idea generation
Required
What examples of tangible non-current assets can you identify?
Solution
(a)
(b)
(c)
(d)
Capital versus revenue expenditure
2.4
2.5
(a)
Capital expenditure:
results in the acquisition, replacement or improvement
of non-current assets.
(b)
Revenue expenditure:
– for the trade of the business, or
– to repair, maintain and service non-current assets.
Capital expenditure results in the appearance of a non-current asset in the statement of
financial position of the business.
Revenue expenditure results in an expense in the statement of profit or loss.
Cost
2.6
Tangible non-current assets should initially be recorded at cost.
Cost includes:

Purchase price:

Directly attributable costs to bring the asset to its intended location and ready to
use. These include:
(a)
(b)
(c)
(d)
excluding sales tax and trade discounts but including import
duties
Initial delivery and handling costs
Installation and assembly costs
Costs of testing whether the asset is working properly
Professional fees
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The following costs may not be included:
(a)
(b)
(c)
2.7
The cost of maintenance contracts
Administration and general overhead costs
Staff training costs
The asset can then be kept at cost and depreciated or the entity may choose to revalue its
tangible non-current assets.
Lecture example 2
Exam standard worth 2 marks
On 10 December 20X7 an entity bought a machine.
The breakdown on the invoice showed:
$
20,000
200
900
21,100
Cost of machine
Delivery costs
One-year maintenance contract
Further installation costs of $500 were also incurred.
At what amount should the machine be capitalised in the entity's records?
A
B
C
D
$20,000
$20,700
$20,200
$21,600
Solution
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3
Depreciation
3.1
The need to depreciate non-current assets arises from the accruals assumption. If money
is expended in purchasing an asset then the amount expended must at some time be
charged against profits.
3.2
Depreciation is a means of spreading the cost of a non-current asset over its useful life in
order to match the cost of the asset with the consumption of the asset's economic benefits.
A formal definition is given by the accounting standard, IAS 16:
'…the systematic allocation of the depreciable amount of an asset over its useful life.'
'Depreciable amount'
'Residual value'
=
=
cost/revalued amount – residual value
the amount the asset is expected to be sold for at the end of its
useful life (scrap value).
3.3
Land normally has an unlimited useful life and is therefore not depreciated. Buildings have
a limited life and, therefore, are depreciable assets.
4
Methods of depreciation
4.1
There are two main methods for calculating depreciation:
(a)
(b)
Straight line method
Reducing balance method
5
Straight line method
5.1
The depreciation charge is the same every year.
Formula
5.2
Depreciation 
cost  residual value
useful life (years)
or
(Cost – Residual value)  %
where:
Residual value = expected proceeds/scrap value at the end of the asset's useful life.
Useful life
5.3
= the number of years the business expects to make use of the asset.
This method is suitable for assets which are used up evenly over their useful life.
Lecture example 3
Preparation question
A business buys a machine for $2,500. It is expected to have a useful life of three years after
which time it will have a scrap value of $250.
Required
(a)
Calculate the annual depreciation charge.
(b)
Calculate the cost, accumulated depreciation and net book value (NBV) for each year of the
asset's life. Note: NBV = cost – accumulated depreciation to date.
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Solution
(a)
(b)
Year
Cost
$
Accumulated
depreciation
$
NBV
$
1
2
3
6
Reducing balance depreciation
6.1
This method is suitable where the benefits obtained by the business from using the asset
declines over time; for example a machine which may become progressively less efficient as
it gets older.
Under this method the depreciation charge will be higher in the earlier years and reduce
over time.
Formula
6.2
Depreciation
=
Depreciation rate (%)  Net Book Value (NBV)
where:
net book value (NBV) = cost – accumulated depreciation to date
Note:
This method does not take account of any residual value, since the NBV under
this method will never reach zero. The depreciation rate percentage will be
provided in the question.
Lecture example 4
Preparation question
A business buys a machine costing $6,000. The depreciation rate is 40% on a reducing balance
basis.
Required
Calculate depreciation expense, accumulated depreciation and net book value of the asset for the
first three years.
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Solution
Year
NBV b/d
$
Depreciation
rate
Depreciation
expense
$
Accumulated
depreciation
$
NBV c/d
$
1
2
3
7
Accounting for depreciation
Dual effect
7.1
Depreciation has a dual effect which needs to be accounted for:
(a)
(b)
7.2
It reduces the value of the asset in the statement of financial position.
It is an expense in the statement of profit or loss.
The asset remains at its original cost in the asset account.
Two accounts are set up to record depreciation:
Dr
Cr
7.3
Depreciation expense
Accumulated depreciation
Depreciation will either be charged:

On a monthly pro-rata basis ('proportionate depreciation in the year of purchase and
disposal'); or

A full year in the year of purchase and none in the year of disposal.
The question will tell you which policy to apply.
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Accumulated depreciation account
7.4
(a)
Used to provide for the reduction in value of the asset.
(b)
Reduces original cost of the asset on the statement of financial position. (The balance
on the account is offset against the cost account for the corresponding asset.)
(c)
Separate account kept for each class of asset (eg motor vehicles, buildings, plant
and machinery).
Lecture example 5
Preparation question
Required
Using the information in Lecture example 3, show:
(a)
The journal entry which would have been written at the end of the first year.
(b)
The treatment of depreciation for all years in the relevant ledger accounts.
(c)
The relevant statement of profit or loss and statement of financial position extracts for each
year.
Solution
(a)
Journal entry
Debit
$
(b)
Machine (SOFP)
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Credit
$
8: TANGIBLE NON-CURRENT ASSETS
Depreciation expense (SPL)
Accumulated depreciation (SOFP)
(c)
Statement of profit or loss (extracts)
Year 1
$
Expenses
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Year 2
$
Year 3
$
8: TANGIBLE NON-CURRENT ASSETS
STATEMENT OF FINANCIAL POSITION (EXTRACTS)
Cost
$
Accumulated
depreciation
$
Net book
value
$
Year 1
Year 2
Year 3
8
Disposal of non-current assets
Profit or loss on disposal
8.1
When a non-current asset is disposed of, its net book value needs to be removed from the
statement of financial position.
The sales proceeds received are unlikely to be exactly the same as the asset's net book
value and so a profit or loss on disposal will arise.
If:
Sales proceeds > NBV  profit on disposal
Sales proceeds < NBV  loss on disposal
This is not a 'true' profit or loss, but rather a book adjustment to reflect the fact that the
depreciation charged over the asset's life wasn't completely accurate.
Accounting treatment
8.2
Everything to do with the disposal is transferred to a Disposal Account.
Steps:
(1)
Remove the cost of the asset:
Dr
Cr
(2)
Disposal account
Non-current asset
Remove the accumulated depreciation charged to date:
Dr
Cr
Accumulated depreciation
Disposal account
Note: Steps (1) and (2) have effectively transferred the NBV of the asset to the disposal
account.
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(3)
Account for the sales proceeds:
Dr
Cr
(4)
Cash
Disposal account
Balance off disposal account to find the profit or loss on disposal.
A gain on disposal is shown in the statement of profit or loss as sundry income, a loss as
an expense.
Lecture example 6
Preparation question
The machine costing $6,000 in Lecture example 4 is sold in Year 3 for $3,000. No depreciation is
charged in the year of disposal.
Required
(a)
(b)
Calculate the profit or loss on disposal of the machine.
Complete the ledger accounts to show how the disposal would be accounted for.
Solution
(a)
(b)
Machine (SOFP)
Bal b/d
$
6,000
Accumulated depreciation (SOFP)
$
Bal b/d
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$
$
3,840
8: TANGIBLE NON-CURRENT ASSETS
Disposal account (SPL)
$
$
Part exchange allowance
8.3
Instead of receiving sales proceeds as cash, a part exchange allowance could be offered
against the cost of a replacement asset:
Dr
Cr
New asset cost
Disposal account
The part exchange allowance takes the place of proceeds in the disposals account.
Lecture example 7
Preparation question
Assume in Lecture example 6 that instead of cash proceeds of $3,000, there is a part exchange
allowance of $3,000 on a replacement machine costing $10,000.
Required
(a)
(b)
(c)
Calculate the profit or loss on disposal of the machine.
Calculate the amount of cash paid for the new machine.
Complete the ledger accounts to show both the disposal and the acquisition.
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Solution
(a)
(b)
(c)
Bal b/d
Old machine (SOFP)
$
6,000
Accumulated depreciation (SOFP)
$
Bal b/d
$
$
3,840
New machine (SOFP)
$
$
Disposal account (SPL)
$
$
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9
Revaluations
9.1
If an entity owns a property it may notice that its value increases over time.
9.2
IAS 16 requires tangible non-current assets to initially be recorded at cost. The entity can
then either keep the asset at cost (and depreciate it) or choose to revalue it (depreciation is
still required).
This is a choice of accounting policy.
9.3
If an entity chooses a policy of revaluation then all items in the same class of assets must be
revalued.
Examples of classes of assets are:



9.4
Land and buildings
Plant and machinery
Motor vehicles
Revaluations must be carried out sufficiently often so that the assets carrying value is not
materially different from its market value.
Steps and accounting treatment
9.5
(1)
Adjust cost account to revalued amount.
(2)
Remove accumulated depreciation charged on the asset to date.
(3)
Put the balance to the revaluation surplus (sometimes referred to as the 'revaluation
reserve').
Note: The balance posted to the revaluation surplus will equal the new revalued amount
less the previous net book value.
9.6
The required journal is:
Dr
Dr
Cr
9.7
Non-current asset cost account
Accumulated depreciation
Revaluation surplus
Depreciation should now be based on the revalued amount.
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Lecture example 8
Preparation question
A building costing $100,000 on which depreciation of $20,000 has been charged is to be revalued
to $150,000.
Required
(a)
Show the double entry to record the revaluation and make the postings to the ledger
accounts.
(b)
What would be the depreciation charge for the year if the building has a remaining useful life
of 40 years?
Solution
(a)
Building (SOFP)
$
$
Accumulated depreciation (SOFP)
$
$
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Revaluation surplus (SOFP)
$
$
(b)
Disposal of a revalued non-current asset
9.8
The disposal of a revalued non-current asset is accounted for in exactly the same way as
disposal of an asset that has not been revalued, using the same proforma to calculate profit
or loss on disposal:
$
Proceeds
X
Less: NBV
(X)
Profit/(loss) on disposal
X
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Lecture example 9
Preparation question
Imagine that the building in Lecture example 8 was sold one year after revaluation for $170,000.
Required
Calculate the profit or loss on disposal of the building.
Solution
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10 Depreciation revisited
10.1 Depreciation is charged to allocate the wearing out of an asset (depreciable amount) to the
statement of profit or loss over its useful life.
There are two main depreciation methods available:
Straight line
Reducing balance


10.2 The useful life and residual value of an item of property, plant and equipment should be
reviewed at least every financial year-end and, if expectations are significantly different from
previous estimates, the depreciation charge for current and future periods should be
revised.
This is achieved by writing the net book value (less the new residual value) off over the
asset's revised remaining useful life.
Lecture example 10
Preparation question
1.1.X1
Asset cost $40,000
Estimated useful life = five years
Residual value = $5,000
1.1.X3
Total useful life revised to four years.
Residual value revised to $4,000
Required
Calculate the depreciation charge, accumulated depreciation and NBV for each year of the asset's
life (year end 31 December).
Solution
Depreciation Accumulated
charge
depreciation
$
$
20X1
20X2
20X3
20X4
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NBV
$
8: TANGIBLE NON-CURRENT ASSETS
Review of depreciation method
10.3 The depreciation method should be reviewed at least every financial year-end and, if there
has been a significant change in the expected pattern of the asset's use, the method should
be changed.
This is achieved by writing the net book amount off over the remaining useful life, using the
revised method.
Lecture example 11
Preparation question
1.1.X1
Asset cost $40,000
Residual value $1,500
Useful life five years
Depreciation: 25% reducing balance
1.1.X3
Change depreciation method to straight line
Required
Calculate the depreciation charge, accumulated depreciation and NBV for each year of the asset's
life (year ended 31 December).
Solution
Depreciation Accumulated
charge
depreciation
$
$
20X1
20X2
20X3
20X4
20X5
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NBV
$
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11 Chapter summary
Section Topic
Summary
1
Introduction
Data about each non-current asset is recorded in the asset
register which is used as an internal check on the nominal
ledger.
2
Non-current
assets
Capital expenditure results in a non-current asset being
shown on the statement of financial position. Revenue
expenditure, such as repairs and maintenance, is shown as
an expense in the statement of profit or loss.
Tangible non-current assets should initially be recorded at
cost. This includes the purchase price of the item plus any
directly attributable costs to bring the item to its intended
location and ready to use.
3
Depreciation
Depreciation is an expense charged in relation to the asset
each year to reflect the using up of the asset.
Land usually has an unlimited useful life and so is not
depreciated.
4
Methods of
depreciation
Depreciation is usually calculated on a straight line or
reducing balance basis.
5
Straight line
method
This method is suitable for assets which are used up evenly
during their life time. The depreciation expense is the same
each year.
6
Reducing
balance
depreciation
This method is suitable where the benefits obtained by the
business from using the asset decline over time. The
depreciation expense is higher in the initial years.
7
Accounting for
depreciation
Depreciation is recorded by way of a journal entry. The
expense is recorded as a debit entry and reduces profit.
The credit is made to the accumulated depreciation account
and reduces the carrying value of the asset in the statement
of financial position.
8
Disposal of
non-current
assets
On disposal of a non-current asset the sales proceeds are
compared to the net book value of the asset in order to
calculate the profit or loss on disposal. Where an asset is
given in part exchange for another asset, the part exchange
allowance takes the place of the sales proceeds.
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Section Topic
Summary
9
Revaluations
An entity may choose to revalue its assets rather than hold
them at cost – this is a choice of accounting policy.
Where an entity revalues, it must revalue all assets in the
same class and the depreciation charge is based on the
revalued amount.
10
Depreciation
revisited
If an entity changes the method of depreciation used from
straight line to reducing balance (or vice versa) or revises
the useful life/residual value of an asset it should write off
the asset's net book value using the revised method or
useful life/residual value.
12 Double Entry Summary for Chapter 8
12.1 Depreciation adjustment:
Dr
Cr
Depreciation expense (SPL)
Accumulated depreciation (SOFP)
12.2 Disposal of a non-current asset (four steps):
(1)
Remove the cost of the asset:
Dr
Cr
(2)
Remove the accumulated depreciation charged to date:
Dr
Cr
(3)
Accumulated depreciation (SOFP)
Disposal account (SPL)
Account for the sales proceeds:
Dr
Cr
(4)
Disposal account (SPL)
Non-current assets (SOFP)
Cash (SOFP)
Disposal account (SPL)
Balance off the disposal account to determine the profit or loss on disposal.
12.3 Revaluation of a non-current asset:
Dr
Dr
Cr
Non-current asset cost account (SOFP)
Accumulated depreciation (SOFP)
Revaluation surplus (SOFP)
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END OF CHAPTER
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Intangible non-current
assets
Syllabus Guide Detailed Outcomes
Having studied this chapter you will be able to:





Recognise the difference between tangible and intangible non-current assets.
Identify types of intangible assets.
Identify the definition and treatment of research and development costs in accordance with IFRS.
Calculate amounts to be capitalised as development expenditure or to be expensed from given information.
Calculate and account for the charge for amortisation and explain its purpose.
Exam Context
Intangible non-current assets are a smaller part of the syllabus than tangible non-current assets; however you should
still expect this area to be tested. Questions are likely to focus on the difference between tangible and intangible assets,
the accounting treatment for research and the capitalisation criteria for development expenditure. You should also be
confident in calculating amortisation.
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Overview
Intangible non-current
assets
Research
Development expenditure
Accounting treatment
Accounting treatment
Amortisation
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1
Definition
1.1
An intangible non-current asset is an identifiable non-monetary asset without physical
substance.
1.2
The following are examples of intangible assets:



Development expenditure
Goodwill
Concessions, patents, licences, trade marks
The syllabus only requires knowledge of the accounting treatment of research and
development expenditure.
1.3
The difference between tangible and intangible non-current assets is that tangible assets
have physical substance whereas intangible assets do not.
2
Research and development expenditure
2.1
Many companies, such as pharmaceutical companies, spend huge amounts on research
and development every year in order to maintain or enhance their competitive position.
2.2
Companies need to account for these costs and whilst the credit entry will be to either cash
(if paid) or a current liability (if owed), the question remains as to where the debit entry
should be shown.
The choices are:
(a)
(b)
To debit the statement of profit or loss with an expense; or
To debit the statement of financial position with an intangible non-current asset.
An intangible non-current asset should only be recorded when the entity is confident that the
expenditure will generate future profit.
3
IAS 38: Intangible assets
Definitions
3.1
(a)
Research is original and planned investigation undertaken with the prospect of
gaining new scientific or technical knowledge and understanding.
(b)
Development is the application of research findings or other knowledge to a plan or
design for the production of new or substantially improved materials, devices,
products, processes, systems or services before the start of commercial production or
use.
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4
Accounting treatment
4.1
Research
Development

No certainty that the expenditure
will generate future profit

Future profits are expected

Show as an expense in statement
of profit or loss

Must capitalise as an intangible noncurrent asset if all of the relevant criteria
are satisfied

Dr Research expense (SPL)
Cr Bank/payables

Dr Intangible non-current assets (SOFP)
Cr Bank/payables
P robable future economic benefits
I ntention to complete and use/sell asset
R esources adequate and available to complete
and use/sell asset
A bility to use/sell the asset
T echnical feasibility of completing asset for
use/sale
E xpenditure can be measured reliably

Amortise asset over its useful life once
asset is ready for use
Lecture example 1
Preparation question
Z Co incurred the following costs during the year ended 31 August 20X8.
(1)
$20,000 on salaries for market research staff sent out to canvass drivers' opinions on a
potential new car.
(2)
$100,000 to purchase a machine to manufacture components for the new car. It has an
estimated useful life of 10 years.
(3)
$25,000 on materials to manufacture a prototype and $50,000 on salaries relating to its
design and manufacture. The new car is expected to go on sale in 20X9.
Required
How should each of the above items be shown in the financial statements for the year ended
31 August 20X8?
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Solution
5
Amortisation of capitalised development expenditure
5.1
A tangible non-current asset, such as a machine, is capitalised and then depreciated over its
useful life. This is to match the cost of the asset with the consumption of its economic
benefits.
5.2
In the same way the development expenditure must be spread on a systematic basis to
reflect the pattern in which the related economic benefits are recognised.
5.3
This is called amortisation.
5.4
Amortisation should begin when the asset is ready for use.
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5.5
It is an expense in the statement of profit or loss and is accounted for using the following
entry:
Dr
Cr
Amortisation expense (SPL)
Accumulated amortisation (SOFP)
Lecture example 2
Technique demonstration
Development Co incurs the following expenditure in years 20X1 – 20X5.
Research
$
35,000
–
–
–
38,000
20X1
20X2
20X3
20X4
20X5
Development
$
55,000
65,000
–
–
–
The development expenditure meets the IAS 38 criteria that require capitalisation ('PIRATE'). The
item developed in 20X1 and 20X2 goes on sale on 1.1.X3 and it will be three years from then until
any competitor is expected to have a similar product on the market.
Required
Show statement of profit or loss and statement of financial position extracts for the
years 20X1 – 20X5 inclusive.
Solution
Expenses
Research expenditure
Amortisation of development expenditure
STATEMENT OF PROFIT OR LOSS (extracts)
X1
X2
X3
X4
X5
$
$
$
$
$
STATEMENT OF FINANCIAL POSITION (extracts)
X1
X2
X3
X4
X5
$
$
$
$
$
Non-current assets
Development expenditure
Amortisation
Net book value
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Lecture example 3
Exam standard question for 2 marks
Which of the following statements best describes the difference between tangible and
intangible non-current assets?
A
Tangible non-current assets are of a long-term nature; intangible non-current assets are of a
short-term nature.
B
Tangible non-current assets must be depreciated but intangible non-current assets should
not be amortised.
C
Tangible non-current assets are always recognised initially in the statement of financial
position; intangible assets are always recognised initially in the statement of profit or loss.
D
Tangible non-current assets are perceptible by touch but intangible non-current assets are
not.
Solution
Lecture example 4
Exam standard question for 2 marks
Which of the following statements best explains the purpose of amortisation of intangible
non-current assets?
A
To show the true value of the intangible non-current assets in the statement of financial
position.
B
To improve the profit figure in the year of purchase of the asset by spreading the cost of the
asset's useful life.
C
To match the cost of the asset to the related economic benefits generated by the asset.
D
To record the replacement cost of an intangible asset in profit or loss.
Solution
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6
Chapter summary
Section Topic
Summary
1
Definition
An intangible non-current asset is an identifiable nonmonetary asset without physical substance.
2
Research and
development
expenditure
Some entities spend significant sums of money on
research and development it is therefore essential
that these transactions are accounted for
appropriately.
3
Intangible assets
IAS 38 defines research and development.
(IAS 38)
Research expenditure is incurred where the entity is
acquiring new scientific or technical knowledge.
Development expenditure relates to the application
of research findings.
4
Accounting treatment
Research relates to costs incurred to obtain
knowledge or understanding. There is no certainty
of future profit from this expenditure and so it should
be shown as an expense in the statement of profit
or loss.
Development expenditure must be capitalised as
an intangible non-current asset provided all of the
PIRATE criteria are met. This asset will then be
amortised over the period during which it is expected
to generate income.
5
Amortisation of
capitalised
development
expenditure
Amortisation is essentially the same as depreciation
but relates to intangibles. Where an entity has
capitalised development expenditure it should
amortise the intangible once the asset is ready for
use.
END OF CHAPTER
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Accruals and
prepayments
Syllabus Guide Detailed Outcomes
Having studied this chapter you will be able to:





Understand how the matching concept applies to accruals and prepayments.
Identify and calculate the adjustments needed for accruals and prepayments in preparing financial statements.
Illustrate the process of adjusting for accruals and prepayments in preparing financial statements.
Prepare the journal entries and ledger entries for the creation of an accrual or prepayment.
Understand and identify the impact on profit and net assets of accruals and prepayments.
Exam Context
Accruals and prepayments are key accounting adjustments and you should expect to see them tested in the exam. You
may be asked to calculate the statement of financial position amount for accruals and prepayments and/or the relevant
expense that would be shown in the statement of profit or loss. Alternatively, you may be asked to determine the
appropriate journal entries to record accruals and prepayments. Note that questions on accruals and prepayments may
well relate to both income and expenses.
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Overview
Accruals and prepayments
Accounting treatment
Year end adjustments
Reversing out accruals and
prepayments
Accrued income
and deferred income
Accounting treatment
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Presentation in the statement
of financial position
10: ACCRUALS AND PREPAYMENTS
1
Introduction
1.1
This chapter is designed to enable you to apply accounting concepts and principles in
relation to the calculation of and adjustments for accruals and prepayments.
1.2
IAS 1 requires financial statements to be prepared on an accruals basis. This is so that
transactions and events are recognised when they occur (even if the resulting cash receipts
and payments occur in a different period) and they are recorded in the accounting records
and reported in the financial statements of the period to which they relate.
Accrual accounting is also required in reporting financial performance by the IASB's
Conceptual Framework.
Accruals
1.3
Accruals are expenses incurred by the business during the accounting period but not yet
paid for, ie expenses in arrears.
Example
1.4
Fred prepares accounts to 31 December each year. On 1 January 20X8, he pays a
telephone bill of $60 which relates to the period October–December 20X7.
Although the payment does not go through the cash book until 20X8, this expense must be
included in the accounts for the year ended 31 December 20X7, as it was incurred during
this period.
Prepayments
1.5
Prepayments arise when expenses are paid for before they have been used, ie expenses in
advance.
Example
1.6
On 20 December 20X7 Fred pays for insurance on his business premises for the 12 months
commencing 1 January 20X8.
Although the payment was made in 20X7, the expense should not appear in the accounts
for 20X7. The accounts for 20X7 will show a prepayment for the full amount of the insurance
cost and the expense will be recorded in 20X8.
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Accounting treatment
Year-end adjustments
2.1
Adjustments for accruals and prepayments tend to occur at the end of the year and are
made by way of a journal entry. The required entries are:
Accruals
Dr Expense (SPL)
Cr Accruals (SOFP)
Prepayments
Dr Prepayments (SOFP)
Cr Expense (SPL)
Presentation in the statement of financial position
2.2
Accruals:
Sub-heading under 'current liabilities'
Prepayments:
Sub-heading under 'current assets'.
Lecture example 1
Preparation question
Fiona set up a business on 1 January 20X7. Her cash payments for the year to 31 December 20X7
included:
Date paid
Amount
$
Period
Electricity
10.3.X7
96
2 months to 28 February 20X7
12.6.X7
120
quarter to 31 May 20X7
14.9.X7
104
quarter to 31 August 20X7
10.12.X7
145
quarter to 30 November 20X7
1.2.X7
375
3 months to 31 March 20X7
6.4.X7
1,584
Rent
12 months to 31 March 20X8
Note: On 6 March 20X8 Fiona received an electricity bill for $168 for the quarter to
28 February 20X8.
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Required
(a)
Calculate the expense incurred by Fiona for electricity and rent for the year ended
31 December 20X7.
(b)
Calculate the amount of any accruals/prepayments at the end of the year.
(c)
State the journal entry required for the year-end adjustments.
Solution
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Lecture example 2
Preparation question
Required
Using the figures from Lecture example 1:
Complete the necessary entries in Fiona's ledger accounts as at 31 December 20X7, then balance
off the accounts.
Solution
10.3.X7
12.6.X7
14.9.X7
10.12.X7
1.2.X7
6.4.X7
Cash
Cash
Cash
Cash
Electricity expense (SPL)
$
96
120
104
145
Cash
Cash
Rent expense (SPL)
$
375
1,584
$
$
Accruals (SOFP)
$
$
Prepayments (SOFP)
$
$
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3
Reversing out accruals and prepayments
Problem
3.1
Using the figures from Lecture example 1, what is Fiona's rent expense for the year to
31 December 20X8 assuming that on 10 April 20X8 she paid rent of $1,740 for the
12 months commencing 1 April 20X8?
3.2
1.1.X8
1.4.X8
31.12.X8
Expense = ( 3 12  $1,584)  ( 9 12  $1,740)  $1,701
Double entry
3.3
10.4.X8
Rent expense
$
1,740
31.12.X8
Cash
Prepayments
$
396
435
1.1.X8
Balance b/d
31.12.X8 Rent
$
Prepayments
( 3 12  1,740 )
435
$
This does not produce a sensible answer! The rent expense in the ledger account would
result in a charge to the statement of profit or loss of $1,305 (not $1,701) and the balance on
the prepayment account would be overstated by $396.
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Solution
3.4
The opening prepayment must therefore be reversed, ie:
Debit
Credit
Rent expense (SPL)
Prepayments (SOFP)
$396
$396
Post this to the ledger accounts in 3.3 and balance off – the expense should now be correct!
Summary
3.5
Accruals and prepayments brought forward at the start of the year must be reversed.
Reversal of accrual
Dr Accruals (SOFP)
Cr Expense (SPL)
Prepayments
Dr Expense (SPL)
Cr Prepayments (SOFP)
Approach to questions
3.6
There are four steps to follow:
(1)
(2)
(3)
(4)
Reverse opening accrual/prepayment.
Post cash paid during the year.
Post closing accrual/prepayment.
Balance off the accounts.
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Lecture example 3
Preparation question
In 20X8 Fiona paid the following electricity bills:
Date paid
Amount
$
Period
12.3.X8
168
quarter to 28 February 20X8
9.6.X8
134
quarter to 31 May 20X8
12.9.X8
118
quarter to 31 August 20X8
12.12.X8
158
quarter to 30 November 20X8
During March 20X9 Fiona received an electricity bill for $189 for the quarter to 28 February 20X9.
Required
Calculate the electricity expense and accrual for the year ended 31 December 20X8 and complete
the ledger accounts.
Solution
Electricity expense (SPL)
$
$
Accruals (SOFP)
$
$
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Lecture example 4
Exam standard question for 2 marks
The following transactions related to Colin's gas expense ledger account for the year ended
31 December 20X8:
$
Prepayment brought forward
1,100
Cash paid
10,800
Accrual carried forward
1,300
What amount should be charged to the statement of profit or loss in the year ended
31 December 20X8 for gas?
A
B
C
D
$10,800
$13,200
$10,600
$11,000
Solution
Lecture example 5
Exam standard question for 2 marks
At the year end, a company decides that an accrual of $750 is required for telephone expenses
and a prepayment of $200 for insurance. There are no brought forward accruals or prepayments
on these expense accounts.
What impact will the recording of this accrual and prepayments have on profit and net assets?
A
B
C
D
A decrease in profit of $550; a decrease in net assets of $550.
An increase in profit of $550; an increase in net assets of $550.
A decrease in profit of $950; an increase in net assets of $950
An increase in profit of $950; a decrease in net assets of $950.
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Solution
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4
Accrued income and deferred income
4.1
Accruals and prepayments relate to when expenses are paid in arrears or advance. Income
may also be received in arrears or advance.
Accrued income
4.2
This relates to when income has been earned during the accounting period but not invoiced
or received.
Illustration
4.3
Jenny owns a property which she rents out for $3,000 per quarter. The property was
occupied all year; however Jenny only received $9,000 in rent because she forgot to send
out the final invoice of the year.
As the property was let for 12 months, Jenny's statement of profit or loss should show
income of $12,000 (4  $3,000) as this is what she has earned.
She will therefore need to accrue the 'missing' income of $3,000 as a year end journal and
also show a receivable for 'rent in arrears'.
The adjustment is:
Dr
Cr
$
3,000
Rent in arrears (SOFP)
Rental income (SPL)
$
3,000
The rent in arrears is shown in the statement of financial position within current assets.
Deferred income
4.4
This relates to when income is received in advance of it being earned.
Illustration
4.5
Ben has a year end of December and rents out his property for $1,000 per month. His
tenant pays on time each month and during December 20X7 paid Ben $2,000 as he would
be away when the January 20X8 payment was due.
Ben has received income of $13,000 but only $12,000 of this relates to the current year. He
must therefore remove $1,000 of income from this year's accounts because it relates to next
year. A liability will also be shown for 'rent in advance'.
The adjustment is:
Dr
Cr
$
1,000
Rental income (SPL)
Rent in advance (SOFP)
$
1,000
The rent in advance is shown in the statement of financial position within current liabilities.
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Approach to questions
4.6
The approach for accrued income and deferred income is exactly the same as for accruals
and prepayments.
There are four steps to follow:
(1)
(2)
(3)
(4)
Reverse opening rent in arrears/advance.
Post cash received during the year.
Post closing rent in arrears/advance.
Balance off the accounts.
Lecture example 6
Exam standard question for 2 marks
A company receives rent from a large number of properties. The total received in the year ended
30 June 20X7 was $962,400.
The following were amounts of rent in advance and in arrears at 30 June 20X6 and 30 June 20X7:
30 June 20X6
$
30 June 20X7
$
Rent received in advance
57,400
62,400
Rent in arrears (all subsequently received)
42,400
36,800
What amount of rental income should appear in the company's statement of profit or loss
for the year ended 30 June 20X7?
A
B
C
D
$973,000
$921,800
$1,003,000
$951,800
Solution
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Chapter summary
Section Topic
Summary
1
An entity should produce its financial statements
using the accruals basis in accordance with IAS 1
and the Conceptual Framework.
Introduction
Accruals are made when expenses are paid in
arrears, whereas prepayments arise when
expenses are paid for in advance.
2
Accounting treatment
Accruals increase expenses and are shown as a
liability on the statement of financial position at the
year end.
Prepayments reduce expenses and are an asset on
the statement of financial position.
3
Reversing out accruals
and prepayments
Accruals and prepayments from the previous year
are reversed at the beginning of the next accounting
period so that the current year expense is correct.
4
Accrued income and
deferred income
These follow a similar theory to accruals and
prepayments but relate to income.
An entity will accrue income where it has earned the
income during the period but not yet invoiced for it.
This will increase income and be shown as a
receivable at the year end.
Where an entity has received income in advance of it
being earned it should be deferred to the following
period. This will reduce income and be shown as a
payable at the year end.
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Double Entry Summary for Chapter 10
6.1
Accruals adjustment:
Dr
Cr
6.2
Prepayments adjustment:
Dr
Cr
6.3
Expense (SPL)
Accruals (SOFP)
Prepayments (SOFP)
Expense (SPL)
Approach to questions (four steps):
(1)
Reverse opening accrual/ prepayment:
Accruals:
Dr
Accruals (SOFP)
Cr
Expense (SPL)
Prepayments:
Dr
Expense (SPL)
Cr
Prepayments (SOFP)
(2)
Post cash paid during the year.
(3)
Post closing accrual/prepayment.
(4)
Balance off the ledger accounts.
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Provisions
and contingencies
Syllabus Guide Detailed Outcomes
Having studied this chapter you will be able to:

Understand the definition of 'provision', 'contingent liability' and 'contingent asset', distinguish between them and
classify items accordingly.

Identify and illustrate the different methods of accounting for provisions, contingent liabilities and contingent
assets.

Calculate provisions and changes in provisions and account for the movement in provisions.

Report provisions in the final accounts.
Exam Context
Questions on this area are likely to focus on identifying when a provision or contingent liability should be made or
disclosed in the financial statements. You may also be required to calculate a provision.
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Overview
Accounting treatment
Recognition criteria
Provisions
Provisions and
contingencies
Contingent assets
Contingent liabilities
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1
IAS 37: Provisions, contingent liabilities and
contingent assets
1.1
Introduction
Before the introduction of IAS 37, there was little guidance on when a provision must and
must not be made.
This caused problems as entities tended to choose to make and then release provisions in
order to smooth out profits, rather than making a provision where they had an obligation to
incur expenditure.
IAS 37 aims to prevent this happening in the future.
2
Provisions
Definition
2.1
A provision is a liability of uncertain timing or amount.
Recognition
2.2
A provision should only be recognised (ie included in the financial statements) when:
(a)
An entity has a present obligation (legal or constructive) as a result of a past event;
(b)
It is probable that an outflow of economic resources will be required to settle the
obligation; and
(c)
A reliable estimate can be made of the amount of the obligation.
Unless all three conditions are met, no provision can be recognised.
Legal obligation
2.3
A legal obligation usually arises out of a contract or a piece of legislation.
2.4
Illustration
Grass Co sells lawnmowers and offers a one-year warranty on all models.
Once Grass Co sells a lawnmower (the past event) it has a legal obligation to repair any
defects according to the warranty agreement.
It should therefore make an estimate of the probable costs of repair and make a provision
for this amount in its financial statements.
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Constructive obligation
2.5
A constructive obligation arises through past behaviour and actions where the entity has
raised a valid expectation that it will carry out a particular action.
2.6
Illustration
Seed Co also sells lawnmowers. It does not offer a warranty on its products; however it has
a reputation for making free reasonable repairs to lawnmowers bought from the business.
Customers buying from Seed Co all expect to receive this benefit.
Here no warranty is offered and so Seed Co does not have a legal obligation. Its past
actions however have created a constructive obligation. It should also therefore make a
provision for the probable costs of repairs.
Probable outflow
2.7
Probable is defined as 'more likely than not to occur'. This can be interpreted as a greater
than a 50% chance of occurring.
Measurement
2.8
The amount recognised as a provision shall be the best estimate of the expenditure
required to settle the present obligation.
2.9
If there is uncertainty surrounding the amount:

For a large population of items, the expected value should be used; and

For a single obligation, the individual most likely outcome may be the best
estimate of the liability.
Double entry
2.10 The provision represents both a cost to the business and a potential liability:
Dr
Cr
Expense (SPL)
Provision (SOFP)
The required provision will be reviewed at each year end and increased or decreased as
necessary.
To increase a provision:
Dr
Cr
Expense (SPL)
Provision (SOFP)
To decrease a provision:
Dr
Cr
Provision (SOFP)
Expense (SPL)
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Lecture example 1
Preparation question
Grass Co is reviewing its warranty obligations. Based on sales during 20X7 it has established that
if all lawnmowers sold required minor repairs this would cost $1m whereas if major repairs were
required this would cost $6m.
Grass Co expects that 75% of lawnmowers will have no faults, 20% will need minor repairs and
5% major repairs.
Required
(a)
(b)
(c)
What provision should be made in 20X7 and what accounting entry is needed to record it?
What entry should be made in 20X8 assuming the provision required then is $0.75m?
What entry should be made in 20X9 assuming the provision required then is $0.3m?
Solution
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Contingent liabilities
3.1
A contingent liability is an uncertain liability that does not meet the three criteria for
recognising a provision.
IAS 37 defines a contingent liability as the following:
(a)
A possible obligation that arises from past events and whose existence will be
confirmed only the occurrence or non-occurrence of one or more uncertain future
event not wholly within the control of the entity; or
(b)
A present obligation that arises from past events but is not recognised because:
(i)
It is not probable that an outflow of economic resources will be required to
settle the obligation; or
(ii)
The amount of the obligation cannot be measured with sufficient reliability.
Contingent liabilities should be disclosed in the notes unless probability of an outflow of
resources embodying economic benefits is remote.
Illustrative example
3.2
Company A has entered into an agreement to act as guarantor on a bank loan taken out by
Mr Smith. Mr Smith is a financially secure individual, and the directors are of the opinion that
the chances of him defaulting on the loan are slim.
How should Company A account for this guarantee?
Solution
3.3
Company A has a present obligation (it is legally obliged to honour the guarantee).
However, as the likelihood of Company A having to pay out under the guarantee is not
probable then no provision for the liability should be made. Instead, the guarantee should be
disclosed in the notes as a contingent liability (unless considered remote, in which case it
should be ignored altogether).
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Decision tree
3.4
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Lecture example 2
Exam standard for 2 marks
Edward Co owns a chain of supermarkets. In the year ended 30 September 20X5, a customer
slipped on a spilt yoghurt in one of the supermarkets and was seriously injured. Prior to the year
end, the customer began legal proceedings seeking damages from Edward Co. Edward Co's
lawyers have stated that there is a 30% chance that Edward Co will win the case and if they lose,
damages of $50,000 are likely.
Which of the following is the correct accounting treatment for the legal proceedings in the
financial statements for the year ended 30 September 20X5?
A
B
C
D
Edward Co should neither provide for nor disclose the legal proceedings
Edward Co should provide for the expected cost of the damages of $50,000
Edward Co should provide for an expected cost of $15,000
Edward Co should disclose a contingent liability of $50,000
Solution
4
Contingent assets
4.1
A possible asset that arises from past events and whose existence will be confirmed only by
the occurrence or non-occurrence of one or more uncertain future events not wholly within
the control of the entity.
Contingent assets should be disclosed in the notes where an inflow of economic benefits is
probable, otherwise they should be ignored.
If the probability of an inflow of economic benefits is virtually certain then the asset is not a
contingent asset and should be recognised in the financial statements.
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5
Chapter summary
Section Topic
Summary
1
Prior to IAS 37, entities could choose when to
provide and how much to provide for and provisions
were often used incorrectly to smooth profits.
IAS 37
Strict recognition rules under IAS 37 put a stop to
this.
2
Provisions
A provision should only be made in the financial
statements when an entity has a present obligation
to incur expenditure. It must also be probable (more
likely than not ie >50% chance) that the expenditure
will be incurred and a reliable estimate of the
amount is known.
3
Contingent liabilities
A contingent liability should be disclosed where
the criteria for making a provision are not met, but
where there is either a possible obligation or a
present obligation but it is only possible that the
expenditure will be incurred.
4
Contingent assets
Contingent assets should only be included in the
financial statements if it is certain to be received and
should be disclosed if probable.
6
Double Entry Summary for Chapter 11
6.1
Adjustment to create or increase a provision:
Dr
Cr
6.2
Expense (SPL)
Provision (SOFP)
Adjustment to decrease a provision:
Dr
Cr
Provision (SOFP)
Expense (SPL)
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Irrecoverable debts
and allowances
Syllabus Guide Detailed Outcomes
Having studied this chapter you will be able to:

Identify the benefits and costs of offering credit facilities to customers.

Understand the purpose of an aged receivables analysis.

Understand the purpose of credit limits.

Prepare the bookkeeping entries to write off an irrecoverable debt.

Record an irrecoverable debt recovered.

Identify the impact of irrecoverable debts on the statement of profit or loss and statement of financial position.

Prepare the bookkeeping entries to create and adjust an allowance for receivables.

Illustrate how to include movements in the allowance for receivables in the statement of profit or loss and how
the closing balance of the allowance should appear in the statement of financial position.
Exam Context
Questions on this topic are likely to require you to perform calculations dealing with writing off debts, adjusting for cash
subsequently received and adjusting the allowance for receivables. You will also need to be able to determine the
balances to be shown in the statement of profit or loss and the statement of financial position. This area could feature as
part of the accounts preparation multi-task question in Section B.
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Overview
Amounts recovered
Irrecoverable debts
Irrecoverable debts
and allowances
Allowances
Create allowance for
receivables
Adjust allowance for
receivables
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1
Introduction
1.1
Businesses offer credit facilities to customers in order to encourage them to buy products
and services. Goods or services sold on credit result in trade receivables being recorded in
the statement of financial position of the seller's books (with a corresponding trade payable
in the buyer's books).
Accounting treatment
When a credit sale is made the accounting treatment is:
1.2
Dr
Cr
Trade receivables (SOFP)
Sales (SPL)
Ideally a business wants to receive money from its customers as quickly as possible. All
being well, when the customer pays the debt the accounting treatment is:
1.3
Dr
Cr
Cash (SOFP)
Trade receivables (SOFP)
1.4
However, there are risks of selling to customers on credit. The associated risks of offering
credit facilities to customers are slow payment and even non-payment.
1.5
To minimise the risk of non-payment, the business should set credit limits for their
customers. This means that if any order would take the customer's account over its credit
limit, it will not be actioned until a payment is received to reduce the customer's outstanding
balance.
If credit limits are not set, then the business may find that the amount that customers owe
the business increases over time. This could lead to cash flow issues for the business.
1.6. Also, they will maintain an aged receivables analysis to identify debts at risk of being
unpaid. An aged receivables analysis is a report of all receivables analysed by customer
and by age of the receivable, eg balances outstanding for 30 days, 60 days and 90+ days.
An aged receivables analysis is an internal document used by the business; it does not form
part of the double entry.
1.7
A trade receivable should only be classed as an asset if it is probable that it is recoverable
(ie that the customer will pay the amounts due). Consequently, if it becomes apparent that a
customer will not pay, the item no longer meets the definition of an asset.
2
Writing off irrecoverable debts
2.1
If a debt is irrecoverable it must be removed from the statement of financial position and
charged as an expense to the statement of profit or loss.
Accounting treatment
2.2
Dr
Cr
Irrecoverable debt expense (SPL)
Trade receivables (SOFP)
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Lecture example 1
Preparation question
Fight & Co has trade receivables at 31 December 20X7 of $65,000. A review of customer files
indicates that two customers, Ali and Tyson, which owe $7,000 and $8,000 respectively, have
gone bankrupt and their debts are considered irrecoverable.
Required
Complete the trade receivable account and the irrecoverable debt expense (SPL) account.
In the trade receivables account show the balance c/d at the end of the year. In the irrecoverable
debt expense (SPL) show the balance transferred to the statement of profit or loss.
Solution
Trade receivables (SOFP)
$
65,000
31.12.X7 Balance b/d
Irrecoverable debt expense (SPL)
$
$
$
3
Irrecoverable debts written off and subsequently paid
3.1
An irrecoverable debt which has been written off might occasionally be unexpectedly paid
(in some cases, in subsequent financial periods). Because the debt has already been written
off, it no longer exists in the statement of financial position and so the cash received cannot
be offset against it in the usual way. Instead, the cash received is offset against the
irrecoverable debts expense.
Accounting treatment
3.2
Dr
Cr
Cash (SOFP)
Irrecoverable debt expense (SPL)
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Lecture example 2
Preparation question
Fight & Co (see Lecture example 1) subsequently receive a cheque of $7,000 from Ali.
Required
Show the treatment of this recovery in the relevant T-accounts.
Solution
1.1.X8 Balance b/d
Trade receivables (SOFP)
$
50,000
Irrecoverable debt expense (SPL)
$
$
$
Cash (SOFP)
$
$
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Allowance for receivables
4.1
As well as writing off irrecoverable debts, a business may make an allowance for
receivables as a prudent precaution to account for the fact that some receivables balances
might not be collectable.
Doubtful debts may occur, for example, when invoices are in dispute, or when customers
are in financial difficulty.
In this situation, such debts are not written off, as it is not certain that they are irrecoverable.
But because there is doubt over whether they will be paid, an allowance for receivables is
made against the doubtful debts.
Trade receivables in the statement of financial position are shown net of any receivables
allowance (although for bookkeeping purposes, trade receivables and the allowance for
receivables are kept as two separate nominal ledger accounts).
4.2
The methods of determining the allowance for trade receivables are governed by the
impairment review required by accounting standards. The detail is beyond the scope of this
syllabus. In practice, when calculating the allowance, many businesses will consider the
total amount of doubtful debts at that point in time. In the exam the allowance is likely to be
expressed simply as a percentage of trade receivables, eg 'an allowance equivalent to 2%
of trade receivables'.
Creating an allowance for receivables
Accounting treatment
When an allowance is first made, the initial allowance is charged as an expense in the statement
of profit or loss for the period in which the allowance is created.
4.3
Dr
Cr
Increase/decrease in allowance for receivables (SPL)
Allowance for receivables (SOFP)
Note that the debit entry could be to the 'irrecoverable debts expense' account. The impact on the
statement of profit or loss is the same.
Lecture example 3
Preparation question
A company has a trade receivables balance of $100,000 but requires an allowance for receivables
equivalent to 5% of the balance.
Required
(a)
Record the allowance for receivables in the accounts below.
(b)
Show how this would appear in extracts to the statement of profit or loss and statement of
financial position.
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Solution
(a)
Allowance for receivables (SOFP)
$
Increase/decrease in allowance for receivables (SPL)
$
Workings
(b)
STATEMENT OF FINANCIAL POSITION (extract)
$
Total value of receivables
Less allowance for receivables
Statement of financial position value
STATEMENT OF PROFIT OR LOSS (extract)
$
Expenses
Allowance for receivables
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$
$
12: IRRECOVERABLE DEBTS AND ALLOWANCES
Adjusting the allowance for receivables at the period end
4.4
In subsequent years, adjustments may be needed to the amount of the allowance. When
adjusting the allowance at the period end the procedure is to:
(a)
Calculate the new allowance required;
(b)
Compare it with the opening balance on the allowance account (ie the balance b/d in
the SOFP from the previous accounting period); and
(c)
Calculate the increase or decrease required.
Accounting treatment
4.5
At the period end, when an allowance already exists but is subsequently increased in size,
the amount of the increase in allowance is charged as an expense in the statement of profit
or loss for the period in which the increased allowance is made.
Increase:
Dr
Cr
4.6
Increase/decrease in allowance for receivables (SPL)
Allowance for receivables (SOPF)
Likewise, when an allowance already exists, but is subsequently reduced in size, the
amount of the decrease in allowance is credited back to the statement of profit or loss for
the period in which the reduction in allowance is made.
Decrease:
Dr
Cr
Allowance for receivables (SOFP)
Increase/decrease in allowance for receivables (SPL)
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Lecture example 4
Preparation question
A business has an allowance for receivables (SOFP) brought forward from the year end
31 December 20X2 of $5,500.
Total receivables outstanding at 31 December 20X3 are $240,000. Upon reviewing the balances, it
is determined that an allowance should be made equivalent to 4% of the total balance.
Required
Complete the statements below.
Solution
(a)
The allowance for receivables to be shown in the statement of financial position at
31 December 20X3 is $_______
(b)
The increase/decrease in allowance for receivables included in the statement of profit or
loss for the year ended 31 December 20X3 is $_______ debit/credit.
Workings
Allowance for receivables (SOFP)
$
Increase/decrease in allowance for receivables (SPL)
$
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$
$
12: IRRECOVERABLE DEBTS AND ALLOWANCES
Lecture example 5
Preparation question
A business has an allowance for receivables (SOFP) brought forward from the year end
31 December 20X6 of $8,400.
Total receivables outstanding at 31 December 20X7 are $210,000. Upon reviewing the balances, it
is determined that an allowance should be made equivalent to 3% of the total balance.
Required
Complete the statements below.
Solution
(a)
The allowance for receivables to be shown in the statement of financial position at
31 December 20X7 is $______
(b)
The increase/decrease in allowance for receivables included in the statement of profit or
loss for the year ended 31 December 20X7 is $______ debit/credit.
Workings
Allowance for receivables (SOFP)
$
Increase/decrease in allowance for receivables (SPL)
$
$
$
Adjusting the allowance for receivables during the year
4.7
During the year it may be found that a debt which had previously been deemed doubtful is
no longer doubtful, but definitely bad (irrecoverable). It should therefore be removed from
trade receivables.
Accounting treatment
4.8
Dr
Cr
Irrecoverable debt expense (SPL)
Trade receivables (SOFP)
4.9
The allowance for receivables will be adjusted when the period end accounts are prepared.
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5
Irrecoverable debts and allowance for receivables,
combined
5.1
A CBE question may test the accounting treatment for irrecoverable debts and allowance for
receivables within one requirement. The order of the calculations is important in these tasks.
The allowance against the trade receivables balance is made after writing off any
irrecoverable debts.
5.2
Remember, in the real world (and in the CBE) it doesn't matter whether the irrecoverable
debt expense account and increase/decrease in allowance for receivables (SPL) account
are combined or shown as two separate accounts. The affect on the statement of profit or
loss is the same.
Lecture example 6
Exam standard for 2 marks
At 31 December 20X2 a company's receivables totalled $450,000 and an allowance for
receivables of $35,000 had been brought forward from the year ended 31 December 20X1.
It was decided to write off debts totalling $22,000. The allowance for receivables is to be adjusted
to 10% of receivables.
Required
What charge for receivables expense should appear in the company's statement of profit or loss
for the year ended 31 December 20X2?
Solution
A
B
C
D
$22,000 debit
$35,000 debit
$7,800 debit
$29,800 debit
Workings
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6
Chapter summary
Section
Topic
Summary
1
Introduction
A trade receivable is an asset of the business which
should only be shown in the financial statements if it is
believed to be recoverable.
2
Writing off
irrecoverable debts
Irrecoverable debts must be written off as an
expense in the statement of profit or loss.
3
Irrecoverable debts
written off and
subsequently paid
As the debt has already been written off, it no longer
exists in the statement of financial position. Therefore,
the cash received is offset against the irrecoverable
debts expense account.
4
Allowance for
receivables
A business may make an allowance for receivables as
a prudent precaution to account for the fact that some
receivables balances might not be collectable.
5
Irrecoverable debts
and allowance for
receivables, combined
A CBE question may ask you to consider the impact on
the statement of profit or loss if there is an irrecoverable
debt and movement on the allowance for receivables.
When doing your calculation remember to write off the
irrecoverable debt first. And then calculate the
increase/decrease in allowance for receivables on the
remaining balance.
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7
Double Entry Summary for Chapter 12
7.1
Irrecoverable debt adjustment:
Dr
Cr
7.2
Recording of cash received from a customer whose balance was previously written off:
Dr
Cr
7.3
Cash (SOFP)
Irrecoverable debt expense (SPL)
Increase in the allowance for receivables at the period end:
Dr
Cr
7.4
Irrecoverable debt expense (SPL)
Trade receivables (SOFP)
Increase/decrease in allowance for receivables (SPL)
Allowance for receivables (SOFP)
Decrease in the allowance for receivables at the period end:
Dr
Cr
Allowance for receivables (SOFP)
Increase/decrease in allowance for receivables (SPL)
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Sales tax
Syllabus Guide Detailed Outcomes
Having studied this chapter you will be able to:


Understand the general principles of the operation of a sales tax.
Calculate sales tax on transactions and record the consequent accounting entries.
Exam Context
This topic is likely to be tested in two main ways. You may be asked to identify the correct journal entry to post sales and
purchases transactions including sales tax. You may also be required to consider how sales tax affects the calculation of
amounts to be capitalised for non-current assets.
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Overview
Output tax
Input tax
Accounting treatment
Sales tax
Rates of sales tax
Irrecoverable sales tax
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1
Introduction
1.1
This chapter is designed to enable you to prepare basic accounting entries for sales tax,
known in many countries as Value Added Tax (VAT).
Sales tax
1.2
A business' sales and purchases are often subject to sales tax. This is an indirect tax, as it
is not levied directly on the individual like personal income tax. Sales tax is collected by
traders who charge it on the goods they sell to the customer.
A business charges sales tax on its sales (output tax) and suffers sales tax on its
purchases (input tax). Typically, a business which is registered for sales tax only needs to
make a payment to the tax authorities of the net amount of sales tax (ie sales tax owed on
outputs less sales tax suffered on inputs).
Purchases
Goods into factory
Sales
Goods out of factory
(input tax)
(output tax)
1.3
A registered business shows:
(a)
(b)
1.4
Items of income and expenditure net of sales tax;
Trade receivables and trade payables gross of sales tax.
Illustration (all figures include sales tax at 15%).
Purchase raw materials
Sell finished product
$115.00
$287.50
Required
Calculate the amounts due to or from the sales tax authority.
$
Input tax
Output tax
The rate of sales tax will always be provided in an exam question.
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2
Accounting treatment
Lecture example 1
A business buys goods for $1,000 plus 15% sales tax. They then sell those goods for $1,500 +
15% sales tax.
The purchases will cost ($1,000 × 1.15) = $1,150
The sales will raise
($1,500 × 1.15) = $1,725
The sales tax payable to tax authorities will be:
Payable on outputs (sales)
Reclaimable on inputs (purchases)
Net sales tax to tax authorities
$
225.00
(150.00)
75.00
(15% × $1,500)
(15% × $1,000)
As the business is purely collecting the sales tax for the tax authorities, and is able to set off its
sales tax suffered it does not include sales tax as either an expense or income in the statement of
profit or loss. The sales tax is accounted for when the transaction occurs.
Required
(a)
Post the double entry to the ledger account below.
$
1,000
150
Dr Purchases
Dr Sales tax control account
Cr Trade payables
$
1,150
Solution
(a)
Purchases (P/L)
Trade payables (SOFP)
Sales tax control account (SOFP)
Points to note
Purchases
–
Trade payables –
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GROSS
13: SALES TAX
Required
(b)
Post the double entry to the ledger account below.
$
1,725
Dr Trade receivables
Cr Sales
Cr Sales tax control account
$
1,500
225
Solution
Sales (P/L)
Trade receivables (SOFP)
Sales tax control account (SOFP)
$
Balance b/d
150
$
Points to note
Sales
Trade receivables
– NET
– GROSS
3
Irrecoverable sales tax
3.1
In some tax regimes, sales tax on certain inputs is never recoverable. For example, sales
tax on business entertaining or on cars may not be recoverable. In this case the tax is a
genuine expense of the business and is charged to the statement of profit or loss or
included in the cost of an asset to be depreciated. For example, the double entry for buying
a car where the sales tax is irrecoverable would be:
Dr
Cr
Motor vehicles account
Cash account
Cost + sales tax
Cost + sales tax
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Lecture example 2
During 20X1 Fergus buys two vans and a car each costing $10,000 plus sales tax at 15%. The car
will be used 70% for business use and 30% personal use. The vans will be used exclusively for
business use. He depreciates vehicles on a straight line basis, vans over five years and cars over
six years.
In the tax regime in which Fergus operates sales tax is only recoverable on items used wholly for
business purposes.
What is his depreciation expense to the nearest $ for the year?
A
B
C
D
$5,666
$5,917
$6,100
$6,517
Solution
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4
Rates of sales tax
4.1
Most goods and services are subject to sales tax at the standard rate.
4.2
Some goods are known as zero rated or exempt goods.
4.3
If goods are zero rated, such as books and newspapers, then sales tax is still charged on
them but it is charged at a rate of 0%. A business making zero rated supplies can still claim
back any input sales tax suffered on its purchases (at the relevant rate).
4.4
Exempt goods, such as banking, however are not subject to sales tax and a business
making only exempt supplies cannot be registered for sales tax and cannot therefore
reclaim input sales tax suffered on its purchases.
5
Chapter summary
5.1
Section
Topic
Summary
1
Introduction
A business acts as a collecting agent for the tax
authorities and charges sales tax (output tax) on its
sales and reclaims sales tax (input tax) on its
purchases.
2
Accounting treatment
Sales and purchases are recorded at the net amount.
Sales tax may be charged at various rates, however
the rate of sales tax will always be provided in an
exam question.
3
Irrecoverable sales tax
Sales tax may not be recoverable on certain purchases.
Where this is the case the question will state that the
sales tax is not recoverable and the cost recorded will
be the gross amount.
4
Rates of sales tax
Zero rated supplies have sales tax charged on them at
0% whereas exempt supplies are not subject to sales
tax.
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7
Double Entry Summary for Chapter 13
7.1
Recording a credit purchase with sales tax:
Dr
Dr
Cr
7.2
Purchases
Sales tax control account
Trade payables
net
tax
gross
Recording a credit sale with sales tax:
Dr
Cr
Cr
Trade receivables
Sales
Sales tax control account
gross
net
tax
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Control accounts
Syllabus Guide Detailed Outcomes
Having studied this chapter you will be able to:

Understand the purpose of control accounts for accounts receivable and accounts payable.

Understand how control accounts relate to the double entry system.

Prepare ledger control accounts from given information.

Perform control account reconciliations for accounts receivable and accounts payable and identify errors which
would be highlighted by performing them.

Identify and correct errors in control accounts and ledger accounts.

Account for discounts allowed and discounts received.

Account for contras between trade receivables and trade payables.

Understand and record sales and purchase returns.

Prepare, reconcile and understand the purpose of supplier statements
Exam Context
Questions on this topic are likely to require you to correct the closing balance on a receivables or payables control
account including items such as contras and discounts or calculate the correct balance per the receivables/payables
ledger. You may also be required to prepare a receivables or payables ledger control account to find a missing figure.
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Overview
Reconciliations
Receivables ledger control account
Payables ledger control account
Receivables ledger
Payables ledger
Control accounts
Contra entries
Returns, credit notes, refunds
and over payments
Trade discounts
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Supplier statement
reconciliations
Discounts
allowed and received
Settlement discounts
14: CONTROL ACCOUNTS
1
Recap
1.1
In Chapters 4 and 5 we saw how a business' transactions were categorised in the books of
prime entry. The totals of these were then posted using double entry to the nominal ledger
to give a summary of the information.
1.2
For example, credit sales:
1.3
The nominal ledger contains three ledger accounts which are affected when a business sells
on credit:
(a)
Sales
(b)
Bank
(c)
Trade receivables – This shows the total amount owed by all customers at a
particular point in time.
– It is also called the receivables ledger control account
(RLCA).
1.4
In order to chase overdue debts however a business must know how much each customer
owes at a particular time.
This balance could be determined by going back into the detail of the books of prime entry
and extracting the information for each customer.
This is a very time consuming process and so instead a memorandum ledger is
maintained for each individual customer showing invoices raised, cash received and
therefore the amount owed to the business.
This memorandum ledger is called a receivables ledger.
1.5
The reverse is true when a business buys on credit.
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Terminology
1.6
In the nominal ledger:

Receivables ledger control account (trade receivables/RLCA):
total owed by all credit customers.

Payables ledger control account (trade payables/PLCA):
total owed to all credit suppliers.
Memorandum ledgers:
2

Receivables ledger:
balance owed by each individual credit customer

Payables ledger:
balance owed to each individual credit supplier
The flow of information
2.1
Memo
Receivables
Ledger
Payment
to
suppliers
Receipt
from
customers
Sales
Invoice
SDB
Cash book
Purchase
Invoice
PDB
Memo
Payables
Ledger
Supplier X
Customer A
Customer B
Nominal Ledger
PLCA
Trade payables
Customer C
Supplier Y
Supplier Z
Bank
Purchases
Sales
Trial Balance
Financial Statements
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2.2
The information in the receivables ledger control account (RLCA) and receivables ledger
(RL) is posted from the same source documents.
Therefore
The balance on the RLCA should equal the sum of all balances from the RL
Similarly
The balance on the PLCA should equal the sum of all balances from the PL
2.3
If the balances do not agree then an error has been made. This will be identified through a
control account reconciliation (Section 5).
Lecture example 1
Preparation question
A Co has the following information:
10 January 20X6
Sells $150 of goods to Customer A
Sells $200 of goods to Customer B
15 January 20X6
A Co purchases $100 of goods from Supplier Y
A Co purchases $1,300 of goods from Supplier Z
21 January 20X6
A Co receives full payment from Customer B and this money is used to pay Supplier Y.
Required
(a)
(b)
(c)
(d)
Record the above transactions in the books of prime entry and the memorandum ledgers.
Post the totals from the books of prime entry to the nominal ledger.
Balance off nominal ledger accounts.
Reconcile the memorandum ledgers to the control accounts.
Solution
(a)
Books of prime entry
Sales day book
Date
Customer
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Amount
14: CONTROL ACCOUNTS
Purchase day book
Date
Supplier
Amount
Cash receipts book
Date
Narrative
Total
Sales
Receivables
Total
Purchases
Payables
Cash payments book
Date
Narrative
Memorandum ledgers
Receivables ledger
Customer A
Customer B
Payables ledger
Supplier Y
Supplier Z
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(b) & (c) Nominal ledger
RLCA (SOFP)
PLCA (SOFP)
Bank (SOFP)
Sales (SPL)
Purchases (SPL)
(d)
Reconciliation
Balance per list of balances
$
Receivables ledger
Customer A
Customer B
Balance per RLCA
Balance per list of balances
$
Payables ledger
Supplier Y
Supplier Z
Balance per PLCA
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3
Other entries
A business must ensure that any transaction recorded in the receivables ledger control
account or the payables ledger control account is also reflected in the memorandum
ledgers.
Contra entries
3.1
Sometimes a business may have a customer which also supplies the business with goods.
Illustration:
P Co is a printing business which sells stationery to F Co, a florist. F Co supplies P Co with
flowers and plants for its offices.
During October, P Co sells stationery worth $200 to F Co and F Co delivers flowers and
plants to P Co worth $70.
P Co has the following amounts in its books:
Receivables:
Payables:
$200
$70
The two businesses agree to offset the balances receivable and payable via a contra.
The contra will be for the lower of the two amounts: $70. This will decrease both
receivables and payables by $70 and the remaining $130 can then be paid in cash.
3.2
A contra entry is always recorded as:
Dr
Cr
PLCA
RLCA
This will reduce both receivables and payables.
3.3
Note that the memorandum ledgers will also need to be updated for the contra entry.
Returns, credit notes and refunds
3.4
Sometimes when a business has made a sale, the customer will return the goods. Equally
when the business has purchased some goods on credit, it may return them to the supplier.
3.5
Steps for sales returns:
(1)
Goods are sold to the customer for $250:
Dr
Cr
(2)
RLCA
Sales
$250
$250
Customer pays for goods:
Dr
Cr
Bank
RLCA
$250
$250
At this point the balance on the receivables ledger control account is nil.
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(3)
Customer returns the goods and is issued with a credit note:
Dr
Cr
Sales (returns)
RLCA
$250
$250
This entry reverses the original sale.
The receivables ledger control account will show a credit balance reflecting that the
business owes money to the customer. This could be offset against future sales or the
customer may request a refund.
(4)
The business refunds the customer:
Dr
Cr
RLCA
Bank
$250
$250
Once again the balance on the receivables ledger control account is nil.
3.6
Steps for purchase returns:
(1)
Goods are purchased from the supplier for $100:
Dr
Cr
(2)
Purchases
PLCA
$100
$100
The business pays the supplier:
Dr
Cr
PLCA
Cash
$100
$100
At this point the balance on the payables ledger control account is nil.
(3)
The business returns the goods to the supplier and is issued with a credit note:
Dr
Cr
PLCA
Purchases (returns)
$100
$100
This entry reverses the original purchase.
The payables ledger control account will show a debit balance reflecting that the
supplier owes money to the company. This could be offset against future purchases
or the business may request a refund.
(4)
The supplier refunds the business:
Dr
Cr
Bank
PLCA
$100
$100
Once again the balance on the payables ledger control account is nil.
3.7
Again, the memorandum ledgers must also be updated.
Over payment
3.8
If a customer pays too much to settle an invoice or pays an invoice twice the business will
owe the excess to the customer.
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This may be held and treated like a credit note or the monies refunded to the customer.
3.9
Equally if the business pays too much to a supplier, the supplier will owe the excess to the
business and as for sales, this may be held and treated like a credit note or the monies
refunded by the supplier.
Interest on overdue accounts
3.10 If a customer is late in settling their account then an entity may decide to charge them
interest.
This will increase the amount they owe and will be shown as interest receivable in the
statement of profit or loss.
The same could apply to late payment to suppliers.
Interest on overdue accounts is recorded using the following journal:
On trade receivables:
Dr
Cr
RLCA
Interest receivable (SPL)
On trade payables:
Dr
Cr
Interest payable (SPL)
PLCA
4
Discounts
4.1
There are two types of discounts:
(a)
(b)
Trade discounts
(i)
Given at the time of the sale/purchase, they reduce the selling price as an
inducement to purchase;
(ii)
Usually for regular customers or bulk buyers.
Settlement discounts
(i)
(ii)
Offered, but not necessarily taken, as an inducement to settle a debt early;
eg 5% discount if settled within 14 days.
Terminology
4.2
Discounts allowed: offered by the business to their customer.
Discounts received: received by a business from their supplier.
Discounts allowed
4.3
Accounting treatment
Sales are always recorded net of (ie after) trade discounts. Therefore trade discounts never
appear in the financial statements.
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If a customer is expected to take up a settlement discount allowed, the discount is
deducted from the invoiced amount when recording the revenue for the sale. If the customer
subsequently does not take up the discount, the discount is then recorded as revenue.
If the customer is not expected to take up the discount, the full invoiced amount is
recognised as revenue when recording the sale. If the customer then does take up the
discount, revenue is reduced by the amount of the discount.
Lecture example 2
(a)
Preparation question
On 1 January 20X7 a business made a sale on credit for $12,000. A trade discount of
$2,000 was available with a further 10% settlement discount if payment were made within
10 days. The business expected the customer to take up the discount.
Required
Record the initial sale.
Solution
The initial sale would be recorded as:
Sales (SPL)
(b)
RLCA (SOFP)
On 4.1.X7, the customer pays for the goods taking advantage of the settlement discount.
Required
Record the full settlement of the amount owed.
Solution
Bank (SOFP)
(c)
RLCA (SOFP)
Required
What would your answer be to part (b) if the settlement discount were not taken?
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Solution
Bank (SOFP)
RLCA (SOFP)
Sales (SPL)
Discounts received
4.4
Accounting treatment
Purchases are recorded net of trade discounts but inclusive of settlement discounts.
Again trade discounts never appear in the financial statements.
Settlement discounts received are recorded as discounts received and are shown as
sundry income in the statement of profit or loss.
Dr
Cr
PLCA (SOFP)
Discounts received (SPL)
Lecture example 3
Preparation question
Ryan Co purchases goods worth $5,000 from Austin Co. Ryan Co will receive a 5% settlement
discount if the goods are paid for within seven days. Ryan Co has every intention of taking
advantage of the settlement discount.
Required
In the books of Ryan:
(a)
(b)
(c)
Show the initial recording of the purchase.
Record the payment for the goods assuming Ryan pays within seven days.
Record the payment for the goods if payment is made after seven days.
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Solution
5
Control account reconciliations
5.1
As mentioned in Section 2 if we add up the balances in the receivables and payables
ledgers, they should agree to the balances per the RLCA and PLCA.
If not, an error must have occurred at some point in the system.
The easiest way to identify the error is to perform a reconciliation between the two amounts.
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5.2
Proforma control account reconciliation
Balance b/d
Sales day book undercast
Sales omitted from SDB
Balance b/d
RLCA
$
X
Transposition error in posting
X
X
Balance c/d
X
X
X
X
Reconciliation Statement
$
+
Total per listing of receivables ledger
balances
Adjustments
Balance omitted
Credit balance listed as debit
$
–
$
X
X
X
(2X)
X
Balance as per adjusted control account
Lecture example 4
(a)
$
X
X
X
Technique demosntration
Required
Post the following transactions to, and balance off, the receivables ledger control account.
(1)
(2)
(3)
(4)
(5)
(b)
Opening balance $614,000
Credit sales made during the month $302,600
Receipts from customers $311,000
Bad debts were written off $35,400
Contras against amounts due to suppliers in payables ledger $8,650
The receivables ledger list of balances totals to $563,900.
You have found the following errors:
(i)
The total of the sales day book was undercast by $3,600.
(ii)
A credit balance of $450 was included in the list of balances as a debit.
(iii)
A customer balance of $2,150 was left out when the receivables ledger list of
balances was totalled.
Required
Reconcile the receivables ledger control account to the receivables ledger list of balances.
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Solution
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6
Exam standard examples
Lecture example 5
Exam standard for 2 marks
The total of the list of balances in Moor's payables ledger was $877,800 at 30 June 20X5. This
balance did not agree with Moor's payables ledger control account balance. The following errors
were discovered:
(1)
A contra entry of $1,960 was recorded in the payables ledger control account, but not in the
payables ledger.
(2)
The total of the purchases returns daybook was undercast by $2,000.
(3)
An invoice for $8,688 was posted to the supplier's account as $8,868.
What amount should Moor report in its statement of financial position for accounts payable
at 30 June 20X5?
A
B
C
D
$875,660
$876,020
$879,580
$873,660
Solution
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Lecture example 6
Exam standard for 2 marks
Would the following errors affect the payables ledger control account (PLCA), the list of
balances or both? Tick as appropriate.
PLCA
A page of the purchases day book was undercast
by $1,000
An invoice of $250 was omitted from the purchases
day book
A cash payment to a supplier for $756 was entered
into the cash book in error as $765
A contra of $100 was omitted from a supplier's
account in the payables ledger
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List of
balances
Both
14: CONTROL ACCOUNTS
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Additional Notes
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7
Supplier statement reconciliations
Supplier statements
7.1
A supplier will usually send a monthly statement showing invoices issued, credit notes,
payments received and discounts issued.
Reconciliations
7.2
These statements should be compared to the supplier's account in the payables ledger to
identify any discrepancies and to correct any errors.
7.3
Neither the supplier's statement nor the payables ledger form part of the double entry
system.
Reconciling items
7.4
Reconciling items may occur as a result of the following:
Reconciling item
Effect
Payments in transit
A payment will go in the payables ledger when
the cheque is issued or when a bank transfer is
made. There will be a delay (postal, processing)
before the payment is entered into the records of
the supplier.
Invoices/credit notes in transit
When a supplier issues an invoice or credit note,
they will enter it into their records. They will be a
delay (postal) before the invoice or credit note is
entered into the business' payable ledger.
Errors of omission
Either the supplier or the business may omit an
invoice or credit note in error.
Addition error
Summation errors can occur, particularly if a
statement of account is prepared manually.
Misposting
Invoice, credit note or payment amounts may be
misposted (eg wrong amount or subtracted
rather than added or vice versa).
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Proforma
7.5
Reconciliation Statement
$
Total per supplier's statement
X
Adjustments
Payment not on statement
Invoice not on payables ledger
Credit note not on payables ledger
Balance as per payables ledger
(X)
(X)
X
X
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8
Chapter summary
Section Topic
Summary
1
The balance of the receivables ledger control account
and the payables ledger control account in the nominal
ledger show the total owed by all credit customers and
due to all credit suppliers.
Recap
The purpose of the memorandum ledgers is to show the
balance on each individual customer or supplier account.
2
The flow of
information
Given that the nominal ledger and the memorandum
ledgers are updated from the same source
documentation, at any point in time the balance on the
control accounts should equal the total of all the
balances in the memorandum ledgers.
Where the two balances are not the same an error must
have arisen and a reconciliation should be performed to
identify the errors (Section 5).
3
Other entries
If an entity has a customer who is also a supplier the two
parties may choose to settle their accounts by making a
contra entry. The contra is always for the lower of the
two balances.
If a customer returns goods having paid for them or
overpays for goods then the entity will owe money back
to that customer and the customer will have a credit
balance on their account.
If the business returns the goods to the supplier having
paid for them or overpays for goods then the supplier will
owe money back to the business and there will be a
debit balance on the supplier's account.
If a customer is late in settling their account or the
business is late in paying its supplier, interest may be
charged on the overdue account. This will increase the
balance owed.
4
Discounts
Sometimes a business may offer discounts to attract
customers. There are two types of discounts: trade
discounts and settlement discounts.
Sales and purchases are recorded after trade discounts.
Sales are recorded net of settlement discounts if the
customer is expected to take them up.
Purchases are recorded before the deduction of
settlement discounts, with the discount (if taken)
recorded as sundry income.
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Section Topic
Summary
5
Control account
reconciliations
As detailed in Section 2 if the balance on the control
account does not agree to the total of all the balances
on the memorandum ledger then an error must have
occurred and a reconciliation will need to be carried out
to identify the differences.
7
Supplier statement
reconciliation
When the monthly supplier statement is received, it
should be reconciled to the payables ledger to identify
any discrepancies or errors. Neither the supplier
statement nor the payables ledger form part of the
double entry system.
9
Double Entry Summary for Chapter 14
9.1
Contra entry adjustment:
Dr
Cr
9.2
Adjustment to record settlement discounts allowed to customers (when not anticipated):
Dr
Cr
9.3
Payables ledger control account (SOFP)
Receivables ledger control account (SOFP)
Revenue
Receivables ledger control account (SOFP)
Adjustment to record settlement discounts received from suppliers:
Dr
Cr
Payables ledger control account (SOFP)
Discounts received (SPL)
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Bank reconciliations
Syllabus Guide Detailed Outcomes
Having studied this chapter you will be able to:





Understand the purpose of bank reconciliations.
Identify the main reasons for differences between the cash book and the bank statement.
Correct cash book errors and/or omissions.
Prepare bank reconciliation statements and identify the bank balance to be reported in the final accounts.
Derive bank statement and cash book balances from given information.
Exam Context
Exam questions are likely to ask you to perform calculations to correct a bank reconciliation. Alternatively they may ask
you to state whether differences between the cash book and the bank statement should be adjusted in the cash book or
in the reconciliation statement. You could also be asked to derive either the bank statement or cash book balance from
given information.
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Overview
Bank reconciliations
Bank statement balance
Cash book balance
Differences
Timing differences
Errors by the business
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Errors by the bank
15: BANK RECONCILIATIONS
1
Introduction
1.1
This chapter is designed to enable you to explain and apply the approach to identifying and
correcting errors through the use of bank reconciliations.
1.2
The cash book is used to record the detailed transactions of receipts and payments into and
out of the bank account. These are then posted to the nominal ledger periodically using
double entry. At the end of each accounting period, the balance on the cash book should
equal the balance in the nominal ledger cash account.
1.3
Bank statements provide an independent record of the balance on the bank account but this
balance is unlikely to agree exactly to the cash book balance – therefore a reconciliation is
required.
Differences between the cash book balance and the bank statement
1.4
Differences essentially occur for three reasons:
(a)
(b)
Timing differences:
(i)
Outstanding lodgements/deposits credited after date (money paid into the
bank by the business but not yet appearing as a receipt on bank statement)
(ii)
Unpresented/outstanding cheques (cheques paid out by business which
have not yet appeared on bank statement)
Errors by the business (ie in the cash book):
(i)
Omissions, such as:
standing orders
direct debits
bank charges
interest
(c)
(ii)
Transposition errors
(iii)
Casting errors
Errors by the bank.
A word of warning
1.5
In the books of the business:
POSITIVE BANK BALANCE = ASSET = DEBIT
NEGATIVE BANK BALANCE (OVERDRAFT) = LIABILITY = CREDIT
But from the bank's point of view:
POSITIVE BALANCE = LIABILITY = CREDIT (the bank owes you your money)
NEGATIVE BALANCE (OVERDRAFT) = ASSET = DEBIT
(you owe the bank  this is an asset for the bank)
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2
Preparing a bank reconciliation
Procedures
2.1
(a)
(b)
Compare the bank statement to the cash account and tick off all items which agree.
Remaining items must represent timing differences or errors – decide which!
Example of how to set out a bank reconciliation
2.2
Cash account
$
X
Dishonoured cheque
Bank charges
Standing orders
X
Direct debits
Balance c/d
X
Balance b/d
Under cast error in balance b/d
$
X
X
X
X
X
X
$
X
X
(X)
X/(X)
Balance per bank statement
plus outstanding lodgements
less unpresented cheques
plus/less bank errors
Balance per adjusted cash account
X
Practical tips
2.3
(a)
On reconciliation, put overdrafts and payments in brackets.
(b)
It is the corrected cash account balance which is shown on the statement of financial
position. This figure will be the recalculated 'Balance c/d' on the cash account (or the
total at the end of the reconciliation statement – which should be identical!).
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Lecture example 1
Preparation question
The cash account of Graham showed a debit balance of $204 on 31 March 20X8. A comparison
with the bank statements revealed the following.
$
(1) Cheques drawn but not presented
3,168
(2)
Amounts paid into the bank but not credited
(3)
Entries in the bank statements not recorded in the cash account
(i)
Standing order payments
(ii) Interest on bank deposit account
(iii) Bank charges
(4)
723
35
18
14
Balance on the bank statement at 31 March 20X8
2,618
Required
Make any necessary adjustments to the cash book balance and complete the bank reconciliation
statement as at 31 March 20X8.
Solution
Adjustment of cash book balance
Cash account
$
$
Bank reconciliation statement
$
Balance per bank statement 31 March 20X8
Outstanding lodgements
Unpresented cheques
Balance per cash account at 31 March 20X8
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Lecture example 2
Exam standard for 2 marks
Whilst preparing a bank reconciliation statement at 31 December. The following items caused a
difference between the bank statement balance and the cash book balance.
(1)
(2)
(3)
(4)
(5)
Bank interest charged to the account in error
Direct debit for $500 for insurance
Bank charges of $70
Cheque paid to a supplier on 29 December
Receipt from a trade receivable by electronic transfer
Which of these items will result in an adjustment to the balance per the bank statement?
A
B
C
D
2, 3, and 5
1 and 4
1, 4, and 5
1, 3 and 5
Solution
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Lecture example 3
Exam standard for 2 marks
The following bank reconciliation has been prepared by a trainee accountant:
$
Overdraft per bank statement
Less: unrepresented cheques
7,720
18,320
10,600
33,380
43,980
Add: outstanding lodgements
Cash at bank
What should be the correct balance per the cash book?
A
B
C
D
$43,980 balance at bank as stated
$22,780 balance at bank
$7,340 balance at bank
$7,340 overdrawn
Solution
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Lecture example 4
Exam standard for 2 marks
Jed is preparing his monthly bank reconciliation. The unadjusted balance per the cash book (prior
to performing a bank reconciliation) is a debit balance of $2,500. The balance per the cash book
and the balance per the bank statement do not agree for the following reasons:
(1)
Cheques to the value of $750 written and sent to suppliers but not yet presented by the
suppliers for payment.
(2)
Bank charges of $100 not yet entered in the cash book.
(3)
An error by the bank in crediting to another customer's account a lodgement of $300 by Jed.
(4)
A payment of $538 was recorded in the cash book as $583.
What was the original balance per the bank statement?
A
B
C
D
$2,445
$1,995
$2,805
$2,895
Solution
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3
Chapter summary
Section Topic
Summary
1
A business maintains a cash book to tell it how much
cash it has at a particular point in time. It should
reconcile this balance to the bank statement in order to
ensure the cash book information is accurate.
Introduction
Differences between the cash book balance and the
bank statement balance will arise for three reasons:
timing differences, errors by the business and
errors by the bank.
2
Preparing a bank
reconciliation
The bank reconciliation is produced by checking all of
the items on the bank statement to the cash book to
ensure that they have all been recorded.
Any items not in the cash book will then need to be
recorded and the cash book updated.
The balance per the bank statement must then be
adjusted for any timing differences (unrecorded
lodgements and outstanding cheques) or errors by the
bank.
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Correction of errors
Syllabus Guide Detailed Outcomes
Having studied this chapter you will be able to:

Identify the types of error which may occur in bookkeeping systems.

Identify errors which would be highlighted by the extraction of a trial balance.

Prepare journal entries to correct errors.

Calculate and understand the impact of errors on the statement of profit or loss and other comprehensive income
and statement of financial position.

Understand the purpose of a suspense account.

Identify errors leading to the creation of a suspense account.

Record entries in a suspense account and make journal entries to clear it.
Exam Context
Questions on this area are likely to focus on three main areas. You may be asked to identify which explanations could
have led to a particular difference or be asked to identify the journal entry to correct an error. You may also need to
determine the effect errors may have on the profit figure.
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Overview
Types of error
Correction of errors
Suspense account
Adjustments to profit
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1
Introduction
1.1
Chapter 6 showed us how the trial balance was extracted from the ledger accounts and that
it should balance, ie total debits should equal total credits.
1.2
If the trial balance doesn't balance then an error has definitely been made and must be
corrected.
2
Types of error
2.1
The following errors will still allow the trial balance to balance.
Type of error
Example
Error of omission
Error of commission
Error of principle
Compensating error
2.2
The trial balance will not balance if total debits do not equal total credits.
This could be due to the following:
(a)
Transposition error
(b)
An entry has been posted where
(i)
Debits  credits
(ii)
A debit entry has been posted and no corresponding credit made (or vice
versa)
Two debit entries or two credit entries have been posted.
(iii)
These errors will be corrected by creating a suspense account and making a journal entry
to correct the error.
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3
Suspense accounts
3.1
A suspense account is a temporary account. They never appear in the final accounts.
3.2
It is used for two main reasons:
3.3
(a)
To account for a debit or credit entry when the accountant is unsure as to where it
should go
(b)
To make a preliminary trial balance balance when an error has been detected
Steps to clear a suspense account.
(1)
(2)
(3)
3.4
Determine the original accounting entry which was made.
Decide what entry should have been made.
Make the required adjustment.
Illustration
W Co sold goods with a value of $2,500 to James, a credit customer. When recording the
sale W Co posted the transaction to the correct accounts but made two debit entries.
Steps
(1)
Entry made was:
Dr
Dr
(2)
$2,500
$2,500
Entry should have been:
Dr
Cr
(3)
Trade receivables
Sales
Trade receivables
Sales
$2,500
$2,500
Correction:
The trade receivables entry is correct but sales have been debited by $2,500 when
they should have been credited by that amount.
The correction is therefore twice the original error:
Dr
Cr
Suspense account
Sales (2  $2,500)
$5,000
$5,000
Being: correction of sales posting.
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Lecture example 1
Technique demonstration
Dan, the bookkeeper of Tiffany's, has made his usual mess of things and produced the following
attempt at a trial balance for the year ended 30 April 20X7.
$
Property, plant and equipment
At cost
Provision for depreciation
Capital at 1 May 20X6
Profit for the year
Inventory, at cost
Receivables ledger control account
Payables ledger control account
Balance at bank
$
60,000
31,000
53,000
12,300
14,000
9,600
1,640
85,240
6,500
102,800
As chief accountant you discover the following:
(1)
A rent payment of $350 in March 20X7 had been debited in the receivables ledger control
account.
(2)
Irrecoverable debts of $500 during the year ended 30 April 20X7 had not been recorded in
the books.
(3)
No entry had been made for the refund of $2,620 made by cheque to V Woolf in March
20X7, in respect of defective goods returned to Tiffany. V Woolf, who had already paid for
the goods, returned them on 28 February 20X7.
(4)
The total column of the cash receipts book had been overcast by $1,900 in March 20X7.
(5)
The purchase of stationery for $1,460 cash in June 20X6 has been correctly entered in the
cash account, but no entry has been made to the appropriate expense account.
(6)
Capital of $35,000 was recorded incorrectly as $53,000.
Required
Prepare:
(a)
(b)
Journal entries to correct the above errors; and
A suspense account showing how it is cleared.
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Solution
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4
Adjustments to profit
4.1
When errors are corrected they may affect the business' profit for the year figure.
4.2
For example in Lecture example 1, item 5 tells us that a stationery expense of $1,460 has
not been recorded in the expense account.
The profit for the year figure in the trial balance of $12,300 is therefore too high and needs
to be corrected.
4.3
This is done by using a statement of adjustments to profit.
Proforma
4.4
$
–
Original profit
Adjustment:
(a) over depreciation
(b) unrecorded expense
(c) unrecorded sale
$
+
$
X
X
X
(X)
X
X
Adjusted profit
Lecture example 2
X/(X)
X
Technique demonstration
Required
Prepare a statement of adjustments to profit for Lecture example 1.
Solution
STATEMENT OF ADJUSTMENTS TO PROFIT FOR THE YEAR ENDED 30 APRIL 20X7
Decreases
$
Draft profit
Adjustments
Revised profit
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Increases
$
$
16: CORRECTION OF ERRORS
Lecture example 3
Exam standard for 2 marks
Z Co's statement of profit or loss showed a profit of $112,400 for the year ended
30 September 20X7. The following errors were later discovered:
(1)
Sales returns of $2,700 had been recorded as a new sale.
(2)
A machine which had been held for two years and had originally cost $15,000 was
depreciated this year using a 33 31 % reducing balance basis. Z Co's policy is to depreciate
machines over four years.
What would be the net profit after adjusting for these errors?
A
B
C
D
$103,250
$105,750
$105,950
$108,450
Solution
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5
Chapter summary
Section Topic
Summary
1
Introduction
If the trial balance does not balance, an error has been
made.
2
Types of error
There are four types of errors: errors of omission,
commission, principle and compensating errors which
will still allow the trial balance to balance.
If an error is made however where debits ≠ credits then
the trial balance will not balance.
3
Suspense accounts
Where the trial balance does not balance a suspense
account will be inserted and the errors, once identified,
will be corrected via a journal entry.
A suspense account should never appear in the final
financial statements.
4
Adjustments to profit
Where the process of correcting errors requires
changes to income and expense accounts the
business' profit will be affected. In this case a
statement of adjustments to profit can be prepared
to determine the revised profit figure.
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Incomplete records
Syllabus Guide Detailed Outcomes
Having studied this chapter you will be able to:

Understand and apply techniques used in incomplete record situations:
(i)
(ii)
(iii)
(iv)
Use of accounting equation
Use of ledger accounts to calculate missing figures
Use of cash and/or bank summaries
Use of profit percentages to calculate missing figures
Exam Context
Questions on this chapter will require you to identify missing figures, for example sales, closing inventories and
drawings.
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Overview
Margin
Cost structures
Mark-up
Incomplete records
Techniques for solving
incomplete records
Accounting equation
Derive missing figures from
given information
Sales
Purchases
Drawings
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Inventory
17: INCOMPLETE RECORDS
1
Issue
1.1
Individuals running small businesses such as a newsagent or greengrocer may not keep all
of the accounting records we have studied or have a detailed understanding of double entry
bookkeeping.
1.2
They still need to know how the business is performing and so will produce financial
statements. If some necessary information isn't maintained by the business, it will need to
be derived from other available information.
2
Cost structures
2.1
Cost structure information is usually expressed in one of two ways, either as a margin or a
mark-up.
(a)
Margin:
Here gross profit is expressed as a percentage of sales, for example a
margin of 25% gives:
Sales
Cost of sales
Gross profit
(b)
Mark-up:
100%
75%
25%
Here gross profit is expressed as a percentage of cost of sales, for
example a mark-up of 35% gives:
Sales
Cost of sales
Gross profit
2.2
135%
100%
35%
Remember that:
Cost of sales = opening inventories + purchases – closing inventories
Lecture example 1
Preparation question
W Co has on average a profit margin of 40%. In 20X7 sales total $476,000.
Required
What is cost of sales?
$
Workings
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Lecture example 2
Preparation question
Y Co operates with a standard mark-up of 30% and has the following information available for
20X7.
$
Sales
221,000
Opening inventories
43,000
Closing inventories
47,500
Required
What is the value for purchases in 20X7?
$
Workings
Lecture example 3
Exam standard for 2 marks
On 1 January 20X7 J Co had inventory of $620,000. Sales for the month amounted to $985,000
and purchases were $700,000. At the end of January a fire in the warehouse destroyed some
inventory items. The owners salvaged inventory valued at $180,000. J Co operates with a mark up
of 25%.
What is the cost of inventory destroyed in the fire?
A
B
C
D
$335,000
$352,000
$401,250
$532,000
Solution
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3
Other techniques for solving incomplete records
Lecture example 4
Exam standard for 2 marks
Emma is a sole trader who does not keep full accounting records. The following details relate to
her transactions with credit customers and suppliers for the year ended 31 December 20X3:
Trade receivables, 1 January 20X3
Trade payables, 1 January 20X3
Cash received from customers
Cash paid to suppliers
Irrecoverable debts written off
Discounts received
Contra between payables and receivables ledgers
Trade receivables, 31 December 20X3
Trade payables, 31 December 20X3
$
65,000
30,000
343,200
151,400
700
1,480
1,000
90,500
42,000
What figure should appear for purchases in Emma's statement of profit or loss for the year
to 31 December 20X3?
A
B
C
D
$162,920
$163,880
$165,100
$165,880
Solution
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Lecture example 5
Preparation question
B Co maintains a cash float of $50. In 20X7, all receipts from credit customers were banked, after
the following payments from the till had been made:
$
General expenses
4,500
Drawings
6,250
Total bankings in the year amounted to $28,454, and opening and closing trade receivables were
$1,447 and $1,928 respectively.
Required
Based on the information above what was the value of sales made during the year? $
Workings
Petty Cash
$
$
Trade receivables
$
$
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Lecture example 6
Exam standard for 2 marks
Bob owns and manages B Co although he does not keep detailed accounting records.
All of Bob's sales are for cash. He pays certain expenses from his till and then banks the remaining
funds.
Bob maintains a $1,000 float and operates with a margin of 20%. He has provided you with the
following information.
$
Purchases of goods (on credit)
20,000
Wages for clerical assistant (per week; there are 52 weeks in the year)
100
Stationery
500
Electricity
1,200
Bankings
12,800
Opening inventories
2,000
Closing inventories
3,000
Bob is unsure of the level of drawings taken during the year but estimates they were between $60
and $90 per week.
Required
What were Bob's drawings during the year?
$
Workings
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4
Goods drawn by proprietor
4.1
The owners of the business may at times take goods or cash from the business for their own
use. We have seen these before as drawings.
In incomplete records questions these drawings need to be included.
Cash drawings
Dr
Cr
Drawings
Cash
Goods taken for own use
Dr
Cr
Drawings
Purchases
These are recorded at the cost to the business not at sale price.
They are taken out of purchases and not recorded against inventories.
Note: If you are using a trade payables T-account to calculate purchases remember to
adjust purchases for any goods taken by proprietor.
Example
4.2
During the year ended 31 December 20X7, Peter Albert, a sole trader, carried out the
following transactions:
$
4,000
2,700
Sales (40 units @ $100)
Purchases (45 units @ $60)
His inventories (at cost) were:
1 January 20X7
31 December 20X7
(5 units @ $60)
(8 units @ $60)
$
300
480
During the year he had withdrawn two units for his own use. Firstly, ignoring the drawings,
an outline trading account would appear as follows:
$
$
Sales
4,000
Cost of sales
Opening inventories
300
Purchases
2,700
3,000
Less: closing inventories
(480)
2,520
Gross profit
1,480
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How should the drawings of goods be treated?
It should be fairly obvious that the debit entry will be to drawings on the statement of
financial position, but what about the credit entry? It will not, as you might initially think, go
to inventories (because these goods were not in hand at the year end so they are not
included in the value of $480) but rather to purchases (as this is where they will have been
previously recorded).
In the trading account, this credit entry is often shown as a separate deduction from cost of
sales, ie:
$
$
Sales
4,000
Cost of sales
Opening inventories
300
Purchases
2,700
Less: goods drawn by proprietor
2 units @ $60
(120)
2,880
Less: closing inventories
(480)
2,400
Gross profit
1,600
Points to note
4.3
(a)
(b)
Drawings of goods are recorded at cost.
Gross profit figure now makes sense, ie profit of $40 per unit  40 units sold.
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5
Accounting equation
5.1
We saw in Chapter 6 that the statement of financial position can be stated as an equation:
Debits = Credits
Assets = Liabilities + Capital + Profit – Drawings
5.2
This can be rearranged as:
Assets – Liabilities (Net assets) = Capital + Profit – Drawings
5.3
Therefore the movement in net assets can be explain by the movement in capital (ie new
capital introduced + profit – drawings).
5.4
If we wish to find a missing figure such as profit or drawings, the accounting equation can be
expressed as:
Closing net assets = Opening net assets + Capital introduced + Profit – Drawings
5.5
It can then be rearranged to find a missing figure such as profit:
Profit = Closing net assets + Drawings – Capital introduced – Opening net assets
Lecture example 7
Exam standard for 2 marks
Joe, a sole trader, set up business on 1 October 20X6 with $40,000 of his own money. During the
year to 30 September 20X7 he won $50,000 on the lottery and paid $30,000 of this into his
business. He took cash drawings of $5,000 during the year and at 30 September 20X7 the net
assets of the business totalled $59,000.
What was the profit or loss of the business for the year ended 30 September 20X7?
A
B
C
D
$6,000 loss
$6,000 profit
$16,000 loss
$4,000 profit
Solution
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6
Chapter summary
Section Topic
Summary
1
Not all businesses keep proper accounting records,
however all businesses need to know how much profit
they have made in a particular year so that they can
pay the relevant amount of tax over to the tax
authorities.
Issue
Where a business does not have sufficient records to
produce financial statements they need to piece
together the missing information.
2
Cost structures
A margin is where a business expresses gross profit as
a percentage of sales.
A mark-up is where gross profit is expressed as a
percentage of cost of sales.
3
Other techniques for
solving incomplete
records
Other techniques that may be used in solving
incomplete records questions involve putting all known
information into one or two ledger accounts and
balancing off to derive the required information. These
questions are essentially a test of double entry skills.
4
Goods drawn by
proprietor
A business is a separate entity from its owner which
means that any monies or goods taken out of the
business for personal use must be classified as
drawings. Drawings of goods are always recorded at
cost.
5
Accounting equation
Closing net assets = Opening net assets + Capital
introduced + Profit – Drawings.
This can be rearranged to find a missing figure such
as profit or drawings.
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7
Double Entry Summary for Chapter 17
7.1
Adjustment to record cash drawings:
Dr
Cr
7.2
Drawings (SOFP)
Cash (SOFP)
Adjustment to record drawings of goods:
Dr
Cr
Drawings (SOFP)
Purchases (SPL)
END OF CHAPTER
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Preparation of
financial statements for
sole traders
Syllabus Guide Detailed Outcomes
Having studied this chapter you will be able to:

Prepare extracts of an opening trial balance.

Prepare journal entries to correct errors

Record entries in a suspense account

Make journal entries to clear a suspense account

Prepare a statement of financial position and statement of profit or loss (or extracts from them) from given
information.
Exam Context
This chapter recaps some of the key skills you have learnt in the chapters covered to date. In the multi-task accounts
preparation question in Section B of the exam, you could be asked to produce extracts from or a full statement of
financial position or statement of profit or loss. This chapter will also help you to see how financial accounting fits
together.
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Overview
Preparation of financial
statements for sole traders
Trial balance
Adjustments
Suspense account
Statement of profit or loss
Statement of financial position
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1
Introduction
1.1
The purpose of this chapter is to recap some of the skills covered in Chapters 1–16.
1.2
In the computer based exam, you are unlikely to have to prepare a full set of financial
statements. In the multi-task accounts preparation question, you are more likely to have to
perform a series of smaller tasks as part of the preparation of final financial statements.
However completing this exercise will revise your understanding of topics covered so far
and enable you to see the end product – a business' transactions ordered into a set of
financial statements.
Lecture example 1
Technique demonstation
You have been given the information below and asked to prepare the accounts of Mugg for the
year ended 31 December 20X7.
Trial balance as at 31 December 20X7.
Dr
$
Capital account at 1 January 20X7
Rent
Inventories 1 January 20X7
Electricity
Insurance
Wages
Trade receivables
Sales
Repairs
Purchases
Discounts received
Drawings
Petty cash
Bank
Motor vehicles at cost
Furniture and fixtures at cost
Accumulated depreciation at 1 January 20X7
Motor vehicles
Furniture and fixtures
Travel and entertaining
Trade payables
Suspense account
Cr
$
2,377
500
510
240
120
1,634
672
15,542
635
9,876
129
1,200
5
762
1,740
830
435
166
192
700
433
19,349
19,349
The following information is also available:
(1)
Closing inventories, valued at cost, amounts to $647
(2)
Mugg has drawn $10 a month and these drawings have been charged to wages
(3)
Depreciation is to be provided at 25% on cost on motor vehicles, and 20% on cost on
furniture and fixtures
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18: PREPARATION OF FINANCIAL STATEMENTS FOR SOLE TRADERS
(4)
Bad debts totalling $37 are to be written off
(5)
$180 received from a credit customer was correctly entered in the trade receivables account
and credited to the bank account
(6)
Mugg has taken goods from inventories for his own use. When purchased by his business
these goods cost $63 and they would have been sold for $91
(7)
The annual rental of the business premises is $600, and $180 paid for electricity in August
20X7 covers the 12 months to 30 June 20X8
(8)
A contra entry of $73 has only been recorded in the trade receivables account
Required
(a)
Prepare journal entries to record items (1) – (8).
(b)
Clear the suspense account.
(c)
Produce a statement of profit or loss for the year ended 31 December 20X7 and a statement
of financial position as at that date.
Solution
(a)
Journals
(1)
(2)
(3)
(4)
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(5)
(6)
(7)
(8)
(b)
Suspense account
$
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18: PREPARATION OF FINANCIAL STATEMENTS FOR SOLE TRADERS
(c)
MUGG
STATEMENT OF PROFIT OR LOSS FOR THE YEAR ENDED 31 DECEMBER 20X7
$
$
Sales
Less: cost of sales
Opening inventories
Purchases
Less: closing inventories
Gross profit
Discounts received
Less: expenses:
Rent
Electricity
Insurance
Wages
Repairs
Depreciation
Travel and entertaining
Bad debts
Profit for the period
MUGG
STATEMENT OF FINANCIAL POSITION AS AT 31 DECEMBER 20X7
Cost
$
Non-current assets
Motor vehicles
Furniture and fixtures
Current assets
Inventories
Trade receivables
Prepayments
Cash and bank balances
Capital
Capital as at 1 January 20X7
Profit for the period
Less: drawings
Current liabilities
Trade payables
Accruals
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Accumulated
depreciation
$
NBV
$
18: PREPARATION OF FINANCIAL STATEMENTS FOR SOLE TRADERS
2
Chapter summary
Section Topic
Summary
1
The statement of financial position and the statement
of profit or loss are the end product produced by a
business. All the business' transactions need to be
categorised into the books of prime entry and posted
to the nominal ledger. The trial balance is then
extracted and some adjustments may need to be
made before the financial statements are drawn up.
Introduction
You may not have to produce a full statement of
financial position or statement of profit or loss;
however this chapter should reinforce your
understanding of Chapters 1 – 16.
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END OF CHAPTER
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Introduction to
company accounting
Syllabus Guide Detailed Outcomes
Having studied this chapter you will be able to:

Understand the capital structure of a limited liability company including ordinary shares, preference shares
(redeemable and irredeemable) and loan notes.

Record movements in the share capital and share premium accounts.

Identify and record the other reserves which may appear in the company statement of financial position.

Define a bonus issue and a rights issue, their advantages and disadvantages and show how they are recorded in
the statement of financial position.

Record dividends in ledger accounts and the financial statements.

Calculate and record finance costs in ledger accounts and the financial statements.

Recognise the legal differences between a sole trader, a partnership and a limited liability company.

Identify the advantages and disadvantages of operating as a limited liability company, sole trader or partnership.
Exam Context
Questions on this chapter are likely to focus on the calculation of share capital movements (new issues, bonus issues
and rights issues), dividends and finance costs and their associated journal entries. You may also see a question
comparing a sole trader and a limited company.
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Overview
Finance costs
Reserves
Long term borrowings
Income taxes
Introduction to
company accounting
Comparison between different
types of business entities
Shares
Accounting treatment
Issue at a premium
Bonus issue
Dividends
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Rights issue
19: INTRODUCTION TO COMPANY ACCOUNTING
1
Introduction
1.1
We have seen how financial statements are produced for sole traders. These accounts are
not subject to any specific regulation and so there is some flexibility as to how they are
presented.
1.2
Companies use exactly the same bookkeeping process as sole traders; however, the
financial statements they produce are subject to regulation and must follow a prescribed
format.
Many of the differences are due to the terminology used by company financial statements.
2
Proforma financial statements
2.1
STATEMENT OF PROFIT OR LOSS FOR THE YEAR ENDED 31 MARCH 20X7
$'000
X
(X)
X
X
(X)
(X)
(X)
X
(X)
X
Revenue
Cost of sales
Gross profit
Other income
Distribution costs
Administrative expenses
Finance costs
Profit before tax
Income tax expense
Profit for the year
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19: INTRODUCTION TO COMPANY ACCOUNTING
2.2
STATEMENT OF FINANCIAL POSITION AS AT 31 MARCH 20X7
$'000
Assets
Non-current assets
Property, plant and equipment
Other intangible assets
X
X
X
Current assets
Inventories
Trade receivables
Other current assets
Cash and cash equivalents
X
X
X
X
X
X
Total assets
Equity and liabilities
Equity
Share capital
Share premium account
Retained earnings
Revaluation surplus
X
X
X
X
X
Non-current liabilities
Long term borrowings
Long term provisions
X
X
X
Current liabilities
Trade payables
Short term borrowings
Current tax payable
Short term provisions
Total equity and liabilities
X
X
X
X
X
2.3
These proformas will be covered in more detail later in the course.
3
Share capital
Share capital
3.1
It is necessary to be able to distinguish between the following types of share capital:
(a)
Authorised share capital –
Maximum number of shares the company may issue.
(b)
Issued share capital
–
Number of shares actually issued to shareholders.
(c)
Called up share capital
–
The amount of issued share capital the company has
asked shareholders to pay for to date.
(d)
Paid up share capital
–
Amount of called up share capital which has been
paid for.
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Types of shares
3.2
Ordinary share
4
Preference share

Equity share

Fixed rate of dividends (eg 7%
preference share)

Ordinary shareholders – own business

Receive dividend in priority to ordinary
shareholders

Usually have voting rights

On winding up, receive capital in priority

No right to a dividend, receive what
directors decide to pay
Share capital: accounting treatment
Issue of new shares
4.1
Rab Co started business on 1 January 20X6 issuing 100,000 ordinary shares of 50c each
for 50c per share. The initial statement of financial position would be:
Cash
$
50,000
Share capital – 50c ordinary shares
50,000
Issue of new shares at a premium
4.2
Where shares are issued for more than their nominal value, the excess must be credited to
a share premium account.
Lecture example 1
Preparation question
On 1 June 20X6 Rab Co issued a further 200,000 ordinary shares of 50c each for 80c per share.
Required
Show how this issue of shares would be accounted for and what the equity section of the
statement of financial position (excluding retained earnings) would look like immediately after the
issue.
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Solution
Dr
$
Cr
$
Dr Cash
Cr Share capital
Cr Share premium account
RAB CO STATEMENT OF FINANCIAL POSITION (EXTRACT) AS AT 1 JUNE 20X6
Equity
$
Share capital – 50c ordinary shares
Share premium account
Bonus issue (capitalisation issue)
4.3
This is used when a company wishes to increase its share capital without needing to raise
additional finance by issuing new shares. Any reserve may be used including the share
premium account.
4.4
Advantages
4.5
Disadvantage

Bonus issue can be made from the share
premium account which has few other
uses

Will allow the share price to fall (without
disadvantaging shareholder wealth) to
make the company's shares more
affordable to new investors

Shareholders will now own more shares
and could sell part of their holding

A bonus issue is always done at nominal value.
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The rationale for a bonus issue is not
always understood by shareholders
19: INTRODUCTION TO COMPANY ACCOUNTING
Lecture example 2
Preparation question
RAB CO
STATEMENT OF FINANCIAL POSITION (EXTRACT)
$
150,000
60,000
200,000
410,000
Share capital – 50c ordinary shares
Share premium account
Retained earnings
Several years later Rab Co is to make a bonus issue on a 1 for 4 basis.
Required
Show how this issue of shares would be accounted for and prepare the equity section of the
statement of financial position of Rab Co immediately after the issue.
Solution
Dr
$
Cr
$
Dr Share premium account
Cr Share capital
RAB CO
STATEMENT OF FINANCIAL POSITION (EXTRACT)
$
Share capital – 50c ordinary shares
Share premium account
Retained earnings
Rights issue
4.6
(a)
A rights issue is an issue of shares for cash (unlike a bonus issue) to existing
shareholders for less than their market value.
(b)
'Rights' are offered to the existing shareholders who can sell them if they wish.
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4.7
Advantages
Disadvantages

More cost effective way for the
company to raise finance than a
fresh issue to the public

Lack of shareholder interest may reflect
badly on the company

A more time efficient way to issue
shares

Unwelcome predators may try to acquire
shares where not all rights are taken up

If all rights are taken up
shareholders will maintain their
existing percentage shareholding

Effect on future dividend policy as company
will have issued more shares under the
rights issue than it would have under a fresh
issue to the public

As shares offered at below market
value, shareholders are more likely
to buy them

Will cause the share price to fall as shares
are issued at below market value
Lecture example 3
Preparation question
One year later, Rab Co is to make a rights issue on a 1 for 5 basis. The rights price is $1.50. All
shareholders take up their rights.
The following statement of financial position extract shows the position before the issue
RAB CO
STATEMENT OF FINANCIAL POSITION (EXTRACT)
$
187,500
22,500
230,000
440,000
Share capital – 50c ordinary shares
Share premium account
Retained earnings
Required
Show how this issue of shares would be accounted for and prepare the equity section of the
statement of financial position of Rab Co immediately following the issue.
Solution
Dr
$
Cr
$
Dr Cash
Cr Share capital
Cr Share premium account
RAB CO
STATEMENT OF FINANCIAL POSITION (EXTRACT)
Share capital – 50c ordinary shares
Share premium account
Retained earnings
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19: INTRODUCTION TO COMPANY ACCOUNTING
5
Preference shares
5.1
There are two types of preference shares – redeemable (the company is obliged to repay
the nominal value of the shares at a later date) and irredeemable (no obligation to repay).
5.2
In substance, redeemable preference shares behave like debt because they contain an
obligation, meeting the Conceptual Framework definition of a liability. Therefore, they should
be treated as a liability (non-current until one year before redemption) in the statement of
financial position and the dividends should be treated as a finance cost (ie interest) in the
statement of profit or loss.
5.3
Irredeemable preference shares contain no obligation so should be treated as equity ie in
the same way as ordinary shares. The dividends should be treated as an appropriation of
profit (see below).
6
Reserves
6.1
The following reserves are commonly found in limited liability company accounts.
(a)
The share premium account:
(i)
Typical permitted uses:
(1)
(2)
To issue bonus shares;
To write off share issue expenses.
(b)
The revaluation surplus (see Chapter 9).
(c)
Other reserves:
As designated by the individual company, for example a 'general reserve'.
(d)
Retained earnings:
Cumulative undistributed profits less any losses.
7
Dividends
Definition
7.1
Dividends – a sharing out/appropriation of retained earnings to owners/shareholders.
Illustration
7.2
Suppose a company with 1,000 ordinary $1 shares in issue made a profit of $500 in its first
year. The company has two choices as to what can be done with this profit:
(a)
(b)
Distribute it as a dividend to the shareholders; or
Retain it in the business.
If this company decides to pay a dividend of 10c per share and retain the remaining profits,
the financial statements would appear as follows:
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STATEMENT OF PROFIT OR LOSS FOR THE YEAR ENDED 31 DECEMBER 20X7
Profit for the year
$
500
STATEMENT OF FINANCIAL POSITION AS AT 31 DECEMBER 20X7 (EXTRACT)
$
1,000
400
1,400
Share capital – $1 shares
Retained earnings (500 – 100)
7.3
Dividends on ordinary shares and irredeemable preference shares are charged directly to
retained earnings as they are an appropriation of profits earned to date. They are not an
expense in the statement of profit or loss.
7.4
The double entry for dividends on ordinary shares and irredeemable preference shares is:
Dr
Cr
7.5
Dividends on redeemable preference shares are treated as a finance cost (interest):
Dr
Cr
7.6
Retained earnings (SOFP)
Cash (if paid)/Dividends payable (if declared) (SOFP)
Finance costs (SPL)
Cash (SOFP)
A company may pay dividends in two stages:
(a)
(b)
Interim
Final
(mid year)
(end year)
In reality the directors will wait until they know the company's full year profit before declaring
the final dividend.
The final dividend will only be accounted for in the current year if it is declared before the
year end. Otherwise it will be disclosed in a note to the financial statements
(see Chapter 22).
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Lecture example 4
Preparation question
ABC Co has the following share capital:
100,000
200,000
6% $1 irredeemable preference shares
50c ordinary shares
Retained earnings at the beginning of the year were $125,000.
During the year ended 31 December 20X7 it made the following profit:
$
60,000
10,000
50,000
Profit before tax
Income tax expense
Profit for the year
Ordinary dividends paid and declared during the year were as follows:
Interim dividend paid
5c per share
Final dividend declared on 20 January 20X8 10c per share
Required
Show the movement in retained earnings for ABC Co for the year ended 31 December 20X7.
Solution
$
Retained earnings at beginning of year
Profit for the year
Dividends
– Irredeemable preference
– Ordinary
Retained earnings at end of year
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$
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Additional Notes
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8
Long term borrowings
8.1
A company may choose to raise finance by issuing shares (equity).
Alternatively it can raise funds by issuing debt.
8.2
One way of raising long term finance is for a company to issue loan notes (also called loan
stock or debentures).
These loans usually carry a fixed rate of interest and have a pre-determined redemption
date, for example, $50,000 10% debentures 20X6. This means the company will pay
interest at 10% on the $50,000 borrowed each year. The capital amount of $50,000 will be
repaid in 20X6.
9
Finance costs
9.1
The interest expense incurred on long term borrowings will be shown as an expense called
'finance costs' in the statement of profit or loss.
9.2
It will be accounted for as follows:
Dr
Cr
Finance costs (SPL)
Bank (SOFP)
10 Income taxes
10.1 Companies must pay income tax on their profits. This tax is payable after the end of the
financial year and so the financial statements will include an accrual for the directors' best
estimate of the tax due on the profit for the period.
10.2 The tax is shown as an expense in the statement of profit or loss and a current liability in the
statement of financial position and will be accounted for as follows:
Dr
Cr
Income tax expense (SPL)
Current tax payable (SOFP)
10.3 Often the actual amount of tax paid will be different from the amount that was recorded in
the financial statements.
This over-or under-provision is simply adjusted in the next financial statements.
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Lecture example 5
Preparation question
Lauren Ltd has a year end of December.
When preparing its financial statements for the year ended 31 December 20X5, Lauren Ltd
estimated that its income tax payable would be $62,000.
Lauren Ltd settled this tax liability on 30 September 20X6, paying $65,000. The tax estimate for the
year ended 31 December 20X6 is $43,000.
Required
(1)
Record the tax entries for the years ended 31 December 20X5 and 20X6 in the ledger
accounts.
(2)
Prepare the tax note which relates to the statement of profit or loss for the year ended
31 December 20X6.
Solution
(1)
Income tax expense (SPL)
$
$
Current tax payable (SOFP)
$
(2)
Tax note for the year ended 31 December 20X6
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19: INTRODUCTION TO COMPANY ACCOUNTING
11 Comparison
11.1 The following table shows a comparison between a sole trader or partnership and a limited
liability company.
Sole trader/partnership
Company
Ownership
The proprietor(s) owns the business.
There are often a large number of
owners, who are called shareholders
or members.
Liability
The proprietor(s) has unlimited legal
liability regarding the business.
Members/shareholders have limited
liability. This means that they are only
liable to the extent of their investment
in the business.
Legal status
The business and the proprietor(s)
share legal identity (although the
business is a separate business entity
for reporting purposes).
A company is a separate legal entity.
Management
The proprietor(s) usually owns and
manages the business.
Members/shareholders do not usually
manage the business, but appoint a
Board of Directors to run the company
on their behalf.
Profits
The proprietor(s) takes 'drawings' out
of the business.
Members/shareholders receive profits
in the form of dividends. The
remainder of the profits are retained in
the company. The directors receive a
salary from the company and this is
an expense in the statement of profit
or loss.
Any cash amounts taken as a salary
are not an expense of the business but
drawings.
Taxation
Business profits are taxed in the hands
of the proprietor(s), using individual's
tax rates.
Income tax is paid on the company
profits.
Statement of
financial
position
For a sole trader, the middle of the
statement of financial position is split
into 'opening capital', 'profits' and
'drawings'.
The middle of the statement of
financial position is split into 'share
capital' and 'reserves'.
For a partnership, the capital is shown
in an account called the 'capital
account' and the profit and drawings in
an account called the 'current account'.
Legal
requirements
There are no legal requirements
specific to a sole trader or partnership.
There are extensive legal
requirements governing limited
companies (eg annual filing of
financial statements).
Other
The business is closed to outside
investors.
Investors can invest in a company.
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19: INTRODUCTION TO COMPANY ACCOUNTING
11.2 Advantages and disadvantages of each type of business entity are shown below:
Advantages
Disadvantages
Sole trader










Partnership
 Less stringent reporting obligations
 Partners jointly personally liable
 Additional capital can be raised
(from other partners)
 Costs of partnership agreements
 Division of roles/responsibilities
 Slower decision making
(consensus between partners)
Limited paperwork (cheaper)
Owner has complete control
Owner entitled to profits and assets
Less stringent reporting obligations
Can be highly flexible
 Increased skills set
Company
Owner is personally liable
Personal property vulnerable
Harder to raise finance
Potentially longer working hours
Continuity problems: death/illness
 Continuity problems: death/illness
 Sharing of risks and losses
 Partner leaving usually causes
dissolution of partnership
 Limited liability
 Has to publish annual accounts
 Easier to raise finance
 Legal and accounting requirement
 Company has separate legal
identify from owners
 Financial statements are audited
(time and cost)
 Tax advantages
 Share issues regulated by law
 Relatively easy to transfer shares
from one owner to another
Lecture example 6
Exam standard for 2 marks
Which of the following are differences between sole traders and limited liability companies?
(1)
Only companies have share capital and reserves
(2)
Withdrawals by owners are treated as dividends by a sole trader and drawings by a
company
(3)
A sole trader is full and personally liable for any losses that the business might make
(4)
New finance can only be raised by companies and not sole traders
A
B
C
D
1 and 4 only
2, 3 and 4
1 and 3 only
1, 3 and 4
Solution
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19: INTRODUCTION TO COMPANY ACCOUNTING
12 Chapter summary
Section Topic
Summary
1
Introduction
Companies use the same method of bookkeeping to record
transactions. There are however some differences in the
terminology and the formats used.
2
Proforma financial
statements
The format in which companies must produce their financial
statements is prescribed by the accounting standard IAS 1.
3
Share capital
An entity may issue two main types of shares. Ordinary or
equity shareholders have voting rights and therefore have
control over the company. Preference shareholders are
really just providers of finance to the business and have
limited rights.
4
Share capital:
accounting treatment
In a limited liability company the shareholders own the
business. A company may raise finance by issuing new
share capital. Where shares are issued at a premium to their
nominal value, the premium is recorded in the share
premium account.
A bonus issue is where the company issues shares for no
cash consideration. With a rights issue, shares are issued
for cash but the price charged is slightly lower than the
current market price.
5
Treat redeemable preference shares as a liability and
redeemable preference dividends as a finance cost.
Preference shares
Treat irredeemable preference shares as equity and
irredeemable preference dividends as a deduction from
retained earnings.
6
Reserves
A company may have several different types of reserve such
as a share premium account, a revaluation surplus and
retained earnings.
7
Dividends
Shareholders may receive a dividend as a return on their
investment. For ordinary shares and irredeemable
preference shares, these are accounted for as a
deduction from retained earnings. For redeemable
preference shares, they are accounted for as a finance
cost.
8
Long term borrowings
A company may also raise finance by issuing debt such as
loan notes or debentures.
9
Finance costs
It will have to pay interest on any debt that it issues and this
will be shown as 'finance costs' in the statement of profit
or loss.
10
Current tax
Companies pay corporation tax on their profits.
11
Comparison
Sole traders are quite different from companies. You must
ensure that you are happy with both the differences,
similarities, advantages and disadvantages.
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19: INTRODUCTION TO COMPANY ACCOUNTING
13 Double Entry Summary for Chapter 19
13.1 Adjustment to record ordinary and irredeemable preference dividends:
Dr
Cr
Retained earnings (SOFP)
Cash (paid)/Dividends payable (declared) (SOFP)
13.2 Adjustment to record redeemable preference dividends and finance costs on long term
borrowings:
Dr
Cr
Finance costs (SPL)
Bank (SOFP)
13.3 Adjustment to record the income tax expense:
Dr
Cr
Income tax expense (SPL)
Current tax payable (SOFP)
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19: INTRODUCTION TO COMPANY ACCOUNTING
END OF CHAPTER
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Preparation of
financial statements for
companies
Syllabus Guide Detailed Outcomes
Having studied this chapter you will be able to:

Recognise how the accounting equation, accounting treatments and business entity convention underlie the
statement of financial position.

Understand the nature of reserves and report them in a company statement of financial position.

Prepare a statement of financial position or extracts as applicable from given information.

Understand why the heading 'retained earnings' appears in a company statement of financial position.

Prepare a statement of profit or loss and other comprehensive income or extracts as applicable from given
information.

Understand how accounting concepts apply to revenue and expenses.

Calculate revenue, cost of sales, gross profit, profit for the year and total comprehensive income from given
information and disclose items of income and expenditure in the statement of profit or loss.

Record income tax in the statement of profit or loss of a company including the over and under provision of tax in
the prior year.

Understand the inter-relationship between the statement of financial position and statement of profit or loss and
other comprehensive income.

Identify items requiring separate disclosure on the face of the statement of profit or loss.

Identify the components of the statement of changes in equity.

Explain the purpose of disclosure notes.

Draft disclosure notes for tangible and intangible non-current assets, inventory, provisions and events after the
reporting period.

Illustrate how non-current asset balances and movements are disclosed in financial statements.

Calculate the transfer of excess depreciation between the revaluation surplus and retained earnings.

Classify items as current or non-current liabilities in the statement of financial position.
Exam Context
In the multi-task accounts preparation question, you might be required to produce an entire statement of profit or loss
and other comprehensive income, statement of financial position or statement of changes in equity or an extract thereof.
Also you may be asked to calculate individual elements of each statement either in an objective test question or as part
of the accounts preparation multi-task question. For example, you may be asked to demonstrate an understanding of
what is included in the statement of changes in equity. You could also be asked to prepare a disclosure note.
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20: PREPARATION OF FINANCIAL STATEMENTS FOR COMPANIES
Overview
Statement of financial
position
Statement of profit or loss and
other comprehensive income
Preparation of financial statements
for companies
Statement of
changes in equity
Notes to the accounts
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20: PREPARATION OF FINANCIAL STATEMENTS FOR COMPANIES
1
Introduction
1.1
The financial statements of a limited liability company are subject to regulation and must
follow a prescribed format.
1.2
Much of the prescribed format is determined by IAS 1 (revised). This accounting standard
states what should be included in a set of financial statements and how they should be
presented.
A complete set of financial statements in accordance with IAS 1 (revised) comprises:
(a)
A statement of financial position;
(b)
A statement of profit or loss and other comprehensive income;
(c)
A statement of changes in equity;
(d)
A statement of cash flows; and
(e)
Notes, comprising a summary of significant accounting policies and other explanatory
notes.
2
Proforma financial statements
2.1
STATEMENT OF PROFIT OR LOSS FOR THE YEAR ENDED 31 MARCH 20X7
$'000
X
(X)
X
X
(X)
(X)
(X)
X
(X)
X
Revenue
Cost of sales
Gross profit
Other income
Distribution costs
Administrative expenses
Finance costs
Profit before tax
Income tax expense
Profit for the year
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20: PREPARATION OF FINANCIAL STATEMENTS FOR COMPANIES
2.2
STATEMENT OF FINANCIAL POSITION AS AT 31 MARCH 20X7
$'000
Assets
Non-current assets
Property, plant and equipment
Other intangible assets
X
X
X
Current assets
Inventories
Trade receivables
Other current assets
Cash and cash equivalents
X
X
X
X
X
X
Total assets
Equity and liabilities
Equity
Share capital
Share premium account
Retained earnings
Revaluation surplus
X
X
X
X
X
Non-current liabilities
Long term borrowings
Long term provisions
X
X
Current liabilities
Trade payables
Short term borrowings
Current tax payable
Short term provisions
Total equity and liabilities
X
X
X
X
X
Note that according to IAS 1 a liability should be classified as current when it is due to be
settled within twelve months of the year end. If it is due to be settled after that, it is to be
classified as non-current.
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20: PREPARATION OF FINANCIAL STATEMENTS FOR COMPANIES
2.3
Illustration
Below are the statement of profit or loss and statement of financial position for Arrow Co for
the year ended 30 September 20X6
ARROW CO
STATEMENT OF PROFIT OR LOSS FOR THE YEAR ENDED 30 SEPTEMBER 20X6
$'000
Revenue
12,740
Cost of sales
(7,040)
Gross profit
5,700
Distribution costs
(2,060)
Administrative expenses
(2,375)
Finance costs
(72)
Profit before tax
1,193
Income tax expense
(270)
Profit for the year
923
ARROW CO
STATEMENT OF FINANCIAL POSITION AS AT 30 SEPTEMBER 20X6
Assets
Non-current assets
Property, plant and equipment
$'000
5,000
5,000
Current assets
Inventories
Trade receivables
Cash and cash equivalents
610
1,000
1,170
2,780
7,780
Total assets
Equity and liabilities
Equity
Share capital
Share premium account
Retained earnings
Revaluation surplus
1,750
585
1,873
1,400
5,608
Non-current liabilities
Long term borrowings
1,200
1,200
Current liabilities
Trade payables
Other payables
Current tax payable
Short term provisions
550
72
270
80
972
7,780
Total equity and liabilities
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The following information was accounted for when the above financial statements were
produced:
2.4
(1)
During the year the company made a rights issue on a 1 for 6 basis. The issue was
fully subscribed and the rights price was $1.27. Prior to the rights issue Arrow Co had
3,000,000 50c ordinary shares in issue.
(2)
The property, plant and equipment were revalued by $600,000 during the year.
(3)
A dividend of $300,000 was paid during the year.
Statement of profit or loss and other comprehensive income
Financial statements have always included a statement of profit or loss and a statement of
financial position
Following a revision to IAS 1, financial statements should also include a statement of profit
or loss and other comprehensive income.
This statement shows all of the realised gains and losses from the statement of profit or
loss and the unrealised gains and losses from the statement of financial position in one
statement of performance.
Statement of profit or loss
Statement of financial position
Realised
gains and losses
(posted to income or expense in SPL)
Unrealised
gains and losses
(posted directly to reserves)
eg profit for the year
eg revaluation gains
Statement of profit or loss and other comprehensive income
The statement can be presented in one of two ways:


As one single statement (Proforma 1)
As two separate statements (Proforma 2)
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20: PREPARATION OF FINANCIAL STATEMENTS FOR COMPANIES
Proforma 1 – one single statement
STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE INCOME
FOR THE YEAR ENDED 31 MARCH 20X7
20X7
20X6
$'000
$'000
Revenue
X
X
(X)
(X)
Cost of sales
Gross profit
X
X
Other income
X
X
Distribution costs
(X)
(X)
Administrative expenses
(X)
(X)
Finance costs
(X)
(X)
X
Investment income
X
Profit before tax
X
X
(X)
(X)
Income tax expense
Profit for the year
X
X
Other comprehensive income:
X
Gains on property revaluation
X
Total comprehensive income for the year
X
X
Proforma 2 – two separate statements
STATEMENT OF PROFIT OR LOSS FOR THE YEAR ENDED 31 MARCH 20X7
Revenue
Cost of sales
Gross profit
Other income
Distribution costs
Administrative expenses
Finance costs
Investment income
Profit before tax
Income tax expense
Profit for the year
20X7
$'000
X
(X)
X
X
(X)
(X)
(X)
X
X
(X)
X
20X6
$'000
X
(X)
X
X
(X)
(X)
(X)
X
X
(X)
X
20X7
$'000
X
20X6
$'000
X
X
X
X
X
STATEMENT OF OTHER COMPREHENSIVE INCOME
FOR THE YEAR ENDED 31 MARCH 20X7
Profit for the year
Other comprehensive income:
Gains on property revaluation
Total comprehensive income for the year
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Lecture example 1
Technique demonstration
Using the illustration, Arrow Co, prepare the statement of profit or loss and other comprehensive
income for the year ended 30 September 20X6:
(a)
(b)
Showing the statement as one statement
Showing the statement as two separate statements
Solution
(a)
One single statement
STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE INCOME
FOR THE YEAR ENDED 30 SEPTEMBER 20X6
$'000
12,740
(7,040)
Revenue
Cost of sales
Gross profit
5,700
Distribution costs
Administrative expenses
Finance costs
Profit before tax
(2,060)
(2,375)
(72)
1,193
(270)
Income tax expense
Profit for the year
Other comprehensive income:
Gains on property revaluation
923
Total comprehensive income for the year
(b)
Two separate statements
STATEMENT OF PROFIT OR LOSS FOR THE YEAR ENDED 30 SEPTEMBER 20X6
$'000
12,740
(7,040)
Revenue
Cost of sales
Gross profit
Distribution costs
Administrative expenses
Finance costs
Profit before tax
5,700
(2,060)
(2,375)
(72)
1,193
(270)
Income tax expense
Profit for the year
923
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20: PREPARATION OF FINANCIAL STATEMENTS FOR COMPANIES
STATEMENT OF OTHER COMPREHENSIVE INCOME
FOR THE YEAR ENDED 30 SEPTEMBER 20X6
$'000
923
Profit for the year
Other comprehensive income:
Gains on property revaluation
Total comprehensive income for the year
2.5
STATEMENT OF CHANGES IN EQUITY
Proforma
Balance at 31 March 20X6
Issue of share capital
2.6
2.7
X
X
Retained
earnings
$'000
X
Revaluation
surplus
$'000
X
Total
equity
$'000
X
X
Dividends
(X)
Total comprehensive income
X
X
X
(X)
Transfer to retained earnings
_
_
X
(X)
_
Balance at 31 March 20X7
X
X
X
X
X
The transfer from the revaluation surplus to retained earnings above is allowed by IAS 16
under two different circumstances:

Annually, the difference between depreciation calculated on the revalued asset and
historic cost depreciation may be transferred from the revaluation surplus to retained
earnings.

On disposal, the balance on the revaluation surplus may be transferred to retained
earnings.
The double entry is:
Dr
Cr
2.8
Share
capital
$'000
X
Share
premium
account
$'000
X
Revaluation surplus
Retained earnings
Illustration
Brian Co buys a property on 1 January 20X1 for $100,000. The property is to be depreciated
on a straight line basis of its 50 year useful life. On 31 December 20X5, the property is
revalued to $135,000.
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Excess depreciation:
Depreciation based on revalued amount (135,000  1/45 *)
Historic cost depreciation (100,000  1/50)
Excess depreciation
$
3,000
(2,000)
1,000
* The asset has been held for 5 years at the date of revaluation so has a remaining useful
life of 45 years (50 years – 5 years).
Double entry for excess depreciation:
Dr Revaluation surplus
Cr Retained earnings
$1,000
$1,000
Lecture example 2
Technique demonstration
Arrow Co had the following equity balances at 1 October 20X5 (the beginning of the year):
$'000
1,500
200
1,250
800
3,750
Share capital – 50c ordinary shares
Share premium account
Retained earnings
Revaluation surplus
Required
Using the information from the illustration in Section 2.3, produce a statement of changes in equity
for Arrow Co for the year ended 30 September 20X6 (assume there is no annual transfer of the
excess depreciation between the revaluation surplus and retained earnings).
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20: PREPARATION OF FINANCIAL STATEMENTS FOR COMPANIES
Solution
Share
capital
Share
premium
account
Retained
earnings
Revaluation
surplus
Total
equity
$'000
$'000
$'000
$'000
$'000
Balance at 30 September 20X5
Issue of share capital
Dividends
Total comprehensive income
Balance at 30 September 20X6
Workings
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Additional Notes
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20: PREPARATION OF FINANCIAL STATEMENTS FOR COMPANIES
3
Notes to the accounts
Notes are included in a set of financial statements to give users extra information. You
should be aware of the following notes:
3.1
Property, plant and equipment
Land and
buildings
$
X
X
X
(X)
(X)
X
Machinery
$
X
X
–
(X)
(X)
X
Office
equipment
$
X
X
–
(X)
(X)
X
Total
$
X
X
X
(X)
(X)
X
At 31 March 20X7
Cost or valuation
Accumulated depreciation
Carrying amount
X
(X)
X
X
(X)
X
X
(X)
X
X
(X)
X
At 31 March 20X6
Cost or valuation
Accumulated depreciation
Carrying amount
X
(X)
X
X
(X)
X
X
(X)
X
X
(X)
X
Carrying amount at 1 April 20X6
Additions
Revaluation surplus
Depreciation charge
Disposals
Carrying amount at 31 March 20X7
The following must also be disclosed in relation to property, plant an equipment:
(a)
The accounting policies for property, plant and equipment
(b)
For each class of property, plant and equipment:
(c)

Depreciation methods;

Useful lives or depreciation rates;

Total depreciation allocated for the period; and

Gross amount on depreciable assets and the related accumulated depreciation
at the beginning and end of the period.
For revalued assets:

Effective date of revaluation;

Whether an independent valuer was involved;

Carrying amount for each class of asset that would have been included in the
statement of financial statements has assets been carried at cost less
depreciation; and

Revaluation surplus.
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3.2
Intangible non-current assets
Carrying amount at 1 April 20X6
Additions
Amortisation charge
Disposals
Carrying amount at 31 March 20X7
Development
expenditure
$
X
X
(X)
(X)
X
At 31 March 20X7
Cost
Accumulated amortisation
Carrying amount
X
(X)
X
At 31 March 20X6
Cost
Accumulated amortisation
Carrying amount
X
(X)
X
The following must also be disclosed in relation to intangible assets:
3.3
(a)
The accounting policies for intangible assets.
(b)
For each class of intangible asset:

The method of amortisation;

The useful life of assets or the amortisation rate;

The gross carrying amount, the accumulated amortisation and the accumulated
impairment losses at the beginning and end of the period;

The carrying amount of internally-generated intangible assets; and

The line item(s) of the statement of profit or loss in which any amortisation of
intangible assets is included.
Inventory
$
X
X
X
X
Raw materials
Work in progress
Finished goods
3.4
Provisions
$
X
X
(X)
X
At 1 April 20X6
Increase in period
Released in period
At 31 March 20X7
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3.5
Contingent liabilities
Unless remote, disclose for each contingent liability:
(a)
(b)
(c)
(d)
3.6
A brief description of its nature; and where practicable
An estimate of the financial effect;
An indication of the uncertainties relating to the amount or timing of any outflow; and
The possibility of any reimbursement
Contingent assets
Where an inflow of economic benefits is probable, an entity should disclose
(a)
(b)
3.7
A brief description of its nature; and where practicable
An estimate of the financial effect
Events after the reporting period
In respect of non-adjusting events after the reporting period disclose
(a)
(b)
The nature of the event; and
An estimate of its financial effect (or a statement that an estimate cannot be made).
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4
Exam standard multi-task examples
Lecture example 3
Exam standard for 8 marks
Harry Co had the following balances in relation to property, plant and equipment at 1 January 20X5
(the beginning of the year):
At 1 January 20X5
Cost
Accumulated depreciation
Carrying amount
Buildings
$
Plant
$
Total
$
500,000
(150,000)
350,000
100,000
(40,000)
60,000
600,000
(190,000)
410,000
The following information is relevant:

On 1 July 20X5, Harry Co purchased a new building for $200,000.

On 31 December 20X5, Harry Co revalued a building to $140,000. It had been purchased
on 1 January 20X1 for $130,000.

On 31 March 20X5, Harry Co sold an item of plant for $11,000. It had been purchased on
1 January 20X4 for $10,000.

Plant is depreciated at 20% per annum using the reducing balance method and buildings
are depreciated at 5% per annum based on their original cost. A full year's depreciation is
charged in the year of acquisition and none in the year of disposal.
Required
Complete the disclosure note for property, plant and equipment for the year ended 31 December
20X5 reconciling the carrying amount at the beginning of the period to the carrying amount at the
end of the period.
Solution
Buildings
$
Carrying amount at 1 January 20X5
Additions
Revaluation surplus
Depreciation charge
Disposals
Carrying amount at 31 December 20X5
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Plant
$
Total
$
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Workings
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20: PREPARATION OF FINANCIAL STATEMENTS FOR COMPANIES
Lecture example 4
Exam standard for 15 marks
Griffin, a limited liability company, has an accounting year end of 30 June. The accountant is
preparing the financial statements as at 30 June 20X6.
Task 1
Which of the balances in the trial balance belong in the statement of profit or loss and other
comprehensive income for the year ended 30 June 20X6? (Tick the relevant balances)
Dr
$'000
Cr
$'000
Share capital ($1 ordinary shares)
1,000
Revenue
3,600
Purchases
Belongs in
SPLOCI for
year ended 30
June 20X6
2,280
Cash
40
Trade receivables
650
Inventory at 1 July 20X5
320
Trade payables
500
Distribution and administrative expenses
640
Allowance for receivables at 1 July 20X5
20
Revaluation surplus 1 July 20X5
140
Building at cost
1,480
Building accumulated depreciation at 30 June 20X6
Plant at cost
120
440
Plant accumulated depreciation at 30 June 20X6
220
Retained earnings at 1 July 20X5
350
Income tax expense
100
5,950
5,950
(4 marks)
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Task 2
The buildings are to be revalued to $1,400,000 at 30 June 20X6.
Calculate the amount to be recorded in other comprehensive income in the statement of
profit or loss and other comprehensive income in relation to the revaluation?
Other comprehensive income: gain on revaluation of buildings
$
'000
Calculate the balance on the revaluation surplus at 30 June 20X6.
Revaluation reserve at 30 June 20X6
$
'000
(3 marks)
Task 3
Closing inventory has been counted and is valued at $150,000.
What is the cost of sales for the year?
$
'000
(1.5 marks)
Task 4
Included in administrative expenses is $24,000 paid in relation to insurance for the year ended
31 December 20X6.
Complete the following statements:
The double entry to post the year end adjustment for insurance is:
Dr
Cr
The amount to be posted within the year end adjustment double entry above is:
$
'000
(1.5 marks)
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Task 5
The allowance for receivables is to be increased to 4% of trade receivables. The allowance for
receivables is treated as an administrative expense.
The year end journal for receivables is given below. Prepare the double entry by ticking the
correct option for each row.
Debit
Credit
No debit or
credit
Trade receivable
Administrative expenses
Allowance for receivables
Revenue
Complete the following:
The amount to be included in the statement of profit or loss after the allowance is increased to 4%
of trade receivables is:
$
'000
(3 marks)
Task 6
Griffin declared a dividend of 5 cents per share on 20 June 20X6 and has not yet recorded this
dividend in the accounting records.
The year end journal for dividends declared is given below. Using the information above,
prepare the double entry by ticking the correct option for each row.
Debit
Credit
No debit or
credit
Dividends expense
Retained earnings
Dividends payable
Cash
Calculate the following:
The amount of the dividend to be recorded in the journal above is:
$
'000
(2 marks)
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20: PREPARATION OF FINANCIAL STATEMENTS FOR COMPANIES
5
Chapter summary
Section Topic
Summary
1
Introduction
The financial statements published by a company
need to follow the format prescribed by IAS 1
(revised).
2
Proforma financial
statements
In the multi-task accounts preparation question, you
might be required to produce an entire statement of
profit or loss and other comprehensive income,
statement of financial position or statement of
changes in equity or an extract thereof.
The statement of profit or loss and other
comprehensive income is a performance
statement which brings together the realised gains
and losses from the statement of profit or loss and
the unrealised gains and losses from the statement
of financial position.
The statement of changes in equity shows the
movements on each of the accounts in the equity
section of the statement of financial position in a
separate statement.
3
Notes to the accounts
The purpose of the notes to the accounts is to
provide additional information of key financial
statement figures.
4
Exam standard
examples
Question practice is key to passing the exam.
END OF CHAPTER
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Events after the
reporting period
Syllabus Guide Detailed Outcomes
Having studied this chapter you will be able to:



Define an event after the reporting period in accordance with International Financial Reporting Standards.
Classify events as adjusting or non-adjusting.
Distinguish between how adjusting and non-adjusting events are reported in the financial statements.
Exam Context
Questions on this topic are likely to require you to identify adjusting and non-adjusting events from a list of options and
the appropriate accounting treatment of each event.
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21: EVENTS AFTER THE REPORTING PERIOD
Overview
Definition
Events after the
reporting period
Adjusting events
Non-adjusting events
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21: EVENTS AFTER THE REPORTING PERIOD
1
Definition
1.1
Events after the reporting period: events, both favourable and unfavourable, that occur
between the end of the reporting period and the date when the financial statements are
authorised for issue.
1.2
There are two types of event after the statement of financial position (period end) date.
2
Adjusting and non-adjusting events
2.1
Adjusting events


Non-adjusting events
Events which provide evidence of
conditions which existed at the end of the
reporting period.
Examples:


(1) Resolution of a court case
(2) Bankruptcy of a major customer
(3) Evidence of NRV of inventories
(2) Major share transactions
Accounting treatment:
(3) Announcement of a plan to close
part of a business

Change the amounts in the financial
statements
2.2
Examples:
(1) Destruction of major asset, eg
by flood or fire
(4) Discovery of fraud or errors that
show the financial statements were
incorrect

Events that relate to conditions which
arose after the end of the reporting
period
Accounting treatment:
Disclose non-adjusting event in a note to
the financial statements
(a)
Dividends proposed or declared after the end of reporting period but before the
financial statements are approved should be disclosed in a note to the financial
statements.
(b)
A non-adjusting event that affects going concern becomes an adjusting event.
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21: EVENTS AFTER THE REPORTING PERIOD
Lecture example 1
Exam standard for 2 marks
Which of the following events after the reporting period would normally qualify as a non-adjusting
event?
1
A fall in the market price of shares held by the entity as investments.
2
Insolvency of a trade receivable with a balance of $200,000 outstanding at the end of the
reporting period.
3
Declaration of the year-end dividend by the directors.
4
Confirmation of the amount of damages awarded to an employee who sued for unfair
dismissal after being sacked two months before the year end.
A
B
C
D
2 only
1 and 3
1, 3 and 4
2 and 4
Solution
3
Chapter summary
Section Topic
Summary
1
Definition
Events after the end of the reporting period are events
which occur between the end of the reporting period
and the date the financial statements are approved for
issue.
2
Adjusting and nonadjusting events
There are two types: adjusting and non-adjusting.
Adjusting events provide evidence of conditions that
existed at the end of the reporting period. The financial
statements should be changed to include this
information.
Non-adjusting events relate to conditions which
arose after the end of the reporting period. These
should be disclosed as a note to the financial
statements.
END OF CHAPTER
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Statements of cash flows
Syllabus Guide Detailed Outcomes
Having studied this chapter you will be able to:

Differentiate between profit and cash flows and understand the need for management to control cash flow.

Recognise the benefits and drawbacks to users of the financial statements of a statement of cash flows.

Classify the effect of transactions on cash flows and how they should be treated in a company's statement of
cash flows.

Calculate the figures needed for the statement of cash flows including cash flows from operating, investing and
financing activities.

Calculate the cash flow from operating activities using the direct and indirect method.

Prepare statements of cash flows and extracts from statements of cash flows from given information.
Exam Context
Questions on this chapter are likely to focus on whether you can identify which items should and should not go into the
statement of cash flows and also on performing basic calculations. For example, in an objective test question, you may
be asked to calculate a figure such as the cash generated from operations from given information or the cash paid to
acquire property, plant and equipment. The multi-task accounts preparation question could also require preparation of a
full statement of cash flows.
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22: STATEMENTS OF CASH FLOWS
Overview
Cash
Cash equivalents
Cash flows
Statements of
cash flows
IAS 7
Cash flows from
operating activities
Indirect method
Cash flows from
investing activities
Direct method
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Cash flows from
financing activities
22: STATEMENTS OF CASH FLOWS
1
Purpose
1.1
To show the effect of a company's commercial transactions on its cash balance.
It is thought that users of accounts can readily understand cash flows, as opposed to
statements of profit or loss and statements of financial position which are subject to
manipulation by the use of different accounting policies.
Cash flows are used as an investment appraisal method such as net present value and
hence a statement of cash flows gives potential investors a method with which to evaluate a
business.
2
IAS 7 Statements of cash flows
2.1
IAS 7 splits cash flows into the following headings:



Cash flows from operating activities
Cash flows from investing activities
Cash flows from financing activities
Definitions
2.2
(a)
Cash


(b)
Cash on hand
Demand deposits
Cash equivalents

Short term, highly liquid
investments

Readily convertible to
known amounts of cash

Insignificant risk of
changes in value
eg treasury bills
(c)
Cash flows

Inflows and outflows of cash and cash equivalents
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22: STATEMENTS OF CASH FLOWS
2.3
XYZ CO
STATEMENT OF CASH FLOWS FOR THE YEAR ENDED 31 DECEMBER 20X7
(indirect method)
$'000
Cash flows from operating activities
Profit before taxation
Adjustment for:
Depreciation
Investment income
Interest expense
Increase in trade and other receivables
Decrease in inventories
Decrease in trade payables
Cash generated from operations
Interest paid
Income taxes paid
$'000
3,390
450
(500)
400
3,740
(500)
1,050
(1,740)
2,550
(270)
(900)
Net cash from operating activities
1,380
Cash flows from investing activities
Purchase of property, plant and equipment
Proceeds from sale of equipment
Interest received
Dividends received
(900)
20
200
200
Net cash used in investing activities
Cash flows from financing activities
Proceeds from issue of share capital
Proceeds from long-term borrowings
Dividends paid*
(480)
250
250
(1,290)
Net cash used in financing activities
(790)
Net increase in cash and cash equivalents
Cash and cash equivalents at beginning of period
Cash and cash equivalents at end of period
110
120
230
* This could also be shown as an operating cash flow.
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22: STATEMENTS OF CASH FLOWS
3
Cash flows from operating activities
3.1
These represent cash flows derived from operating or trading activities.
An entity should report cash flows from operating activities using either:
(a)
The direct method, whereby major classes of gross cash receipts and payments are
disclosed (preferred method per IAS 7 – see Section 6.1), or
(b)
The indirect method (as above), whereby reported profit or loss is adjusted for the
effects of transactions of a non cash nature, any accruals or prepayments of
operating expenses, and items relating to investing or financing cash flows.
Income taxes paid
3.2
Income taxes paid may need to be calculated from other data given to you. This is best
achieved by putting the relevant figures into a 'T' account working.
Lecture example 1
Preparation question
In the statements of financial position of Tacks Co as at 31 December 20X9 and
31 December 20X8 were the following amounts for income tax payable.
31 December
20X9
20X8
$
$
156,000
168,000
Income tax payable
The statement of profit or loss tax charge for 20X9 amounted to $104,000.
Required
What is the amount of income taxes paid during the year?
$
Workings
Income tax payable (SOFP)
$'000
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$'000
22: STATEMENTS OF CASH FLOWS
4
Cash flows from investing activities
4.1
The cash flows included in this section are those related to the acquisition or disposal of any
non-current assets or investments together with returns received in cash from investments,
ie dividends and interest. This section shows the extent to which expenditures have been
made for resources intended to generate future income and cash flows.
Lecture example 2
Preparation question
On 31 December 20X8 the value of plant and equipment in the books of Erosion Co was as
follows:
$
200,000
80,000
120,000
Plant and equipment at cost
Accumulated depreciation
Plant and equipment at net book value
On 1 January 20X9 an item of plant was sold for $8,000 which had originally cost $20,000 when
new, but had a net book value of $11,000 at the time of sale. (The statement of financial position
values shown above do not show that this sale has taken place.)
On 31 December 20X9 the value of plant and equipment in the statement of financial position was:
$
280,000
Plant and equipment at cost
Accumulated depreciation
111,000
Plant and equipment at net book value
169,000
Required
Show the relevant entries for property, plant and equipment which would appear in a statement of
cash flows (under the indirect method) for Erosion Co in 20X9.
Solution
(i)
Cash flows from operating activities (extract)
$
Adjustments for
Depreciation
Loss on sale of plant
(ii)
Cash flows from investing activities (extract)
Purchase of property, plant and equipment
Proceeds from sale of plant
Workings
Plant & equipment – cost (SOFP)
$'000
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$'000
22: STATEMENTS OF CASH FLOWS
Accumulated depreciation (SOFP)
$'000
$'000
Disposal (SPL)
$'000
$'000
5
Cash flows from financing activities
5.1
Financing cash flows comprise receipts from or repayments to external providers of finance
in respect of principal amounts of finance. Examples of financing cash flows are:

Cash proceeds from issuing shares

Cash proceeds from issuing debentures, loans notes, bonds, mortgages and other
short or long term borrowings

Cash repayments of amounts borrowed

Dividends paid to shareholders
In order to calculate such figures the closing statement of financial position figure for debt or
share capital and share premium is compared with the opening position for the same items.
Dividends paid
5.2
The cash outflows included in dividends paid are dividends paid on the reporting company's
equity shares.
Lecture example 3
Preparation question
DISTRIBUTION CO
STATEMENT OF FINANCIAL POSITION EXTRACT
FOR THE YEAR ENDED 31 DECEMBER 20X9
Dividends payable
Dividends charged to retained earnings were $60,000.
20X9
$'000
45
20X8
$'000
35
Required
What are the dividends paid during the year ended 31 December 20X9?
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$
22: STATEMENTS OF CASH FLOWS
Workings
Dividends payable (SOFP)
$'000
$'000
Lecture example 4
Technique question
The summarised accounts of the Emma Co for the year ended 31 December 20X8 are as follows:
STATEMENT OF FINANCIAL POSITION AS AT 31 DECEMBER
Non-current assets
Property, plant and equipment
Current assets:
Inventories
Trade receivables
Cash
Equity
Share capital ($1 ordinary shares)
Share premium account
Retained earnings
Revaluation surplus
Non-current liabilities
10% debentures
Current liabilities
Trade payables
Income tax payable
Dividends payable
Overdraft
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20X8
$'000
20X7
$'000
628
514
214
168
7
389
1,017
210
147
–
357
871
250
70
314
110
744
200
60
282
100
642
80
50
136
39
18
–
193
1,017
121
28
16
14
179
871
22: STATEMENTS OF CASH FLOWS
STATEMENT OF PROFIT OR LOSS FOR THE YEAR ENDED 31 DECEMBER 20X8
$'000
600
319
281
186
8
87
31
56
Revenue
Cost of sales
Gross profit
Other expenses (including depreciation of $42,000)
Finance costs (interest paid)
Profit before tax
Income tax expense
Profit for the year
Movement of retained earnings
$'000
282
56
(24)
314
Balance at 31 December 20X7
Profit for the year
Dividends
Balance at 31 December 20X8
You are additionally informed that there have been no disposals of property, plant and equipment
during the year. The new debentures were issued on 1 January 20X8.
Required
Produce a statement of cash flows for Emma Co for the year ended 31 December 20X8.
Solution
EMMA CO
STATEMENT OF CASH FLOWS FOR THE YEAR ENDED 31 DECEMBER 20X8
$'000
Cash flows from operating activities
Profit before taxation
Adjustments for:
Depreciation
Interest expense
Increase in trade receivables
Increase in inventories
Increase in trade payables
Cash generated from operations
Interest paid
Income taxes paid
Net cash from operating activities
Cash flows from investing activities
Purchase of property, plant and equipment
Net cash used in investing activities
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$'000
22: STATEMENTS OF CASH FLOWS
$'000
$'000
Cash flows from financing activities
Proceeds from issue of shares
Proceeds from issue of debentures
Dividends paid
Net cash from financing activities
Net increase in cash and cash equivalents
Cash and cash equivalents at beginning of year
Cash and cash equivalents at end of year
Workings
1
2
3
Property, plant and equipment (NBV)
Property, plant and equipment (NBV)
$'000
$'000
Income tax payable
$'000
$'000
Dividends payable
$'000
$'000
Income tax payable
Dividends payable
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Additional Notes
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22: STATEMENTS OF CASH FLOWS
6
Cash flows from operating activities using the direct
method
6.1
As noted in Section 3.1, IAS 7 has two methods available under which the statement of cash
flows can be prepared:


6.2
Indirect method (seen previously)
Direct method
The only difference is the direct method derives the 'cash generated from operations' figure
in a different way. The operating element of the statement of cash flows should be shown as
follows:
$000
$000
Cash flows from operating activities
Cash receipts from customers
30,150
Cash payments to suppliers and employees
(27,600)
Cash generated from operations
2,550
Interest paid
Income taxes paid
(270)
(900)
Net cash from operating activities
1,380
Cash received from customers
6.3
This represents cash flows received during the accounting period in respect of sales.
Cash payments to suppliers and employees
6.4
This represents cash flows made during the accounting period in respect of goods and
services and amounts paid to employees.
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22: STATEMENTS OF CASH FLOWS
Lecture example 5
Technique question
Required
Using the information in Lecture example 4 produce the 'cash flows from operating activities'
section of the cash flow statement using the direct method.
Solution
EMMA CO
STATEMENT OF CASH FLOWS FOR YEAR ENDED 31 DECEMBER 20X8 (EXTRACT)
$
$
Cash flows from operating activities
Cash receipts from customers
Cash payments to suppliers and employees
Cash generated from operations
Interest paid
Income taxes paid
Net cash used in operating activities
Workings
1
Trade receivables
Trade receivables
$'000
2
$'000
Trade payables
Trade payables
$'000
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$'000
22: STATEMENTS OF CASH FLOWS
3
Expenses
$'000
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$'000
22: STATEMENTS OF CASH FLOWS
7
Chapter summary
Section Topic
Summary
1
Purpose
The statement of cash flows shows the movement
between a company's cash and cash equivalents at
the beginning and the end of the year.
2
Statements of cash
flows
(IAS 7)
Cash comprises cash on hand and on demand
deposits, less bank overdrafts.
3
Cash flows from
operating activities
This section of the statement of cash flows shows the
cash and cash equivalents generated by and used in
the entity's main trading activities.
4
Cash flows from
investing activities
This section shows the cash flows related to the
acquisition and disposal of non-current assets and
returns on investments such as interest and
dividends received.
5
Cash flows from
financing activities
Cash flows from financing activities include the
monies raised from issuing shares and loans and the
cash used in the repayment of loans and the
payment of dividends.
6
Cash flow from
The statement of cash flows can be produced using
operating activities
one of two methods: the indirect or the direct
using the direct method method.
Cash equivalents are short term, highly liquid
investments such as current asset investments
(shares) which can be converted in to known
amounts of cash relatively quickly without having a
major impact on the entity's activities.
The direct method provides exactly the same cash
flow information but calculates the cash flow from
operating activities using a slightly different
calculation from the indirect method.
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22: STATEMENTS OF CASH FLOWS
END OF CHAPTER
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Introduction
to consolidated financial
statements
Syllabus Guide Detailed Outcomes
Having studied this chapter you will be able to:

Define and describe the following terms in the context of group accounting:
(i)
(ii)
(iii)
(iv)
(v)
Parent
Subsidiary
Control
Consolidated or group financial statements
Trade/simple investment

Identify subsidiaries within a group structure.

Define and identify an associate and significant influence and identify situations where significant influence or
participating interest exists.

Describe the key features of a parent-associate relationship and be able to identify an associate within a group
structure.

Describe the principle of equity accounting.
Exam Context
This chapter introduces the concept of group accounting. Questions on this area will most likely focus on:


Identifying whether an entity is a subsidiary, associate or trade investment
The accounting treatment for a subsidiary or associate in the consolidated financial statements
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23: INTRODUCTION TO CONSOLIDATED FINANCIAL STATEMENTS
Overview
Concept
Accounting for associates
Introduction to consolidated
financial statements
Types of investment
Parent's separate financial
statements
Consolidated statement of
financial position
Group financial statements
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23: INTRODUCTION TO CONSOLIDATED FINANCIAL STATEMENTS
1
Concept
1.1
Companies may expand organically by building up their business from their own trading, or
by acquisitive growth (ie by acquiring shares in other entities).
Illustration
1.2
Shareholders
Ocean plc
100%
80%
Waterfall Ltd
River Ltd
1.3
Ocean plc is known as the parent or holding company.
2
Types of investment
30%
Stream Ltd
Subsidiary
2.1
Subsidiary (IFRS 10)
A subsidiary is an entity that is controlled by another entity.
2.2
An investor controls an investee if and only if the investor has all the following:
(a)
Power over the investee to direct the relevant activities;
(b)
Exposure, or rights, to variable returns from its involvement with the investee; and
(c)
The ability to use its power over the investee to affect the amount of the investor's
returns.
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23: INTRODUCTION TO CONSOLIDATED FINANCIAL STATEMENTS
2.3
Application:
CONTROL
Power to direct relevant
activities
Exposure or rights to
variable returns
Examples of power:
Examples of variable returns:







Voting rights
Rights to appoint,
reassign or remove key
management personnel
Rights to appoint or
remove another entity
that directs relevant
activities
Management contract


Examples of relevant activities:




2.4
Selling and purchasing
goods/services
Selecting, acquiring, disposing
of assets
Researching & developing
new products/processes
Determining funding
structure/obtaining funding




Dividends
Interest from debt
Changes in value of
investment
Remuneration for servicing
investee's assets or
liabilities
Fees/exposure to loss from
providing credit/liquidity
support
Residual interest in assets
and liabilities on liquidation
Tax benefits
Access to future liquidity
Returns not available to
other interest holders,
eg cost savings
Ability to use power to affect
the amount of returns
An investor can have the
current ability to direct the
activities of an investee
even if it does not actively
direct the activities of the
investee
In the exam, in absence of any other information, if the parent owns greater than 50% of
the equity (ordinary) shares, the entity can be assumed to be a subsidiary.
Associate
2.5
2.6
Associate (IAS 28)
An associate is an entity over which the investor has significant influence.
Significant influence is the power to participate in the financial and operating policy
decisions of the investee but is not control or joint control over those policies. This could be
shown by:
(a)
(b)
(c)
(d)
(e)
Representation on the board of directors
Participation in policy-making processes
Material transactions between the entity and investee
Interchange of managerial personnel
Provision of essential technical information.
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23: INTRODUCTION TO CONSOLIDATED FINANCIAL STATEMENTS
Presumptions
2.7
If an investor holds, directly or indirectly:
(a)
20% or more of voting power
–
(b)
Presumption of significant influence unless demonstrated otherwise.
< 20% of voting power
–
Presumption of no significant influence unless demonstrated otherwise
Trade investment
2.8
Trade investment
A trade
investment
is a simple
investment
in the shares
of another
is notpolicy
an
2.5
Significant
influence
is the
power to participate
in the
financialentity
and that
operating
associateofor
subsidiary.
decisions
thea investee
but is not control or joint control over those policies.
2.9
This means that the investor does not have significant influence or control. In absence of
information to the contrary, if an investor holds less than 20% of the voting power, the entity
is considered to be a trade investment.
2.10 Trade investments are simply shown as investments under non-current assets in the
statement of financial position. Dividends received from trade investments are recorded as
investment income in the statement of profit or loss and other comprehensive income.
Summary
2.11 The solution to the information gap depends on the type of investment held by an investor.
The accounting treatment depends on the extent of influence achieved.
Degree of
influence
Presumed if size Type of investment
of investment is
Accounting
treatment
Control
> 50%
Subsidiary
Consolidate
Significant influence
20%  50%
Associate
Equity account
No influence
0% to < 20%
Trade investment
Investment in SOFP
& investment income
in SPLOCI
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23: INTRODUCTION TO CONSOLIDATED FINANCIAL STATEMENTS
Lecture example 1
Exam standard for 2 marks
J has a 40% shareholding in each of the following three companies:
K: J has a management agreement with K stating that J is responsible for all key operating and
financial decisions in K.
L: J has significant influence over the affairs of L
M: J has the right to appoint or remove a majority of the directors of M
Required
Which of these companies are subsidiaries of J for financial reporting purposes?
A
B
C
D
None of them
K, L and M
K and L only
K and M only
(2 marks)
Solution
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23: INTRODUCTION TO CONSOLIDATED FINANCIAL STATEMENTS
3
Parent's separate financial statements
Statement of financial position
3.1
When the parent company acquires shares in a subsidiary, associate or trade investment, in
the parent's statement of financial position, an investment is recorded at cost (for exam
purposes) within non-current assets.
Statement of comprehensive income
3.2
Any dividends received from the subsidiary, associate or trade investment are recorded as
investment income in the parent company's statement of profit or loss and other
comprehensive income.
4
Group financial statements
Information gap
4.1
The parent company's shareholders will only have access to the parent's separate financial
statements (not the subsidiary's financial statements). Therefore they will only be able to see
the investment at cost in the statement of financial position and dividend income in the
statement of profit or loss and other comprehensive income. They will not be able to see the
impact of the parent's control over the net assets and profit of the subsidiary.
4.2
The purpose of group financial statements is to bridge the information gap. Provided the
parent has a controlling influence, it is required to produce an additional set of financial
statements which aim to record the substance of its relationship with its subsidiaries (single
economic entity) rather than its strict legal form (separate legal entities).
This additional set of accounts is referred to as group, or consolidated financial statements
which:
(a)
Present the results and financial position of a group of companies as if it was a single
business entity;
(b)
Are issued to the shareholders of the parent;
(c)
Are issued in addition to and not instead of the parent's own financial statements;
and
(d)
Provide information on all companies controlled by the parent.
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5
Consolidated statement of financial position
Consolidation method for statement of financial position (SOFP)
5.1
Part of SOFP
Action required
Reason
Assets & liabilities
(excluding the investment in
subsidiary)
Add parent and
subsidiary's assets and
liabilities line by line
To show control
Investment in subsidiary
Cancel with share capital From a group perspective, the
and pre-acquisition
shares are held internally so
reserves of subsidiary
need to be eliminated.
The pre-acquisition reserves of
the subsidiary were not
generated under the parent's
control and should be
eliminated.
Share capital & share
premium
Show the parent's only
Reserves
Show the parent's plus
the group share of post
acquisition reserves of
subsidiary.
To show ownership.
Group accounts are prepared for
the parent's shareholders and
the subsidiary's share
capital/premium is eliminated
above.
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To show ownership.
Only want to include subsidiary's
reserves generated under
parent's control.
23: INTRODUCTION TO CONSOLIDATED FINANCIAL STATEMENTS
Lecture example 2
Preparation question
Pegasus acquired 100% of the share capital of Sylvester on 1 January 20X1 for $1,300,000 in
cash.
The statements of financial position of Pegasus and Sylvester as at 1 January 20X1 are set out
below:
Pegasus
Sylvester
$'000
$'000
Assets
Non-current assets
Property, plant and equipment
20,000
900
Investment in Sylvester
1,300
21,300
Current assets
Inventories
3,200
400
Trade receivables
2,500
175
125
Cash
500
6,200
700
27,500
1,600
Equity and liabilities
Equity
Share capital
5,000
100
1,200
Retained earnings
19,450
1,300
24,450
Current liabilities
Trade payables
2,500
260
40
Income tax payable
550
300
3,050
27,500
1,600
Required
Prepare the consolidated statement of financial position of the Pegasus Group as at
1 January 20X1.
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23: INTRODUCTION TO CONSOLIDATED FINANCIAL STATEMENTS
Solution
PEGASUS GROUP
CONSOLIDATED STATEMENT OF FINANCIAL POSITION AT 1 JANUARY 20X1
$'000
Assets
Non-current assets
Property, plant and equipment
Current assets
Inventories
Trade receivables
Cash
Equity and liabilities
Equity
Share capital
Retained earnings
Current liabilities
Trade payables
Income tax payable
Workings
1
Group structure
2
Cancellation
$'000
Consideration (investment)
Share capital
Retained earnings
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$'000
23: INTRODUCTION TO CONSOLIDATED FINANCIAL STATEMENTS
Pre-and post-acquisition reserves
5.2
In Lecture example 2, Sylvester's net assets were represented not just by share capital but
also reserves. We call those reserves 'pre-acquisition reserves' since they were controlled
by someone else prior to Pegasus' investment in Sylvester on 1 January 20X1. They are not
consolidated as they are cancelled with the cost of the investment.
5.3
Any profits made after acquisition – post-acquisition reserves – must be consolidated in
the group financial statements.
Lecture example 3
Preparation question
Three years later, 31 December 20X3, the summarised statement of financial position of Pegasus
and Sylvester are as follows.
Pegasus
$'000
Assets
Non-current assets
Property, plant and equipment
Investment in Sylvester
Current assets
Equity and liabilities
Equity
Share capital
Retained earnings
Current liabilities
24,000
1,300
25,300
8,500
33,800
4,200
2,100
6,300
5,000
26,800
31,800
2,000
33,800
100
5,200
5,300
1,000
6,300
Required
Prepare the consolidated statement of financial position of the Pegasus Group as at
31 December 20X3.
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Sylvester
$'000
4,200
23: INTRODUCTION TO CONSOLIDATED FINANCIAL STATEMENTS
Solution
PEGASUS GROUP
CONSOLIDATED STATEMENT OF FINANCIAL POSITION AT 31 DECEMBER 20X3
$'000
Assets
Non-current assets
Property, plant and equipment
Current assets
Equity and liabilities
Equity
Share capital
Retained earnings
Current liabilities
Workings
1
Group structure
2
Cancellation
$'000
$'000
Pegasus
$'000
Sylvester
$'000
Consideration (investment)
Share capital
Retained earnings
3
Retained earnings
Per question
Pre-acquisition retained earnings
Sylvester – share of post acq'n
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23: INTRODUCTION TO CONSOLIDATED FINANCIAL STATEMENTS
Additional Notes
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23: INTRODUCTION TO CONSOLIDATED FINANCIAL STATEMENTS
6
Accounting treatment for an associate
Definition
6.1
Remember that an associate is an entity in which the parent has significant influence. In
absence of other information, this is presumed when the parent holds 20% to 50% of the
voting rights.
Consolidated financial statements
6.2
An investment in an associate is accounted for in consolidated financial statements using
the equity method.
6.3
As the parent does not have control, 100% of the associate's assets, liabilities, income and
expenses cannot be added to the parent's line by line. Instead, significant influence is
reflected by bringing in the group share of the associate in two lines in each of the
consolidated statement of financial position and statement of profit or loss and other
comprehensive income.
Equity method
6.4
STATEMENT OF FINANCIAL POSITION
IAS 28 states the following treatment:
Non-current assets
Investment in associates (Working)
X
Working
Cost of associate
Share of post-acquisition retained reserves
Less: impairment losses on associate to date
X
A
(B)
X
Retained earnings
Parent
X
Per question
Pre-acquisition retained earnings
Subsidiary – share of post acquisition
Associate – share of post acquisition
X
A
Less: impairment of associate
(B)
X
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Subsidiary
X
(X)
X
Associate
X
(X)
X
23: INTRODUCTION TO CONSOLIDATED FINANCIAL STATEMENTS
6.5
STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE INCOME
Profit or loss
A's Profit for the year  Group % (less impairment loss for year)
X
Shown before group profit before tax.
Other comprehensive income
A's Other comprehensive income for the year  Group %
X
Illustration of equity method
6.6
Scenario
P owns several subsidiaries. On 1 January 20X5, P purchased 30% of the ordinary shares
of A for $100,000. At that date, A's retained earnings were $40,000.
As at 31 December 20X7, A's retained earnings had risen to $90,000. A's profit and other
comprehensive for the year ended 31 December 20X7 were $24,000 and $6,000
respectively. A has not paid any dividends since the acquisition date.
Up to 31 December 20X6, there was no impairment of the investment in the associate but
during the year ended 31 December 20X7, the investment in the associate suffered an
impairment loss of $3,000.
6.7
Solution
CONSOLIDATED STATEMENT OF FINANCIAL POSITION AS AT 31 DECEMBER 20X7
(EXTRACT)
Non-current assets
$
112,000
Investment in associate (Working)
Working
Cost of associate
Share of post-acquisition retained reserves [(90,000 – 40,000)  30%]
Less: impairment losses on associate to date
Retained earnings
Parent
X
Per question
Pre-acquisition retained earnings
Subsidiary – share of post acquisition
Associate – share of post acquisition
(50,000  30%)
X
15,000
Less: impairment of associate
(3,000)
X
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Subsidiary
X
(X)
X
$
100,000
15,000
(3,000)
112,000
Associate
90,000
(40,000)
50,000
23: INTRODUCTION TO CONSOLIDATED FINANCIAL STATEMENTS
CONSOLIDATED STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE
INCOME
FOR THE YEAR ENDED 31 DECEMBER 20X7 (EXTRACT)
Profit or loss
Share of associate's profit for year [(24,000 × 30%) – 3,000 impairment]
$
4,200
Shown before group profit before tax.
Other comprehensive income
Share of associate's other comprehensive income (6,000 × 30%)
Lecture example 4
1,800
Exam standard for 2 marks
Which of the following statements regarding associates is true?
(1)
(2)
(3)
(4)
Associates are consolidated in the group financial statements.
An associate is an entity in which the parent has control.
Associates are equity accounted in the group financial statements.
An associate is an entity in which the parent has significant influence.
A
B
C
D
(1) and (4)
(1) and (2)
(3) and (4)
(2) and (3)
Solution
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23: INTRODUCTION TO CONSOLIDATED FINANCIAL STATEMENTS
7 Chapter summary
Section Topic
Summary
1
Concept
Consolidated accounts are prepared for a group of
inter-related companies.
2
Types of investment
There are three types of investment in the syllabus:



Subsidiaries (where there is control)
Associates (where there is significant
influence)
Trade investments (no influence)
3
Parent's separate
financial statements
An investment in a subsidiary, associate or financial
asset is shown in the parent's statement of financial
position at cost (for exam purposes). Dividends are
show as investment income in the statement of
profit or loss and other comprehensive income.
4
Group financial
statements
Group financial statements are issued to the
shareholders of the parent only, in addition to the
parent's own financial statements. They show the
group as a single business entity.
5
Consolidated
statement of financial
position
Add parent and subsidiary's assets and liabilities
line by line. Show parent's share capital and
share premium only.
The investment cancels with the share capital and
pre-acquisition reserves of the subsidiary.
Consolidated reserves comprise the parent's
reserves plus the group share of the subsidiary's
post acquisition reserves.
6
Accounting for
associates
Associates should be equity accounted in the
consolidated financial statements.
Consolidated statement of financial position:
Investment in associate (cost + share of post
acquisition reserves – impairment)
Consolidated reserves (include group share of
associate's post acquisition reserves and deduct
impairment in associate)
Consolidated statement of profit or loss and
other comprehensive income:
Share of associate's profit for the year
Share of associate's other comprehensive
income
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23: INTRODUCTION TO CONSOLIDATED FINANCIAL STATEMENTS
END OF CHAPTER
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The consolidated
statement of financial
position
Syllabus Guide Detailed Outcomes
Having studied this chapter you will be able to:

Define and describe the term 'non-controlling interest' in the context of group accounting.

Describe the components of and prepare a consolidated statement of financial position or extracts thereof,
including:

(i)
Fair value adjustments at acquisition on land and buildings (excluding depreciation adjustments);
(ii)
Fair value of consideration transferred from cash and shares (excluding deferred and contingent
consideration) ;
(iii)
Elimination of inter-company trading balances (excluding cash and goods in transit) ;
(iv)
Removal of unrealised profit arising on inter-company trading; and
(v)
Acquisition of subsidiaries part way through the financial year.
Calculate goodwill (excluding impairment of goodwill) using the full goodwill method only.
Exam Context
This chapter focuses on the skills required to prepare a consolidated statement of financial position. This topic is most
likely to be tested in the groups multi-task question. Questions on this area will most likely focus on:

Preparing one or more of the consolidated statement of financial position workings (eg goodwill, consolidated
retained earnings, non-controlling interest);

Consolidation adjustments (eg fair value adjustment or elimination of unrealised profit); and

Preparation of a consolidated statement of financial position or extracts thereof.
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24: THE CONSOLIDATED STATEMENT OF FINANCIAL POSITION
Overview
Approach to consolidated
statement of financial
position
Mid-year acquisitions
Consolidated statement of
financial position
Fair values
Goodwill
Non-controlling interest
Other reserves
Inter-company trading
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24: THE CONSOLIDATED STATEMENT OF FINANCIAL POSITION
1
Approach to the consolidated statement of financial
position
1.1
Step 1 Read the question (requirement first) and draw up the group structure (W1),
highlighting useful information:



The % owned
Acquisition date
Pre-acquisition reserves
Step 2 Draw up a proforma taking into account the group structure identified:


Leave out cost of investment
Put in lines for goodwill and non-controlling interest (will see in Sections 2 & 3)
Step 3 Work methodically down the statement of financial position, transferring
figures to proforma or workings:

Add P and 100% of S's assets/liabilities line by line in brackets on face of
proforma, ready for adjustments

Investment in subsidiary to goodwill working

Reserves to consolidated reserves working(s)

Share capital & share premium (parent only) to face of answer

Open up a (blank) working for non-controlling interest (will see in Section 3)
Step 4 Read through the additional notes and attempt the adjustments showing workings
for all calculations (will see in Sections 4 & 5).
Do the double entry for the adjustments onto your proforma answer and onto your
group workings (where the group workings are affected by one side of the double
entry).
Examples:


Cancel any intragroup items eg current a/c balances, loans
Adjust for unrealised profits:
Unrealised profit on intragroup sales
% held @ y/e
= Provision for unrealised profit (PUP)
(adjust in company selling goods)

Make fair value adjustments:
–
–
–
Fair value of land & buildings
Book value of land & buildings
Fair value adjustment
X
(X)
X
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X
%
X
DR
CR
Retained earnings
Group inventories
Post to goodwill working & add to PPE
24: THE CONSOLIDATED STATEMENT OF FINANCIAL POSITION
Step 5 Complete goodwill calculation (will see in Section 2):
Fair value of consideration
Fair value of non-controlling interest
Less:
–
–
–
–
–
X
X
Fair value of net assets at acquisition
Share capital
Share premium
Retained earnings at acquisition
Other reserves at acquisition
Fair value adjustments at acquisition
X
X
X
X
X
(X)
X
Goodwill at acquisition
Step 6 Complete the consolidated retained earnings calculation:
Per question
Provision for unrealised profit (seller's column)
Pre-acquisition retained earnings
Group share of post acq'n ret'd earnings:
Subsidiary (A  %)
Parent
X
(X)
Subsidiary
X
(X)
(X)
A
X
X
Note: Other reserves are treated in a similar way.
Step 7 Complete the non-controlling interest calculation (will see in Section 3)
NCI at acquisition (from goodwill working)
NCI share of post acq'n reserves (from reserves working  NCI %)
2
X
X
X
Goodwill
Position to date
2.1
In Chapter 23, the cost of the investment equalled the value of the identifiable net assets
acquired and accordingly, no surplus or deficit remained on cancellation.
Goodwill
2.2
Where the value of a business as a whole (cost of the investment + any non-controlling
share not purchased) is greater than the net assets acquired, the investor controls (and has
paid for) something more than the net assets of the acquired business.
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24: THE CONSOLIDATED STATEMENT OF FINANCIAL POSITION
The difference is called goodwill and is measured at the acquisition date (under IFRS 3
Business Combinations) as:
Goodwill
Fair value of consideration (investment)
Fair value of non-controlling interest
$
X
X
Less: Fair value of net assets at acquisition
Goodwill at acquisition
(X)
X
Accounting treatment
2.3
Goodwill
Purchased (IFRS 3)
Internally generated
 Not recognised in the books
'Negative' (acquired net
assets exceed cost)
 Reassess and then
credit any remainder to
profit or loss
Positive
 Capitalise as an
intangible noncurrent asset
Lecture example 1
Preparation question
Pogo acquired the entire share capital of Stick for $8m on 1 February 20X0 when the statements
of financial position of the two companies were as follows.
Investment in Stick
Other assets
Share capital
Retained earnings
Liabilities
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Pogo
$'000
8,000
9,500
17,500
Stick
$'000
– –
6,500
6,500
9,000
6,000
15,000
2,500
17,500
3,000
2,000
5,000
1,500
6,500
24: THE CONSOLIDATED STATEMENT OF FINANCIAL POSITION
Required
Prepare the consolidated statement of financial position of the Pogo group as at 1 February 20X0.
Solution
POGO GROUP
CONSOLIDATED STATEMENT OF FINANCIAL POSITION AS AT 1 FEBRUARY 20X0
$'000
Goodwill
Other assets
Share capital
Retained earnings
Liabilities
Workings
1
Group structure
2
Goodwill
$'000
$'000
Fair value of consideration
Fair value of non-controlling interest
Fair value of net assets at acquisition:
Share capital
Retained earnings
Goodwill arising on acquisition
3
Retained earnings
Pogo
$'000
Per question
Pre-acquisition retained earnings
Group share of post acquisition earnings:
Stick
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Stick
$'000
24: THE CONSOLIDATED STATEMENT OF FINANCIAL POSITION
3
Non-controlling interest
What is the non-controlling interest?
3.1
The parent
controls a
subsidiary
because it has
> 50% of the
voting power
P
The parent
does not own
80% all of the
subsidiary
S
The non-controlling interest is the 'equity in a subsidiary not attributable, directly or indirectly,
to a parent', ie the non-group shareholders' interest in the net assets of the subsidiary.
Points to note
3.2
(a)
Add P and 100% of S's net assets line by line to show control
(b)
In the equity section, include a new heading for 'non-controlling interest' to show
the extent to which the assets and liabilities are controlled by the parent, but are
owned by other parties, namely the non-controlling interest.
Measurement of non-controlling interest at acquisition
3.3
For the purposes of the exam, non-controlling interest at the acquisition date is to be
measured at fair value (ie how much it would cost of the acquirer to acquire the remaining
shares).
3.4
If not given in a question, the fair value of non-controlling interest (NCI) can be calculated as
the number of shares belonging to NCI multiplied by the share price.
3.5
The fair value of non-controlling interest (NCI) at acquisition is effectively the NCI share of
the subsidiary's net assets and goodwill at the acquisition date.
Measurement of non-controlling interest at the year end
3.6
The subsidiary's net assets (or equity) will increase as the subsidiary's reserves increase.
Therefore, to update NCI to its year end value, the NCI share of post acquisition reserves
needs to be added to the NCI at acquisition.
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24: THE CONSOLIDATED STATEMENT OF FINANCIAL POSITION
Proforma for non-controlling interest working
3.7
X
NCI at acquisition [at fair value] (from goodwill working)
NCI share of post acquisition reserves
[(year end reserves – pre-acquisition reserves]*  NCI %)
NCI at year end (ie NCI share of year end net assets & goodwill)
X
X
* from reserves working
Lecture example 2
Preparation question
Pop acquired 75% of the issued share capital of Snap on 1 January 20X8 when Snap had a
retained earnings balance of $1m. The fair value of the non-controlling interest at that date was
$1.5m. One year later the two companies had the following statements of financial position.
Investment in Snap
Other assets
Share capital
Retained earnings
Liabilities
Pop
$'000
6,000
10,500
16,500
Snap
$'000
–
9,200
9,200
10,000
1,500
11,500
5,000
16,500
4,000
2,200
6,200
3,000
9,200
Required
Produce the consolidated statement of financial position of Pop and its subsidiary as at
31 December 20X8.
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24: THE CONSOLIDATED STATEMENT OF FINANCIAL POSITION
Solution
POP GROUP
CONSOLIDATED STATEMENT OF FINANCIAL POSITION AS AT 31 DECEMBER 20X8
$'000
Goodwill
Other assets
Share capital
Retained earnings
Non-controlling interest
Liabilities
Workings
1
Group structure
2
Goodwill
$'000
Fair value of consideration
Fair value of non-controlling interest
Fair value of net assets at acquisition:
Share capital
Retained earnings
Goodwill arising on acquisition
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$'000
24: THE CONSOLIDATED STATEMENT OF FINANCIAL POSITION
3
Retained earnings
Pop
$'000
Snap
$'000
Per question
Pre-acquisition retained earnings
Group share of post acquisition earnings:
4
Non-controlling interest
$'000
NCI at acquisition (W2)
NCI share of post acquisition earnings
Points to note
3.8
(a)
The assets and liabilities sections of the statement of financial position show what the
group controls.
(b)
The equity section of the statement of financial position shows who actually owns the
consolidated net assets of the group.
4
Other reserves
4.1
Exam questions may give other reserves (such as a revaluation surplus) as well as retained
earnings. These reserves should be treated in exactly the same way as retained
earnings, which we have already seen.
4.2
If the reserve is pre-acquisition it forms part of the calculation of net assets at the date of
acquisition and is therefore used in the goodwill calculation.
4.3
If the reserve is post-acquisition or there has been some movement on a reserve existing at
acquisition, the consolidated statement of financial position will show the parent's reserve
plus its share of the movement on the subsidiary's reserve.
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24: THE CONSOLIDATED STATEMENT OF FINANCIAL POSITION
5
Fair values
5.1
We calculate goodwill as:
Goodwill
Fair value of consideration (investment)
Fair value of non-controlling interest
$
X
X
Less: Fair value of net assets at acquisition
Goodwill at acquisition
(X)
X
Fair value of net assets acquired
5.2
Assets and liabilities in an entity's own financial statements are often not stated at their
fair value, eg where the entity's accounting policy is to use the cost model for assets. If the
subsidiary's financial statements are not adjusted to their fair values, where, for example, an
asset's value has risen since purchase, goodwill would be overstated (as it would include
the increase in value of the asset).
5.3
Under IFRS 3 the net assets acquired are therefore required to be brought into the
consolidated financial statements at their fair value rather than their book value.
The difference between fair values and book values is a consolidation adjustment made only
for the purposes of the consolidated financial statements.
Fair value of consideration
5.4
The consideration transferred (which is the same as the figure recorded as the cost of the
investment in the parent's separate financial statements) is also measured at fair value.
For the purposes of the exam, the consideration could consist of cash or shares. The fair
value of cash is simply the amount of cash paid. The fair value of shares is the quoted share
price at the acquisition date.
Fair value of non-controlling interest
5.5
For the purposes of the exam, non-controlling interest at the acquisition date is to be
measured at fair value (ie how much it would cost of the acquirer to acquire the remaining
shares).
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24: THE CONSOLIDATED STATEMENT OF FINANCIAL POSITION
Lecture example 3
Exam standard
X acquired 300,000 of Y's 400,000 $1 ordinary shares on 1 January 20X5 when Y's retained
earnings were $500,000. The fair value of the non-controlling interest in Y at that date was
$280,000.
The purchase consideration comprised:


$250,000 in cash payable at acquisition
New shares issued in X on a 1 for 3 basis
The quoted price of X's shares on the acquisition date was $7.35.
The fair value of Y's land and buildings at 1 January 20X5 was $160,000 but the book value was
only $100,000. All other net assets had a fair value equivalent to their book value.
Required
Calculate the goodwill arising on acquisition of Y.
Solution
Goodwill
$
Fair value of consideration:
Cash
Shares
Fair value of non-controlling interest
Less: Fair value of net assets at acquisition
Share capital
Retained earnings
Fair value adjustment
Goodwill at acquisition
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$
24: THE CONSOLIDATED STATEMENT OF FINANCIAL POSITION
Workings
1
Group structure
6
Inter-company trading
Issue
6.1
IFRS 10 Consolidated Financial Statements requires inter-company balances, transactions,
income and expenses to be eliminated in full.
The purpose of consolidation is to present the parent and its subsidiaries as if they are
trading as one entity.
Therefore, only amounts owing to or from outside the group should be included in the
statement of financial position, and any assets should be stated at cost to the group.
Inter-company balances
6.2
Trading transactions will normally be recorded via a current account between the trading
companies, which would also keep a track of amounts received and/or paid.
The current account receivable in one company's books should equal the current account
payable in the other. These two balances should be cancelled on consolidation as intercompany receivables and payables should not be shown.
The double entry required is:
–
–
DR (↓) Inter-company payable
CR (↓) Inter-company receivable
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Unrealised profit
6.3
Illustration:
3rd party
supplier
Supplier sells goods to
P for $100
P
P sells goods on to S
for $120, making a
profit of $20
80%
S
6.4
S holds inventories of
$120 at the year end
There are 2 issues here:

In the consolidated accounts, we treat the group as a single entity. In substance, P has
made profit from selling goods to itself (as the goods are still in inventory at the year
end). This unrealised profit must be eliminated

Inventories should be valued at the lower of cost and NRV to the group. Inventories
are currently in S's books at $120 but they cost the group (to buy from the 3rd party
supplier) $100. So inventories are overvalued by $20.
Adjustment for unrealised profit
6.5
The double entry for closing inventories is:
DR Inventories (SOFP)
CR Cost of sales (SPLOCI)
6.6
Therefore, as closing inventories have been overvalued, the double entry to remove the
unrealised profit is simply the opposite:
DR Cost of sales (SPLOCI) (increasing expenses & reducing profit, eliminating the
unrealised profit)
CR Inventories (SOFP)
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6.7
When preparing a consolidated SOFP, the debit to cost of sales must feed through to
retained earnings. Therefore, the adjustment required to eliminate the unrealised profit in the
consolidated SOFP is:
DR (↓) Retained earnings of the seller
CR (↓) Consolidated inventories
Note that this adjustment only applies to goods from inter-company trading still left in
inventories at the year end.
Method for unrealised profit
6.8
Calculate the unrealised profit included in inventories and mark the adjustments by reducing
inventories on your proforma answer and by reducing the seller's retained earnings in the
retained earnings working.
Lecture example 4
Exam standard
Poach acquired 60% of the share capital of Steal on its incorporation. The statements of financial
position of the two companies as at 31 December 20X8 are as follows.
Non-current assets
Property, plant and equipment
Investment in Steal
Current assets
Inventories
Receivables – from Poach
– other
Cash
Equity
Share capital
Retained earnings
Current liabilities
Trade payables – to Steal
– other
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Poach
$'000
Steal
$'000
200
6
206
50
50
22
–
96
4
122
18
30
29
15
92
328
142
100
147
247
10
73
83
30
51
81
–
59
59
328
142
24: THE CONSOLIDATED STATEMENT OF FINANCIAL POSITION
Notes
(i)
The fair value of the non-controlling interest in Steal at acquisition was $4,000.
(ii)
Steal sells goods to Poach at a profit margin of 25% on selling price. At the year end,
$12,000 of the goods that Poach had purchased from Steal remained in inventories.
Required
Prepare a consolidated statement of financial position as at 31 December 20X8.
Solution
POACH GROUP
CONSOLIDATED STATEMENT OF FINANCIAL POSITION AS AT 31 DECEMBER 20X8
$'000
Non-current assets
Property, plant and equipment
Current assets
Inventories
Receivables – from Poach
– other
Cash
Equity attributable to the owners of the parent
Share capital
Retained earnings
Non-controlling interest
Current liabilities
Trade payables – to Steal
– other
Workings
1
Group structure
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2
Consolidated retained earnings
Poach
$'000
Steal
$'000
Per question
Provision for unrealised profit (PUP) (W4)
Pre-acquisition retained earnings
Group share of post acquisition retained earnings:
Steal
3
Non-controlling interest
$'000
NCI at acquisition
NCI share of post acquisition retained earnings
4
Provision for unrealised profit
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7
Mid-year acquisitions
7.1
So far, we have considered acquisitions only at the end of the reporting period. Thus, since
companies produce statements of financial position at that date anyway, there has been no
special need to establish the net assets of the acquired company at that date.
With a mid-year acquisition, a statement of financial position is unlikely to exist at the date of
acquisition as required. Accordingly, we have to estimate the net assets at the date of
acquisition using various assumptions.
Rule for mid-year acquisitions
7.2
Assume that profits accrue evenly throughout the year unless specifically told otherwise.
Lecture example 5
Exam standard
Pat acquired 80% of the issued share capital of Slap on 30 September 20X7. The share price for
each of the non-controlling interest shares in Slap was $4.50 at the acquisition date.
At the year end 31 December 20X7 the two companies have the following statements of financial
position:
Pat
$'000
Investment in Slap
Other assets
Share capital ($1 shares)
Share premium
Retained earnings
1 Jan 20X7
Profit for 20X7
Slap
$'000
4,000
10,500
14,500
$'000
6,000
–
4,000
2,000
Required
Calculate the goodwill at the date of acquisition.
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1,000
500
1,500
1,000
6,000
12,000
2,500
14,500
Liabilities
$'000
–
6,000
6,000
2,500
4,000
2,000
6,000
24: THE CONSOLIDATED STATEMENT OF FINANCIAL POSITION
Solution
Goodwill
$'000
$'000
Fair value of consideration
Fair value of non-controlling interest
Fair value of net assets at acquisition:
Share capital
Share premium
Retained earnings (W2)
Goodwill
Workings
1
Group structure
2
Slap – retained earnings 30.9.X7
$'000
Retained earnings at 1.1.X7
For the 9 months to 30.9.X7
Retained earnings at 30.9.X7
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8
Exam standard multi-task example
Lecture example 6
Exam standard for 15 marks
On 1 January 20X1, Reprise Co purchased 80% of Encore Co for $2,400,000. The retained
earnings at that date were $1,700,000.
The following draft statements of financial position for the two companies have been prepared as
at 31 December 20X7 and are as follows:
Reprise
Encore
$'000
$'000
Investment in Encore
2,400
0
3,470
Other assets
6,820
3,470
Total assets
9,220
Equity
Share capital - $1 ordinary shares
Retained earnings
1,000
6,720
7,720
1,500
9,220
Liabilities
The non-controlling interest (NCI) was valued at $600,000 as at 1 January 20X1.
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500
2,600
3,100
370
3,470
24: THE CONSOLIDATED STATEMENT OF FINANCIAL POSITION
Task 1
Complete the following to determine the goodwill arising on acquisition
$'000
Select from
Value of investment at acquisition
Investment in Encore Co held by Reprise Co
500, 600, 1044, 2400, 2600
_____________________________________ (type in)
2400, 2600, 1044, 500, 600
Select from:





Investment in Encore held by Reprise
Equity share capital
Other assets
Retained earnings
NCI at acquisition
Total value of investment at acquisition (A)
Fair value of Encore Co's net assets at acquisition
Equity share capital
3470, 500, 2600, 1700, 370
_____________________________________(type in)
500, 3470, 1700, 2600, 370
Select from:




Liabilities
Equity share capital
Other assets
Retained earnings
Total fair value of Encore's net asset at acquisition (B)
Goodwill at acquisition expressed as a formula
A – 100% of B
A + 75% of B
A – 75% of B
A + 100% of B
(4.5 marks)
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24: THE CONSOLIDATED STATEMENT OF FINANCIAL POSITION
Task 2
Are each of the following statements regarding consolidation correct? (tick the appropriate
answer)
Yes
No
Consolidation shows legal form rather than substance
The parent's and the group share of the subsidiary's assets
and liabilities should be aggregated
Goodwill is calculated using the acquisition date fair values
(3 marks)
Task 3
Select the formula which correctly calculates NCI at 31 December 20X7, in accordance with
IFRS 10 Consolidated Financial Statements.
Tick correct
formula
Fair value of NCI at acquisition + 20% of retained earnings at 31 December 20X7
Fair value of NCI at acquisition + 20% of post acquisition retained earnings
25% of net assets at 31 December 20X7
(1.5 marks)
Task 4
Calculate the following figures which will be reported in Reprise's consolidated statement
of financial position at 31 December 20X7.
$'000
Investment
Select from
0, 2400
Other assets
Share capital
Retained earnings
Liabilities
(6 marks)
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24: THE CONSOLIDATED STATEMENT OF FINANCIAL POSITION
9
Chapter summary
Section Topic
Summary
1
Approach to
consolidated financial
position
In the exam, a methodical approach to consolidation is
key.
2
Goodwill
Positive goodwill is capitalised as an intangible noncurrent asset. 'Negative' goodwill (once reassessed to
ensure it is accurate) is recognised as a bargain
purchase in the profit or loss.
3
Non-controlling interest
Non-controlling interest shows the amount of the assets
and liabilities under the control of the parent, but
which are not owned by the parent's shareholders.
4
Other reserves
Other reserves, ie a revaluation surplus, are calculated
using the same process as retained earnings, ie only
post-acquisition reserve movements are consolidated.
5
Fair values
In order for the goodwill figure to be accurately
measured, both the consideration transferred and the
fair value of the assets acquired and liabilities assumed
must be recognised at fair value at the date of
acquisition.
6
Inter-company trading
At the year end, inter-company payables and
receivables must be eliminated.
Unrealised profit in year end inventories from intercompany trading must be eliminated by reducing
inventories and the seller's retained earnings.
7
Mid-year acquisitions
Only post-acquisition profits are consolidated.
Therefore, if the acquisition is mid-year, a retained
earnings figure must be estimated for the goodwill and
retained earnings calculations.
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END OF CHAPTER
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The consolidated
statement of profit or
loss
Syllabus Guide Detailed Outcomes
Having studied this chapter you will be able to:

Describe the components of and prepare a consolidated statement of profit or loss or extracts thereof including:
(i)
(ii)
(iii)
Elimination of inter-company trading
Removal of unrealised profit arising on inter-company trading
Acquisition of subsidiaries part way through the financial year
Exam Context
The multi-task groups question could ask you to prepare a full consolidated statement of profit or loss, figures from a
consolidated SPL and/or consolidation adjustments (such as inter-company trading and unrealised profit) .
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25: THE CONSOLIDATED STATEMENT OF PROFIT OR LOSS
Overview
Consolidated statement of profit
or loss
Purpose
Approach to the consolidated
statement of profit or loss
Inter-company trading
Mid-year acquisitions
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25: THE CONSOLIDATED STATEMENT OF PROFIT OR LOSS
1
Purpose
Consolidated statement of profit or loss
1.1
The aim of the consolidated statement of profit or loss and other comprehensive income is
to show the results of the group for an accounting period as if it were a single entity. The
'Other comprehensive income' element of this statement is beyond the scope of the FFA/FA
syllabus.
Exactly the same philosophy is adopted as for the consolidated statement of financial
position ie control in the first instance. Accordingly, we are then able to show the profits
resulting from the control exercised by the parent.
1.2
Method
Revenue
Add 100% P + 100% S as represents what is controlled
Profit for the year (PFY)
Profit attributable to:
Owners of parent
NCI
β – balancing figure
S's PFY  NCI%
Ownership reconciliation
2
Approach to the consolidated statement of profit or
loss
2.1
Step 1
Read the question (requirement first) and draw up the group structure and where
subsidiaries are acquired in the year identify the proportion to consolidate. A
timeline may be useful.
Step 2
Draw up a proforma:

Step 3
Remember the ownership reconciliation at the foot of the statement
Work methodically down the statement of profit or loss, transferring figures to
proforma or workings:

Add 100% of all income and expenses (time apportioned  x/12 if
appropriate) in brackets on face of proforma, ready for adjustments

Exclude dividends receivable from subsidiary

Subsidiary's PFY (for NCI) to face of proforma in brackets (or to a working if
many adjustments)
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25: THE CONSOLIDATED STATEMENT OF PROFIT OR LOSS
Step 4
For any inter-company trading, cancel inter-company revenue and cost of
sales in brackets, directly on the face of your proforma. For any inventories
remaining at the year end from inter-company trading, cancel the
unrealised profit by increasing the seller's cost of sales and adjusting noncontrolling interest where the subsidiary is the seller.
Step 5
Complete non-controlling interest in subsidiary's PFY calculation:
PFY per question (time-apportioned 
appropriate)
PUP on sales made by S
x/
12
 NCI%
if
PFY
X
(X)
X
X
Then post to the ownership reconciliation at the foot of the consolidated
statement of profit or loss.
Step 6
Complete the ownership reconciliation:

Copy down consolidated PFY

Find profit attributable to the owners of the parent as a balancing
figure (ie total – NCI).
Lecture example 1
Preparation question
On 1 July 20X4 Patois acquired 90% of Slang at a cost of $55,000. The balance on Slang's
reserves was $15,000 at that date. Patois has ordinary share capital of $100,000 and Slang
$20,000 ($1 ordinary shares).
Statements of profit or loss for both companies for the year ended 30 June 20X9:
Patois
$'000
100
(75)
25
(5)
(8)
4.5
16.5
(4)
12.5
Revenue
Cost of sales
Gross profit
Distribution costs
Administrative expenses
Dividend from subsidiary
Profit before tax
Income tax expense
Profit for the year
Slang
$'000
90
(55)
35
(6)
(10)
–
19
(6)
13
Required
Prepare the consolidated statement of profit or loss for the Patois group for the year ended 30
June 20X9.
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25: THE CONSOLIDATED STATEMENT OF PROFIT OR LOSS
Solution
PATOIS GROUP
CONSOLIDATED STATEMENT OF PROFIT OR LOSS
FOR THE YEAR ENDED 30 JUNE 20X9
$'000
Revenue
Cost of sales
Gross profit
Distribution costs
Administrative expenses
Profit before tax
Income tax expense
Profit for the year
Profit attributable to:
Owners of the parent
Non-controlling interests
Workings
1
Group structure
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25: THE CONSOLIDATED STATEMENT OF PROFIT OR LOSS
3
Inter-company trading
Issue
3.1
When considering the group as if it were a single entity, inter-company trading represents
transactions, which the group undertakes with itself. Clearly, these have to be stripped out
of the results. The value of inventories in the consolidated statement of profit or loss needs
to be checked to make sure it represents the cost to the group.
Method
3.2
There are two potential adjustments needed when group companies trade with each other:
(a)
Eliminate inter-company transactions from the revenue and cost of sales figures:
DR (↓) Group revenue
X
CR (↓) Group cost of sales
X
with the total amount of the inter-company sales between the companies. This
adjustment is needed regardless of whether any of the goods are still in inventories
at the year end or not.
(b)
Eliminate unrealised profit on goods still in inventories at the year end:
DR (↑) Cost of sales (P/L) X (PUP) (& Dr (↓) Seller's retained earnings (SOFP))
CR (↓) Inventories (SOFP)
X (PUP)
in the books of the company making the sale. If the subsidiary is the seller, need to
adjust non-controlling interest in PFY.
Lecture example 2
Exam standard
Pouch acquired 75% of the issued share capital of Sack on 1 January 20X2.
Sack had sold goods to Pouch during the year for $8,000,000 at a mark up of 25%. At the year
end, three quarters of these goods had been sold on to third parties.
STATEMENTS OF PROFIT OR LOSS
FOR THE YEAR ENDED 31 DECEMBER 20X2
Pouch
$'000
24,500
(14,000)
1,500
12,000
(5,000)
7,000
Revenue
Cost of sales and expenses
Dividend from subsidiary
Profit before tax
Income tax expense
Profit for the year
Sack
$'000
15,600
(10,000)
–
5,600
(1,600)
4,000
Required
Prepare the consolidated statement of profit or loss for the Pouch group for the year ended 31
December 20X2.
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Solution
POUCH GROUP
CONSOLIDATED STATEMENT OF PROFIT OR LOSS FOR THE YEAR ENDED 31 DECEMBER
20X2
$'000
Revenue
Cost of sales and expenses
Profit before tax
Income tax expense
Profit for the year
Profit attributable to:
Owners of the parent
Non-controlling interest
Workings
1
Group structure
2
Non-controlling interest
Per question
PUP on sales made by Sack (W3)
 NCI %
3
Unrealised profit
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PFY
$'000
25: THE CONSOLIDATED STATEMENT OF PROFIT OR LOSS
Points to note
3.3
4
(a)
The provision for unrealised profit on inventories reduces the closing inventories
figure. It is therefore added to cost of sales in the working thereby reducing gross
profit.
(b)
When it is the subsidiary that sells goods to other group companies which remain
unsold at the year end, any provision for unrealised profit must be shared between
the group and the non-controlling interest.
Mid-year acquisitions
Rule for mid-year acquisitions
4.1
Simply include results in the normal way but only from date of acquisition ie time apportion
them as appropriate. Assume revenue and expenses accrue evenly unless told otherwise.
Lecture example 3
Exam standard for 10 marks
Perilous acquired 80% of the issued share capital of Safe on 1 January 20X5. The statements of
profit or loss for the two companies for the year ended 30 September 20X5 are as follows.
Statements of profit or loss
Perilous
$'000
10,000
(6,000)
4,000
(1,400)
2,600
Revenue
Cost of sales and expenses
Profit before tax
Income tax expense
Profit for the year
Safe
$'000
1,000
(700)
300
(120)
180
On 14 September 20X5, Perilous sold inventories to Safe at a transfer price of $200,000, which
included a profit on transfer of $30,000. Half of these inventories had been sold by Safe by the
year end.
Required
Prepare the consolidated statement of profit or loss for Perilous Group for the year ended
30 September 20X5.
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Solution
PERILOUS GROUP
CONSOLIDATED STATEMENT OF PROFIT OR LOSS
FOR THE YEAR ENDED 30 SEPTEMBER 20X5
$'000
Revenue
Cost of sales and expenses
Profit before tax
Income tax expense
Profit for the year
Attributable to:
Owners of the parent
Non-controlling interest
Workings
1
Group structure and timeline
1.10.X4
2
1.1.X5
30.9.X5
Non-controlling interest
PFY
$000
Per question (pro-rated)
x NCI %
3
Unrealised profit
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5
Exam standard multi-task example
Lecture example 4
Exam standard for 15 marks
On 1 July 20X4, Panther paid $2,000,000 to acquire a 60% interest in Sabre.
The statements of profit or loss of Panther and Sabre for the year ended 31 December 20X4 are
as follows:
Panther
$'000
22,800
13,600
9,200
4,700
4,500
1,300
3,050
Revenue
Cost of sales
Gross profit
Less: Operating expenses
Profit before tax
Less: Tax
Profit for the year
Sabre
$'000
4,300
2,600
1,700
800
900
220
680
Since acquisition, Panther sold goods costing $280,000 to Sabre for $320,000. At 31 December
20X4, 25% of these goods remained in Sabre's inventory.
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25: THE CONSOLIDATED STATEMENT OF PROFIT OR LOSS
Task 1
Use the information above to complete the following extract from the consolidated
statement of profit or loss:
$'000
Revenue
Select from (tick):






Cost of sales
22,800 + 4,300 – 320 – (25% x 40)
22,800 + (4,300 x 6/12) – (320 x 6/12)
22,800 + (4,300 x 6/12) - 320
22,800 + (4,300 x 60%)
22.800 + (4,300 x 6/12 x 60%) – 320
22,800 + (4,300 x 6/12) - 280
Select from (tick):






13,600 + (2,600 x 6/12) – 320 – (25% x 40)
13,600 + (2,600 x 6/12) – 320 + (25% x 40)
13,600 + (2,600 x 60%) - 280
13,600 + (2,600 x 6/12) – (320 x 6/12) + (25% x 40)
13,600 + 2,600 - 320 – (25% x 40)
13,600 + (2,600 x 6/12 x 60%) - 320
Gross profit
Less: Operating expenses
Profit before tax
Less: Tax
Profit for the year
(9 marks)
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25: THE CONSOLIDATED STATEMENT OF PROFIT OR LOSS
Task 2
Calculate the profit for the year ended 31 December 20X4 attributable to the non-controlling
interest of Sabre.
Profit attributable to NCI of Sabre: $
'000
Select the formula to calculate profit attributable to the owners of the parent:
Tick correct answer
Group profit before tax
Group profit before tax+ non-controlling interest
Group profit after tax – non-controlling interest
Group profit after tax + non-controlling interest
(2 marks)
Task 3
Which of the following factors indicate the existence of a parent-subsidiary relationship?
(tick the correct answer)
Yes
No
Power over the investee to direct relevant activities
Owning greater than 50% of the preference shares
Owning 90% of the equity shares
Significant influence
Right to appoint the majority of the directors on the board
Exposure to variable returns (change in share price, dividends)
Inability to direct the activities of the investee
Control
(4 marks)
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25: THE CONSOLIDATED STATEMENT OF PROFIT OR LOSS
6
Chapter summary
Section Topic
Summary
1
Purpose
The purpose of the consolidated statement of profit or
loss is to show the results of the group as a single
business entity.
2
Approach to the
consolidated statement
of profit or loss
(1) Group structure
(2) Proforma
(3) Add P + 100% S's income/expenses line by line
and post S's PFY to NCI working
(4) Adjustments
(5) Complete NCI working
(6) Complete ownership reconciliation
3
Inter-company trading
In order not to overstate group revenue and costs,
revenue and cost of sales from inter-company trading
are cancelled. Similarly, unrealised profits on year
end inventories from intragroup trading are eliminated
by increasing cost of sales (NCI working is also
adjusted if the subsidiary is the seller).
4
Mid-year acquisitions
Where an acquisition occurs part way through an
accounting period, income and expenses are only
consolidated for the number of months that the
subsidiary is controlled by the parent.
5
Exam standard multitask example
Exam standard question practice is key to success.
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END OF CHAPTER
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Interpretation of
financial statements
Syllabus Guide Detailed Outcomes
Having studied this chapter you will be able to:

Describe how the interpretation and analysis of financial statements is used in a business environment

Explain the purpose of interpretation of ratios

Calculate key accounting ratios:
(i)
(ii)
(iii)
(iv)
Profitability
Liquidity
Efficiency
Position

Explain the interrelationships between ratios

Calculate and interpret the relationship between the elements of the financial statements with regard to
profitability, liquidity and efficient use of resources and financial position

Draw valid conclusions from the information contained within the financial statements and present these to the
appropriate user of the financial statements.
Exam Context
The exam is likely to test one or more of:



Calculating specified ratio(s);
Explaining the difference in ratio(s) between years or different companies; and
Explaining/ identifying the purpose and limitations of interpretation of financial statements.
One or more of these areas could feature in either an objective test question in Section A or as part of the groups' multitask question in Section B.
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Overview
Importance and purpose of
interpretation of financial
statements
Analysis of financial
statements
Interpretation of financial
statements
Limitations of ratio analysis
Ratio analysis
Profitability ratios
Liquidity ratios
Efficiency ratios
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Position ratios
26: INTERPRETATION OF FINANCIAL STATEMENTS
1
Importance and purpose of interpretation of financial
statements
1.1
The financial statements of a company are designed to provide users with information about
its performance and financial position. The figures by themselves, however, are not
particularly useful and it is only through comparisons (usually with ratios) that their
significance can be established. This will then enable the end user to make an informed
decision.
Comparisons may be made with:
•
•
•
Previous financial periods
Similar businesses
Industry averages.
Users of financial statements
1.2
There are a number of users of a company's financial statements. Each user has differing
needs. In the exam, you may need to interpret financial statements or ratios for a particular
user so it is important to understand the key concerns each type of user will have.
Lecture example 1
Preparation question
Required
How do the following users of financial statements benefit from ratio analysis?
Solution
(a)
Shareholders
(b)
Potential investors
(c)
Bank and other capital providers
(d)
Employees
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26: INTERPRETATION OF FINANCIAL STATEMENTS
(e)
Management
(f)
Suppliers
(g)
Government
2
Analysis of financial statements
2.1
If you are presented with a set of accounts, you should make a note of all the obvious trends
or changes in figures before calculating any ratios.
You are likely to be given a set of figures with comparatives either to the previous year, or to
a different company, or to the industry averages.
Examples of the above are:
(i)
Increase / decrease in revenue
(ii)
Increase / decrease in cash balance
(iii)
Issue of shares during the year
(iv)
Increase / decrease in non-current assets
(v)
Increase / decrease in receivables/inventory not justified by increase/ decrease in
revenue
(vi)
Increase/ repayment of loans during the year.
If asked for, wherever possible, give realistic reasons for any trends/ changes.
For example, if non-current assets have increased; why was this (purchase or revaluation?)
and how were any purchases financed?
If required, you should also try to explain the significance of this change for the future eg has
the purchase of non-current assets increased the productive capacity of the business; are
they now short of cash? Which of the two businesses is more profitable? etc.
Ratio analysis will then assist in a more detailed investigation into why the figures differ
between years or companies.
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3
Ratio analysis
3.1
Accounting ratios help to summarise and present financial information in a more
understandable form. Once calculated, they can then be interpreted to give an indication of
the company's performance and position. The ratios can be split into the following
categories:
(i)
(ii)
(iii)
(iv)
Profitability
Liquidity
Efficiency
Position
3.2
Ratios do not give us much information when taken in isolation. In order for them to be
useful, we need to have something to compare them to such as previous periods, similar
businesses or industry averages.
4
Profitability ratios
Purpose
4.1
Profitability ratios measure the company's use of its assets and control of its expenses to
generate an acceptable rate of return.
Ratios
4.2
Gross profit margin
Gross profit margin =
Gross profit
 100%
Revenue
The gross profit margin measures how well a company is running its core operations. The
gross profit percentage should be similar from year to year for the same company.
A significant change may be due to:




A change is sales price
A change in product mix
An incorrect inventory valuation (will affect 2 years)
A change in cost of sales due to efficiency or price movements.
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4.3
Operating profit margin
Operating profit margin =
Profit before interest and taxation
 100%
Revenue
Profit before interest and taxation (PBIT) is used because it avoids distortion when
comparisons are made between two different companies where one is heavily financed by
means of loans, and the other is financed entirely by ordinary share capital.
The extra consideration for the operating margin over the gross margin is how well the
company is controlling its overheads.
A significant change (especially a fall) may be due to:



4.4
The reasons for the movement in the gross profit margin as stated above
Changes in control over administration and distribution costs
One off expenses eg advertising.
Return on capital employed
Return on capital employed =
Profit before interest and taxation
 100%
Total equity + non- current liabilities *
* or total assets less current liabilities
Total equity includes share capital, share premium and reserves. Return on capital
employed measures how efficiently a company uses its capital to generate profits. A
potential investor or lender should compare the return to a target return or a return on other
investments/ loans.
Careful consideration of the industry is required as ROCE for a manufacturing company is
likely to be lower than that of a services company as a manufacturing company has higher
assets (eg factories, plant & machinery, three types of inventories – raw materials, work in
progress, finished goods). Reasons why profits may change have been discussed above.
Other reasons for a significant change may include:



4.5
New assets acquired during the year which are not yet running at capacity
Assets aging
Revaluations.
Return on equity
Return on equity =
Profit after tax and preference dividend
 100%
Total equity
Whilst the return on capital employed looks at the overall return on the long-term sources of
finance, return on equity focuses on the return for the ordinary shareholders. Reasons for
changes in the ROE will be similar to the ROCE with the extra consideration of changes in
interest paid and gearing. This is because ROE uses profit after tax whereas ROCE uses
PBIT.
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5
Liquidity ratios
Purpose
5.1
Liquidity measures the availability of a company's cash to pay its short term debts.
Ratios
5.2
Current ratio (working capital ratio)
Current ratio (working capital ratio) =
Current assets
Current liabilities
This ratio measures a company's ability to pay its current liabilities out of its current assets.
Working capital (current assets – current liabilities) is needed by all companies in order to
finance day-to-day trading activities. Sufficient working capital enables a company to:



Hold adequate inventories,
Allow a measure of credit to its customers
Pay its suppliers on the due date.
A company should not operate at a level that is too low as they will not have sufficient
assets to cover their debts as they fall due. However, a company should not operate at a
level that is too high as this may suggest that the company has too much inventory,
receivables or cash.
The specific industry the company operates in should also be taken into account as for
example, a supermarket holds relatively low levels of inventories as they are perishable, few
receivables as customers generally pay in cash and high payables as supermarkets typically
have superior bargaining power to their smaller suppliers.
5.3
Quick ratio
Quick ratio (liquid capital ratio or acid test) =
Current assets - inventories
Current liabilities
This is similar to the current ratio except that it omits the inventories figure from current
assets. This is because inventories are the least liquid current asset that a company has, as
it has to be sold, turned into receivables and then the cash has to be collected.
A ratio of less than 1:1 could indicate that the company would have difficulty paying its debts
as they fall due.
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6
Efficiency ratios
Purpose
6.1
Efficiency measures how well the company uses its assets to generate profit, revenue and
cash.
Ratios
6.2
Inventory turnover period (days)
Inventory turnover period (days) =
Inventories
× 365 days
Cost of sales
This ratio measures the number of days inventories are held by a company on average.
This figure will depend on the type of goods sold by the company.
A company selling fresh fruit and vegetables should have a low inventory holding periods as
these goods will quickly become inedible.
A manufacturer of aged wine will by default have very long inventory holding periods. It is
important for a company to keep its inventory days as low as possible, subject of course to
being able to meet its customers' demands.
A significant change may be due to:



6.3
A change in type of inventory held;
Improved or worsened inventory controls; or
Changes in the popularity of certain inventory items.
Receivables collection period (days)
Receivables collection period (days) =
Trade receivable s
× 365 days
Revenue
This ratio shows, on average how long it takes for the trade receivables to settle their
account with the company. The average credit term granted to customers should be taken
into account as well as the efficiency of the credit control function within the company.
A significant change may be due to:



Increased / decreased credit terms offered to customers;
Change in the mix between cash and credit transactions; or
Better / worse credit control.
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6.4
Payables payment period (days)
Payables payment period (days) =
Trade payables
× 365 days
Cost of sales
This ratio is measuring the time it takes the company to settle its trade payable balances.
Trade payables provide the company with a valuable source of short term finance, but
delaying payment for too long a period of time can cause operational problems as suppliers
may stop providing goods and services until payment is received.
A significant change may be due to:



6.5
Increased/ decreased credit terms from suppliers;
Increase/ decrease in cash; or
Better/ worse management of the payables ledger.
Working capital cycle
Inventory days + receivable days – payable days
Purchase
inventory
Sell goods
Inventory days
Payables payment period
Receivables
collection period
Cash
IN
Cash
OUT
WORKING CAPITAL CYCLE
The working capital cycle has to be financed as cash has not yet been received from the
sale of goods before the supplier has to be paid. The longer the cycle, the more financing is
required and the higher the risk of bankruptcy. This is why it is good to have short inventory
days and receivables collection periods, and longer payables payment periods.
However, this must be weighed up with the fact that a company must not run a risk of stockouts (if inventory days are too low) or customer and supplier dissatisfaction by insisting on
short and long payment periods respectively.
6.6
Asset turnover ratio
Asset turnover ratio =
Revenue
= X times
Total assets – current liabilities
This ratio measures the efficiency of the use of net assets in generating revenue. Ideally the
ratio should be increasing, but we need to be careful when making assessments based on
this ratio, because the company could have bought lots of assets late in the year and they
simply have not had much time to start generating revenue. If this is the case, the ratio will
almost certainly fall, but this is not a reflection on the ability of the assets to generate
revenue, it is simply a timing issue.
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Link between ratios
6.7
Analysing ROCE in more detail
Return on capital employed is a useful primary ratio in analysing profitability and efficiency
together. However, to sub-analyse ROCE, two secondary ratios can be used to consider
profitability and efficiency separately:


Profitability – operating profit margin
Efficiency – asset turnover ratio
This is because when the operating profit margin is multiplied by the asset turnover ratio;
this results in the ROCE ratio:
Operating profit margin × Asset turnover ratio = Return on capital employed
PBIT
Revenue
PBIT
×
=
Revenue Total assets – current liabilities * Total assets – current liabilities *
* or total equity + non-current liabilities
7
Position ratios
Purpose
7.1
Position ratios consider the company's long term solvency and its capital structure.
Ratios
7.2
Interest cover
Interest cover =
Profit before interest and taxation
= X times
Finance costs
The interest cover ratio considers the number of times a company could pay its interest
payments using its profit from operations. The main concern is that a company does not
have so much debt finance that it risks not being able to settle the debt as it falls due.
7.3
Gearing
Gearing =
Non – current liabilities
Total equity + Non – current liabilities
Gearing is concerned with the long-term financial stability of the company. It is looking at
how much the company is financed by debt. Debt is cheaper than equity as interest is tax
deductible but the higher the gearing ratio, the less secure the financing of the company will
be and possibly the company's future.
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26: INTERPRETATION OF FINANCIAL STATEMENTS
Lecture example 2
Preparation question
TJF is a national supermarket chain selling food, clothes and household appliances with a
31 December year end. The finance director would like the management accountant to prepare
some financial data and analysis to present to the board. He has provided the management
accountant with extracts from the financial statements to assist him in his analysis.
EXTRACTS FROM STATEMENT OF PROFIT OR LOSS
FOR THE YEAR ENDED 31 DECEMBER 20X5 (WITH COMPARATIVES)
20X5
$m
20,510
18,970
1,540
650
200
Revenue
Cost of sales
Gross profit
Operating profit
Finance costs
20X4
$m
17,835
16,835
1,000
530
130
EXTRACTS FROM STATEMENT OF FINANCIAL POSITION AS AT 31 DECEMBER 20X5 (WITH
COMPARATIVES)
20X5
20X4
$m
$m
Non-current assets
9,100
8,390
Inventories
850
1,000
Total current assets
1,570
1,610
Trade payables
2,100
2,280
Total current liabilities
2,920
2,650
Non-current liabilities
3,250
2,530
Equity
5,050
4,935
Gross profit margin
Operating profit margin
ROCE
Current ratio
Inventory holding period
Payables payment period
Interest cover
20X4
5.6%
3.0%
7.1%
0.61
22 days
49 days
4.08
The finance director has also supplied the following information regarding events in the year ended
31 December 20X5:
(1)
Online food home delivery increased by 25%.
(2)
The number of stores grew by 10% in the year. This was financed by long term borrowings.
(3)
In the year ended 31 December 20X5, 40% of customers purchased at least one clothing
item during the year whereas in the year ended 31 December 20X4, only 20% of customers
did.
(4)
A strong marketing campaign took place during the year.
(5)
The new strengthened Grocery Supplier Code of Practice came into force to improve
grocery retailers' treatment of suppliers.
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26: INTERPRETATION OF FINANCIAL STATEMENTS
Required
(a)
Calculate the ratios below for the year ended 31 December 20X5, state whether it has
improved or deteriorated and provide one possible reason for the movement in each ratio:
•
•
•
•
•
•
•
(b)
Gross profit margin
Operating profit margin
Return on capital employed
Current ratio
Inventory holding period
Payables payment period
Interest cover
Explain why it would not be relevant to calculate receivables collection period in this
example.
Solution
(a) Ratios
20X5
Gross profit
 100%
Revenue
Improved / deteriorated?
Gross profit margin =
20X4 (given)
5.6%
Possible reason:
Operating profit margin =
Profit before interest and taxation
 100%
Revenue
Improved / deteriorated?
Possible reason:
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3.0%
26: INTERPRETATION OF FINANCIAL STATEMENTS
Return on capital employed =
Profit before interest and taxation
 100%
Total equity  non - current liabilitie s *
7.1%
Improved / deteriorated?
Possible reason:
Current assets
Current liabilities
Improved / deteriorated?
Current ratio =
0.61
Possible reason:
Inventory holding period =
Inventories
 365 days
Cost of sales
Improved / deteriorated?
22 days
Possible reason:
Payables payment period =
Trade payables
 365 days
Cost of sales
Improved / deteriorated?
49 days
Possible reason:
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26: INTERPRETATION OF FINANCIAL STATEMENTS
Interest cover =
Profit before interest and taxation
Finance costs
Improved / deteriorated?
4.08
Possible reason:
(b)
8
Why not relevant to calculate receivables collection period
Limitations of ratio analysis
Issue
8.1
The usefulness of ratio analysis is limited by distorting factors. For example:

Inflation when comparing to previous years

Different accounting policies/classifications when comparing to different companies
eg ROCE higher if use cost models for assets

Lack of information/ breakdown of information

Trading may be seasonal within a period (or over different accounting periods)

Year end figures not representative because they include year end accounting
adjustments and may be subject to 'window dressing' ('window dressing' is the
intentional manipulation of year end figures)

Related party transactions make the ratios incomparable with other companies (ie
selling to your friend at a discount will have an adverse effect of your overall margin
vs. a competitor)

Different ratio definitions/formula used by different companies

Different companies in the same business may have different risk profiles or
specific factors affecting them, making industry comparisons less meaningful

Where financial statements are manipulated, this is often done to improve key ratios

A new company will have no comparatives to compare with.
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26: INTERPRETATION OF FINANCIAL STATEMENTS
9
Exam standard questions
Lecture example 3
Exam standard for 2 marks
Priestly has the following working capital ratios:
20X2
20X1
1.1
0.9
Receivables days
65 days
75 days
Payables days
50 days
45 days
Inventory turnover
36 days
41 days
Quick ratio
Which of the following statements is correct?
A
B
C
D
Priestly's credit control has worsened in 20X2.
Priestly's inventory is at greater risk of obsolescence in 20X2 than 20X1.
Priestly is paying its suppliers more quickly in 20X2 than in 20X1.
Priestly's working capital management and liquidity have improved in 20X2.
Solution
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Lecture example 4
Exam standard for 2 marks
The following extracts are from Mya's financial statements:
$
21,230
(2,000)
(5,200)
14,030
Profit before interest and tax
Interest on loan notes
Tax
Profit after tax
Share capital
Share premium
Reserves
40,000
10,000
26,500
76,500
20,000
96,500
10% loan notes
What is Mya's return on capital employed?
A
B
C
D
15%
22%
20%
18%
Solution
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26: INTERPRETATION OF FINANCIAL STATEMENTS
10 Chapter summary
Section Topic
Summary
1
Importance and
purpose of
interpretation of
financial statements
To provide users with information about financial
performance and position to enable them to make a
decision.
2
Analysis of financial
statements
Make a note of all obvious changes or trends before
calculating any ratios.
If required, give reasons for the change and
significance in the future.
3
Split into categories:
Ratio analysis




Profitability
Liquidity
Efficiency
Position
Only useful if compare with:



Previous financial periods
Similar businesses
Industry averages
4
Profitability ratios




Gross profit margin
Operating profit margin
Return on capital employed
Return on equity
5
Liquidity ratios


Current ratio
Quick ratio
6
Efficiency ratios




Inventory turnover period (days)
Receivables collection period (days)
Payables payment period (days)
Asset turnover
7
Position ratios


Interest cover
Gearing
8
Limitations of ratio
analysis
Inflation, different accounting policies, lack of
information, trading may be seasonal, year end
figures not representative, related party
transactions, different ratio definitions, different risk
profiles, financial statements manipulated to improve
key ratios and a new company has no comparatives.
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26: INTERPRETATION OF FINANCIAL STATEMENTS
END OF CHAPTER
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Appendix A:
Overview Summaries
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27: APPENDIX A
Chapter 1: Overview summary
Statement of profit or
loss
Statement of financial
position
 Shows the income and expenses for
a business over a period of time,
usually a year
 Shows the assets and liabilities
of the business at a point in time
Financial statements
Users of financial
information
 Investors
Introduction
to accounting
Governance
 Employees
 Lenders
 Suppliers
 Customers
 The process by which
businesses are
directed and controlled
Types of business entities
Sole trader
Partnership
'An individual sets up business on
their own'
 All the risks and rewards are
borne by the sole trader
'More than one individual enter into
business together'
 Risks and rewards are shared
between the partners
 Governments and
their agencies
 Public
Limited liability
company
'A separate legal entity from the owners'
 The company bears the risks and
rewards
 The owners have limited liability
Concept of separate entity


A business is a separate entity from its owner
Personal transactions must be recorded separately (drawings)
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27: APPENDIX A
Chapter 2: Overview summary
Regulatory
framework
IFRSF
 22 Trustees who:
– Appoint members to the IASB, IFRS IC and IFRS AC
– Oversee the regulatory system
– Raise finance to support the system
 Not involved in standard setting process
IFRS AC
 Aim to advise the IASB on:
– Their agenda and timetable for
developing IFRS; and
IASB
 Aim to develop a single set of high quality
accounting standards (IFRS)
 Liaises with national accounting standard
setters (for example the UK's ASB)
– Areas that may need to be considered
by IFRS IC.
Issue IFRS
 IFRS set out recognition, measurement,
presentation and disclosure requirements
 Application of IFRS required to achieve
fair presentation
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IFRS IC
 Issues guidance on how to
apply existing IFRS
27: APPENDIX A
Chapter 3: Overview summary
The qualitative characteristics of
financial information
The IASB's conceptual framework
Other accounting concepts

Materiality (if omission or misstatement would
influence users' decisions)

Substance over form (follow economic reality)

Business entity concept (keep personal and business
transactions separate)

Fair presentation (application of IFRSs)

Consistency (use same methods for same items)
 Expenses (decreases in equity other than distributions
to equity participants)
The objective of
financial statements
 To provide information
about the reporting entity
that is useful to existing
and potential investors,
lenders and other creditors
in making decisions.
 Accruals accounting –
reporting transactions in
period in which they occur
Qualitative
characteristics
Underlying
assumption
 Going concern –
assumes the entity will
continue in operational
existence for the
foreseeable future
 Relevance – to users'
decisions (predictive and
confirmatory value)
 Faithful representation –
complete, neutral, free from
error
 Comparability (between years
and entities)
 Verifiability (direct or indirect)
 Timeliness (in time to make
decisions)
 Understandability (assume
reasonable knowledge)
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Elements of financial
statements
 Asset (control, past event,
future economic benefits)
 Liability (obligation, past
event, future outflow)
 Equity (residual interest in
assets after deducting
liabilities)
 Income (increases in equity
other than contributions from
equity participants)
 Expenses (decreases in
equity other than distributions
to equity participants)
27: APPENDIX A
Chapter 4: Overview summary
 Shows the assets and liabilities of the
business at a point in time.
 Shows the income and expenses for a business
over a period of time, usually a year
Statement of profit or loss
Statement of financial
position
Types of business
documentation
Sources, records and
books of prime entry
 Quotation
 Order
 Goods
received/despatched
note
 Receivables ledger:
– Amount owed by a particular
customer
 Payables ledger:
– Amount owed to a particular
supplier
 Invoice
Memorandum ledgers
 Credit/debit note
 Receipt/remittance
advice
Books of prime entry
'Categorise similar transactions together'
Cash book
 Cash receipts
into the bank
 Cash
payments from
the bank
Sales day book
 Credit sales
Purchase day
book
 Credit purchases
Petty cash book
Journal book
 Small cash transactions
made via the petty cash
tin
 Correction of errors
and period end
adjustments
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27: APPENDIX A
Chapter 5: Overview summary
Ledger accounts
and double entry
Double entry
Ledger accounts
 The totals from the books of prime entry
are totalled and then are posted to the
nominal ledger.
Debit
 Increases:
– Expenditure
– Asset
– Drawings
Balancing off
 Steps:
(1) Add the debit and credit sides
separately
(2)
Fill in the higher of the two totals
on both sides
(3)
Balance the account by inserting
the 'balance c/d' on the relevant
side
(4)
Complete the double entry and put
the 'balance b/d' on the opposite
side
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Credit
 Increases:
– Liability
– Income
– Capital
27: APPENDIX A
Chapter 6: Overview summary
Trial balance
'A list of the balances brought down on
each ledger account'
From trial balance
to financial statements
Statement of profit or loss
(SPL)

Part of the double entry system

Can be shown in T account


Statement of financial
position

Balances on income and
expense accounts transferred
to SPL
Lists all asset and liability
ledger account balances at the
year end

Not part of the double entry
system
New income and expense
accounts opened each year

At end of period, clear
balances on the statement of
profit or loss and drawings to
the capital account
Accounting equation
Assets = capital + profit – drawings + payables
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27: APPENDIX A
Chapter 7: Overview summary
 Opening inventory:
Dr Cost of sales (SPL)
Cr Inventories (SOFP)
 Closing inventory:
Dr Inventories (SOFP)
Cr Cost of sales (SPL)
Accounting adjustments
Inventory
Effects on profit and
assets
Valuation
'Inventories should be measured at the lower of cost
and net realisable value'
 This is on a line by line basis
Net realisable value
Cost
 Calculation:
Selling price
Less: completion costs
Less: selling costs
 Cost includes:
– Costs of purchase
– Costs of conversion
– Other costs
X
(X)
(X)
X
Methods of estimating cost
FIFO
'First in, first out'
 The first goods
purchased will be
the first sold
 Year-end
inventories relate
to the most recent
purchases
AVCO
'Average cost'
 Simple average calculation:
Total purchases cost  total number of units purchased
 Weighted average (required by IAS 2):
A new average is recalculated each time inventories are
purchased
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 Closing inventory
valuation will differ
depending on cost
method used
 This has a direct
impact on cost of
sales and
therefore on gross
profit
 When prices are
rising FIFO will
give higher
inventory values
and therefore
higher profits
27: APPENDIX A
Chapter 8: Overview summary
 Capital expenditure: acquisition, replacement or improvement of
non-current assets
 Revenue expenditure: trading expenses or the repair,
maintenance and service of non-current assets
 Cost includes the purchase price plus directly
attributable costs
 Directly attributable costs include:
– Delivery
– Installation/ testing
– Professional fees
 Directly attributable costs exclude:
– Maintenance contracts
– Administration and general overheads
– Staff training
Capital versus
revenue expenditure
Cost
Tangible non-current
assets
Revaluations
Depreciation
 Steps:
'The wearing out of an asset as it
(1) Adjust cost to
generates revenue'
revalued amount
 Accounting adjustment:
(2) Remove the
Dr Depreciation expense
accumulated
Cr Accumulated depreciation
depreciation
charged to date
(3) Put the balance to
the revaluation
Reducing
Straight line
surplus
balance
method
 The balance transferred
to the revaluation surplus
depreciation
is:
'revalued amount
 Depreciation charge is the  Depreciation charge
– net book value'
is higher in the earlier
same each year
 Revaluation is a choice
years of the asset's
of accounting policy. All  Formula:
life
cost - residual value
assets in the same class
 Formula:
useful life
must be revalued
Depreciation rate
 Depreciation is now
or
(%)  net book value
based on the revalued
(cost – residual
amount
value)  %
If depreciation method, useful life or residual
value revised, write off the net book value
using the revised method, useful life or
residual value
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Disposals
 Steps:
(1) Remove the cost
of the asset
(2) Remove the
accumulated
depreciation
charged to date
(3) Account for sales
proceeds
(4) Balance off
disposal account to
find the profit or
loss on disposal
 Profit/ loss on disposal
calculation:
Proceeds
X
(X)
Less: NBV
X/(X)
Profit/(loss)
27: APPENDIX A
Chapter 9: Overview summary
Intangible non-current
assets
‘An identifiable non-monetary asset without physical
substance'
Research
Development expenditure
'Investigation to gain new scientific or technical knowledge
and understanding'
'Application of research findings or other
knowledge to produce new/substantially improved
materials, processes etc'
Accounting treatment
 There is no certainty of future profits
 Write-off as an expense in the
statement of profit or loss
Accounting treatment
 Future profits are expected
 Capitalise as an intangible non-current asset if all PIRATE
criteria are satisfied
 PIRATE:
Probable future economic benefits
Intention to complete and use/sell asset
Resources adequate and available to use/sell asset
Ability to use/sell asset
Technical feasibility of completing asset for use/sale
Expenditure can be measured reliably
Amortisation
 Amortise asset over its useful life once asset is ready for
use
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27: APPENDIX A
Chapter 10: Overview summary
'Accruals:
Expenses incurred by the business during the period but not yet paid for'
'Prepayments:
Expenses paid for before they have been used'
Accruals and prepayments
Accounting treatment
Year end adjustments
Reversing out accruals and
prepayments
 Accruals increase expenses
and represent a liability: Accruals and prepayments brought forward
at the start of the year must be reversed
Dr Expenses (SPL)

Steps to answering questions:
Cr Accruals (SOFP)
(1) Reverse opening accrual/prepayment
(2) Post cash paid during the year
 Prepayments decrease
expenses and are an asset at (3) Post closing accrual/prepayment
(4) Balance off the accounts
the year end:
Dr
Cr
Presentation in the statement
of financial position
 Accruals: current liabilities
 Prepayments: current assets
Prepayments (SOFP)
Expenses (SPL)
Accrued income
and deferred income
'Accrued income:
'Deferred income:
income earned but not yet invoiced'
income invoiced but not yet earned'
Accounting treatment
Accrued income:
Dr Receivable (SOFP)
Cr Income (SPL)
Deferred income:
Dr Income (SPL)
Cr Payable (SOFP)
 Opening accrued and deferred income balances
must be reversed at the beginning of each year.
419
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27: APPENDIX A
Chapter 11: Overview summary
 Entity has a present obligation as a result of a past
event
 It is probable that an outflow of economic resources
will be required to settle the obligation
 Recognise in financial statements:
Dr Expense (SPL)
Cr Provision (SOFP)
 A reliable estimate can be made of the amount
Accounting treatment
Recognition criteria
Provisions
'A liability of uncertain timing or amount'
Provisions and
contingencies
Contingent liabilities
Contingent assets
'An uncertain liability that does not meet the
three criteria for recognising a provision'
 Possible obligation
 Present obligation
– Which is not probable
– Where the amount cannot be
measured reliably
 Disclose in a note to the financial
statements
'A possible asset that arises from past events
and whose existence will be confirmed by one or
more uncertain future events not wholly within
the control of the entity'.
 Disclose where probable
 Recognise if virtually certain
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27: APPENDIX A
Chapter 12: Overview summary
To record the cash received from a customer whose balance
was previously written off:
Dr Cash (SOFP)
Cr Irrecoverable debt expense (SPL)
Cr Trade receivables (SOFP)
Amounts recovered
Irrecoverable debts
To write off an irrecoverable debt:
Dr Irrecoverable debt expense (SPL)
Cr Trade receivables (SOFP)
Irrecoverable debts
and allowances
Allowances
Adjust allowance for
receivables
Create allowance for
receivables
To increase the allowance for receivables at the period end:
Dr Increase/decrease in allowance for receivables (SPL)
Cr Allowance for receivables (SOFP)
To decrease the allowance for receivables at the period end:
Dr Allowance for receivables (SOFP)
Cr Increase/decrease in allowance for receivables (SPL)
To create an allowance for receivables:
Dr Increase/decrease in allowance for receivables (SLP)
Cr Allowance for receivables (SOFP)
421
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27: APPENDIX A
Chapter 13: Overview summary
Output tax
Input tax
 A business charges sales tax on its sales
 This is paid over to the tax authority once any
recoverable input tax is deducted
 A business will recover sales tax on its
purchases
Accounting treatment
 Sales and purchases are recorded net of sales tax
 Trade receivables and trade payables are recorded gross of sales tax
Sales tax
Rates of sales tax
Irrecoverable sales tax
 Sales tax cannot be recovered on
certain items such as some noncurrent assets
 Zero rated supplies have sales tax
charged on them at 0%
 Exempt supplies are not subject
to sales tax
 The question will always state if
this is the case
422
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27: APPENDIX A
Chapter 14: Overview summary
 The RLCA and the RL and the
PLCA and the PL are showing
information from the same source
(totals and individual accounts) so
the overall balance should
reconcile.
Reconciliations
Receivables ledger control account
Payables ledger control account
 RLCA: The total owed by all
credit customers at a particular
point in time.
 PLCA: Total owed to all credit
suppliers at a particular point in
time
Contra entries
'Where a business has a customer
which is also a supplier'
 A contra will always be for the
lower of the two amounts and
will always reduce both
receivable and payables:
Dr PLCA
Cr RLCA
 The memorandum ledgers must
also be updated for the contra
entry
 RL: a list of the amounts owed by
each individual credit customer at
a particular point in time
 PL: a list of the amounts owed to
each individual credit supplier at
a particular point in time
Receivables ledger
Payables ledger
 Each month the supplier
statement should be reconciled
to the supplier's account in the
payables ledger.
Control accounts
Supplier statement
reconciliations
Returns, credit notes, refunds
and over payments
Discounts
allowed and received
 If a customer returns goods having already paid
for them or over pays an invoice they will show
a credit balance on their account
 The business may issue the customer with a
credit note which they can use to pay for future
purchases or the customer may request a
refund
 Both the control accounts and the
memorandum ledgers must be updated for
these entries
Trade discounts
 Given at the time of sale/purchase
 For example: bulk buying discounts
 Never appear in the financial statements
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 Discounts allowed are offered by a
business to their customer (an expense)
 Discounts received are received by a
business from their supplier (sundry
income)
Settlement discounts
 Offered as an incentive to
settle a debt early
 For example: 3% discount if
settled within 10 days
 May or may not be taken
 Sales and purchases are
recorded after trade
discounts
 Settlement discounts allowed
are deducted if expected to
be taken
27: APPENDIX A
Chapter 15: Overview summary
Bank reconciliations
Bank statement balance
Cash book balance
 Business's record of the amount
of cash held by the business at
any point in time
 Bank's record of the amount of
cash held by the business at
any point in time
Differences
Timing differences
 Items shown in the cash book
but not currently on the bank
statement
 Examples:
- Unrecorded lodgements
- Outstanding cheques
 Adjust bank statement balance
Errors by the business
 Items on the bank statement which
have been omitted from the cash
book
 Examples:
- Bank charges
- Direct debits
 Adjust in the cash book
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Errors by the bank
 Examples:
- Cheque incorrectly debited to
the business's account
- Lodgement incorrectly credited
to the business's account
 Adjust bank statement balance
27: APPENDIX A
Chapter 16: Overview summary
Types of error
 Error of omission:
 Error of commission:
 Error of principle:
 Compensating error:
 Transposition error:
Transaction not recorded
Debits and credits balance but the entry is made to the wrong account
For example, an expense is debited to the rent account rather than the electricity account
Debits and credit balance but the entry is made to the wrong 'type' of account
For example, machine repairs debited to the machine asset account
Two separate errors are made which correct each other
Here debits  credits and so the trial balance will not balance
For example, the posting of a credit sale as
Dr
Trade receivables
$210
Cr
Sales
$120
Correction of errors
Adjustments to profit
Suspense account
'A temporary account which never appears in
the financial statements'
 Used when:
– An accountant is unsure of a double entry
– A preliminary trial balance does not
balance
 Must be cleared out
 Steps:
(1) What entry was made?
(2) What entry should have been made?
(3) What entry is required to correct the
entries?
'When errors are corrected they may affect the
business' profit'
 Only errors relating to items of income or
expenses will affect profit
425
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27: APPENDIX A
Chapter 17: Overview summary
Margin
Cost structures
Mark-up
'Gross profit expressed as a
percentage of cost of sales'
 For example, a 25% mark-up:
Sales
$1.25
$1.00
COS
$0.25
Gross profit
'Gross profit expressed as a
percentage of sales'
 For example, a 20% margin:
Sales
$1.00
$0.80
COS
$0.20
Gross profit
Incomplete records
Techniques for solving
incomplete records
Accounting equation
Closing net assets = Opening net
assets + Capital Introduced + Profit –
Drawings
Derive missing figures from
given information
Sales
 Derive sales figure by:
Purchases
Can rearrange to find missing figure
(eg profit or drawings)
Drawings
 Derive purchases figure by:
– Putting all known
information into a trade
receivables T account
– Putting all known information
into a trade payables T
account
– Using cost structure
information to work from
cost of sales back to
sales
– Using cost structure
information to derive
purchases as part of the cost
of sales figure
 Put all known information into
a cash T account
 If the question states that
drawings were between $50
and $80 per week this
indicates that drawings are
the missing figure
 Cash drawings:
Dr Drawings
Cr Cash
 Drawing of goods:
Dr Drawings
Cr Purchases
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Inventory
 Derive using cost structure
information
 Drawings of inventory are
always valued at their cost
and not their selling price
27: APPENDIX A
Chapter 18: Overview summary
Preparation of financial
statements for sole traders
Trial balance
'A list of the balances brought down on each ledger account'
Adjustments
Suspense account
'A temporary account which never
appears in the financial
statements'
 For example:
– Closing inventories
– Depreciation
– Bad and doubtful
debts
– Accruals and
prepayments
Statement of profit or loss
Statement of financial position
– Correction of errors
427
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27: APPENDIX A
Chapter 19: Overview summary
Finance costs
 Interest is shown as a finance cost in the statement of profit or loss
Reserves




Long term borrowings
Share premium account
Revaluation surplus
Other reserves
Retained earnings:
- Cumulative undistributed profits
 Debt finance, for example:
- Debentures
- Loan notes
Introduction to
company accounting
Four main types of share capital:
– Authorised
– Issued
– Called up
– Paid up
Shares
Accounting treatment
Issue at a premium
'When shares are issued at a premium
to their nominal value, the excess
should be credited to the share
premium account'
 Dr Cash
Cr Share capital
Cr Share premium
Dividends
Bonus issue
'Shares are issued for no cash consideration'
 Always done at nominal value
 Dr Reserves (SPA)
Cr Share capital
 Advantages
– Enables company to use the share
premium account
– Price of shares will fall making them
more affordable to new investors
 Disadvantage:
– Rationale is not always understood by
shareholders
Income taxes
 Expense in the statement of profit or
loss and a liability at the year end
 Dr Income tax expense
Cr Current tax payable
 Any under/ over provision is adjusted in
the next year's financial statements
 Ordinary shares:
– Equity share
– Voting rights
– No right to a dividend
 Preference shares:
– Receive a fixed rate of dividends
– No voting rights
– If redeemable = liability
– If irredeemable = equity
Rights issue
'Shares issued to existing shareholders for cash'
 Issued at rights price which is below current
market price
 Dr Cash
Cr Share capital
Cr Share premium account
 Advantages
– Cost effective way for company to raise finance
– If all rights are taken up shareholders will
maintain their percentage shareholding
 Disadvantages
– 'Bad press' for the company if all rights are not
taken up
– Effect on future dividend policy
 Dividends on ordinary shares and irredeemable preference shares are debited to retained earnings
 Dividends relating to redeemable preference shares are a finance cost in the statement of profit or loss
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27: APPENDIX A
Chapter 20: Overview summary
Statement of financial
position
Statement of profit or loss and other
comprehensive income
'Shows the income and expenses for a period under
specific headings'
 Points to note:
– SPL relates to realised gains/losses; OCI relates to
unrealised gains/losses (posted directly to reserves)
– Distribution costs: delivery costs
– Administrative expenses: general costs that do not
'fit' under the other captions
– Finance costs: bank interest, debenture/loan note
interest
– Income tax expense: estimate of income tax due on
the profits for the period plus/minus any under/over
provision in respect of prior periods
'Shows the assets and liabilities of a business at
a point in time'
Preparation of financial statements
for companies
Statement of
changes in equity
Notes to the accounts
 Examinable notes:
– Property, plant and equipment
– Intangible non-current assets
– Inventory
– Provisions
– Contingent liabilities
– Contingent assets
– Events after the reporting period
'Explains the movements between the equity
section of the statement of financial position at
the beginning and the end of the year'
 Key components:
– Issue of share capital
– Dividends (on ordinary shares)
– Total comprehensive income for the year
– Profit for the year
– Revaluation surplus on non-current
assets
– Transfer to retained earnings
429
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27: APPENDIX A
Chapter 21: Overview summary
Definition
'Events, both favourable and unfavourable, that occur between the end of the
reporting period and the date when the financial statements are authorised for
issue'
Events after the
reporting period
Adjusting events
Non-adjusting events
'Events which provide evidence of conditions
which existed at the end of the reporting
period'
'Events that relate to conditions which arose
after the end of the reporting period'
 Disclose in a note to the financial
statements
 Examples:
– Destruction of a major asset by flood
or fire
 Include in the financial statements
 Examples:
– Resolution of a court case
– Bankruptcy of a major customer
– Evidence of the NRV of inventories
– Discovery of fraud or errors
– Major share transactions
– Announcement of a plant to close part
of a business
– Dividends proposed/declared after the
end of the reporting period
430
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27: APPENDIX A
Chapter 22: Overview summary
Cash
Cash equivalents
'Cash on hand and demand
deposits'
'Short-term, highly liquid investments'
 Example:
– Current asset investments
Cash flows
'Inflows and outflows of cash and cash equivalents'
Statements of
cash flows
IAS 7
'Requires that a company show the movement in cash and cash equivalents
between the beginning and the end of the year under three headings'
 Cash flows from operating activities
 Cash flows from investing activities
 Cash flows from financing activities
Cash flows from
operating activities
Cash flows from
investing activities
'Cash flows from trading activities'
Indirect method
Direct method
 Cash generated from operations
 Adjust profit before tax figure for:
– Non-cash items
– Items shown elsewhere in the
cash flow
– Movements in working capital
 Then deduct interest and income
taxes paid
Cash flows from
financing activities
'Cash flows relating to the acquisition or 'Cash flows relating to the issue or repayment
disposal of non-current assets and the of long term finance'
returns on investments'
 Includes
 Includes
– Proceeds from share capital/debenture
– Purchase of non-current assets
issue
– Proceeds from sale of non-current
– Repayment of loans
assets
– Ordinary dividends paid
– Interest/dividends received
 Cash generated from operations:
 Derived by calculating:
– Cash receipts from customers
– Cash payments to suppliers and employees
 Then deduct interest and income taxes paid
431
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27: APPENDIX A
Chapter 23: Overview summary
Concept
Accounting for associates
Consolidated accounts are
prepared for a group of
companies
Introduction to consolidated
financial statements
Types of investment
3 types of investment (in syllabus):
 Subsidiary (control)
 Associate (significant influence)
 Trade investment (no influence)
Parent's separate
financial statements
SOFP: Investment at cost (for exam)
SPLOCI: Investment income (ie
dividends)
Equity accounting:
Consol SOFP: Investment in associate
 Cost of associate X
 Share of post
acquisition reserves X
 Less: impairment (X)
X
Consol SPLOCI: % of A's profit for year
% of A's OCI
Consolidated statement of
financial position




Add P + 100% S assets & liabilities
line by line
Cancel investment with S's share
capital and pre-acquisition reserves
Share capital/premium = P only
Reserves = P + Group share of S post
acquisition
Group financial statements



For parent's shareholders
In addition to parent's individual
financial statements
To show group as single
business entity
432
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27: APPENDIX A
Chapter 24: Overview summary
Approach to consolidated
statement of financial
position
1.
2.
3.
4.
5.
6.
7.
Group structure
Proforma
Add P + 100% S's assets &
liabilities line by line, post
P's share capital/premium &
1st line of workings
Adjustments
Goodwill working
Retained earnings working
NCI working
Mid-year acquisitions
Consolidated statement of
financial position
Estimate pre-acquisition retained earnings
(if not given):
B/f retained earnings
X
Profit for year
(pro-rated up to acq'n date) X
Pre-acq'n retained earnings X
Fair values
Non-controlling interest
Goodwill
FV of consideration
FV of NCI
FV of net assets acquired:
Share capital
X
Retained earnings
X
FV adjustment
X
Goodwill
X
X
Fair value of net assets
X
Book value of net assets (X)
Fair value adjustment
X*
3rd party shareholders in subsidiary
NCI working for consol SOFP:
NCI at acquisition (goodwill working)
NCI share of post acquisition reserves
(X)
X

Positive goodwill – capitalise as
intangible non-current asset

Negative goodwill – to SPL
* Post to goodwill working and face
of consol SOFP
X
X
X
Other reserves
Parent + group share of sub's post
acquisition
Inter-company trading

Eliminate year end inter-company
payables & receivables

Eliminate unrealised profit in year
end inventories. company trading:
DR (↓) Seller's retained earnings
CR (↓) Consolidated inventories
433
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27: APPENDIX A
Chapter 25: Overview summary
Consolidated statement of profit
or loss
Purpose
Show results of group as a single
business entity
Approach to the consolidated
statement of profit or loss
1.
Group structure
2.
Proforma
3.
Add P + 100% S line by line &
post S's PFY to NCI working
4.
Adjustments
5.
NCI working
6.
Ownership reconciliation
Inter-company trading

Cancel I/Co revenue & cost of
sales (for all I/Co sales in the
year)

Cancel unrealised profit on
inventories from I/Co trading
left at year end by increasing
seller's cost of sales (if sub =
seller, adjust NCI)
Mid-year acquisitions
Pro-rate sub's income, expenses &
NCI for number of months controlled
by parent
434
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27: APPENDIX A
Chapter 26: Overview summary
Importance and purpose of
interpretation of financial
statements
Analysis of financial
statements
To provide users with information about
financial performance and position and
to enable them to make decisions.
Make a note of all obvious changes or
trends before calculating any ratios.
Give reasons for change and significance
for the future.
Interpretation of financial
statements
Only useful if compare with:
 Previous financial periods
 Similar businesses
 Industry averages
Profitability ratios









Ratio analysis
Liquidity ratios
Limitations of ratio analysis
Efficiency ratios
See next page
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Inflation
Different accounting policies
Lack of information
Seasonal trading
Year end figures not representative
Related party transactions
Different ratio definitions
Financial statements manipulated
New company – no comparatives
Position ratios
27: APPENDIX A
Current ratio
The quick
ratio or ‘acid
test' ratio
Current assets
 X :1
Current liabilities
Current assets – Inventories
Current liabilities
Interest
cover
Proft before interest and taxation
Finance costs
Non - current liabilities
Gearing
 X :1
 X times
Total equity  Non - current liabilities
Liquidity
 X times
Position
Ratio analysis
Profitability
Gross profit
margin
Operating
profit
percentage
Return on
capital
employed
Return on
equity
Gross profit
Efficiency
Inventory
turnover period
 100%
Revenue
PBIT
 100%
Revenue
PBIT
Total equity  non - current liabilities
 100%
Profit after tax & preference dividends
Total equity
Receivables
collection
period
Payables
payment period
Working capital
cycle
 100%
Asset turnover
Inventories
 365 days
Cost of sales
Trade receivables
 365 days
Revenue
Trade payables
 365 days
Cost of sales
Inventory days + Receivable days –
Payable days
Revenue
Total assets – Current liabilities
436
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 X times
27: APPENDIX A
437
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438
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