1
WELCOME TO
FINANCIAL ACCOUNTING (FA)
2
SOME NOTES FOR LEARNING FA
FA Main capabilities
A. The context and
purpose of financial
reporting
B. The qualitative
characteristics of
financial information
C. The use of double-entry and accounting systems
D. Recording
transactions and
events
E. Preparing a trial balance
F. Preparing basic financial statements
H. Interpretation
of financial
statements
G. Preparing simple consolidated financial statements
3
CHAPTER 1
INTRODUCTION TO FINANCIAL
ACCOUNTING
4
OVERVIEW
What will you learn?
BUSINESS
III. Types of business
Sole traders
Accounting for transactions
Partnerships
Management
accounting
I. Financial accounting
Limited liability
companies
II. Financial statements
II.1. Main
elements of
financial
statements
II.2. The need
of financial
statements
II.3. Users of
financial
information
IV. Those
charged with
governance
(Prepare F.S)
5
I. FINANCIAL ACCOUNTING
1. Definition
Financial accounting is a specific branch of accounting involving Record to Report
Process (R2R) of recording financial data.
Financial reporting is a way of recording, analysing and summarising financial data.
Record to Report Process (R2R) is as follow:
R
Actual transactions are recorded in books of prime entry
The transactions are analyzed in the books of prime entry and the
totals are posted to the ledger accounts
The transactions are summarized in the trial balance
R
Numerous statistics and key performance indicators are reported in
financial statements
6
I. FINANCIAL ACCOUNTING
1. Definition
Financial accounting
Specific
1. Definition
branch
Management accounting
of Management
accounting involving record analyses
Reporting
the
financial
performance & position of a
business
3. Requirement
Mandatory
Decision making & planning
for the future
Optional
Internal
5. Regulations
None
7. External
review
that
provide
managerial action
4. Primary users External
6. Frequency
to
to report process (R2R) of information as a basis for
recording financial data
2. Purpose
system
data
GAAP, IFRS, IAS
Quarterly,
annual or per
period
Auditors, regulators
As needed and ongoing
None
7
II. FINANCIAL STATEMENTS
5 Main financial statements
There are 5 main financial statements:
Financial statements
1.1 Statement of Financial Position
Point
of
time
1.2 Statement of Comprehensive Income
1.3 Statement of Cash Flows
Period
1.4 Statement of Changes in Equity
1.5 Notes to Financial Statements
8
II. FINANCIAL STATEMENTS
1. Main elements of financial statements
1.1
Statements of financial position (SOFP)
The statement of financial position is simply a list of all the assets owned and all the
liabilities owed by a business as at a particular date.
The statement of financial position includes 3 components:
EQUITY
ASSETS
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.
There are 2 types of assets:
▪ Non-current assets
▪ Current assets
Equity is the residual interest in the
assets of the entity after deducting
all its liabilities.
LIABILITIES
A liability is a present obligation of
the entity to transfer an economic
resource as a result of past events.
There are 2 types of liability:
▪ Non-current liabilities
▪ Current liabilities
9
II. FINANCIAL STATEMENTS
1. Main elements of financial statements
1.1
Statements of financial position (SOFP)
STATEMENT OF FINANCIAL POSITION AS AT 31 DECEMBER 20X3
$
Asset
Non-current assets
Property, plant, and equipment
Current assets
Inventory
Trade receivables
Total assets
$
87,500
12,000
11,200
110,700
Equity and liabilities
Equity
Equity shares capital @ $1 shares
Retained earnings
Total equity
Non-current liabilities
6% bank loan
Current liabilities
Trade payables
Total liability
Total equity and liabilities
47,000
43,650
90,650
10,000
10,050
20,050
110,700
10
II. FINANCIAL STATEMENTS
1. Main elements of financial statements
1.2
Statement of Comprehensive Income (SOCI)
A Statement of Comprehensive Income is a record of income generated and
expenditure incurred over a given period; known as Statement of Profit or Loss and
other comprehensive income (SOPLOCI)
There are 2 components included in SOCI:
Income
“Income is the increases in assets or decreases in liabilities that result
in increases in equity, other than those relating to contributions from
holders of equity claims.”
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.”
(Conceptual Framework for Financial Reporting 2018, para. 4.68)
11
II. FINANCIAL STATEMENTS
1. Main elements of financial statements
1.2
Statement of Comprehensive Income (SOCI)
STATEMENT OF COMPREHENSIVE INCOME FOR THE
YEAR ENDED 31 DECEMBER 20Y2
$
Sales revenue
150,000
Less: Cost of sales (Cost of goods sold)
(75,000)
Gross profit
75,000
Distribution costs
(10,700)
Administrative and selling expense
(15,560)
Operating profit
48,740
Finance costs
(740)
Profit before tax
48,000
Income tax
(600)
Profit for the year
47,400
Other comprehensive income: Revaluation surplus
2,000
Total comprehensive income for the year
49,400
12
II. FINANCIAL STATEMENTS
1. Main elements of financial statements
1.3
Statement of Cash Flows (SOCF)
Statement of cash flows is a financial statement which concentrate on the changes of
cash and cash equivalent during the period.
Cash flows must be classified as operating, investing and financing activities:
Operating
activities
The main revenue-producing activities of the entity and
other activities that are not investing or financing activities.
Investing
activities
The acquisition and disposal of long-term assets and
other investments not included in cash equivalents.
Financing
activities
Activities that result in changes in the size and composition
of contributed equity capital and borrowings of the entity.
Note:
More information about SOCF will be mentioned in Chapter 22 – Statement of Cash
flows (IAS 7).
13
II. FINANCIAL STATEMENTS
1. Main elements of financial statements
1.4
Statement of Changes in Equity (SOCIE)
Statement of changes in equity is a reconciliation of the beginning and ending
balances in a company’s equity during a reporting period.
STATEMENT OF CHANGES IN EQUITY FOR THE YEAR ENDED 31 DECEMBER 20Y2
Balance at 1.1.Y2
Share
capital
Share
premium
3,000
200
Revaluation Retained
surplus
earnings
100
Changes in accounting policy
Restated balance
3,000
200
100
Total
500
3,800
(200)
(200)
300
3,600
(100)
(100)
800
1,000
Changes in equity for 20Y2
Dividends
Total comprehensive income
200
Issue of share capital
1,000
300
Balance at 31.12.Y2
4,000
500
1,300
300
1,000
5,800
14
II. FINANCIAL STATEMENTS
1. Main elements of financial statements
1.4
Notes to Financial Statements
Notes to the financial statements disclose the detailed assumptions made by
accountants when preparing a company’s: income statement, balance sheet, statement
of changes of financial position or statement of retained earnings. The notes are
essential to fully understanding these documents.
Example of Notes to Financial Statements:
• The first note to the financial statements is usually a summary of the company's
significant accounting policies for the use of estimates, inventories, property and
equipment, goodwill and other assets, fair value measurement, discontinued
operations, recently issued accounting pronouncements, and others.
• The remaining notes contain the details (including schedules of amounts) for items
such as inventories, accrued liabilities, income taxes, employee benefit plans,
leases, business segment information, fair value measurements, derivative
instruments and hedging, stock options, commitments and contingencies, and
more.
15
II. FINANCIAL STATEMENTS
2. Users of financial statements & financial information
A stakeholder is a party that has an interest in a company and can either affect or be
affected by the business.
There are 2 types of users of financial statements and financial information:
Users of financial statements and financial information
Internal stakeholders
External stakeholders
Internal stakeholders are intimately
associated to the organisation and
their objectives are likely to have a
strong influence on how it is run.
External stakeholders have quite
diverse objectives and have varying
ability to ensure that the
organisation meets its objectives.
Example: employment, ownership, or
investment.
Example: lenders, tax authority,
government, etc.
16
II. FINANCIAL STATEMENTS
2. Users of financial statements & financial information
Need information for investment decisions with
the aims:
Shareholders
• To access their investment’s performance
• To evaluate the company’s ability to pay
dividends through plans and prospects
• To determine whether they should increase,
hold or sell their investments
Need information for planning and decision
making with the aims:
Internal
stakeholders
Managers
• To formulate plans based on related
information
• To compare actual results against plan
• To improve ahead performance through
feedback on results of previous decisions
• Need the most information to make planning
and control decision
Need information relating to their benefits:
Employees
• To access the company’s ability in providing
remuneration, employment opportunities, job
security, etc. In the long term
17
II. FINANCIAL STATEMENTS
2. Users of financial statements & financial information
External
stakeholders
Lenders/
Creditors
Interested in the security of their loan:
• To access the company’s liability to meet
interest payments and eventually repay the
amount advanced
Trade
contacts
• Suppliers (provide goods/services on credit): To
evaluate the company’s long-term health and
liquidity position
• Customers: To secure the sources of supply for
themselves
Financial
analysts and
advisers
• Interested in profit performance and estimates
of future operations to identify investment
opportunities and prospects
Tax authority
• Need information for the collection of taxes and
duties through assessing the profit on which the
company’s tax liability is to be computed
Government
and their
agencies
• Allocation of resources and activities of
enterprises
• Collecting statistical information to reveal
trends within the economy
The public
• Members of the public in a variety of ways:
contribution to the local economy
• The environment: regards pollution
18
II. FINANCIAL STATEMENTS
3. The need of financial statements (FSs)
“The objective of financial statements is to provide information about the financial
position, financial performance and cash flows of an entity that is useful to a wide
range of users in making economic decisions.”
(IAS 1, para. 9)
Example: reasons why stakeholders need FSs
1. Identifying Business Profitability
2. Evaluate Tax Liability
3. Improve Debt Management
4. Identify & Mitigate Errors
5. Improved Decision Making
6. Proof of Business Success
19
III. TYPES OF BUSINESS
1. Main types of business entity
Businesses of whatever size or nature exist to make a profit
Types of business
Sole traders
Partnerships
Limited liability
company
Management
Only sole trader
can participate in
management.
Partnerships must
have at least two
partners.
Have separation
between board of
directors and
management.
Liability
Liability is
unlimited.
Partners' liability
is unlimited.
Members' liability
can be limited.
Entity
A sole trader is
not legally
separate.
No existence
outside of its
members.
Is a legal entity
separate from its
members
Assets
A sole trader
owns assets.
Partners own
assets jointly.
Shareholders own
assets but they
appoint someone
else operating
20
III. TYPES OF BUSINESS
2. Advantages & Disadvantages
Advantages
• No financial accounts and audit
requirement.
Sole traders
• Limited paperwork 🡪 cost savings
• Can increase or decrease capital
as and when the owner wish.
• No financial accounts and audit
requirement
Partnerships
• Additional capital can be raised
• No company tax on the business
• Can increase or decrease capital
as the owner wish.
Disadvantages
• Owner is personally liable for all
debts (unlimited liability)
• Personal property may be
vulnerable.
• Reliance on overdrafts and
personal saving.
• Are jointly personally liable for
all debts (unlimited liability)
unless they have formed an LLP.
• Costs associated with setting up
partnership agreements.
• Must publish annual financial
• Tax advantages: tax rate on
Limited
liability
companies
companies may be lower than the
tax rate for individuals.
• Easy to transfer shares from one
owner to another.
statements.
• Financial statements must comply
with legal and accounting
requirements.
• Share issues are regulated by law
🡪 difficult to reduce share
capital.
21
IV. GOVERNANCE
Corporate governance
Corporate governance is the system by which companies and other entities are
directed and controlled.
The board of directors of a company are usually the top management and are those
who are charged with the governance of that company.
Shareholders
Executive directors
(Led by CEO)
Non-Executive directors
(Led by Chairman)
Execution
Oversight, set
objective, strategy
Prepare
Oversee
Financial
statements
Public to
Boards of directors
22
IV. GOVERNANCE
Responsibilities and duties of directors
The responsibilities and duties of directors as below:
Legal responsibilities
Responsibilities for financial statements
• Be responsible for the preparation of the
• Main aim: To create wealth for
the shareholders.
• Duty of care to show reasonable
competence.
• To be in a fiduciary position.
• Must act honestly in best
interests of company.
financial statements
• To ensure that the entity complies with the
relevant laws and regulations.
• To explain their responsibility for preparing
accounts.
• To present a balanced and understandable
assessment of the company's position and
prospects
• Strategy for delivering the company's longerterm objectives.
23
CHAPTER 2:
THE REGULATORY FRAMEWORK
24
OVERVIEW
What will you learn?
The regulatory system
I. Introduction
II.1.
IFRS
Foundation
II. Structure
II.2.
International
Accounting
Standards
Board (IASB)
II.3.
The IFRS
Advisory
Council
III. International Financial
Reporting Standards (IFRSs)
II.4.
The IFRS
Interpretations
Committee
25
I. INTRODUCTION OF
THE REGULATORY SYSTEM
6 Factors Shaped Financial Accounting
National
legislation
Accounting
concepts
and
individual
judgment
Other
international
influences
FINANCIAL
ACCOUNTING
Accounting
standards
True and fair
presentation
Generally
Accepted
Accounting
Principles
(GAAP)
26
I. INTRODUCTION OF
THE REGULATORY SYSTEM
6 Factors Shaped Financial Accounting
6 factors can be detailed as follow:
National/local legislation
Regulated the form and content of the accounts
Accounting concepts and
individual judgment
Developed to try to address subjectivity
Accounting standards
To achieve comparability between different organizations,
deal with some of the subjectivity
Generally accepted
accounting principles
(GAAP)
Signifies all the rules from govern accounting: The
Companies Act 2006, UK and international FRS, Statutory
requirements and stock exchange listing requirements
True and fair view/ fair
presentation
Relevant and faithfully represented financial information
Other international
influences
Influence of agreement between 2 or more countries
27
II. STRUCTURE OF
INTERNATIONAL REGULATORY SYSTEM
Organizations of Regulatory System
The Monitoring Board
IFRS Foundation (the Foundation)
The IFRS Advisory
Council
(the Council)
Key
Appoint
The IFRS
Interpretations
Committee (IFRIC)
The IASB
(the Board)
Develops
& issues
Report
Advise
IFRS Standards
Interprets
28
II. STRUCTURE OF
INTERNATIONAL REGULATORY SYSTEM
1. IFRS Foundation (The Foundation)
The IFRS Foundation (formally called the International Accounting Standards
Committee Foundation or IASCF) a not for profit, private sector body that oversees the
IASB.
Develop a set of IFRSs
Main responsibilities
Develop single set of high quality, understandable, enforceable and
globally accepted IFRSs
Promote use & application
Promote the use and rigorous application of those standards
Take account of the financial reporting needs
Financial reporting needs of emerging economies and small and
medium-sized entities (SMEs)
Bring about convergence
Bring about convergence of national accounting standards and IFRSs to
high-quality solutions
29
II. STRUCTURE OF
INTERNATIONAL REGULATORY SYSTEM
2. International Accounting Standards Board (IASB)
Main responsibilities
The International Accounting Standards Board (IASB) an independent, privately funded
body that develops and approves IFRSs.
Responsible for Standard of financial reporting
Raise the standard of financial reporting
Responsible for global harmonization
Eventually bring about global harmonization of accounting standards
30
II. STRUCTURE OF
INTERNATIONAL REGULATORY SYSTEM
3. The IFRS Advisory Council (The Council)
The IFRS Advisory Council (The Council) a forum used by the IASB to consult with the
outside world
Main responsibilities
Consults with relevant parties
Consults with national standard-setters, academics, user groups, and a
host of other interested parties
Advise the IASB
Giving practical advice on the implementation of particular standards
from the IASB's work program for developing new IFRSs
31
II. STRUCTURE OF
INTERNATIONAL REGULATORY SYSTEM
4. The IFRS Interpretations Committee (IFRIC®)
The IFRS Interpretations Committee formerly called the International Financial
Reporting Interpretations Committee or IFRIC
Main responsibilities
Review identified issues
Review, on a timely basis, newly identified financial reporting issues
not specifically addressed in IFRSs
Clarify issues to develop guidance
Clarify issues where unsatisfactory or conflicting interpretations have
developed or seem likely to develop in the absence of authoritative
guidance, to reach a consensus on the appropriate treatment.
32
III. THE INTERNATIONAL
FINANCIAL REPORTING STANDARDS (IFRS)
1. Use, application and scope of IFRS
The use of IFRS
Application of IFRS
•
Improve international
financial reporting
The standards can be used in the
following ways:
•
Harmonize financial
reporting around the world
•
As national requirements
•
As the basis for all or some
Scope of IFRS
•
IFRSs are NOT intended to
be applied to immaterial
items, nor are they
retrospective
national requirements
•
As international benchmark for
countries
developing
their
requirements
•
By
regulatory
authorities
for
domestic and foreign companies
•
•
Each individual standard
lays out its scope at the
beginning of the standard
By companies themselves
33
III. THE INTERNATIONAL
FINANCIAL REPORTING STANDARDS (IFRS)
2. Standard-setting Process
The procedure for the development of an IFRS Standard is as follows:
STEP 1
Establish an Advisory Committee to advise on issues arising in the project.
Consultation with the Advisory Committee and the IFRS Advisory Council
throughout the project.
STEP 2
IASB may develop and publish Discussion Papers for public comment.
STEP 3
IASB develops and publishes an Exposure Draft for public comment.
STEP 4
IASB issues a final IFRS.
34
CHAPTER 3: THE QUALITATIVE
CHARACTERISTICS OF
FINANCIAL INFORMATION
35
OVERVIEW
What will you learn?
I. IASB's Conceptual framework
Accounting concepts
I.1. Going concern
assumption
I.2. Accruals basis
III. Other concepts
Financial statements
II. Qualitative characteristics of financial information
II.1. Fundamental characteristics
II.2. Enhancing qualitative
characteristics
36
I. THE IASB’S CONCEPTUAL FRAMEWORK
Introduction to the Conceptual Framework
The IASB's Conceptual Framework is the basis on which IFRSs are formulated.
The Conceptual Framework for Financial Reporting is a set of principles which
underpin the foundations of financial accounting.
It is a conceptual framework on
which all IFRSs are based and
hence determines how financial
statements are prepared
It is not a standard itself,
although it is used as a reference
document when standards are
developed.
37
I. THE IASB’S CONCEPTUAL FRAMEWORK
1. Going concern assumption
Going concern concept is an important assumption for financial statements.
THE GOING CONCERN CONCEPT ASSUMES THAT:
Continuing
Not break-up
The business will continue to
operate in approximately the
same manner for the
foreseeable future (at least
the next 12 months).
The assets should NOT be
valued at their 'break-up'
value (*).
(*) Break-up value: The amount they would sell for if they were sold off
piecemeal and the business were broken up.
38
I. THE IASB’S CONCEPTUAL FRAMEWORK
1. Going concern assumption
Example 1
A retailer commences business on 1 January and buys inventory of 20 washing
machines, each costing $100. During the year they sell 17 machines at $150 each.
How should the remaining machines be valued at 31 December in the following
circumstances?
1. They are forced to close down their business at the end of the year and the
remaining machines will realise only $60 each in a forced sale.
2. They intend to continue their business into the next year.
Answer:
1. If the business is to be closed down, the remaining three machines must be valued at
the amount they will realise realized in a forced sale, i.e. 3 × $60 = $180
2. If the business is regarded as a going concern, the inventory unsold at 31 December
will be carried forward into the following year, when the cost of the three machines
will be matched against the eventual sale proceeds in computing that year's profits.
The three machines will therefore be valued at cost, 3 × $100 = $300.
39
I. THE IASB’S CONCEPTUAL FRAMEWORK
2. Accrual basis
The accruals basis is not an underlying assumption, but the Conceptual Framework
makes it clear that financial statements should be prepared on an accrual basis.
ACCRUAL BASIS
Occur
Match
The transactions and events
• are recognized when they
occur
• not as cash or its
equivalent is received or
paid
Profit revenue earned
• must be matched against
the expenditure incurred
in earning it. (*)
(*) This is also known as the matching convention.
40
I. THE IASB’S CONCEPTUAL FRAMEWORK
2. Accrual basis
Example 2
Emma is a T-shirt retailer. At the beginning of the period, she purchases 20 T-shirts at a
cost $5 each. Then she can sell them for $10 each.
1. In case Emma sells all of 20 T-shirts, the revenue $200 (20 x $10) and the cost $100
(20 x $5) match with each other. And the profit is $100.
Purchasing
20 T shirts
Selling 20 T-shirts and
collecting fully payment
Start of the
period
Recording profit of $100
($200 – $100)
2. Emma sells all of the 20 T-shirts. Although the customer pays immediately just for 15
T-shirts, she has to record the revenue for 20 T-shirts sold.
Purchasing
20 T shirts
Selling 20 T-shirts and
collecting payment of
15 T-shirts
Start of the
period
Recording profit of $100
($200 – $100)
Collecting payment of
remaining 5 T-shirts
41
II. QUALITATIVE CHARACTERISTICS
OF FINANCIAL INFORMATION
Definition & Classification
The Conceptual Framework states that qualitative characteristics are the attributes
that make the information provided in financial statements useful to users.
Qualitative characteristics of financial information includes 2 main groups of
characteristics: Fundamental qualitative characteristics and Enhancing qualitative
characteristics
QUALITATIVE OF
FINANCIAL
STATEMENTS
Fundamental
qualitative
characteristics
Enhancing
qualitative
characteristics
(More detail in II.1)
(More details in II.2)
42
II. QUALITATIVE CHARACTERISTICS
OF FINANCIAL INFORMATION
1. Fundamental qualitative characteristics
The Conceptual Framework identifies two fundamental qualitative characteristics that
make financial information useful: relevance and faithful representation.
Predictable
•
Based on past performance to
predict the future.
Relevant financial information is
capable of making a difference
in the decisions made by users.
•
Unusual items are disclosed
separately.
Relevant information has:
• predictive value
• confirmatory value
• or both
Confirmatory
Relevance
The relevance of information is
affected by:
• its nature and
• Materiality.
Information provides feedback on
previous evaluations (i.e. it allows
users to confirm or change their
opinion on such evaluations)
Materiality
•
Professional judgement.
•
Affects
process
decision
making
43
II. QUALITATIVE CHARACTERISTICS
OF FINANCIAL INFORMATION
1. Fundamental qualitative characteristics
Complete
Faithful representation
Financial reports represent
economic phenomena in words
and numbers.
Financial must not only
represent relevant phenomena.
But must faithfully represent
the
substance
of
the
phenomena that it purports to
represent.
Financial information would
possess
the
following
characteristics:
•
•
•
•
Complete
Neutral
Free from error
Substance over form
All necessary information for users
to understand the phenomenon is
depicted.
Neutral
•
Free from bias in both content
and presentation.
•
No manipulation for misleading
purpose.
Free from error
•
No errors or omission in
description.
•
No errors in producing financial
information.
Substance over form
Economic reality of transactions
rather than its legal form.
44
II. QUALITATIVE CHARACTERISTICS
OF FINANCIAL INFORMATION
1. Fundamental qualitative characteristics
Example 3
Materiality: According to IAS 10 – Events after the Reporting Period, non-adjusting
events should be disclosed if they are materiality.
It means that they are such important that non-disclosure would affect the ability of
users to make proper evaluations and decisions.
Faithful representation: With inventory account, accountant should:
• Completeness: Fully record the number of goods purchased and sold in the period
• Neutrality: If the manager request to record goods reserving his personal purpose,
accountant should do not recognize these goods.
• Free-from-error: Record correctly the value of good purchased or sold with the right
double-entries.
• Substance over form: A firm withdrawing inventory for internal use, accountant
should record to a separate account, not on sale account. Because the sale account
reflects only actual sales in substance.
45
II. QUALITATIVE CHARACTERISTICS
OF FINANCIAL INFORMATION
2. Enhancing qualitative characteristics
Enhancing qualitative characteristics are comparability, verifiability, timeliness, and
understandability.
Comparability
Verifiability
Information faithfully represents
economic phenomena
• With previous period, with other
entities
• Consistency and comparability are
not the same
Understandability
Timeliness
Information available to decision makes
in time
Classifying representing information
clearly
Enhancing qualitative characteristics
46
II. QUALITATIVE CHARACTERISTICS
OF FINANCIAL INFORMATION
2. Enhancing qualitative characteristics
Example 3
Verifiability
The profit of the company is considered to be verifiable when there are specific proofs
for the revenue and expense. For example, the company completely has invoices and
contracts for 200 goods sold.
Comparability
The profit of the company must be compared with the previous years to see that there
is an increase or decrease in it.
Timeliness
The information of the company’s profit should be given to users in time.
Understandability
When the accountant presents the information of the company’s profit, she should
not use a lot of jargon and difficult phrasing.
47
III. OTHER ACCOUNTING CONCEPT
Other accounting concept
01
Fair presentation
06
The business
entity concept
02
Prudence
Other accounting
concept
03
Matching
05
Consistency
04
Historical cost
48
III. OTHER ACCOUNTING CONCEPT
Other accounting concept
1
Fair presentation
A fair presentation or present fairly in all material respects:
• Compliance with IFRSs
• All relevant IFRSs must be followed
• Use of appropriate accounting policies
2
Prudence
The concept is to prevent the business from being over-optimistic about
future profits:
• Anticipated profit: Do not be recorded until actually realized
• Anticipated loss: A provision is created
3
Matching
Revenue earned should be matched against the expenditure incurred in
earning it
49
III. OTHER ACCOUNTING CONCEPT
Other accounting concept
4
Historical cost
Transactions are recorded in the accounts with their original costs
5
Consistency
A business should be consistent in the accounting treatment of similar
items within each accounting period and between the accounting period
to the next
6
The business entity concept
• For accounting purpose, the business unit is separate and distinct
from its owners
• The business exists in its own rights
50
CHAPTER 4: SOURCES,
RECORDS AND BOOKS OF
PRIME ENTRY
51
OVERVIEW
What will you learn?
I.1. Business transactions
I.2. Sources of information
II. Books of prime entry
II.1. The sales
daybook
II.2. The sales
returns daybook
II.5. The cash
book
II.3. The
purchases
daybook
II.6. Petty cash
book
II.7. Bank statements
II.4. The
purchases
returns daybook
II.8. The journal
52
I. BUSINESS TRANSACTIONS
& SOURCES OF INFORMATION
1. Business transactions
In every business, several transactions and events will take place every day.
We are considering the manufacturing business process to get some main transactions:
Input
Process
Output
Sales management
Materials
Manufacturing management
Property, Plant
Human resource management
Labour
Equity management
Equity
Expense management
Main
transactions
Main transactions
Main
transactions
Purchases
materials
Payroll related transactions
Sales
Rent plant
Expense payment (rental cost)
Raise finance
Repayment of finance
Daily transactions
53
I. BUSINESS TRANSACTIONS
& SOURCES OF INFORMATION
2. Sources of information
Business transactions are recorded on source documents.
2. Sales order
5. Credit note
3. Good
dispatched note
6. Receipt note
4. Invoice
7. Statement
8. Purchase order
10. Debit note
9. Good received
note
11. Remittance
advice
Supplier
Customer
1. Quotation
54
I. BUSINESS TRANSACTIONS
& SOURCES OF INFORMATION
2. Sources of information
Contents
Purposes
1.
Quotation
• Quantity
• Description
• Details of goods required.
• To establish price from various
suppliers
• Cross
refer
to
purchase
requisition.
2.
Sale order
• Quantity
• Description
• Details of goods required
and price.
• Cross checked with the order
placed by customer
• Sent to the stores/ warehouse
department for processing of the
order.
3.
Goods
dispatched
note (GDN)
• Details of supplier, e.g.
name and address.
• Quantity and description
of goods
• Provided by supplier
• Checked with goods received and
purchase order.
4.
Invoice
• Name and address of
supplier and customer;
• Details of goods, e.g.
quantity, price, value, sales
tax, terms of credit, …
• Issued by supplier as a request
for payment.
• For the supplier, this will be
treated as a sale invoice
• For the customer, this will be
treated as a purchase invoice.
55
I. BUSINESS TRANSACTIONS
& SOURCES OF INFORMATION
2. Sources of information
Contents
Purposes
5.
Credit note
• Details of supplier, e.g.
name and address.
• Details of goods returned,
e.g. quantity, price, value,
sales tax, terms of credit, …
• Issued by the supplier.
• Checked
with
documents
regarding goods returned.
6.
Receipt note
• Details
received.
payment
• Issued by the selling company
indicating the payment received.
• Details of supplier, e.g.
name and address.
• Details of date
• Invoice
numbers
and
values
• Issued by the supplier.
• Checked with other documents to
ensure that the amount owing is
correct.
7.
Statement
of
• Payments made, refunds,
amount owing.
56
I. BUSINESS TRANSACTIONS
& SOURCES OF INFORMATION
2. Sources of information
8.
Purchase
order
Contents
Purposes
• Details of supplier, e.g.
name and address.
• Quantity
• Description
• Sent to supplier as request for
supply.
• To check the quotation and
delivery note.
• Details of goods required
and price.
• Terms and conditions of
delivery, payment, etc.
9.
Goods
received note
(GRN)
• Quantity and description of
goods.
• Produced by company receiving
the goods as proof of receipt.
• Matched with delivery note and
purchase order.
10.
Debit note
• Details of the supplier
• Details of goods returned,
e.g. quantity, price, value,
sales tax, terms of credit,
…
• Issued by the company receiving
the goods.
• Cross referred to the credit note
issued by the supplier.
11.
Remittance
advice
• Method of payment
• Invoice number
• Account number, date, …
• Sent to supplier with, or as
notification of, payment.
57
I. BUSINESS TRANSACTIONS
& SOURCES OF INFORMATION
2. Sources of information
Example 1
Exam focus: Sources of information
Which one of the following statements best describes the purpose of a goods
dispatched note (delivery note)?
A. It is issued by a customer returning faulty goods to their supplier.
B. It is issued by a customer to their supplier and specifies the quantity and type of
goods they require to be dispatched.
C. It is issued by a supplier to their customer and specifies the quantity and type of
goods delivered to that customer.
D. It is issued by a supplier to their customer and specifies what goods will be provided
to them at a specified future date.
Answer: C
Goods dispatched note is produced by supplier 🡪 A, B is incorrect
Goods dispatched note includes details of supplier (e.g. name and address), quantity
and description of goods 🡪 C is correct and D is incorrect.
58
II. BOOKS OF PRIME ENTRY
Main books of prime entry
Books of prime entry are books in which we first record transactions.
Several books of prime entry exist, each recording a different type of transaction:
Books of prime entry
Transaction types
1
Sales daybook
Credit sales
2
Purchase daybook
Credit purchases
3
Sales returns daybook
Returns of goods sold on credit
4
Purchases returns daybook
Returns of goods bought on credit
5
Cash book
• All bank transactions
• Cash sales
• Cash purchase
6
Petty cash book
All small cash transactions
7
The journal
Other transactions
59
II. BOOKS OF PRIME ENTRY
1. The sales day book
The sales daybook is the book of prime entry for credit sales.
The sales daybook is used to keep a list of all invoices sent out to customers each day.
Invoices sent out to customers and credit notes are recorded in day book.
An extract from a sales day book might look like this:
SALES DAYBOOK
Date
Invoice
Customer
Total amount
invoiced
$
Jan 10 20X0
247
Jones & Co
105.00
248
Smith Co
86.40
249
Alex & Co
31.80
250
Enor College
1,264.60
1,487.80
60
II. BOOKS OF PRIME ENTRY
2. The sales returns day book
The sales returns day book is the book of prime entry for credit notes raised.
A credit note is raised when customers return goods for some reason.
An extract from the sales returns day book follows.
SALES RETURNS DAY BOOK
Date
Invoice
Customer
Total amount
invoiced
$
Jan 18 20X0
CR008
Jones & Co
20.00
CR009
Smith Co
26.40
CR010
Alex & Co
30.20
76.60
61
II. BOOKS OF PRIME ENTRY
3. The purchase day book
The purchase day book is the book of prime entry for credit purchases.
The purchase day book records other people's invoices, which have all sorts of
different numbers.
The purchase day book records other people's invoices.
An extract from a purchase day book might look like this:
PURCHASE DAY BOOK
Date
Internal
inv
No.
Supplier
Supplier
Inv. No.
Total
amount
invoiced
Electricity
Purchases
Etc
$
$
Mar 15
654
YH0939
Cook & Co
315.00
315.00
20X0
655
A00167
W Butter
29.40
29.40
656
1267
EEB
116.80
657
GB1789
SF Co
100.00
100.00
561.20
444.40
$
116.80
116.80
62
II. BOOKS OF PRIME ENTRY
4. The purchase returns day book
The purchase returns day book is the book of prime entry for credit notes received
from suppliers.
An extract from the purchase returns day book follows:
PURCHASE RETURNS DAY BOOK
Total amount
Date
Supplier and goods
invoiced
$
Mar 18 20X0
W Butter – 300 boxes
20.00
EEB – 150 boxes
26.40
SF CO – 50 boxes
10.00
56.40
63
II. BOOKS OF PRIME ENTRY
5. Cash book
The cash book is the book of prime entry for cash receipts and payments.
The cash book may be a manual record or a computer file.
The cash book is also a day book,
used to keep a record of:
•
money received
•
money paid out
This could be money received on the
business premises in notes, coins and
cheques, subsequently paid into the
bank.
Many businesses have two distinct
cash books
•
a cash payments book
•
a cash receipts book.
64
II. BOOKS OF PRIME ENTRY
5. Cash book
The cash book (receipts) might look as follows:
CASH BOOK (RECEIPTS)
Date
Narrative
Accounts
Cash
receivable
sales
$
$
Total
$
Other
1 Sep
Balance b/d
20X7
Cash sale
80
Accounts receivable: Hay
380
380
Accounts receivable: Been
720
720
Account receivable: Seed
140
140
Loan: Len Dinger
1,800
Cash sale
150
Sale of non- current asset
200
$
900
4,370
80
1800
150
200
1,240
230
2,000
65
II. BOOKS OF PRIME ENTRY
5. Cash book
The cash book (payments) might look as follows:
CASH BOOK (PAYMENTS)
Date
Narrative
Accounts
Petty
payable
cash
$
Total
Other
$
$
1 Sep
Accounts payable: Kew
120
120
20X7
Accounts payable: Hare
310
310
Telephone
400
400
Gas bill
280
280
Petty cash
100
Machinery purchase
1,500
Balance c/d
1,660
4370
$
100
1,500
430
100
2,180
66
II. BOOKS OF PRIME ENTRY
6. Petty cash book
6.1
The petty cash book
Most businesses keep a small amount of cash on the premises to make occasional small
payments in cash, e.g staff refreshments, postage stamps, to pay the office cleaner, taxi
fares, etc.
This is often called the cash float or petty cash account.
A petty cash book is a cash book for
small payments.
Example: stamps, fares, pay the
cleaner, …
There are usually more payments
than receipts.
Petty cash must be ‘topped up’ from
time to time with cash from the
business bank account.
67
II. BOOKS OF PRIME ENTRY
6. Petty cash book
6.1
The petty cash book
A typical layout follows:
PETTY CASH BOOK
Receipts
Date
Narrative
$
250
Milk
Postage
Travel
Other
$
$
$
$
$
25
25
1 Sep Bal b/d
20X7 Milk bill
250
Total
Postage stamps
5
Taxi fare
10
Flowers for staff
15
Bal c/d
195
250
5
10
15
25
5
10
15
68
II. BOOKS OF PRIME ENTRY
6. Petty cash book
6.2
Imprest system
The imprest system is a form of the financial accounting system.
The most common imprest system is the petty cash system.
The amount of money in petty cash is
kept at an agreed sum or “float”
The total float is made up regularly
to the agreed sum
This replenishment will come from
another account source
e.g cash from the bank account is
transferred into the petty cash
69
II. BOOKS OF PRIME ENTRY
6. Petty cash book
6.2
Imprest system
Example 2
DDTQ operates an imprest system for petty cash. During February 20X9, the following
petty cash transactions took place.
2.2.X9
Stamps
$12.00
3.2.X9
Milk
$25.00
8.2.X9
Taxi fare
$15.00
17.2.X9
Stamps
$5.00
18.2.X9
Received from staff for photocopying
$8.00
28.2.X9
Stationery
$7.50
Require: The amount remaining in petty cash at the end of the month was $93.50.
What is the imprest amount?
70
II. BOOKS OF PRIME ENTRY
6. Petty cash book
6.2
Imprest system
Example 2
Answer:
Total expenditure = $12 + $25 + $15 + $5 + $7.50 = $64.50
Opening balance (Imprest amount)
$150.00
Less expenditure
($64.50)
$85.50
Add amount received from staff
$8.00
Closing balance
$93.50
(Balancing
figure)
71
II. BOOKS OF PRIME ENTRY
7. Bank statements
Bank statements should be used to check that the amount shown as a balance in the
cash book agrees with the amount on the bank statement.
Balance in
the cash
book
Reconciliation
Notes:
Weekly or monthly, a business will receive a bank statement.
Bank
statements
72
II. BOOKS OF PRIME ENTRY
8. The journal
The journal is a book of prime entry, which records transactions which are:
• Not routine
• Not recorded in any other book of prime entry
There are some examples for transactions, which can be recorded in the journal:
1
Year-end adjustments:
•
Depreciation charge for the year
•
Irrecoverable debt write-off
•
Record the movement in the allowance for receivables
•
Accruals and prepayments
•
Closing inventory
2
Acquisitions and disposals of non-current assets
3
Opening balances for statement of financial position items
4
Correction of errors
73
II. BOOKS OF PRIME ENTRY
8. The journal
Whatever type of transaction is recorded, the format of a journal entry is:
Date
Account to be debited
Account to be credited
Dr
Cr
$
$
X
X
(Narrative to explain the transaction)
Notes:
• In due course, the ledger accounts will be written up to include the transactions
listed in the journal.
• A narrative explanation must accompany each journal entry.
74
II. BOOKS OF PRIME ENTRY
8. The journal
Example 3
Exam focus: Books of prime entry
Which of the following would be recorded in the sales day book?
A. Cash received
B. Sales invoices
C. Credit notes received
D. Trade discounts
Answer: B
Cash received is recorded in the cash book. 🡪 A is incorrect
Sales invoices is recorded in sales day book (Apply theory in Section II.1).
🡪 B is correct
Credit notes received are to do with returned purchases (not sales).
🡪 C is incorrect
Trade discounts are not recorded, as they are deducted on the sales invoices and only
net sale is recorded
🡪 D is incorrect
75
CHAPTER 5: LEDGER ACCOUNTS
AND DOUBLE ENTRY
76
OVERVIEW
What will you learn?
Business
transactions
Sources of
information
Books of prime entry
II. Double entry bookkeeping
III. Receivables
ledger
Reconcile
I. Nominal ledger
(General ledger)
Trial balance
Financial statements
Reconcile
III. Payables
ledger
77
I. LEDGERS AND LEDGER ACCOUNTS
Overview on ledgers and ledger accounts
Ledgers
Receivables
ledger
Payables
ledger
Customers’
personal
accounts
Suppliers’
personal
accounts
Nominal ledger/
General ledger
Payables
control account
Reconciliation
Receivables
control account
78
I. LEDGERS AND LEDGER ACCOUNTS
1. Ledgers and the division ledgers
The information in the general ledger, receivables ledger and payables ledger is showed in
the chart below.
Receivables ledger
Contains an account
for
each
credit
customer to show
how much each one
owes.
Reconcile
General ledger
(Nominal ledger)
contains all accounts or a summary of
all accounts necessary to produce trial
balance and financial statements.
Reconcile
Payables ledger
Contains an account
for
each
credit
supplier to show how
much each one owed.
Assets
(things owned)
Equipment
Machinery
Receivables (control
account)
…
Liabilities
(things owed)
Bank loan
Owner’s capital
Payables (control
account)
…
Income
Sales
Interest earned
…
Expenses
Purchases for sales
Rent
…
Sales daybook
Lists credit sales.
Cash book
Petty cash
book
Purchases daybook
Lists credit purchases.
From this the general
ledger
sales
and
receivable
control
accounts are updated
together with detailed
receivables accounts in
receivables ledger
Dr Receipts
Cr Payments
Dr Receipts
Cr Payments
From this, general
ledger purchases and
payables
control
accounts are updated
together with detailed
payables accounts in
payables ledger
X
X
X
X
Reconcile
JU Co
FLC Co
Berry
…
Total
Journal
Makes adjustments to accounts in
the double entry system
An account for each
credit customer:
Reconcile
An account for each
credit customer:
Summer Co
Jelly Co
Jessi
…
Total
X
X
X
X
79
I. LEDGERS AND LEDGER ACCOUNTS
2. Ledger accounts
There are two sides to a ledger account, and an account heading on top, and so they are
often referred to as T-accounts.
• On top of the account is its name.
• There is a left-hand side, or debit side.
• There is a right-hand side, or credit side.
NAME OF ACCOUNT
DEBIT SIDE
Date
$
CREDIT SIDE
Corresponding
Accounts/Narratives
Date
$
Corresponding
Accounts/Narratives
Example 1: Ledger account
ADVERTISING EXPENSES
Date
Narratives
Ref.
$
15
April
20X6
JFK Agency for the
quarter to 31 March
PL
348
2,500
Date
Narratives
Ref.
$
80
II. DOUBLE ENTRY BOOKKEEPING
1. Dual effect (Duality concept)
Each transaction that a business enters into affects the financial statements in two
ways, the dual effect.
Example 2: Dual effect
A business buys a vehicle for cash. The two effects on the business are:
(1) It has increased the vehicle assets
(2) There is a decrease in cash available
to the business.
Ledger accounts, with their debit and credit sides, are kept in a way that allows the twosided nature of every transaction to be recorded. This is known as the “double entry”
system of bookkeeping because every transaction is recorded twice in the accounts.
81
II. DOUBLE ENTRY BOOKKEEPING
2. The rules of double entry bookkeeping
The basic rule is that every financial transaction gives rise to 2 accounting entries, one a
debit and the other a credit. Total value of debit entries is always equal at any time to total
value of credit entries.
Which account receives the credit entry, and which receives the debit depends on the
nature of the transaction.
Double entry
FSs
Account type
Debit (DR)
ASSETS
Except from (adversely recorded):
▪ Accumulated depreciation/Provision for
SOFP
depreciation
▪ Provision for slow moving stocks
▪ Provision for doubtful debts/irrecoverable debts
LIABILITIES
CAPITAL
Except from (adversely recorded):
▪ Drawings
SALES/INCOME
SOPL
COS/COGS
Except from (adversely recorded):
▪ Return outwards
EXPENSES
Credit (CR)
82
II. DOUBLE ENTRY BOOKKEEPING
2. The rules of double entry bookkeeping
Example 3: Double entry bookkeeping
Jones Co has the following transactions:
1) Payment of $400 to J Bloggs for a cash purchase.
2) Payment of $250 to J Doe in respect of an invoice for goods purchased last month.
What are the correct ledger entries to record these transactions?
A. Debit Cash
$650
Credit Purchases
B. Debit Purchases
$650
C. Debit Purchases $400
$650
Credit Cash
D. Debit Cash
$650
$650
Debit Trade Payables $250
Credit Trade Payables
$250
Credit Cash
Credit Purchases
$400
$650
Guidance:
Step 1: Determine accounts to record these transactions
Step 2: Determine account types for these accounts
Step 3: Determine there is an increase or decrease in these account types
Step 4: Determine double entries for these transactions
(Note: Total debit = Total credit)
83
II. DOUBLE ENTRY BOOKKEEPING
2. The rules of double entry bookkeeping
Example 3: Double entry bookkeeping
Answer: C
Step 1: Determine accounts to record these transactions
1) Payment of $400 to J Bloggs for a cash purchase
There are 2 accounts used here:
•
Cash account for the amount of cash paid.
•
Purchases account for the value of goods bought.
2) Payment of $250 to J Doe in respect of an invoice for goods purchased last month.
There are 2 accounts used here:
•
Cash account for the amount of cash paid
•
Trade Payables account for the value of goods purchased last month.
Step 2: Determine account types for these accounts
1) Cash account → Assets
Purchases account → Assets
Liabilities
2) Cash account → Assets
Trade payables account →
84
II. DOUBLE ENTRY BOOKKEEPING
2. The rules of double entry bookkeeping
Example 3: Double entry bookkeeping
Step 3: Determine there is an increase or decrease in these account types
1) Decrease $400 in Cash account → Assets go down
Increase $400 in purchases account → Assets go up
2) Decrease $250 in Cash account → Assets go down
Decrease $250 in Trade payables account → Liabilities go down
Step 4: Determine double entries for these transactions
1) Debit Purchases account $400
Credit Cash account $400
We combine 2 double entries:
Debit Purchases $400
Debit Trade payables account $250
Credit Cash account $650
→ The correct answer is C
2) Debit Trade payables account $250
Credit Cash account $250
85
III. RECEIVABLES LEDGER AND PAYABLES LEDGER
1. Impersonal account and personal account
Generally, there are two types of accounts: Personal Accounts and Impersonal Accounts;
are employed in every sector of business transactions.
Impersonal account is:
• The accounts in the nominal
ledger (ledger accounts).
• The account shows balances
relating to types of income,
expense, asset, liability rather
than to the specific person.
Personal account
Personal account is:
• Commonly for
and payables.
receivables
• Contained in the receivables
ledger and payables ledger.
• Usually is part of double
entry system.
• Shows more detail about
money paid to specific
supplier or money received
from specific customer.
Impersonal account
• Do not normally form part of
the double entry system.
86
III. RECEIVABLES LEDGER AND PAYABLES LEDGER
2. The receivables ledger
The receivables ledger is a ledger for customers' personal accounts.
Sales transactions
Selling goods on credit
Goods returned
Sales daybook
Sales return daybook
Receivables ledger
Debit personal
account
Debit Sales return
Debit Output sales
Tax
Credit Receivables
Credit Receivables
(personal account)
Credit personal
account
Reconcile total
debit balance of AR
Daily/Monthly
total value
Value of personal
transaction
Debit Receivables
(personal account)
Value of personal
transaction
Daily/Monthly
total value
Debit Receivables
Credit Sales
Credit Output
sales Tax
Nominal ledger
• Each customer account is given a reference or code number, and it is that reference
which appears in the sales day book.
• The amounts are posted from the sales day book to the receivables ledger.
87
III. RECEIVABLES LEDGER AND PAYABLES LEDGER
2. The receivables ledger
Example 4: The receivables ledger
In May 20X2, the company has the following transactions:
(1) On 2nd May 20X2, the company sold some truck parts of $20,000 to ENOR Co on
credit. But there were some parts of $1,000 not meet the quality. ENOR returned them
on the same day.
(2) On 2nd May 20X2, the company sold some truck parts of $40,000 to TU Co on credit.
There is no part returned.
Assume that sales tax rate assumed is 10%.
88
III. RECEIVABLES LEDGER AND PAYABLES LEDGER
2. The receivables ledger
(1) Debit Receivables
$22,000
Credit Sales
$20,000
Credit Output sales Tax $2,000
Sales daybook
Selling goods on credit
Example 4: The receivables ledger
(2) Debit Receivables
$44,000
Credit Sales
$40,000
Credit Output sales Tax $4,000
(1) Debit Receivables
(ENOR Co)
$22,000
(2) Debit Receivables
(TU Co)
$44,000
Receivables ledger
(1) Debit Receivables (1) Credit Receivables
(ENOR Co): $22,000 (ENOR Co): $1,100
(2) Debit Receivables
(TU Co): $44,000
Balance: $64,900
Nominal ledger
Sales return daybook
Goods returned
Receivables control account
(1) Debit Sales return
Debit Output sales Tax
Credit Receivables
$1,000
$100
$1,100
(1) Credit Receivables
(ENOR Co)
$1,100
Debit Receivables
account: $66,000
Credit Receivables
account: $1,100
Balance: $64,900
Notes:
Post total value on 2nd May 20X2
to nominal leger
Post personal transaction
to division ledgers
Reconcile
89
III. RECEIVABLES LEDGER AND PAYABLES LEDGER
3. The payables ledger
The payables ledger is a ledger for suppliers' personal accounts.
Purchase transactions
Goods returned
Buying goods on credit
Purchases return daybook
Purchases daybook
Credit Payables
(personal account)
Payables ledger
Debit personal
account
Credit personal
account
Reconcile total
credit balance of AP
Debit Purchases
Debit Input sales
Tax
Credit Payables
Daily/Monthly
total value
Value of personal
transaction
Debit Payables
(personal account)
Value of personal
transaction
Daily/Monthly
total value
Debit Payables
Credit Input sales tax
Credit Purchase
returns
Nominal ledger
After entries are made in the purchase daybook, cash book, or purchase returns daybook,
they are also made in the relevant supplier account in the payables ledger.
90
III. RECEIVABLES LEDGER AND PAYABLES LEDGER
3. The payables ledger
Example 5: The payables ledger
In May 20X2, the company has the following transactions:
(1) On 2nd May 20X2, the company buy some truck parts of $20,000 from ENOR Co on
credit. But there were some parts of $1,000 not meet the quality. The company
returned them on the same day.
(2) On 2nd May 20X2, the company buy some truck parts of $40,000 from TU Co on
credit. There is no part returned.
Assume that sales tax rate assumed is 10%.
91
III. RECEIVABLES LEDGER AND PAYABLES LEDGER
3. The payables ledger
Goods returned
Purchases return daybook
Example 5: The payables ledger
(1) Debit Payables
$1,100
Credit Input sales tax
$100
Credit Purchase returns $1,000
(1) Debit Payables
(ENOR Co)
Receivables ledger
(1) Debit Payables
(ENOR Co): $1,100
$1,100
(1) Credit Payables
(ENOR Co): $22,000
(2) Credit payables
(TU Co): $44,000
Purchases daybook
Buying goods on credit
Balance: $64,900
(1) Debit Purchases
Debit Input sales Tax
Credit Payables
$20,000
$2,000
$22,000
(2) Debit Purchases
Debit Input sales Tax
Credit Payables
$40,000
$4,000
$44,000
(1) Credit Payables
(ENOR Co)
$22,000
(2) Debit Payables
(TU Co)
$44,000
Notes:
Nominal ledger
Receivables control account
Debit Payables
account: $1,100
Credit Payables
account: $66,000
Balance: $64,900
Post total value on 2nd May 20X2
to nominal leger
Post personal transaction
to division ledgers
Reconcile
92
CHAPTER 6: SALES TAX
93
OVERVIEW
What will you learn?
Trading transactions
I, II. Sales tax
Recoverable
tax
Irrecoverable
tax
Input tax
Output tax
III. Discounts
Trade
discount
Settlement
discount
Sale &
purchase
returns
Accounting
for returns
in Chapter 4
94
I. NATURE OF SALES TAX
1. Definition
Sales tax is an indirect tax levied on the sale of goods and services. It is usually
administered by the local tax authorities.
Final consumer
Goods/services
Sales tax
Enterprise
Sales tax
Tax authorities
Note: Sales tax is a cumulative tax, collected at various stages during the life of goods or
services.
95
I. NATURE OF SALES TAX
2. Input and output sales tax
Registered businesses charge output sales tax on sales and suffer input sales tax on
purchases.
Sales tax
Suffered on goods and services bought
by a business
Collected on good and services sold
by a business
Input tax
Output tax
IF
Output tax > Input tax
Output tax < Input tax
Business pays the difference in tax to
the authorities
Tax authorities will refund the
difference to business.
96
I. NATURE OF SALES TAX
2. Input and output sales tax
Example 1: Input and output sales tax
A manufacturer buys materials to manufacture a computer → Then sells the computer to a
wholesaler → Then the wholesaler sells it to a retailer → Retailer sells it to a customer.
It is assumed that the rate for sales tax is 10%.
The sale tax can be calculated as follow:
97
I. NATURE OF SALES TAX
2. Input and output sales tax
Example 1: Input and output sales tax
Total sales tax is:
Supplier of materials and components
Manufacturer
Wholesaler
Retailer
Total sales tax paid
$
10
10
10
25
55
The total tax of $55 is borne by the ultimate consumer but is collected on behalf of the
tax authorities at the different stages in the product's life.
98
I. NATURE OF SALES TAX
3. Irrecoverable sales tax
Irrecoverable sales tax is sales tax paid on inputs cannot be reclaimed (e.g. where a
trader is not registered for sales tax or where inputs are not related to taxable business
activities).
Where sales tax is irrecoverable:
01
Part of costs
It must be regarded as part of the cost of the items
purchased; and
02
Included
in FSs
Included in the statement of profit or loss charge or in
the statement of financial position as appropriate.
Example 2: Irrecoverable sales tax
•
•
A business pays $500 for entertaining expenses and suffers irrecoverable input sales
tax of $75 on this amount.
The total of $575 should be charged to the statement of profit or loss (SOPL) as an
expense.
99
I. NATURE OF SALES TAX
4. Amount inclusive and exclusive of tax
In business, you are likely to come across sales and purchases figures quoted as gross or
net of sales tax.
•
The gross amount of a sale or purchase is the amount inclusive of sales tax.
•
The net amount of a sale or purchase is the amount exclusive of sales tax.
Example 3: Amount inclusive and exclusive of tax
If the net amount of a purchase is $100, and the rate of sales tax is 15%, the amounts
are as follows.
Net amount exclusive of sales tax
Sales tax
Gross amount inclusive of sales tax
= $100
= $100 x 15%
= $100 + $15
= $15
= $115
100
II. ACCOUNTING FOR SALES TAX
1. Double entry
Here are some transactions that generate sales tax:
Double entries
Note
• The purchases account does not include
Debit Purchases
sales tax because it is not an expense – it
will be recovered.
Sales tax paid on
Debit Sales tax
purchases (input tax)
• The payables account does include sales
Credit Payables/cash
Debit Receivables/cash
Sales tax charged on Credit Sales
sales (output tax)
Credit Sales tax
tax, as the supplier must be paid the full
amount due the full amount due must be
paid to supplier.
• The sales account does not include sales tax
because it is not income - it will be paid to
the tax authority.
• The receivables account does include sales
tax, as the customer must pay the full
amount due.
Payment of output tax Debit Sales tax
on sales to the tax
Credit Cash
authority
Output sales tax > input sales tax
Receipt of input tax on Debit Cash received
purchases from the tax
Credit Sales tax
authority
Output sales tax < input sales tax
101
II. ACCOUNTING FOR SALES TAX
2. Sales tax in day books
2.1
Sales day book
When a business makes a credit sale the total amount invoiced, including sales tax, will be
recorded in the sales day book.
The analysis columns will then separate the sales tax from the sales income of the
business as follows.
SALES DAY BOOK
Date
10 Jan
20X1
Invoice
247
Customer
A Detter and
Sons
Total
Sales
income
Sales tax
$
$
$
230
200
30
102
II. ACCOUNTING FOR SALES TAX
2. Sales tax in day books
2.2
Purchases day book
When a business is invoiced by a supplier the total amount payable, including sales tax, will
be recorded in the purchase day book.
The analysis columns will then separate the recoverable input sales tax from the net
purchase cost to the business as follows.
PURCHASES DAY BOOK
Date
15 Mar 20X1
Customer
A Splier (Merchants)
Total
Sales
income
Sales
tax
$
$
$
184
160
24
103
II. ACCOUNTING FOR SALES TAX
2. Sales tax in day books
2.3
Cash book
When receivables pay what they owe, or payables are paid, there is no need to show the
sales tax in an analysis column of the cash book.
Sales tax charged on cash sales or sales tax paid on cash purchases will be analyzed in a
separate column of the cash book.
CASH BOOK (RECEIPTS)
Date
Narrative
20X1
Total
Sales
ledger
Cash
sales
Output sales
tax on cash
sales
$
$
$
$
300
30
300
30
3 Dec
A Dalee and
Sons
440
440
3 Dec
Ohee
770
770
5 Dec
Cash sales
330
1,540
1,210
104
II. ACCOUNTING FOR SALES TAX
2. Sales tax in day books
2.3
Cash book
CASH BOOK (PAYMENTS)
Date
Narrative
20X1
Total
Purchases
ledger
Cash
purchases
and
sundry
items
Input
sales tax
on cash
purchases
$
$
$
$
187
3 Nov
A Spid
(Merchants)
187
7 Nov
Telephone bill
paid
143
130
13
8 Nov
Cash purchase
of
stationery
55
50
5
9 Nov
Sales tax paid
to tax
authorizes
1,500
1,500
1,885
187
1,680
18
105
II. ACCOUNTING FOR SALES TAX
2. Sales tax in day books
2.3
Cash book
Example 4: Accounting for sales tax
Alana is not registered for sales tax purposes. She has recently received an invoice for
goods for resale which cost $500 before sales tax, which is levied at 15%. The total value
was therefore $575.
What is the correct entry to be made in Alana's general ledger in respect of the
invoice?
A. DEBIT Purchases $500, DEBIT Sales tax $75, CREDIT Payables $575
B. DEBIT Purchases $575, CREDIT Sales tax $75, CREDIT Payables $500
C. DEBIT Purchases $500, CREDIT Payables $500
D. DEBIT Purchases $575, CREDIT Payables $575
Answer: D
Alana is not registered for sales tax purposes and therefore cannot reclaim the input
sales tax of $75.
106
II. ACCOUNTING FOR SALES TAX
2. Sales tax in day books
2.3
Cash book
Example 5: Accounting for sales tax
The following information relates to Eva Co's sales tax for the month of March 20X3:
$
Sales (including sales tax)
109,250
Purchases (net of sales tax)
64,000
Sales tax is charged at a flat rate of 15%. Eva Co's sales tax account showed an opening
credit balance of $4,540 at the beginning of the month and a closing debit balance of
$2,720 at the end of the month.
What was the total sales tax paid to regulatory authorities during the month of March
20X3?
Answer: $11,910
SALES TAX CONTROL ACCOUNT
Purchase ($64,000 x 15%)
Cash
$
9,600
$
4,540
b/d
Sales (109,250 x 15%/115%) 14,250
2,720
c/d
11,910
21,510
21,510
107
III. DISCOUNTS
1. Type of discounts
There are 2 types of discounts as follows.
Trade
discount
Cash
discount/
Trade
discount
Settlement
discount
- A reduction in the list price of
goods
- Given by a wholesaler or
manufacturer to a retailer
- It is often given in return for
bulk purchase orders.
- A reduction in the amount
payable
- It is often given in return for
payment in cash, or within an
agreed period.
Example
A customer is quoted a price of
$1 per unit for a particular item,
but a lower price of $0.95 per
unit if the item is bought in
quantities of more than 100
units at a time.
Example
A supplier charges $1,000 for
goods, but offers a discount of
5% if the goods are paid within
1 week.
108
III. DISCOUNTS
2. Accounting for discounts
2.1
Trade discount
Trade discount consists of Trade discount received and Trade discount allowed.
The treatment is as following:
Trade discount received
(given by suppliers to the business)
Discount is deducted from gross cost of purchases
Trade discount allowed
(given by business to the customers)
Discount is deducted from gross sale price
109
III. DISCOUNTS
2. Accounting for discounts
2.1
Trade discount
Example 6: Trade discount
Trade discount received
A Co purchases inventory on credit from supplier B Co at a gross cost of $100 and
receives a trade discount of 5% from the supplier. The double entry for the purchase is
as follow:
Debit
Inventory
$95
Credit
Trade payables
$95
Trade discount allowed
B Co sells inventory on credit to customer C Co at a gross sale price of $100 and offers a
trade discount of 10% to the customer. The double entry for the sale is as follow:
Debit
Trade receivables
$90
Credit
Income
$90
110
III. DISCOUNTS
2. Accounting for discounts
2.2
Cash discount / Settlement discount
For the settlement discount received, the treatment is as following:
Settlement discount received
(given by the suppliers to business)
Discount received is
recorded as other income
Example 7: Settlement discount received
This means the business is in purchaser perspective.
Using the example of goods sold for $200 with discount of 3% available for early settlement
within 10 days, the purchaser would initially record the purchase as follows:
Debit
Credit
Purchases
Payables
$200
$200
• If the invoice is paid later than the early
• If the invoice is paid within the 10-day
settlement period, the full amount is
payable to the supplier, with the
payment recorded as follows:
early settlement period, $194 will be
paid to the supplier in full settlement of
the amount due, and discount received
for $6 will be recorded as follows:
Debit
Payables
Credit Bank
$200
$200
Debit
Payables
Credit Bank
$200
$194
Credit Discount received $6
(Other income)
111
III. DISCOUNTS
2. Accounting for discounts
2.2
Cash discount / Settlement discount
For the settlement discount allowed, the treatment is more complex:
Settlement discount allowed (given by the business to customers)
If customer is expected to take
up discount
If customer is not expected to
take up discount
The discount is deducted from
sales revenue
Full invoiced amount with no
discount is recognised as
revenue
If it transpires that customer
does not take up the discount,
the discount is subsequently
recognised as revenue
If it transpires that customer
does take up discount, the
revenue is subsequently
reduced by the amount of
discount
112
III. DISCOUNTS
2. Accounting for discounts
2.2
Cash discount / Settlement discount
Example 8: Settlement discounts allowed
Chippies sells goods to Table Tops at a price of $7,600 including delivery. Table Tops is
allowed 60 days’ credit before payment, but is also offered a discount of 5% for
payment within 10 days of the invoice date.
(1) Chippies expects Table Tops to take advantage of the discount. Therefore, the
invoiced sales value less the discount, i.e $7,220 ($7,600 less 5%) is recorded as revenue,
with a corresponding amount in trade receivables.
(2) Chippies does NOT expect Table Tops to take advantage of the discount. Therefore,
the full invoiced amount of $7,600 is recorded as revenue.
113
III. DISCOUNTS
2. Accounting for discounts
2.2
Cash discount / Settlement discount
Example 8: Settlement discounts allowed
(1) Chippies expects
Table Tops to take
the discount
Accounting for the sale
Accounting for
payment received
The discount is deducted
from sales revenue.
$7,600 x (1 – 5%) = $7,220
Debit Receivables $7,220
Credit Sales
$7,220
Accounting for the payment
depends on whether or not
the customer takes up the
discount
Table Tops does not take
the discount (pays $7,600)
If it transpires that
customer does not take
up the discount
Debit Bank
Credit Receivables
Credit Sales
The discount is
subsequently recognised
as revenue
$7,600
$7,220
$380
Table Tops takes the
discount (pays $7,220
– 7 days later)
Debit Bank
Credit Receivables
$7,220
$7,220
114
III. DISCOUNTS
2. Accounting for discounts
2.2
Cash discount / Settlement discount
Example 8: Settlement discounts allowed
(2) Chippies does not
expect Table Tops to take
the discount
Accounting for the sale
Accounting for
payment received
Full invoiced amount with
no discount is recognised
as revenue.
Full amount of revenue =
$7,600
Debit Receivables $7,600
Credit Sales
$7,600
Accounting for the payment
depends on whether or not
the customer takes up the
discount
Table Tops takes the
discount (pays $7,220
– 7 days later)
If it transpires that
customer takes up
discount
Table Tops does not take
the discount (pays $7,600)
Debit Bank
Debit Sales
Credit Receivables
$7,220
$380
$7,600
The discount is
subsequently deducted
from revenue
Debit Bank
Credit Receivables
$7,600
$7,600
115
CHAPTER 7: INVENTORY
116
OVERVIEW
What will you learn?
INVENTORY
(IAS 02)
I. Definition
II.1. Counting
inventories
II. Measurement
II.2. Valuation
III. Recognition
III.1. Goods
written down
or written off
III.2.
Accounting
methods
IV. Disclosures
III. 3.
Accounting for
opening &
closing
inventory
117
I. DEFINITIONS
1. Inventory
International Accounting Standard 2 (IAS 2) defines inventory as “asset”:
Held for sale in the ordinary course of
business
 Goods purchased and held for resale
(e.g. land and buildings held for resale)
 Finished goods produced
01
03
Inventory
comprise
assets
that
are
02
In the process of production
for sale
 Work-in-progress being
produced
In the form of materials or supplies to be consumed in the production process
or in the rendering of services.
 Raw materials
Note:
• Inventory is only recorded in the ledger accounts at the end of the accounting period.
• During the year the relevant sales and purchases are recorded but the increase and
decrease in inventory assets is ignored. The movement in inventory is only considered on an
annual basis.
118
I. DEFINITIONS
2. Cost of goods sold
To match 'sales' and the 'cost of goods sold', it is necessary to adjust the cost of goods
manufactured or purchased to allow for increases or reduction in inventory levels during
the period.
The cost of goods sold is calculated as:
COGS = Opening inventory + Purchases – Closing inventory
Opening inventory
Closing inventory
Goods available for
sale
Purchases
Cost of goods sold
119
I. DEFINITIONS
2. Cost of goods sold
Standard pro-forma for calculating COGS is illustrated below:
$
Opening inventory value
Add: Cost of purchases
(or Cost of production
manufacturer)
X
in
case
of
a
X
X
Less: Closing inventory value
(X)
Cost of goods sold
X
Standard pro-forma for calculating gross profit from sales and COGS is illustrated below:
$
Revenue
X
Less: Cost of goods sold (COGS)
(X)
Gross profit
X
120
I. DEFINITIONS
2. Cost of goods sold
Example 1
Variant 1: Calculate Closing inventory = Opening inventory + Purchases – Cost of sales
The financial year of Mitex Co ended on 31 December 20X1. An inventory count on 1
January 20X1 gave a total inventory value of $527,300.
The following transactions occurred between 1 January and 31 December.
$
Purchases of goods
7,900
Sales of goods (gross profit margin 40% on
sales)
15,00
0
Goods returned to a supplier
800
What inventory value should be included in ABC's financial statements at 31.12.20X1?
A. $525,400
B. $527,600
C. $529,200
D. $535,200
121
I. DEFINITIONS
2. Cost of goods sold
Example 1: Guidance
Closing inventory (value) = Opening inventory (Step 1) + Purchase (Step 2) – Cost of sales
(Step 3)
Step 1: Calculate value of the Opening inventory
Step 2: Calculate Purchases
Step 3: Calculate Cost of sales
Step 4: Calculate Closing inventory = Opening inventory + Purchase – Cost of sales
Note:
Question may include Mark-up% or Margin%
Mark-up% =
Margin% =
Gross profit
x 100 → Cost of sales = Gross profit / Mark-up%
Cost of sales
Gross profit
x 100 → Cost of sales = (1 - Margin%) x Sales
Sales
122
I. DEFINITIONS
2. Cost of goods sold
Example 1: Answer
A is correct.
$
Opening inventory (Inventory count, 1 January 20X1) (Step 1)
527,300
Purchases (Step 2)
7,900
Cost of sales (15,000 x 60%) (Step 3)
(9,000)
Purchase returns since end of year
(800)
Inventory at 31 December 20X1 (Step 4)
525,400
123
I. DEFINITIONS
2. Cost of goods sold
Example 2
Variant 2: Calculate revenue
The following information is available about the transactions of Mykyx, a sole trader
who does not keep proper accounting records:
$
Opening inventory
100,000
Closing inventory
150,000
Purchase
750,00
0
Gross profit as a percentage of sales 30%
Based on this information, what is ABC's sales revenue for the year?
A.
$980,000
B.
$1,100,000
C.
$2,500,000
D.
$1,000,000
124
I. DEFINITIONS
2. Cost of goods sold
Example 2: Guidance
Revenue = Cost of sales (Step 1) + Gross profit (Step 2)
Step 1: Calculate Cost of sales = Opening inventory + Purchases – Closing inventory
Step 2: Calculate Gross profit
Step 3: Calculate Revenue = Cost of sales (Step 1) + Gross profit (Step 2)
Note:
Question may include Mark-up% or Margin%
Gross profit
Mark-up% = Cost of sales x 100 → Gross profit = Cost of sales x Mark-up%
Margin% =
Gross profit
Cost of sale x Margin%
x 100 → Gross profit =
Sales
1 − Margin%
125
I. DEFINITIONS
2. Cost of goods sold
Example 2: Answer
D is correct.
$
Revenue (balancing figure) (Step 3)
$
1,000,000
Opening inventory
100,000
Purchases
750,000
850,000
Closing inventory
150,000
Cost of sales (70%) = (100,000 + 750,000 - 150,000)
(Step 1)
700,000
Gross profit (700,000 x 30/70) (Step 2)
300,000
126
I. DEFINITIONS
3. The cost of carriage inwards and outwards
Carriage refers to the cost of transporting purchased goods (i.e. delivery costs) from the
supplier to the premises of the business which has bought them.
Carriage inwards is included in purchases cost. Carriage outwards is a selling expense.
'Carriage' refers to the cost of transporting
purchased goods
(i.e. delivery costs)
Customer
Carriage outwards paid
(Selling expense)
Carriage inwards paid
(Cost of purchase)
Supplier
Business
127
II. MEASUREMENT
1. Counting inventories
The quantity of inventories held at the year ended is established by means of a physical
count, or by a 'continuous' inventory count.
Simple cases
Complicated cases
VS
Business holds easily counted
& small amounts of inventory
Situation
to apply
Business holds considerable
quantities of varied inventory
Physically counted
at the reporting date
Counting
method
Maintain continuous
inventory records
128
II. MEASUREMENT
2. Valuation
2.1 The basic rule
2.2 Cost of inventory
II.2.
Valuation
2.3 Net realizable value (NRV)
2.4 Applying the rule
2.5 Methods of calculation of cost of inventory
2.1
The basic rules
Inventories shall be measured at the lower of:
• Cost
• Net realisable value (NRV)
129
II. MEASUREMENT
2. Valuation
Cost of inventory
Cost of conversion
Cost of inventory
Cost of
purchase
2.2
Purchase
price
Direct cost
Cost of
purchase
Other cost
directly
attributable (*)
Trade
discount
Costs directly relate to the units of production (e.g. direct
materials, direct labour)
Fixed production overheads
Overheads
cost
Other
costs
Variable production overheads
Incur in bringing the inventories to their present location and condition
(*) Other costs directly attributable: Transport, handling and any other cost directly
attributable to the acquisition of finished goods, services and materials
130
II. MEASUREMENT
2. Valuation
2.2
Cost of inventory
The standard lists types of cost which would not be included in cost of inventories
should be recognised as an expense.
Expense off
Abnormal amounts of wasted materials, labour or other production costs
Storage costs, unless those costs are necessary in the production
process before a further production stage
Administrative overheads that do not contribute to bringing
inventories to their present location and condition
Selling costs
131
II. MEASUREMENT
2. Valuation
2.3
Net realizable value (NRV)
The net realizable value (NRV) is calculated as:
NRV = Estimated selling price – (Estimated completion costs + Costs need to make sales)
Reasons why
NRV is less than Cost
1
An increase in costs or a fall in selling price
2
A physical deterioration in the condition of
inventory
3
Obsolescence of products
4
A marketing decision to manufacture and sell
products at a loss
5
Errors in production or purchasing
Note: Inventories would be write down on an item-by-item basis, but similar items may
be grouped together
132
II. MEASUREMENT
2. Valuation
2.4
Applying the rule
Example 3
Exam focus: Calculate the value of inventory using basic valuation rules
Valuation of inventory
Cole’s business sells three products A, B and C. The following information was available
at the year-end:
Product A
Product B
Product C
Number of units
1,000
600
240
Purchase price/unit
$20
$40
$30
Carriage inwards/unit
$4
$4
$6
Selling price/unit
Cost
of
packing
delivering/unit
$40
$80
$36
$4
$6
$2
and
What was the value of the closing inventory?
133
II. MEASUREMENT
2. Valuation
2.4
Applying the rule
Example 3: Guidance
Step 1: Calculate cost
(Cost of inventory = Cost of purchase + Cost of conversion + Other costs incurred in
bringing the inventories to their present location and condition.)
Step 2: Calculate NRV
(NRV = Estimated selling price – Estimated completion costs – Costs need to make sales)
Step 3: Select lower of cost and NRV to measure goods
Step 4: Calculate Total value of inventory = Sum value of goods
(Volume x Value selected in step 3)
Note:
Normally, exam require the candidates to value two or more products. It requires
candidate to compare cost and NRV of each product and then calculate sum of
them to value total inventories.
134
II. MEASUREMENT
2. Valuation
2.4
Applying the rule
Example 3: Answer
Step 1: Calculate cost
Cost of inventory = Cost of purchase + Cost of conversion + Other costs incurred in
bringing the inventories to their present location and condition.
In this case, Purchase price is Cost of purchase and Carriage inwards is Other cost.
So, the cost of inventory can be calculated as follow:
Purchase price/unit
Carriage
inwards/unit
Cost
Product A
Product B
Product C
$20
$40
$30
$4
$4
$6
$24
$44
$36
Step 2: Calculate the NRV
NRV = Estimated selling price – Estimated completion costs – Costs need to make sales
The NRV of this company:
Selling price/unit
Cost of packing &
delivering/unit
NRV
Product A
Product B
Product C
$40
$80
$36
$4
$6
$2
$36
$74
$34
135
II. MEASUREMENT
2. Valuation
2.4
Applying the rule
Example 3: Answer (continued)
Step 3: Select lower of cost and NRV to measure goods
Cost (Step 1)
NRV (Step 2)
The lower of
Cost/NRV
Product A
$24
$36
$24
Product B
$44
$74
$44
Product C
$36
$34
$34
Step 4: Calculate Total value of inventory = Sum value of goods
(Volume x Value selected in step 3)
Inventory
value/unit
Number of
units
Inventory value
Product A
$24
1,000
$24,000
Product B
$44
600
$26,400
Product C
$34
240
Total
$8,160
$58,560
136
II. MEASUREMENT
2. Valuation
2.5
Methods of calculation of cost of inventory
A. Specific identification method:
Keeping track of each specific item in inventory and assigning cost individually instead
of grouping items together.
Situation to apply:
+ Inventories which are not interchangeable or individually distinguishable
+ High value inventories
+ Goods or services produced and segregated for specific projects
Beginning inventory
4
5
5
Purchases
8
8
8
9
9
First in
= 56
Last in
Goods available for sale
Cost of sales
5
8
= 13
Ending inventory
4
5
8
8
9
9
= 43
137
II. MEASUREMENT
2. Valuation
2.5
Methods of calculation of cost of inventory
B. First in first out – FIFO
The first items of inventory received are assumed the first ones sold.
The cost of closing inventory is the cost of the most recent purchases of inventory.
Beginning inventory
4
5
5
Purchases
8
8
8
9
9
First in
= 56
Last in
Goods available for sale
Cost of sales
4
5
=9
First out
Ending inventory
5
8
8
8
9
9
= 47
C. Last in first out – LIFO
We assume that components used formed part of the most recent delivery, and
inventories are the oldest receipts. Now, the LIFO formula is not permitted by IAS 2.
138
II. MEASUREMENT
2. Valuation
2.5
Methods of calculation of cost of inventory
D. Weighted average cost
The cost of an item of inventory is calculated by taking the average of all inventory held.
The average cost can be calculated periodically or continuously.
Beginning inventory
4
5
5
Purchases
8
8
8
9
9
7
7
= 56
Weighted average
7
7
7
7
7
7
First in
= 56
Last in
Goods available for sale
Cost of sales
7
7
= 14
Ending inventory
7
7
7
7
7
7
= 42
139
II. MEASUREMENT
2. Valuation
2.5
Methods of calculation of cost of inventory
Example 4
Exam focus: Calculate closing inventory using cost estimation techniques (FIFO, AVCO)
Cost of inventory: Invicta has closing inventory of 5 units at a cost of $3.50 per unit at 31
December 20X5. During the first week of January 20X6, Invicta entered into the
following transactions:
Purchases
•
2nd January – 5 units at $4.00 per unit
•
4th January – 5 units at $5.00 per unit
•
6th January – 5 units at $5.50 per unit
Invicta sold 7 units for $10.00 per unit on 5th January.
Required: Calculate the value of the closing inventory at the end of the first week of
trading using the following inventory valuation methods:
a)
FIFO
b)
Periodic weighted average cost
c)
Continuous weighted average cost.
140
II. MEASUREMENT
2. Valuation
2.5
Methods of calculation of cost of inventory
Example 4:
a) Calculate closing inventory using the FIFO method:
Guidance
Step 1: Calculate Opening inventory (unit) + Total purchased (unit)
Step 2: Calculate Total units sold
Step 3: Calculate Closing inventory (unit) = Opening inventory (unit) + Total units purchased Total units sold
Step 4: Identify FIFO closing inventory.
With FIFO method, closing inventory (unit) includes the most recently purchased items.
Answer
Step 1: Calculate Opening inventory (unit) + Total purchased (unit) = 20 units
Step 2: Calculate Total units sold = 7 units
Step 3: Calculate Closing inventory (unit) = 20 – 7 = 13
Step 4: Identify FIFO closing inventory.
With FIFO method, closing inventory (unit) includes the most recently purchased items, which
are the following items:
5 units × $5.50 (6th February)
$27.50
5 units × $5.00 (4th February)
$25.00
3 units × $4.00 (2nd February)
$25.00
Closing inventory cost
$64.50
141
II. MEASUREMENT
2. Valuation
2.5
Methods of calculation of cost of inventory
Example 4:
b) Calculate closing inventory using the periodic weighted average method:
Guidance
With this inventory valuation method, we work out an average cost per unit based on the cost
of opening inventory plus the cost of all purchases made during the accounting period as
follows:
Step 1: Calculate Opening inventory cost + Total purchased cost
Step 2: Calculate Opening inventory (unit) + Total purchased (unit)
Step 3: Calculate Average cost per unit =
Opening inventory + Total purchased
Opening inventory (unit) + Total purchased (unit)
Step 4: Calculate Closing inventory value = Closing inventory (units) x Average cost per unit in
step 3
Answer
Step 1: Calculate Opening inventory (unit) + Total purchased (unit) = 20 units
Step 2: Calculate Total units sold = 7 units
Step 3: Calculate Average cost per unit
(5 × $3.5) + (5 × $4) + (5 × $5) + (5 × $5.5)
= $4.50 per unit
20 units
Step 4: Calculate Closing inventory value
Average cost per unit =
Closing inventory value = 13 units × $4.50 = $58.50
142
II. MEASUREMENT
2. Valuation
2.5
Methods of calculation of cost of inventory
Example 4:
c) Calculate closing inventory using the continuous weighted average method:
Guidance:
With this inventory valuation method, we work out an updated average cost per unit each time
a purchase of inventory is made. Any subsequent sales are accounted for at that average cost
per unit until the next purchase is made and a new average cost per unit is calculated.
Step 1: Calculate Total cost of each purchase beginning from opening balance = Units * Unit
cost
Total costs
Step 2: After each purchase, calculate New average unit cost = Total units
Step 3: Any subsequent sales are accounted for at that average cost per unit the next purchase
is made and a new average cost per unit is calculated.
Continue these 3 steps until the end.
Answer: (The following slide)
143
II. MEASUREMENT
2. Valuation
2.5
Methods of calculation of cost of inventory
Example 4:
c) Calculate closing inventory using the continuous weighted average method:
Date
Transaction
Units
Cost
$
1 Jan X6
Inventory b/f
5
3.50
2 Jan X6
Purchase
5
10
4 Jan X6
Purchase
5
15
5 Jan X6
Sale at cost
(7)
4.00
Step 2:
(37.5/ 10) = 3.75
5.00
Step 2:
(62.5/ 15) = 4.17
Step 3: 4.17
8
6 Jan X6
Purchase
5
7 Jan X6
c/f inventory
13
Total cost
$
17.50
Step 1:
20.00
37.50
Step 1:
25.00
62.50
(29.19)
33.31
5.50
Step 2:
(60.81/13) = 4.68
Step 1:
27.50
60.81
144
III. RECOGNITION
1. Goods written off or written down
A trader might be unable to sell all the goods that they purchase, because a number of
things might happen to the goods before they can be sold.
Goods
Obsolete or out of fashion
Can be damaged,
thrown away
Can be lost
Their value less than their
original cost
They are worthless
Written down
Written off
To their net realisable
value
To nothing
Note: The costs of inventory written off or written down should not usually cause any
problems when calculating the gross profit of a business, because the cost of goods
sold will include the cost of inventories written off or written down.
145
III. RECOGNITION
1. Goods written off or written down
Example 5: Question
Inventories written off and written down
Logan Lee, trading as Sweet Candy, ends his accounting period on 31 December.
At 1 January 20X3 he had goods in inventory valued at $17,600. During the year to 31
December 20X3, goods costing $96,000 were bought. In inventory, $4,200 of candy
goods are still held at 31 December 20X3. Logan Lee estimated that these goods could
be sold at $800. The goods still held in inventory at 31 December 20X3 (including the
candy goods) had an original purchase cost of $15,200. Sales for the year were $162,800.
Required: Calculate the gross profit of Fairlock Fashions for the year ended 31.12.20X3
146
III. RECOGNITION
1. Goods written off or written down
Example 5: Answer
Inventory written down
Candy goods
Other
goods
figure)
(balance
At cost
Realizable
value
Amount
written down
$
4,200
$
800
$
3,400
11,000
11,000
15,200
11,800
3,400
Gross profit calculation
Sales
Value
of
inventory
Purchases
162,800
opening
17,600
96,000
113,600
Less: Closing inventory
11,800
Cost of goods sold
(101,800)
Gross profit
61,000
By using the figure of $11,800 for closing inventories, the cost of goods sold
automatically includes the inventory written down of $3,400.
147
III. RECOGNITION
2. Accounting methods
Two types of inventory are periodic and perpetual inventory. Both are accounting
methods that businesses use to track the number of products they have available. But they
are inherently different.
Definition
Advantages
Perpetual inventory system
Periodic inventory system
Records the sale or purchase of
inventory immediately
Determine the the inventory
amount at the end of each
accounting period
•
•
Better inventory control
Less inventory calculation
at the end of the
accounting period
Must maintain continuously
Disadvantages records of inventory movements
 Additional costs
•
•
Cheaper in most situations
Simpler admin system
Only determine the inventory
value at the period end
 Difficult to ascertain value of
lost, stolen, spoiled goods
148
III. RECOGNITION
3. Accounting for opening & closing inventory
3.1
Accounting for COGS
In Section I, we saw that in order to calculate gross profit it is necessary to work out the
cost of goods sold.
In order to calculate the cost of goods sold it is necessary to have values for the opening
inventory (i.e inventory in hand at the beginning of the accounting period) and closing
inventory (i.e inventory in hand at the end of the accounting period).
You should remember that the trading part of a statement of profit or loss includes:
Formula for calculating
COGS
$
Opening inventory
X
Plus: purchases
X
Less closing inventory
(X)
Cost of goods sold
X
149
III. RECOGNITION
3. Accounting for opening & closing inventory
3.2
Ledger accounting for inventories
A debit balance of inventory will be shown in the statement of financial position as a
current asset.
The accounting entries for recording inventory have some differences between perpetual
inventory system and periodic inventory system:
Perpetual inventory system
Periodic inventory system
Records the sale or purchase of
inventory immediately
Determine the amount of the
inventory at the end of each
accounting period
Start of period
No entry
Dr Purchases
Cr Inventory
Purchase of
goods
Dr Inventory
Cr Account payables
Dr Purchases
Cr Account payables
Definition
150
III. RECOGNITION
3. Accounting for opening & closing inventory
3.2
Ledger accounting for inventories
Perpetual inventory system
Periodic inventory system
Purchase
discount
Dr Account payables
Cr Inventory
Dr Account payables
Cr Purchases discounts
Freight costs
Dr Inventory
Cr Account payables
Dr Freight costs
Cr Account payables
Purchase
return
Dr Account payables
Cr inventory
Dr Account payables
Cr Purchase returns
Sales of goods
(1) Dr Cost of goods sold
Cr Inventory
(2) Dr Account receivables
Cr Sales
Dr Accounts receivable
Cr Sales
Sales return
(1) Dr Inventory
Cr Cost of goods sold
(2) Dr Sales returns
Cr Account receivables
Dr Sales returns
Cr Account receivables
151
III. RECOGNITION
3. Accounting for opening & closing inventory
3.2
Ledger accounting for inventories
Perpetual inventory system
Periodic inventory system
Dr Loss on inventory write off
Cr Inventory
No entry here since the written
off amount is detected at the
end of periods and is included in
the entry of “Inventory count
shortage”
Write down
inventory
(Small and Not
Significant)
Dr Cost of good sold
Cr Inventory
Dr Cost of good sold
Cr Purchases
Write down
inventory
(Significantly
high)
Dr Inventory Write down
Cr Inventory
Dr Inventory Write down
Cr Purchases
Write off
inventory
152
III. RECOGNITION
3. Accounting for opening & closing inventory
3.2
Ledger accounting for inventories
Perpetual inventory system
Periodic inventory system
Write down inventory:
1) Small and Note Significant
Write down inventory:
1) Small and Note Significant
Dr Inventory
Reversal
Inventory
count shortage
End of period
Cr Cost of good sold
2) Significantly high
Dr Inventory
Cr Inventory write down
Dr Loss on write down
Cr Inventory
No entry
Dr Purchases
Cr Cost of good sold
2) Significantly high
Dr Purchases
Cr Inventory write down
Dr Loss on write down
Cr Purchases
Note: The number must include
the write off amount (if any)
Dr Closing Inventory (by count)
Dr Cost of goods sold
Cr Purchases
153
IV. DISCLOSURES
Disclosures in the financial statements
IAS 02 requires disclosures:
The accounting policies adopted in measuring inventories,
including the cost of formula used
The total carrying amount of inventories and the carrying amount
in classifications appropriate to the entity
The carrying amount of any inventories carried at NRV
Amount of any write-down of inventories recognized as an
expense in the period
Amount of any reversal of a write-down to NRV and the
circumstances that led to such reversal
Carrying amount of inventories pledged as security for liabilities
Cost of inventories recognized as expense (COGS)
154
CHAPTER 8: TANGIBALE NONCURRENT ASSETS
155
OVERVIEW
What will you learn?
1. Definition
2. Capital and
revenue expenditure
1. Definition
2. Recognition
3. Measurement
4. Disclosures
1. Definition
2. Depreciation
methods
3. Change in
depreciation
4. Ledger entries for
depreciation
1. Principle
2. Accounting for
revaluation of NCA
3. Depreciation on
revalued assets
4. Example
V. NCA Disposal
1. Gain or loss on
disposal
2. Accounting for
disposal
VI. The asset
register
1. Data kept in an
asset register
2. Purpose and
function
I. NCA
Tangible non-current assets (NCA)
II. IAS 16 - PPE
III. Depreciation
IV. Revaluation of
NCA
156
I. NON-CURRENT ASSETS
1. Definition
What are non-current assets?
Non-current assets
Characteristics




Use in the long term
Not for resale
Generate income directly or indirectly
for a business
Not liquid
Types

Tangible assets

Intangible assets
157
I. NON-CURRENT ASSETS
2. Capital and revenue expenditure
Capital expenditure is expenditure which forms part of the cost of non-current assets.
Revenue expenditure is expenditure incurred for the purpose of the trade or to
maintain non-current assets.
Business’ Expenditure
Capital Expenditure (CAPEX)
Revenue Expenditure (OPEX)
• Expenditure on the acquisition of
non-current assets
• Expenditure on existing non-current
assets aimed at increasing their
earning capacity
• Expenditure on current assets
• Expenditure relating to running the
business
• Expenditure on maintaining the
existing non-current assets
Recognize as NCA in the SOFP
Recognize as expense in the SOPL
Capital Expenditure such as:
• Purchase price
• Delivery costs
• Legal fees
• Trials and tests
• Subsequent expenditure which
enhances the asset
Revenue Expenditure such as:
• Repairs
• Renewals
• Repainting
• Administration
• General overheads
• Training costs
• Wastage
158
I. NON-CURRENT ASSETS
2. Capital and revenue expenditure
Example 1
Exam focus: Capital and revenue expenditure
Which one of the following costs would be classified as revenue expenditure on the
invoice for a new company car?
A.
Road tax
B.
Number plates
C.
Fitted stereo
D.
Delivery costs
Answer: A
Number plates, stereo and delivery costs are included in the capital cost of acquiring
the car.
Road tax is an annual charge against revenue.
159
II. IAS 16 – PROPERTY, PLANT AND EQUIPMENT
1. Definition
Term
Definition
Property, Plant
and Equipment
Property, Plant and Equipment are tangible items that are:
• held for use in the production or supply of goods or services, for
rental to others, or for administrative purposes
• expected to be used during more than one period
Cost
• The amount of cash or cash equivalents paid; or
• The fair value of the other consideration given to acquire an
asset at the time of its acquisition or construction
Fair value
The amount for which an asset could be exchanged in an arm's
length transaction between:
• knowledgeable, and
• willing parties
Carrying amount
Recoverable
amount
The amount at which an asset is recognized after deducting:
• any accumulated depreciation
• and impairment losses.
• The amount at which the entity is expected to recover from the
future use of an asset, including its residual value on disposal.
• This is the higher of the net selling price or value in use.
160
II. IAS 16 – PROPERTY, PLANT AND EQUIPMENT
2. Recognition
Recognition simply means incorporation of the asset in the business's accounts.
The recognition of property, plant and equipment depends on two criteria below:
2 criteria
A probable future
economic benefit
from the asset will
flow to the entity
The asset’s cost
can be measured
reliably
Note: Smaller items such as tools are often written off as expenses of the period.
161
II. IAS 16 – PROPERTY, PLANT AND EQUIPMENT
3. Measurement
3.1
Initial measurement
Once an item of property, plant and equipment qualifies for recognition as an asset, it
will initially be measured at cost.
Formula to measure initial cost:
COST
Purchase price:
• include any import
duties paid
• exclude any trade
discount or rebate
Initial estimate of
dismantling, removing,
restoring costs
Directly attributable
costs of bringing the
asset to working
condition for its
intended use. (*)
Note: Examples of directly attributable costs are:
Cost of site preparation
Installation costs
Initial delivery & handling costs
Professional fees (architects,
engineers)
162
II. IAS 16 – PROPERTY, PLANT AND EQUIPMENT
3. Measurement
3.1
Initial measurement
Costs below will be recognised as an expense rather than as part of the cost of the asset:
Expenses of operations that are incidental to the
construction or development of the item
Expense off
Administration and other general overhead costs
Start-up and similar pre-production costs
Initial operating losses before the asset reaches
planned performances
Staff training costs
Maintenance contracts purchased with the asset
163
II. IAS 16 – PROPERTY, PLANT AND EQUIPMENT
3. Measurement
3.1
Initial measurement
The double entry to record an acquisition of a non-current asset is:
Debit
Non-current asset - Cost
Credit
Cash/Payables
Credit
Provision for dismantling, removing and restoring cost
Example 2
Initial measurement
A company buys 10 machines to producing tire on 1 Jan 20X0 with cost of $200,000 for
each and company receive a trade discount at $5,000 for each due to purchase in bulk.
In addition, for enhancing the capacity of these machines, company pays $500 more for
each machine to upgrade rotating wheel of the machines. The project related to these
PPE last for 5 years. When the project ended at 31/12/20X5. The dismantling cost is
$80,000 for each, discount rate 8%.
Required: Calculate the initial cost of the machines
Answer:
Initial costs for each machine = (200,000 - 5,000) + 500 +
Initial costs for all machine = 10 × 250,000 = 2,500,000
80,000 ≈ 250,000
(1 + 0.08)5
164
II. IAS 16 – PROPERTY, PLANT AND EQUIPMENT
3. Measurement
3.2
Subsequent expenditure
The accounting treatment for subsequent expenditure depends on whether there is an
improvement of the asset or not
Case 1
Asset’s condition
improves
Case 2
No improvement
Add to the carrying amount
Recognise as an expense in the
period in which it is incurred
Example:
• Modify plants to extend
useful life & increase capacity
• Upgrade machine parts to
improve the output quality
Subsequent expenditure is measured either using a cost or revaluation model.
Cost model
Carrying
amount
Cost
Accumulated
depreciation
Accumulated
impairment loss
Revaluation
model
FV
Cost
Subsequent
accumulated
depreciation
Subsequent
accumulated
impairment loss
165
II. IAS 16 – PROPERTY, PLANT AND EQUIPMENT
4. Disclosures (additional reading)
The disclosure requirements in IAS 16 are extensive and include both numerical and
narrative disclosures as below:
01
In accounting
policy note
Measurement bases used to determine
the amounts at which depreciable assets
are stated
02
For each
PPE class
For
revalued
assets
03
• Depreciation method
• Useful life (or depreciation rate)
• Cost & accumulated depreciation at
the start and the period end
• Effective date of the revaluation
• Whether an independent valuer was
involved
• Carrying amount of each PPE class
• Revaluation surplus: Movement in the
period & any restrictions to distribute
balance to shareholders
166
III. DEPRECIATION
1. Definition
Term
Definition
•
Depreciation
•
A systematic allocation of the asset’s depreciable amount over its
useful life
Begin when an asset is available for use.
Depreciable
amount
Depreciable amount = Cost of an asset - Its estimated residual value
Residual
value
The estimated amount that an entity could currently obtain from asset
disposal after deducting the estimated disposal costs
Useful life
• The period over which an asset is expected to be available for use
by an entity; or
• The number of production or similar units expected to be obtained
from the asset by an entity
167
III. DEPRECIATION
2. Depreciation methods
IFRS allows two methods below to charge depreciation for tangible non-current assets:
01
02
Straight line
Reducing balance
Assumption
Assumption
Consume the benefit evenly
Consume more benefit in earlier years
Rationale
Rationale
Each year, charge an equal amount of
depreciation
Each year, charge an reducing amount
of depreciation
Formula
Depreciation Cost − Residual value
=
charge
Expected useful life
Formula
Depreciation
= X % × Carrying amount
charge
168
III. DEPRECIATION
2. Depreciation methods
Example 3
Exam focus: Depreciation methods
A business’s policy is to charge depreciation on a machinery at 20% per year on cost,
with proportional depreciation for items purchased or sold during a year.
The company’s machinery at cost account for the year ended 30 September 20X6 is
shown below.
MACHINERY ACCOUNT
$
20X5
1 Oct
$
20X6
Transfer
disposal
account
30 Sep Balance
Balance
200,000 30 Jun
40,000
210,000
20X6
1 Apr
Cashpurchase
machinery
of
50,000
250,000
250,000
What should be the depreciation charge
for plant and machinery (excluding any
profit or
loss on the disposal) for the year ended 30 September 20X6?
A. $21,500
B. $32,000
C. $43,000
D. $38,000
169
III. DEPRECIATION
2. Depreciation methods
Example 3
Answer: C
$
Plant held all year (200,000 – 40,000) x
20%
32,000
Disposal 40,000 x 20% x 9/12
6,000
Additions 50,000 x 20% x 6/12
5,000
43,000
170
III. DEPRECIATION
3. Change in depreciation
3.1
Change in method
Review depreciation method at least each financial year-end
If the expected pattern of economic benefits from the asset changes significantly
Change the method to suit the new pattern
Depreciate the remaining carrying amount under the new method
171
III. DEPRECIATION
3. Change in depreciation
3.1
Change in method
Example 4
TUSS Co bought a new truck for $20,000 on 1/1/20X5. The truck’s estimated useful life is
4 years, scrap value is $4,000, and it was depreciated using the reducing balance method
(with a rate of 20%). However, on 1/1/20X7 it was decided to change in method to a
straight line.
Answer:
Year
Brought forward
Depreciation in year
Carrying amount
20X5
20,000
20,000 x 20% = 4,000
16,000
20X6
16,000
3,200
12,800
20X7
12,800
(12,800 - 4,000)/2 =
4,400
8,400
20X8
8,400
4,400
4,000 (scrap value)
172
III. DEPRECIATION
3. Change in depreciation
3.2
Change in estimates
If the estimated useful life and/or residual value are/is inappropriate
Change the useful life and/or residual value
Charge the new depreciation based on the revised useful life and/or residual value
173
III. DEPRECIATION
3. Change in depreciation
3.2
Change in estimates
Example 5: Change in estimate
NQD Co bought a new truck for $20,000 on 1/1/20X5. The truck’s estimated useful life
is 5 years, scrap value is $4,000, and it was depreciated using the straight line method.
However, on 1/1/20X7 it was decided that the estimated useful life is revised to 2
more years due to damage caused by an accident at the end of the year 20X6
Answer:
Year
Brought
forward
Depreciation in year
Carrying amount
20X5
20,000
(20,000 – 4,000)/5 = 3,200
16,800
20X6
16,800
3,200
13,600
20X7
13,600
(13,600 – 4,000)/2 = 4,800
8,800
20X8
8,800
4,800
4,000
174
III. DEPRECIATION
4. Ledger entries for depreciation
The double entry to record depreciation expense charge:
Debit
Depreciation expense (statement of profit or loss)
Credit
Accumulated depreciation account (statement of financial
position)
175
IV. REVALUATION OF NON-CURRENT ASSETS
Subsequent measurement
As mentioned above, IAS 16 allows a choice to the subsequent measurement between:
Cost model:
Keeping asset at cost
01
Subsequent
measurement
Revaluation model:
Revaluing to fair value
02
176
IV. REVALUATION OF NON-CURRENT ASSETS
1. Principle
Principals of revaluation are summarized as below:
Professional valuation
Should be stated at fair value
Depreciated replacement
cost
Indexation (*)
Principles of
revaluation
If an item is revalued, the entire class of it should be revalued
If an item is revalued, the revaluation should be regularly updated
When a non-current asset is revalued, depreciation is charged on
the revalued amount
(*) Indexation method:
Under this method, the index is applied to know the current cost. Index list being used
is issued by the statistical department.
177
IV. REVALUATION OF NON-CURRENT ASSETS
1. Principle
There are 2 cases in the revaluation of PPE below:
Upward
revaluation
Downward
revaluation
Fair value > Carrying amount
Fair value < Carrying amount
Gain/Surplus Revaluation
Loss/Deficit Revaluation
Include in OCI
Include in SOPL
178
IV. REVALUATION OF NON-CURRENT ASSETS
2. Accounting for revaluation of non-current assets
Carrying amount of NCA at revaluation date
X
Valuation of NCA
X
Difference = Gain/Loss on revaluation
X
For the initial revaluation
Revaluation gain
Dr NCA - Cost
Difference between the revalued & the original cost
Dr Accumulated depreciation
Any historical accumulated depreciation
Cr Revaluation surplus/reserve
Gain on revaluation
Revaluation loss
Dr Revaluation loss
Loss on revaluation
Dr Accumulated depreciation
Any historical accumulated depreciation
Cr NCA - Cost
Difference between the revalued & the original cost
Note:
• Must disclose gain/loss on revaluation in both SOCE and in OCI
• Offset of gains and losses between different properties is not permitted
179
IV. REVALUATION OF NON-CURRENT ASSETS
2. Accounting for revaluation of non-current assets
For the subsequent revaluation
If the initial revaluation is revaluation gain
Revaluation gain
Dr NCA - Cost
Difference between the current valuation & the
valuation right before
Dr Accumulated depreciation
Cr Revaluation surplus/reserve
Gain on revaluation
Revaluation loss
Dr Revaluation surplus/reserve
To maximum of original gain
Dr Income statement
Any residual loss
Dr Accumulated depreciation
Cr NCA - Cost
Difference between the current valuation & the
valuation right before
180
IV. REVALUATION OF NON-CURRENT ASSETS
2. Accounting for revaluation of non-current assets
For the subsequent revaluation
If the initial revaluation is revaluation loss
Revaluation gain
Dr NCA - Cost
Difference between the current valuation & the
valuation right before
Dr Accumulated depreciation
Cr Revaluation loss
To maximum of original loss
Cr Revaluation surplus/reserve
Any residual gain
Revaluation loss
Dr Revaluation loss
Loss on revaluation
Dr Accumulated depreciation
Cr NCA - Cost
Difference between the current valuation & the
valuation right before
181
IV. REVALUATION OF NON-CURRENT ASSETS
3. Depreciation on revalued assets
If there is a revaluation gain, an excess depreciation will appear. The calculation is below:
New depreciation based on the revalued carrying
amount
X
Old depreciation charge based on the original cost
X
Excess depreciation
X
The accounting treatment for depreciation on revaluation assets go through two steps:
Step 1
Revalued amount
New depreciation = Remaining useful life of the asset
 Charge the new depreciation to SOPL in full
Make an annual reserves transfer of excess depreciation from revaluation
surplus to retained earnings
Step 2
Dr Revaluation surplus
Cr Retained earnings
Excess depreciation
Excess depreciation
Notes:
IAS 16 allows annual reserves transfer to address the imbalance between a nondistributable gain held in revaluation surplus and the reduction in retained earnings due
to the increased depreciation charge
182
IV. REVALUATION OF NON-CURRENT ASSETS
4. Example
Example 6:
NQD owns a retail unit in central Summertime. It bought the property 25 years ago for
$100,000, depreciating it over 50 years on a straight-line basis. At the start of 20X3 the
company decides to revalue the unit to $800,000. The unit has a remaining useful life
of 25 years at the date of the revaluation. It is company policy to make the annual
transfer of excess depreciation between revaluation surplus and retained earnings
within equity.
Required: What accounting entries should be made in 20X3 financial statements?
Revaluation
Step 1
Calculate carrying amount
Carrying amount = Cost of non-current asset – Accumulated depreciation
Determine whether there is gain or loss by comparing the carrying
amount (step 1) and the revalued amount of non-current asset
Step 2
Gain: Carrying amount (step 1) < Revalued amount
Loss: Carrying amount (step 1) > Revalued amount
Record gain or loss on revaluation
Step 3
Gain:
Loss:
Dr NCA cost
Dr Revaluation loss
Dr Accumulated depreciation
Dr Accumulated depreciation
Cr Revaluation surplus/reserve
Cr Non-current asset
183
IV. REVALUATION OF NON-CURRENT ASSETS
4. Example
Example 6: Answer
Revaluation
Step 1
Calculate carrying amount
Carrying amount = Cost of non-current asset – Accumulated depreciation
Accumulated depreciation of property = (100,000/50) x 25 = 50,000
Cost of NCA = $100,000
 Carrying amount at revaluation = 100,000 – 50,000 = 50,000
Step 2
Determine whether is gain or loss by comparing the carrying amount
(step 1) and the revalued amount of non-current asset
Carrying amount (Step 1) = $50,000 < Revalued amount = $800,000
 There is a gain on revaluation as below:
Step 3
Revalued amount of property
800,000
Carrying amount at revaluation
(50,000)
Gain on revaluation
750,000
Record gain or loss on revaluation
Debit
Non-current assets (Property)
700,000
Debit
Accumulated depreciation
50,000
Credit
Revaluation surplus
750,000
184
IV. REVALUATION OF NON-CURRENT ASSETS
4. Example
Example 6: Guidance (continued)
Depreciation on revalued asset
Compute the new depreciation:
Step 1
Revalued amount
New depreciation = Remaining useful life of the asset
Step 2
Compare new depreciation (step 1) to old depreciation
Step 3
If New depreciation charged > Old depreciation charged  Make an
annual reserves transfer of excess depreciation from revaluation surplus
to retained earnings
Dr Revaluation surplus
Cr Retained earnings
Excess depreciation
Excess depreciation
185
IV. REVALUATION OF NON-CURRENT ASSETS
4. Example
Example 6: Answer (continued)
Depreciation on revalued asset
Step 1
Compute the new depreciation
New depreciation =
Step 2
Revalued amount
$800,000
=
= $32,000
Remaining useful life of the asset 25 years
Compare new depreciation (step 1) to old depreciation
$100,000
Old depreciation = 50 years = $2,000
New depreciation = $32,000 > Old depreciation = $2,000
Step 3
If New depreciation charged > Old depreciation charged  Make an
annual reserves transfer of excess depreciation from revaluation surplus
to retained earnings
Excess depreciation = $32,000 – $2,000 = $30,000 is transferred from
revaluation surplus to retained earnings
Dr Revaluation surplus
30,000
Cr Retained earnings
30,000
186
IV. REVALUATION OF NON-CURRENT ASSETS
4. Example
Example 7:
Exam focus: Revaluation of non-current assets
A company bought a property four years ago on 1 January 20X1 for $ 170,000. Since
then, property prices have risen substantially and the property has been revalued at
$210,000.
The property was estimated as having a useful life of 20 years when it was purchased.
What is the balance on the revaluation surplus reported in the statement of financial
position?
A.
$210,000
B.
$136,000
C.
$74,000
D.
$34,000
Answer: C
Revaluation = $210,000
Carrying amount = $170,000 x 16/20 = $136,000
Revaluation surplus = $210,000 - $136,000 = $74,000
187
V. NON-CURRENT ASSET DISPOSAL
1. Gain or loss on disposal
There are three cases can happen when the business incur an disposal transaction:
Gain
Neither gain or loss
Proceeds
amount
= Carrying
at disposal date
Proceeds
amount
> Carrying
at disposal date
Loss
Proceeds
amount
< Carrying
at disposal date
188
V. NON-CURRENT ASSET DISPOSAL
2. Accounting for disposal
2.1
Disposal for cash consideration
Record the proceeds
Step 1
Dr Cash
Cr Disposals account
Remove the original cost of the non-current asset from the ‘noncurrent asset’ account
Step 2
Dr Disposals account
Cr NCA
Remove accumulated depreciation on the non-current asset from the
‘accumulated depreciation’ account
Step 3
Step 4
Dr Accumulated depreciation
Cr Disposals account
Transfer gain on disposal
Dr Disposal account
Cr Income & expense account
Transfer loss on disposal
Dr Income & expense account
Cr Disposal account
189
V. NON-CURRENT ASSET DISPOSAL
2. Accounting for disposal
2.1
Disposal for cash consideration
Example 8: Disposal on cash consideration
On 1/1/X7, a plant which had cost $84,000 and with accumulated depreciation at
30/6/X9 of 25,000. On 30/6/X9, a plant was sold for $60,000. The company makes up
account to 30 June each year.
Required: What is the journal entry for disposal at 30/6/X9?
Answer:
Step 1
Step 2
Step 3
Record the proceeds
Debit
Cash
60,000
Credit
Disposal account
60,000
Remove the original cost of the non-current asset from the ‘non- current
asset’ account
Debit
Disposals account
84,000
Credit
NCA
84,000
Remove accumulated depreciation on the non-current asset from the
‘accumulated depreciation account
Debit
Accumulated depreciation
25,000
Credit
Disposal
25,000
190
V. NON-CURRENT ASSET DISPOSAL
2. Accounting for disposal
2.1
Disposal for cash consideration
Example 8: Disposal on cash consideration
Step 4
Transfer gain/loss on disposal
Carrying amount of the plant = $84,000 - $25,000 = $59,000
Proceeds gained = $60,000 > Carrying amount = $59,000
 Gain on disposal = $1,000
Debit
Disposal account
1,000
Credit
Income and expense account
1,000
Disposal account
$
$
Original cost
84,000 Accumulated depreciation
25,000
Gain on disposal
1,000 Proceeds
60,000
85,000
85,000
191
V. NON-CURRENT ASSET DISPOSAL
2. Accounting for disposal
2.2
Disposal through a part-exchange agreement (PEA)
Recognize cost of new asset, trade-in value and payment
Step 1
Dr NCA (at cost of the new asset)
Cr Disposal account (Trade-in value)
Cr Cash (additional payment for the exchange)
Remove cost of the disposal asset
Step 2
Dr Disposal account (the disposal asset)
Cr NCA (at cost of the disposal asset)
Remove accumulated depreciation of disposal asset
Step 3
Step 4
Dr Accumulated depreciation (of the disposal asset)
Cr Disposal account (of the disposal asset)
Transfer gain on disposal
Dr Disposal account
Cr Income & expense account
Transfer loss on disposal
Dr Income & expense account
Cr Disposal account
192
V. NON-CURRENT ASSET DISPOSAL
2. Accounting for disposal
2.2
Disposal through a part-exchange agreement (PEA)
Example 9: Disposal through a part exchange
NQD Co needs a new truck. The cost of it $30,000. NQD pays $18,000 and exchanges its
existing car on the last day of the accounting period. The car had cost of $10,000 three
years ago. Depreciation on car is 20% on the straight line basis.
Required: What is the journal entry for the period end?
Answer:
Step 1
Step 2
Recognize cost of new truck, trade-in value and payment
Debit
Truck at cost
30,000
Credit
Disposal account (30,000 - 18,000)
12,000
Credit
Cash
18,000
Remove cost of the disposal asset
Debit
Disposal account
10,000
Credit
Car at cost
10,000
193
V. NON-CURRENT ASSET DISPOSAL
2. Accounting for disposal
2.2
Disposal through a part-exchange agreement (PEA)
Example 9: Disposal through a part exchange
Answer (continued):
Step 3
Step 4
Remove accumulated depreciation of disposal asset
Debit
Accumulated depreciation (10,000 x 20% x 3)
6,000
Credit
Disposal account
6,000
Transfer gains/losses on disposal
Carrying amount = $10,000 - $6,000 = $4,000
Gain on disposal = $30,000 - $18,000 - $4,000 = $8,000
Debit
Disposal account
8,000
Credit
Income and expense account
8,000
194
VI. THE ASSET REGISTER
1. Data kept in an asset register
Data kept in an asset register about each non-current asset usually include:
1
Internal reference number
(for physical identification)
An asset register
7
Depreciation method &
estimated useful life (for
calculation of depreciation)
8
Cost of asset
9
Purchase date (for
calculation of depreciation)
4 Location of asset
2
Manufacturer’s serial
number (for maintenance)
Department that 'owns'
5 the asset
3
Description of asset
6 Carrying amount
195
VI. THE ASSET REGISTER
1. Data kept in an asset register
Data kept in an asset register about each non-current asset usually include:
Purchase date
(for calculation
of depreciation)
Internal reference
number (for physical
identification)
Serial number of
manufacturer (for
maintenance)
Cost of asset
Method of
depreciation &
estimated useful life
(for calculation of
depreciation)
Description of asset
An asset register
Location
of asset
Carrying amount
Department that
'owns' the asset
196
VI. THE ASSET REGISTER
2. Purpose and function of an asset register
Its main use is as an internal control:
To make sure information of NCA
in the nominal ledger (and thus the
financial statements) is accurate
To reconcile regularly the carrying
amount in the asset register with
the one in the nominal ledger
Note:
Regular reconciliations helps to deter theft and ensures that all items are accounted for
197
VI. THE ASSET REGISTER
2. Purpose and function of an asset register
Example 10
Exam focus: The asset register
An asset register showed a carrying amount of $67,460. A non-current asset costing
$15,000 had been sold for $4,000, making a loss on disposal of $1,250. No entries had
been made in the asset register for this disposal.
Required: What is the correct balance on the asset register, once the disposal has
been accounted for?
A. $62,210
B. $61,220
C. $61,120
D. $62,201
Answer: A
$
Balance b/d
67,46
0
Less: Carrying amount of NCA sold (4,000 +
1,250)
5,250
62,21
0
198
CHAPTER 9: INTANGIBLE
NON-CURRENT ASSETS
199
OVERVIEW
What will you learn?
Intangible non-current assets
I. IAS 38 – Intangible
assets
Definition
Recognition
Measurement
Disclosures
II. Research and
development cost
III. Comparison with
Tangible non current assets
200
I. IAS 38 – INTANGIBLE ASSETS
1. Definition
An intangible asset is an identifiable non-monetary asset without physical substance.
(IAS 38, para 8)
Three critical attributes of an intangible asset are:
Identifiability
Control
- Separable (capable of
being separated and
sold, transferred,
licensed, rented, or
exchanged) or
- Arises from contractual
or other legal rights
Entity has power to
obtain benefits from
the asset
Future
economic
benefits
Revenues, reduced
future costs, etc.
201
I. IAS 38 – INTANGIBLE ASSETS
1. Definition
The other definitions given by IAS 38:
Term
Definition
Research
Original & planned investigation taken to gain new scientific or
technical knowledge and understanding
Development
Application of research findings or other knowledge to plan or
design new or improved materials, products, processes, systems or
services before the commercial production or use
Amortisation
Systematic allocation of the depreciable amount of an intangible
asset over its useful life
Depreciable
amount
Cost of an asset, or other amount substituted for cost, less its
residual value
•
Useful life
•
Period over which an asset is expected to be available for use
by an entity; or
Number of production or similar units expected to be obtained
from the asset by an entity
202
I. IAS 38 – INTANGIBLE ASSETS
2. Recognition
As a kind of asset, Intangible NCA must simultaneously satisfy two criteria of asset
recognition:
2 criteria
A probable future
economic benefit
from the asset will
flow to the entity
The cost of the
asset
can
be
measured reliably
203
I. IAS 38 – INTANGIBLE ASSETS
3. Measurement
3.1
Initial measurement
Once an item qualifies for recognition as an asset, the initial measurement will depend on
the way that the intangible asset is acquired.
Acquire
separately
Acquire as part
of a business
combination
Recognize at cost
Intangible asset’s cost
is its fair value at the
acquisition date
204
I. IAS 38 – INTANGIBLE ASSETS
3. Measurement
3.2
Subsequent measurement
It is a must to choose either the cost model or the revaluation model for each class of
intangible asset.
IA has active
market or not?
Yes
Apply
revaluation model
No
Apply
cost model
IA has finite
useful life or not?
No
Not amortise IA, review
impairment annually
Yes
Amortise IA
205
I. IAS 38 – INTANGIBLE ASSETS
3. Measurement
3.2
Subsequent measurement
Cost model
Formula:
Carrying
amount
Cost
Accumulated
amortisation
Accumulated
impairment loss
Note: Cost model is more common in practice
IA with a finite useful life
IA with an infinite useful life
Example
Example
Patented technology, license, royalty
Land use rights, goodwill, brand name
Treatment
Treatment
Amortise over asset’s life
Test for impairment
Method
Frequency
Normally, using straight-line method
with zero residual value
Annually or more often if having
indication of possible impairment
206
I. IAS 38 – INTANGIBLE ASSETS
3. Measurement
3.2
Subsequent measurement
Revaluation model
Formula:
Carrying
amount
Fair
value
Subsequent
accumulated
amortisation
Subsequent
accumulated
impairment loss
Note:
• Must measure the fair value reliably with reference to an active market
• If revalue an intangible asset, must also revalue all intangible assets within that type
• Should revalue regularly at the end of reporting period
207
I. IAS 38 – INTANGIBLE ASSETS
3. Measurement
3.3
Amortisation
Useful life of intangible assets
Useful life of intangible assets is classified as finite and infinite.
Nature
Nature
Limited period of
benefit to the entity
No foreseeable limit
to the period of benefit
Treatment
Treatment
Must be amortised
Not amortise
Finite
useful life
Infinite
useful life
208
I. IAS 38 – INTANGIBLE ASSETS
3. Measurement
3.3
Amortisation
Intangible assets with finite useful lives
Subject
Allocate the depreciable amount on a systematic basis
over its useful life
When?
Start when the asset is available for use and cease when
classify the asset as held-for-sale or derecognize it
Method
Should reflect the benefit pattern. If can’t determine
the pattern reliably, use the straight-line method
Record
Recognise the amortisation charge for each period in
profit or loss
Review
Review at least at each financial year-end
209
I. IAS 38 – INTANGIBLE ASSETS
3. Measurement
3.3
Amortisation
Example 1: Amortisation of intangible asset with finite useful life
This year, Tiger Ltd has developed a new material from which the next generation of
wetsuits will be made. The costs incurred meet the capitalisation criteria and by the 31
December 20X5 year end $250,000 has been capitalised. The wetsuits are expected to
generate revenue for five years from the date that commercial production commences
on 1 January 20X6.
Required:
What amount is charged to the statement of profit or loss in the year ended 31
December 20X6?
Answer:
Amortisation will be charged on a straight-line basis for each of the five years that
revenue is generated. Therefore, the amortisation charge for each of the years ended
31 December 20X6 - 20Y0 will be: $250,000/5 years = $50,000.
210
I. IAS 38 – INTANGIBLE ASSETS
3. Measurement
3.3
Amortisation
Example 2: Recognition intangible assets
A company buys a customer list for $100,000, and expects to use for the next five years
to expand customer size.
Required:
Based on this information, is customer list classified as an intangible non-current asset?
Answer:
Customer list is recognized as an asset under IAS 38 because:
•
It can bring future economic benefits from expand the customer size of company
(next 5 years)
•
The cost can be measured reliably (at $100,000)
Note:
If customer list is generated by company itself, it should be not recognised as an
intangible non-current asset since its value cannot be measured reliably
211
I. IAS 38 – INTANGIBLE ASSETS
4. Disclosures (additional reading)
IAS 38 requires below disclosures
Useful life or amortisation rate
Amortisation method
Gross carrying amount
Accumulated amortisation and impairment losses
Line items in the income statement in which amortisation is included
Reconciliation of the carrying amount at the beginning and the end
of the period showing:
•
Additions
•
Disposals
•
Reductions in carrying amount
•
Amortisation
•
Any other movements included
212
II. RESEARCH AND DEVELOPMENT COST
1. Introduction
R&D costs is an internally-generated type of intangible assets, see details below:
Research
Original
&
planned
investigation taken to gain
new scientific or technical
knowledge and understanding
Internal
generated
Definition
Application of research findings
or other knowledge to plan or
design new or improved
materials, products, processes,
systems or services before
commercial production or use
Example
Design, construction & testing
of pre-production prototypes
Design of tools, jigs, moulds
and dies involving new
technology
Design,
construction
&
operation of a pilot plant that
is not of a scale economically
feasible
for
commercial
production
Design, construction & testing
of a chosen alternative for new
or improved materials
Activities aimed to obtain new
knowledge
Search applications of research
findings or other knowledge
Search for product or process
alternatives
Formula & design of possible
new or improved product or
process alternatives
Development
213
II. RESEARCH AND DEVELOPMENT COST
2. Components of research and development costs
R&D costs will include all costs that are directly attributable to R&D activities, or that can
be allocated on a reasonable basis.
Salaries, wages and other employment-related
costs of personnel engaged in R&D activities
01
02
03
04
05
Costs of materials and services consumed in
R&D activities
Depreciation of PPE to the extent that these
assets are used for R&D activities
Overheads, besides general admin costs,
related to R&D activities (same allocation as
allocating overheads to inventories in IAS 2)
Other costs (e.g. amortisation of patents and
licences) to the extent that these are used for
R&D activities
214
II. RESEARCH AND DEVELOPMENT COST
3. Recognition
Accounting treatment is different for research expenditure and development expenditure.
Research expenditure
Development expenditure
Write off as expense to SOPL
when incurred
Recognise as an intangible asset
if the entity can demonstrate all
capitalisation criteria
Details of capitalisation criteria for development expenditure is as below:
PIRATE
215
II. RESEARCH AND DEVELOPMENT COST
3. Recognition
Probable future economic benefits
P
The entity should demonstrate the existence of a market for the output of
the intangible asset or the usefulness of the intangible asset to the business
Intention to complete and use or sell
I
The entity has intention to complete the intangible asset and use or sell it
which is showed through plan, press release, etc.
Resources adequacy
R
Resources (technical, financial and other resources) are adequate and
available to complete and use the asset
Ability to use or sell
A
Intangible assets should be useful and serve for entity’s purpose or demand
of other parties
Technical feasibility
T
The entity has the technical feasibility to complete the intangible asset (so
that it will be available for use or sale)
Probable future economic benefits
E
Expenditure can be measured reliably
Note: All expenditure which does not meet the criteria for recognition either as an identifiable
intangible asset or as goodwill arising on an acquisition should be expensed as incurred.
(e.g. start-up costs, training costs, advertising costs)
216
II. RESEARCH AND DEVELOPMENT COST
3. Recognition
Example 4: Research and development cost
1.
If meeting certain conditions, an entity may capitalise development expenditure
2.
Research expenditure, other than capital expenditure on research facilities, must
be written off as incurred
3.
Capitalised development expenditure must be amortised over a period not
exceeding 5 years
4.
Capitalised development expenditure must be disclosed in SOFP under intangible
non-current assets
Required: According to IAS 38 - Intangible Assets, which of the above statements about
research and development expenditure are correct?
A. 1, 2 and 4
B. 1 and 3
C. 2 and 4
D. 3 and 4
Answer: C
1 is false: Development expenditure must be capitalised if the criteria are met
2 is true: Research expenditure must be written off as expenses incurred
3 is false: There is no requirement that development expenditure should be amortised
over a period not exceeding 5 years
4 is true: Development expenditure must be recognised as intangible assets in SOFP
217
III. COMPARISON WITH
TANGIBLE NON-CURRENT ASSETS
Key differences
Key differences between tangible and intangible non-current asset are as follows:
Tangible
non-current asset
Identification
Have physical substance
(e.g. land & building)
Intangible
non-current asset
No physical substance
(e.g. copyright)
•
Cost
Involve expenditure incurred to
bring assets to present condition
•
•
Purchased or generated
internally
If not meet certain criteria,
expenditure incurred is not
be recognised as an asset
Purchased intangible NCA
are capitalised
Internally generated assets
may be capitalised when
certain criteria are met
Capitalisation
Cost of the tangible NCA is
capitalised
•
Depreciation
Depreciation reflects the wearing
out of assets
Amortisation reflects the wearing
out of capitalised assets
218
CHAPTER 10:
ACCRUALS AND PREPAYMENTS
219
OVERVIEW
What will you learn?
I. Accruals basis
II. Accrued expenses
(accruals)
II. Prepaid expenses
(prepayments)
Definition
Definition
Accounting
entry
Accounting
entry
III. Deferred income
and accrued income
Definition
Accounting
treatment
Impact on
Financial
Statements
Example
220
I. ACCRUALS BASIS
1. Accruals basis
The accruals basis means that we must include all the income and expenditure relating
to the period whether or not the cash has been received or paid or an invoice received.
Profit is, therefore:
Income earned
Expenditure incurred
Profit
X
(X)
X
221
II. ACCRUED EXPENSES AND PREPAID EXPENSES
1. Definition
Accrued expenses (accruals) and prepaid expenses (prepayments) are following the
matching principle and accruals basis of accounting.
Accruals
Accrual
basis
Prepayments
Accruals (accrued expenses)
are expenses which:
∙ Incurred, but
∙ invoices have not yet been
received and thus have not
yet been paid.
Definition
Prepayments (prepaid
expenses) are payments which:
∙ Relate to the subsequence
accounting period, but
∙ have already been paid.
Accruals are shown in the SOFP
as a liability.
Presentation
Prepayments are shown in the
SOFP as an asset.
Example:
∙ Utilities: Electricity, Water,
…
∙ Wages incurred, for which
payment to employees has
not yet been made
Example
Example:
∙ Rental charges
∙ Insurance premium
222
II. ACCRUED EXPENSES AND PREPAID EXPENSES
2. Accounting for accruals and prepayments
2.1
Accounting for accruals
1
First period
Record estimate expense:
DR
CR
(Liability)
2
Subsequent
periods
Expenses
Accruals
When the invoiced received:
Record accrual reversal:
DR
Accruals
(Liability)
CR
Expenses
Record actual expense (invoiced amount):
DR
Accruals
(Liability)
CR
Expenses
223
II. ACCRUED EXPENSES AND PREPAID EXPENSES
2. Accounting for accruals and prepayments
2.1
Accounting for accruals
Example 1: Accounting for accruals
At 1/1/20X4, Tree Co signed a contract to rent an apartment at $2,000 per
month with payment in arrears at end of each 8-month interval. The company
prepares the account semi-annually.
Start of
period
Reporting
date
1staccruals
1/1/20X4
End of
period
2nd accruals
30/6/20X4 31/8/20X4
31/12/20X4
Rental expense payment
Accounting entries:
At reporting date, record estimate
expense:
DR Expense: $ 12,000 ($2,000*6)
CR Accruals: $ 12,000 ($2,000*6)
224
II. ACCRUED EXPENSES AND PREPAID EXPENSES
2. Accounting for accruals and prepayments
2.2
Accounting for prepayments
1
First period
Record full amount of prepayment as
prepaid expenses in the period
DR
CR
2
Subsequent
periods
Prepayment (Asset)
Cash
Allocate prepayment to expenses at the
end of the period
DR
CR
Expenses
Prepayment (Asset)
225
II. ACCRUED EXPENSES AND PREPAID EXPENSES
2. Accounting for accruals and prepayments
2.2
Accounting for prepayments
Example 2: Accounting for prepayments
At 1/1/20X4, Tree Co signed a contract to rent an office at $2,000 per month
with payment in advance at the beginning of each 8-month interval. The
company prepares the account semi-annually.
2nd prepayment
1st prepayment
1/1/20X4
End of
period
Reporting
date
Start of
period
30/6/20X4 31/8/20X4
Rental expense
31/12/20X4
30/4/20X5
226
II. ACCRUED EXPENSES AND PREPAID EXPENSES
2. Accounting for accruals and prepayments
2.2
Accounting for prepayments
Example 2: Accounting entries:
Period 1
1/1
30/6
Recording full amount of 8-month prepayment as prepaid expenses in the
period
DR
Prepayment (Asset)
16,000
CR
Cash
16,000
Allocating prepayment for 6 months (1/1 – 30/6) as expense in the period
DR
Rental expense
12,000
CR
Prepayment
12,000
Prepayment has balance of $4,000
227
II. ACCRUED EXPENSES AND PREPAID EXPENSES
2. Accounting for accruals and prepayments
2.2
Accounting for prepayments
Example 2: Answer
Period 2
31/8
Recording full amount of 8-month prepayment (1/9 – 30/4) as prepaid
expenses in the period
DR
Prepayment
16,000
CR
Cash
16,000
Prepayment has balance of $16,000 + $4,000 = $20,000
31/12
Allocating prepayment for 6 months (30/6 – 31/12) to expense in the
period
DR
Rental Expense
12,000
CR
Prepayment
12,000
Prepayment has balance of $8,000
228
III. DEFERRED INCOME AND ACCRUED INCOME
Comparisons between deferred income and accrued income
Deferred income
Accrued income
When received income in
advance of being earned, it
should be deferred to the period
in which the company delivered
goods or services to customers.
When received income in arrears.
(e.g. An entity received payment
from customer but it has not
delivered the goods yet)
(e.g. An entity accrues income
when it earned the income in the
period but has not yet been
invoiced or received.)
Not affect income in the
statement of profit or loss.
Shown as a payable in the
statement of financial position.
Increase income in the
statement of profit or loss.
Shown as a receivable in the
statement of financial position.
Definition
Impact on
Financial
statements
229
III. DEFERRED INCOME AND ACCRUED INCOME
Comparisons between deferred income and accrued income
Deferred income
1
When received deferred
income
Dr Cash (payment received in
advance from the customer)
Cr Deferred income (*)
(liability owe to the customer
until the delivery of goods)
Accounting
treatment
2
When delivered goods
and services
Dr Deferred income (remove the
liability no more needed)
Cr Sales (as the income has been
‘earned’ now)
Accrued income
1
Dr Accrued income (as an ‘uninvoiced receivable’)
Cr Sales (recognise the income
generated as the goods have
been delivered)
2
When raise the invoice
for the goods, can
eliminate the accrued
income
Dr Sales
Cr Accrued income
3
(*) If more than 1 year, record
deferred income as non-current
liability
When received accrued
income
Then, we record an entry
for the income generated:
Dr Cash/Receivable
Cr Sales
230
III. DEFERRED INCOME AND ACCRUED INCOME
Comparisons between deferred income and accrued income
Example
Deferred income
Accrued income
A software company signs a
customer to a three-year service
contract for $12,000 per year,
and the customer pays the
company $12,000 upfront on
January 1st for the maintenance
service for the entire year.
ABC International has a consulting
project with a large client. After
each of two milestones, the client
owes $10,000 to ABC since the
agreement only allows for billing
at the end of the project for
$20,000.
• After receiving payment:
Debit Cash
$12,000
Credit Deferred income $12,000
Reaching the first milestone Recorded accrual income:
Debit Accrued income $10,000
Credit Revenue
$10,000
As the fiscal year progresses, the
company sends the newspaper
to its customer each month and
recognizes revenue. Monthly,
the accountant records:
Debit Deferred income $1,000
Credit Revenue
$1,000
When complete the second
milestone:
Eliminate the accrued income as
follows:
Debit Revenue
$10,000
Credit Accrued income $10,000
Record an entry for the income
generated:
Debit Receivable
$20,000
Credit Revenue
$20,000
231
CHAPTER 11
IRRECOVERABLE DEBTS &
ALLOWANCE
232
OVERVIEW
What will you learn?
I. Credit sales
II. Credit control
III. Irrecoverable debts
IV. Doubtful debts
Write off
irrecoverable debts
Make allowance
of receivables
233
I. CREDIT SALES
2 typical types of sales
There are 2 typical types of sales we have already known: Cash sales and Credit sales
Credit sales
Cash sales
Most businesses
buy and sell on credit
Few businesses pay
cash immediately
Recognise revenue
Recognise revenue &
payment at a same time
Debit Receivables
Credit Sales
Recognise payment
Debit Cash
Credit Receivables
Debit Cash
Credit Sales
234
II. CREDIT CONTROL
2 typical credit controls
There are two credit controls including Set credit limit and Analyse aged receivables
1
Set credit limit
2
Analyse aged
receivables
Control actions
Analyse criteria
Give each customer a credit
limit that can’t be exceeded
By customer
By age of receivable
Not action orders make a
balance over its limit until
further payments
Control actions
Indicate long outstanding
balances as customers are
unable to pay
Chase up payment for long
outstanding invoices
235
III. IRRECOVERABLE DEBTS
1. Definition
Irrecoverable debt (bad debt) is a debt that is definitely not expected to be paid
Situation
to occur
Customer has gone bankrupt
Write off immediately when occur
Treatment
Recover if being paid unexpectedly in a subsequent period
236
III. IRRECOVERABLE DEBTS
2. Accounting treatment
Details of two accounting treatments of irrecoverable debts are presented below:
Write off
Rationale
The customer can’t pay invoices
No economic benefit from receivable
The receivable is no longer an asset
Write off irrecoverable debt
Double entry
Debit Irrecoverable debts expense
Credit Receivables
237
III. IRRECOVERABLE DEBTS
2. Accounting treatment
Details of two accounting treatments of irrecoverable debts are presented below:
Recover
Rationale
Irrecoverable debt is unexpectedly paid
Offset cash received against irrecoverable debts expense
Double entry
Debit Cash
Credit Irrecoverable debts expense
238
III. IRRECOVERABLE DEBTS
2. Example
Example 1
Celia Jones had receivables of $3,655 at 31 December 20X7. At that date she wrote off
a debt from Lenny Smith of $699. During the year to 31 December 20X8 Celia made
credit sales of $17,832 and received cash from her customers totaling $16,936. She
also received the $699 from Lenny Smith that had already been written off in 20X7.
What is the final balance on the receivable account at 31 December 20X7 and 20X8?
Answer:
RECEIVABLES (20X7)
31 Dec
$
3,655
Balance b/f
3,655
2,956
Irrecoverable debts - Lenny
Balance c/f
$
699
2,956
3,655
IRRECOVERABLE DEBTS EXPENSE (20X7)
Receivables - Lenny
$
699
699
Profit or loss
$
699
699
239
III. IRRECOVERABLE DEBTS
2. Example
Example 1
Answer (continued):
RECEIVABLES (20X8)
Balance b/f
Sales
$
2,956
17,832
Balance b/f
20,788
3,852
$
Cash received
Balance c/f
16,936
3,852
20,788
IRRECOVERABLE DEBTS EXPENSE (20X8)
Profit or loss
�
$
699
699
Cash
The financial balance on receivable account:
At 31 Dec 20X7 is $2,956
At 31 Dec 20X8 is $3,852
$
699
699
240
IV. ALLOWANCE FOR RECEIVABLES
1. Definition
Doubtful debt is a debt which is possibly irrecoverable
Situation
to occur
Invoices are in dispute
Customers are in financial difficulty
Not written off
Treatment
Made allowance for doubtful debt
241
IV. ALLOWANCE FOR RECEIVABLES
1. Definition
Allowance for receivable is an allowance set up to recover an estimated doubtful debt
There is two types of allowance for receivables as below:
Basis
Made against a
particular receivable
Specific
allowance
Example
Allowance against an
invoice, allowance
against an customer
Basis
Made on the past
experience of
irrecoverable debts
General
allowance
Example
Allowance up to 2% of
trade receivables
242
IV. ALLOWANCE FOR RECEIVABLES
2. Determine the allowance for receivables
The method of determining the allowance for receivables is summarized as below:
Standard
&
Nature
Steps
to
determine
IFRS 9: Financial instrument
Step 1
Write off any irrecoverable
debts to get doubtful debts
An impairment review
of trade receivables
Step 2
Made allowance as a
percentage of remaining
balance (e.g. 2%)
243
IV. ALLOWANCE FOR RECEIVABLES
3. Accounting treatment
The accounting treatment for an allowance for receivables is as follows:
1
2
First time
making allowance
Charge initial allowance as an expense
Further times
onwards
Case 1: Subsequent allowance increase
(Balance b/f < Balance c/f)
Debit Irrecoverable debts expense
Credit Allowance for receivables
Charge increase amount as an expense
Debit Irrecoverable debts expense
Credit Allowance for receivables
Case 2: Subsequent allowance decrease
(Balance b/f > Balance c/f)
Credit decrease amount back to SoCI
Debit Allowance for receivables
Credit Irrecoverable debts expense
244
IV. ALLOWANCE FOR RECEIVABLES
4. Example
Example 2
X Co has total receivables outstanding at 31/12/20X1 of $100,000. He calculated that
2% of these might not be collected and wishes to make an allowance. Before that, he
hasn’t made any allowance for receivables.
On 31/12/20X2 his trade accounts receivable is $80,000. When review, he calculated
that an allowance 10% of the total balance should be made. During the year, the
company wrote off $5,000 of irrecoverable debt.
What accounting entries should X Co make on 31/12/20X1 and 31/12/20X2? What
figures for trade receivables will appear on his statements of financial position as at
those dates?
Guidance:
Initial year
Step 1
Take the receivables balance after posting credit sales and cash
received from credit customers
Step 2
Deduct bad debts from this receivables balance
Step 3
Also deduct any specific allowances
Step 4
Calculate the general allowance by applying the percentage given to
the remaining balance
245
IV. ALLOWANCE FOR RECEIVABLES
4. Example
Example 2: Guidance (continued)
Subsequent year
Step 1
Take the receivables balance
Step 2
Deduct bad debts from this receivables balance
Step 3
Also deduct any specific allowances
Step 4
Calculate the new allowance required
Step 5
Compare with the existing allowance balance
(i.e. balance b/f from the previous period)
Step 6
Calculate increase or decrease required
Step 7
Record double entry for the difference
Case 1: If higher allowance is required
Debit Irrecoverable debts expense
Credit Allowance for receivables
Case 2: If lower allowance is required
Debit Allowance for receivables
Credit Irrecoverable debts expense
246
IV. ALLOWANCE FOR RECEIVABLES
4. Example
Example 2: Answer
Initial year (31/12/20X1)
Step 1
Take the receivables balance
The balance of receivables 20X1 = 100,000
Step 2
Deduct bad debts from this receivables balance
During the year, X Co didn’t write off any irrecoverable debts
Step 3
Also deduct any specific allowances
There is no specific allowance in the year ended 31/12/20X1
Step 4
Calculate the general allowance by applying the percentage given to
the remaining balance
Allowance for receivables = 100,000 x 2% = 2,000
Double entry
Dr. Irrecoverable debts expense
Cr. Allowance for receivables
2,000
2,000
Receivable will appear under current assets as follows
Receivable balances
Less: Allowance for receivables
100,000
(2,000)
98,000
247
IV. ALLOWANCE FOR RECEIVABLES
4. Example
Example 2: Answer (continued)
Subsequent year (31/12/20X2)
Step 1
Take the receivables balance
The balance of receivables in 20X2 = 80,000
Step 2
Deduct bad debts from this receivables balance
During the year, X Co wrote off $5,000 of irrecoverable debts
Receivables after bad debts = 80,000 - 5,000 = 75,000
Double entry
Dr. Irrecoverable debts expense
Cr. Receivables
Step 3
Also deduct any specific allowances
Step 4
Calculate the new allowance required
Step 5
Compare with the existing allowance balance
5,000
5,000
There is no specific allowance in the year ended 31/12/20X2
Allowance for receivables = 75,000 x 10% = 7,500
Allowance for 20X2 is 7,500 > Allowance for 20X1 is 2,000
248
IV. ALLOWANCE FOR RECEIVABLES
4. Example
Example 2: Answer (continued)
Subsequent year (31/12/20X2)
Step 6
Calculate increase or decrease required
Increase in allowance = 7,500 - 2,000 = 5,500
Step 7
Record double entry for the difference
Double entry
Dr. Irrecoverable debts expense
Cr. Allowance for receivables
5,500
5,500
Receivable will appear under current assets as follows
Receivable balances
Less: Allowance for receivables
20X1
31 Dec
20X2
31 Dec
75,000
(7,500)
67,500
ALLOWANCE FOR RECEIVABLES (SOFP)
$
20X1
31 Dec
P/L account
Balance c/d
2,000
20X2
Balance c/d
1 Jan
Balance b/d
7,500
31 Dec
P/L account
7,500
20X3
1 Jan
Balance c/d
$
2,000
2,000
5,500
7,500
7,500
249
V. PRESENTATION
1. Presentation on financial statements
1
Statement of comprehensive income
The item of irrecoverable debts expense in SoCI shows both irrecoverable debts
written off and allowance for receivables.
STATEMENT OF COMPREHENSIVE INCOME
(extract)
Irrecoverable debts expense
Irrecoverable debt written off
X
Increase/(Decrease) in specific allowance for receivables
Increase/(Decrease) in general allowance for receivables
X/(X)
X/(X)
Recovery of debts written off
(X)
X/(X)
2
Statement of financial position
Trade receivables in SoFP are shown net of any receivables allowance.
STATEMENT OF FINANCIAL POSITION
(extract)
Trade receivables
Less: Allowance for receivables
X
(X)
Net trade receivables
X
250
V. PRESENTATION
2. Example
Example 3
X Co had receivables of $800,000 at 31/12/20X5. The allowance for receivables of
$120,000 was brought forward from the previous year. X Co decided to write off the
irrecoverable debts totaling $76,000. The allowance for receivables was adjusted to
15% of receivables.
What receivables expense should be shown in the X Co’s statement of
comprehensive income for the year ended 31/12/20X5?
Answer:
Double entry to write off $76,000 irrecoverable debts at 31/12/20X5:
Dr. Irrecoverable debts expense
Cr. Receivables
76,000
76,000
Adjustment in the allowance for receivables is as follows:
Closing balance [(800,000 - 76,000) x 15%]
Opening allowance
Decrease in allowance
108,600
120,000
11,400
Double entry to reduce allowance:
Dr. Allowance for receivables
Cr. Irrecoverable debts expense
SoCI charge = 76,000 - 11,400 = 64,600
11,400
11,400
251
CHAPTER 12: PROVISIONS
AND CONTINGENCIES
252
OVERVIEW
What will you learn?
Provisions and contingencies
I. Provision
II. Contingencies
Contingent
assets
Contingent
liabilities
253
I. PROVISION
1. Definition
'A provision is defined as a liability of uncertain timing or amount.’
'A liability is a present obligation of the entity arising from past events, the settlement
of which is expected to result in an outflow from the entity of resources embodying
economic benefits.’
(IAS 37, para 10).
Example:
A company may face a legal action for a breach of health and safety law. Your lawyers
estimate the probability of losing the case at 80%. The likely repercussion is that it may
be fined if the court judgement is made against them. The timing and potential fine of
the fine is uncertain because it will be decided by a court at some future date.
Note:
IAS 37 distinguishes provisions from other liabilities, such as trade payables and accruals.
This is on the basis that for a provision there is uncertainty about the timing or amount
of the future expenditure.
While uncertainty is clearly present in the case of certain accruals, the uncertainty is
generally much less than for provisions.
254
I. PROVISION
2. Recognition
Provision should be recognised when all three of the following conditions are met:
01
Entity has a present obligation (legal or construction)
Legal obligation
Arise from:
• A contract,
• legislation
• other operation of law
E.g. Warranties required in sales contracts.
Constructive obligation
Arise through:
• Past behaviors and actions
E.g. Business which doesn't offer warranties has a history of usually
carrying out free small repairs on its products, so that customers
have come to expect this benefit when they make a purchase.
02
A transfer of economic benefits is probable (> 50% likely)
03
A reliable estimate can be made
255
I. PROVISION
3. Measurement
Although provision have uncertain amount but we can estimate provision.
For a single obligation
For a large population of items
The most likely amount payable
An expected value
Example 1: Damages provision (Single obligation)
A customer has brought a lawsuit against Bone Co and is claiming $800,000 in damages.
Bone Co’s legal advisors have assessed the probability of Bone Co losing and having to
pay the damages at 80%.
What should the provision in Bone Co’s financial statements be?
Answer:
There is single obligation and provision is measured at the single most likely outcome
$800,000.
The provision is NOT measured at 80% × $800,000 = $640,000 because there is not a
large population of items.
256
I. PROVISION
3. Measurement
Example 2: Warranty provision (A large population of items)
Parker Co sells goods with a warranty under which customers are covered for the cost
of repairs of any manufacturing defect that becomes apparent within the first six
months of purchase. The company's past experience and future expectations indicate
the following pattern of likely repairs.
% of goods sold
Defects
Cost of repairs
$m
75
None
–
20
Minor
1.0
5
Major
4.0
What should the warranty provision in Parker Co's financial statements be?
Answer:
Parker Co should provide on the basis of the expected cost of the repairs under
warranty.
The expected cost is calculated as (75% × $nil) + (20% × $1.0m) + (5% × $4.0m) =
$400,000.
Parker Co should include a provision of $400,000 in the financial statements.
257
I. PROVISION
4. Accounting for provisions
4.1
Initial recognition
When a business first sets up a provision, the full amount of the provision should be:
Debit
Expenses (Statement of profit or loss)
Credit
Provisions (Statement of financial position)
4.2
Subsequent recognition
In subsequent years, adjustments may be needed to the amount of the provision.
The procedure is as below:
Step 1
Calculate the new provision required
Step 2
Compare it with the existing balance on the provision account.
(ie the balance b/f from the previous accounting period).
Step 3
Calculate increase/ decrease amount.
Increase
(Higher provision)
Decrease
(Lower provision)
Debit Expenses
Credit Provision
With the amount increase
Debit Provision
Credit Expenses
With the amount decrease
258
I. PROVISION
4. Accounting for provisions
Example 3: Accounting for provisions
A business has been told by its lawyers that it is likely to have to pay $10,000 damages
for a product that failed. The business duly set up a provision at 31 December 20X7.
However, the following year, the lawyers found that damages were more likely to be
$50,000.
How is the provision treated in the accounts at:
a) 31 December 20X7? (Initial recognition)?
b) 31 December 20X8? (Subsequent recognition)?
Answer:
a) 31 December 20X7 (Initial recognition)
Debit
Expenses (Statement of comprehensive income) $10,000
Credit
Provisions (Statement of financial position)
$10,000
EXTRACT FROM STATEMENT OF COMPREHENSIVE INCOME
$
Expenses
Provision for damages
EXTRACT FROM STATEMENT OF FINANCIAL POSITION
Non-current liabilities
10,000
$
10,000
* Because it is uncertain when the amount relating to the provision will be paid, or indeed
if it definitely will be paid, it is classified as a non-current liability.
259
I. PROVISION
4. Accounting for provisions
Example 3: Accounting for provisions
b) 31 December 20X2 (Subsequent recognition)
In 20X2, the lawyers found that damages were more likely to be $50,000 (Step 1), which
is more than the existing balance on the provision account ($10,000) (Step 2). Therefore,
the business needs to increase the provision.
New provision required = $50,000 - $10,000 = $40,000 (Step 3)
Debit
Damages
$40,000(*)
Credit
Provision
$40,000
(*) Do not forget that the provision account already has a balance brought forward of
$10,000, so we only need to account for the increase in the provision.
EXTRACT FROM STATEMENT OF COMPREHENSIVE INCOME
$
Expenses
Provision for damages
EXTRACT FROM STATEMENT OF FINANCIAL POSITION
40,000
$
Non-current liabilities
Provision for damages (10,000 + 40,000)
50,000
260
I. PROVISION
5. Disclosure
Disclosures required in the financial statements for provisions fall into two parts.
Disclosure of details of the change in carrying amount of a provision
from the beginning to the end of the year, including:
Additional provisions made;
Amounts used, and;
Other movements.
For each class of provision, disclosure of the background to the
making of the provision and the uncertainties affecting its outcome,
including:
A brief description of:
•
the nature of the provision, and;
•
the expected timing of any resulting outflows relating to
the provision.
An indication of:
•
the uncertainties about the amount or timing of those
outflows, and;
•
where necessary to provide adequate information, the
major assumptions made concerning future events,
Any expected reimbursement relating to the provision:
•
including any asset that has been recognised for that
expected reimbursement.
261
II. CONTINGENCIES
1. Contingent liabilities
Contingent liability is:
•
'a possible obligation 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; or
•
a present obligation that arises from past events but is not recognised because:
o it is not probable that an outflow of resources embodying of economic
benefits will be required to settle the obligation; or
o the amount of the obligation cannot be measured with sufficient reliability.’
(IAS 37, para. 10)
See the flow chart below as a reference:
A contingent liability
A possible obligation
Arises from
past events
Its existence
depending on
whether some
uncertain
future events
occur
or
A present obligation
But is not
recognised
because:
Arises from
past events
or
The payment is
not probable
(< 50% likely)
The amount
cannot be
measured
reliably
262
II. CONTINGENCIES
1. Contingent liabilities
Note:
Contingent liability is required to be recognised or disclosed, which determined by the
possibility of an economic benefits outflow. To be more specific:
Virtually certain
(≥ 90%)
Recognise liability
Probable
(50% ≤ X < 90%)
Possible
(5% ≤ X < 50%)
Remote
(X < 5%)
Recognise provision
Disclose contingent liability
Ignore
Contingent liabilities should be disclosed in the notes.
The required disclosures are:
• A brief description of the nature of the contingent liability
• An estimate of its financial effect
• An indication of the uncertainties that exist
• The possibility of any reimbursement
263
II. CONTINGENCIES
1. Contingent liabilities
Example
D Co might face a lawsuit, but D Co’s lawyers estimate the probability of losing the case
at 30% – in this case, it’s not probable that D Co will have to incur any expenditures to
settle the claim and they should not book a provision. It’s typical contingent liability.
If D Co identify they have a contingent liability, they do NOT recognize it – no journal
entry. D Co should only make appropriate disclosures in the notes to the financial
statements.
The differences between provision and contingent liability are as follow:
Provision
Contingent liability
Recognition
Present obligation with the
probability of more than 50%
(probable)
∙ Present obligation with the
probability of between 5%
and 50% (possible), which is
less likely than provision
∙ Possible obligation
Accounting
treatment
Make a provision
Disclosure if significant, ignore if
not significant
264
II. CONTINGENCIES
1. Contingent liabilities
Example 4: Distinguish between provision and contingent liability
A former director of Sen Co has commenced an action against the company claiming
substantial damages for wrongful dismissal. The company's solicitors have advised that
the former director is unlikely to succeed with his claim, although the chance of Sen Co
paying any monies to the ex-director is not remote. The solicitors' estimates of Sen Co's
potential liabilities are:
$
Legal costs (to be incurred whether the claim is successful or not)
70,000
Settlement of claim if successful
700,000
-----------770,000
How should this claim be treated in Sen Co's financial statements?
A. Provision of $770,000
B. Disclose a contingent liability of $770,000
C. Make a provision of $70,000 and a contingent liability of $700,000
D. Provision for $700,000 and a contingent liability of $70,000
Answer: C
As the claim is unlikely to succeed, the potential settlement of $700,000 should be
disclosed as a contingent liability note.
However, given that the legal costs of $70,000 must be paid whether the claim is
successful or not, this amount should be provided for in the company's financial
statements.
265
II. CONTINGENCIES
1. Contingent liabilities
Example 5: Distinguish between provision and contingent liability
After a wedding in 20X0, ten people became seriously ill, possibly as a result of food
poisoning from products sold by Callow Co. Legal proceedings are started seeking
damages from Callow but it disputes liability.
Up to the date of approval of the financial statements for the year to 31 December
20X0, Callow’s lawyers advise that it is probable that it will not be found liable.
However, when Callow prepares the financial statements for the year to 31 December
20X1 its lawyers advise that, owing to developments in the case, it is probable that it will
be found liable.
What is the required accounting treatment:
a) At 31 December 20X0
b) At 31 December 20X1
Answer:
a) At 31 December 20X0
On the basis of evidence available when the financial statements were approved, there
is no obligation as a result of past events.
No provision is recognised. The matter is disclosed as a contingent liability unless the
probability of any transfer is regarded as remote.
b) At 31 December 20X1
On the basis of evidence available, there is present obligation. A transfer of economic
benefits in settlement is probable. A provision is recognised for the best estimate of the
amount needed to settle the present obligation.
266
II. CONTINGENCIES
2. Contingent assets
Contingent asset is:
'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’.
(IAS 37, para. 10)
Note:
Contingent asset is required to be recognised or disclosed, which determined by the
possibility of an economic benefits inflow. To be more specific:
Virtually certain
(≥ 90%)
Probable
(50% ≤ X < 90%)
Possible
(5% ≤ X < 50%)
Remote
(X < 5%)
Recognise asset
Disclose contingent asset
Ignore
Ignore
Contingent assets should be disclosed in the notes.
The required disclosures are:
• A brief description of its nature, and where practicable
• An estimate of its financial effect
Example
Let’s say Company ABC has filed a lawsuit against Company XYZ for infringing a patent. If
there is a decent chance that Company ABC will win the case, it has a contingent asset.
This potential asset will generally be disclosed in its financial statement, but not
recorded as an asset until the lawsuit is settled.
267
II. CONTINGENCIES
3. Summary
IAS 37 has a good summary of rules on contingencies, see the flow chart below:
Start
Present obligation as a result
of an obligating event?
No
Yes
No
Possible obligation?
Yes
No
No
Probable outflow?
Possible outflow?
Yes
No
Reliable estimate?
(Rare)
Yes
Yes
Provision
Disclose contingent
liability
Ignore
268
CHAPTER 13: IFRS 15
- REVENUE FROM CONTRACTS
WITH CUSTOMERS
269
OVERVIEW
What will you learn?
IFRS 15 - Revenue from contracts with customers
I. Overview
II. Revenue recognition
5-step model
Step 1: Identify the contracts with the
customers
Step 2: Identify the separate
performance obligations
Step 3: Determine the transaction price
Step 4: Allocate the transaction price to
the performance obligations
Step 5: Recognize revenue when (or as)
a performance obligation is satisfied
III. Disclosure
of revenue
270
I. OVERVIEW
1. Terminologies
Key definitions are given by IFRS 15 as follows:
Terminology
Definition
Income
Increases in economic benefits during the accounting period in the
form of inflows or enhancements of assets or decreases of liabilities
that result in an increase in equity, other than those relating to
contributions from equity participants
Revenue
Income arising in the course of an entity's ordinary activities
Contract
An agreement that creates enforceable rights and obligations
Customer
A party that has contracted with an entity to obtain goods or services
that are an output of the entity’s ordinary activities in exchange for
consideration.
Performance
obligation
A promise in a contract with a customer to transfer to the customer:
A good or service (or a bundle of goods or services) that is distinct; or
A series of distinct goods or services that are substantially the same
and that have the same pattern of transfer to the customer.
Transaction
price
The amount of consideration to which an entity expects to be
entitled in exchange for transferring promised goods or services to a
customer, excluding amounts collected on behalf of third parties.
271
I. OVERVIEW
2. Scope of IFRS 15
IFRS 15 applied to all contracts with customers, except:
Lease contracts (IFRS 16 Leases)
Insurance contracts (IFRS 17 Insurance Contracts)
Financial instruments and other contractual rights or obligations
(IFRS 9 Financial Instruments, IFRS 10 Consolidated Financial Statements, IFRS 11
Joint Arrangements, IAS 27 Separate Financial Statements and IAS 28 Investments in
Associates and Joint Ventures)
Non-monetary exchanges between entities in the same line of business
272
II. REVENUE RECOGNITION – FIVE-STEP MODEL
5-step model introduction
To recognise revenue under IFRS 15, an entity applies the following five steps:
Step 1: Identify the contracts with the customers
5-step model
Step 2: Identify the separate performance obligations
Step 3: Determine the transaction price
Step 4: Allocate the transaction price to the performance obligations
Step 5: Recognize revenue when (or as) a performance obligation is
satisfied
273
II. REVENUE RECOGNITION – FIVE-STEP MODEL
1. Step 1: Identify the contracts with the customers
The contracts with the customers must satisfy 5 following criteria:
1
All parties have approved the contract and committed to
perform their respective obligations.
2
The entity can identify each party’s rights and obligations
regarding the goods or services to be transferred.
3
The payment terms for the goods or services can be identified.
4
The contract has commercial substance.
5
It is probable to collect consideration.
274
II. REVENUE RECOGNITION – FIVE-STEP MODEL
1. Step 1: Identify the contracts with the customers
Example 1: Identify the contract
Hawkeye has a fiscal year end of 31 December 20X8. On 30 September 20X8, Hawkeye
signed a contract with a customer to provide them with an asset on 31 December 20X8.
Control over the asset passed to the customer on 31 December 20X8. The customer will
pay $10m on 30 June 20X9. By 31 December 20X8, Hawkeye did not believe that it was
probable that it would collect the consideration that it was entitled to.
Identify that whether this is a contract.
Guidance:
Apply 5 criteria above to consider
•
Hawkeye signed a contract with a customer 🡪 Approved by all parties.
•
Hawkeye provide customer with an asset on 31 December 20X8 and Customer:
Pay $10m on 30 June 20X9 🡪 Be able to identify right and obligations.
•
Pay $10m on 30 June 20X9 🡪 Be able to identify payments term.
•
This is a contract to purchase asset 🡪 Have commercial substance.
•
Hawkeye did not believe that it was probable that it would collect the
consideration
Do not satisfy criteria. So, this is NOT a contract.
275
II. REVENUE RECOGNITION – FIVE-STEP MODEL
2. Step 2: Identify the separate performance obligations
Two cases occur when an entity identifies single performance obligations:
Distinct
goods/services
•
•
Customer can benefit from
the goods or services.
Entity’s promise to transfer
the good or service is
separately identifiable.
Series of distinct
goods/services
•
A performance obligation
that is satisfied over time.
•
A
single
measuring.
method
of
Example 2: Identify the separate performance obligations – Distinct
goods/services or Series of distinct goods/services
(1) Company X is contracted to build an office for a customer. It will design the building,
purchase materials, prepare the site, construct the property, install printer and air
conditioning and finish the property.
(2) Company X is contracted to provide office equipment as well as technical support for
the customer. The customer agrees to pay more money for the technical support.
Answer:
(1) Although each element of the construction process is capable of being distinct, the
company provides a significant service in integrating the input processes to produce a
property (performance obligation that is satisfied over time).
-> Series of distinct goods/services.
There is a single performance obligation, being the construction of the property.
(2) Company X can receive benefit from office equipment or technical support
The customer agrees to pay office equipment and technical support separately.
-> The good or service is separately identifiable -> Distinct goods/services.
There are 2 single performance obligation in this case.
276
II. REVENUE RECOGNITION – FIVE-STEP MODEL
3. Step 3: Determine the transaction price
When determining the transaction price of a contract, an entity should consider the effects
of following elements:
Significant financing component
Different between amount of promised consideration and the cash selling price.
Ex: Entity allows customer pay lower the amount of contract if they pay by cash.
•
Different between transfer of the goods or services & payment date.
Ex: Receive payment for a long time after transfer goods/services
-> The company will have difficulty in revolving capital for production.
•
Variable consideration
• An amount of consideration can vary because of discounts, rebates, refunds,
credits, price concessions, incentives, performance bonuses, penalties or other
similar items.
277
II. REVENUE RECOGNITION – FIVE-STEP MODEL
3. Step 3: Determine the transaction price
When determining the transaction price of a contract, an entity should consider the effects
of following elements:
Non-cash consideration
The value of the non-cash consideration may vary because of the form of the
consideration.
Ex: A change in the price of a share to which an entity is entitled to receive from a
customer.
•
Consideration payable to customer
• Consideration payable as an exchange of goods/services.
-> Accounted like other purchase transaction.
• Consideration payable NOT as an exchange of goods/services.
-> Reduction of transaction price.
278
II. REVENUE RECOGNITION – FIVE-STEP MODEL
4. Step 4: Allocate the transaction price
to the performance obligations
Example 3: Allocate the transaction price to the performance obligations
Wayne plc sells a modern PPE and one year’s free technical support for $2,000,000.
The PPE is usually sale at $1,800,000 and technical support is not sale for this PPE as a
stand-alone product. This support services offered by Wayne attract a margin of 50%.
It is expected that the technical support will cost $200,000. How should the
transaction price be allocated between the machine and the technical support?
Answer:
Step 4.1: Identify stand-alone price of each performance
The selling price of the PPE = $1,800,000.
The selling price for the technical support is NOT mentioned  The stand-alone
selling price needs to be estimated. Using the expected costs plus a margin  The
100%
selling price of the service = $200,000 ×
50% = $400,000
Step 4.2: Calculate total standalone selling prices
The total standalone selling prices of the PPE and support = $2,200,000 ($1,800,000 +
$400,000).
Stand alone price ($)
%Total
Revenue ($)
PPE
1,800,000
82%
1,640,000
Service
400,000
18%
360,000
Total
2,200,000
100%
2,000,000
279
II. REVENUE RECOGNITION – FIVE-STEP MODEL
5. Step 5: Recognize revenue
when (or as) a performance obligation is satisfied
The entity satisfies a performance obligation by transferring control of a promised good or
service to the customer.
A performance obligation can be satisfied at a point in time, such as when goods are
delivered to the customer or over time.
The graph below shows how to a performance obligation can satisfied at a point in time or
over time.
Customer simultaneously receives and
consumes the benefits provided by entity’s
performance
Entity’s performance creates or enhances
an asset that the customer controls as the
asset is created or enhanced
If satisfied
ANY ONE of above criteria
Recognize
revenue
over time
Entity’s performance does NOT create an
asset with an alternative use to the entity
and the entity has an enforceable right to
payment (for performance completed to
date)
If revenue is not recognized overtime, then it must be recognized at a point in time
(IFRS 15)
280
II. REVENUE RECOGNITION – FIVE-STEP MODEL
5. Step 5: Recognize revenue
when (or as) a performance obligation is satisfied
Example 4: Apply 5-step model
Lingard Co sells a cable TV system to Reus under the following terms on 1 January 20X8.
Reus has to pay a monthly fee of $160 for 12 months. Reus receives a cable TV set top
box and access to all the TV channels.
The contract does not contain any other conditions and, once signed, the receipt of the
consideration is unconditional.
Lingard Co sells the set top box by itself for $500 and charges monthly access to the TV
service without the set top box for $130 a month.
What amount of revenue should Lingard Co recognize in the year ended 31 March
20X8?
Guidance:
Step 1: Identify the contract
This is an agreement between Lingard and Reus for the provision of 12 months period.
Step 2: Identify the separate performance obligations within a contract
There are two performance obligations within the contract:
•
Deliver a set top box
•
Deliver cable TV access for 12 months
Step 3: Determine the transaction price
The total transaction price is $1,920 ($160 × 12 months).
281
II. REVENUE RECOGNITION – FIVE-STEP MODEL
5. Step 5: Recognize revenue
when (or as) a performance obligation is satisfied
Example 4: Apply 5 steps model
Step 4: Allocate the transaction price to the performance obligations in the contract
Stand alone price
%Total
Revenue
Box
$500
24.27%
$465.98 (= $1,920 × 24.27%)
Cable TX
access
$1,560 ($130 × 12)
75.73%
$1,454.02 (= $1,920 × 75.73%)
Total
$2,060
$1,920
Step 5: Recognize revenue when (or as) a performance obligation is satisfied
•
Box has been passed to the Reus so the full goods revenue of
$465.98 should be recognized on 31 March 20X8.
•
Access is provided over time (12 months), so revenue from this
should be recognized over time. In the year ended 31 March 20X8, revenue of $363.51
(3/12 x $1,454.02) should be recognized.
Debit Cash
Debit Trade receivable
Credit Revenue
$480 ($160 x 3)
$349.49
$829.49 ($465.98 + $363.51)
282
III. DISCLOSURE
Key disclosure requirements
The disclosure objective stated in IFRS 15 is for an entity to disclose sufficient information
to enable users of financial statements to understand the nature, amount, timing and
uncertainty of revenue and cash flows arising from contracts with customers.
(b
283
CHAPTER 14: FROM TRIAL
BALANCE TO FINANCIAL
STATEMENTS
284
OVERVIEW
What will you learn?
The General ledger
Open, update and balance off the ledger accounts
I. The trial balance
The financial statement
II. Statement of
comprehensive income
III. Statement of
financial position
Accounting equation
& business equation
285
I. THE TRIAL BALANCE
1. Overview about the trial balance
A trial balance is a list of ledger balances shown in debit and credit columns (known as
list of account balance).
The form of trial balance can be shown as follows:
Account name
Debit
Credit
$
Cash at bank
$
6,500
Capital
5,100
Bank loan
1,000
Purchases
5,000
Rent
3,500
Shop fitting
2,000
Sales
12,500
Bank loan interest
100
Other expenses
1,500
18,600
18,600
286
I. THE TRIAL BALANCE
1. Overview about the trial balance
A trial balance can be used to test the accuracy of the double entry accounting records. It
works by listing the balances on ledger accounts, some of which are debits and some
credits. Total debits should equal total credits.
There are some errors, which are not disclosed by preparing a trial balance:
Error of commission
A transaction has been recorded in the wrong
account.
e.g. putting a debit/credit entry in the wrong
account; errors of casting (adding up)
2
Error of principle
A transaction has conceptually been recorded
incorrectly.
e.g. a NCA purchase of $1,000 has been debited to
the repair expense account rather than an asset
account
3
Error of omission
A transaction has been completely omitted from the
accounting records.
e.g. a cash sale of $100 was not recorded
4
Compensating error
Two different errors have been made which cancel
each other out. in the administration expenses
account, $1,450 might be written instead of $1,540,
while in the sundry income account, $450 might be
written instead of $540
5
Error of original entry
An incorrect figure is entered in the records and
then posted to the correct account.
e.g. a cash sale of $76 has been recorded as $67
1
287
I. THE TRIAL BALANCE
2. Example
Example 1: The trial balance
As at 30.3.20X7, your business has the following balances in its ledger accounts.
Accounts
Bank loan
Cash at bank
Capital
Local business taxes expense
Trade accounts payable
Purchases
Sales
Sundry payables
Trade accounts receivable
Bank loan interest
Other expenses
Vehicles
Balance
$
12,000
11,700
13,000
1,880
11,200
12,400
14,600
1,620
12,000
1,400
11,020
2,020
During 31.3.20X7, the business made the following transactions:
a) Bought materials for $1,000, half for cash and haft on credit
b) Made $1,040 sales, $800 of which was for credit
c)Paid wages to shop assistants of $260 in cash
You are required to draw up a trial balance showing the balances as at the end of
31.3.20X7.
288
I. THE TRIAL BALANCE
2. Example
Example 1: The trial balance
Answer:
Account
Bank loan
(liability)
Cash at bank
(asset)
Capital
(equity)
Local taxes
(expense)
Trade accounts payable
(liability)
Purchases
(expense)
Sales
(revenue)
Sundry payables
(liability)
Trade accounts receivable
(asset)
Bank loan interest
(expense)
Other expenses
(expense)
Vehicles
(asset)
30/03/20X7
DR
During 31/03/20X7
CR
DR
CR
31/03/20X7
DR
$12,000
$11,700
$240 (W2)
$500 (W1)
$260 (W3)
$11,180
$13,000
$13,000
$1,880
$1,880
$11,200
$500 (W1)
$1,000
(W1)
$12,400
$11,700
$13,400
$1,040
(W2)
$14,600
$15,640
$1,620
$12,000
$1,620
$800 (W2)
$1,400
$11,020
$2,020
CR
$12,000
$12,800
$1,400
$260 (W3)
$11,280
$2,020
289
I. THE TRIAL BALANCE
2. Example
Example 1: The trial balance
The trial balance at 31/03/20X7 is as follows:
Account
Bank loan
Cash at bank
Debit
Credit
$
$
12,000
11,180
Capital
Local taxes
13,000
1,880
Trade accounts payable
Purchases
11,700
13,400
Sales
Sundry payables
Trade accounts receivable
Bank loan interest
Other expenses
Vehicles
15,640
1,620
12,800
1,400
11,280
2,020
53,960
53,960
290
I. THE TRIAL BALANCE
2. Example
Example 1: The trial balance
Workings:
Working 1: Adjustment for section (a)
(a) Debit
Credit
Credit
Purchases
Cash at bank
Trade accounts payable
Working 2: Adjustment for section (b)
(b) Debit
Cash at bank
Debit
Trade accounts receivable
Credit
Sales
Working 3: Adjustment for section (c)
c) Debit
Other expenses
Credit
Cash at bank
$
1,000
500
500
240
800
1,040
260
260
291
II. STATEMENT OF COMPREHENSIVE INCOME
1. Overview of statement of comprehensive income
A profit or loss ledger account is opened up to gather all items relating to income and
expenses. When rearranged, these items make up the statement of comprehensive
income (SOCI).
The basic form of SOCI is as follows:
$
Sales revenue
120,000
Less: Cost of sales (Cost of goods sold)
(72,500)
Gross profit
47,500
Distribution costs
(10,700)
Administrative and selling expense
(15,560)
Operating profit
21,240
Finance costs
(600)
Profit before tax
20,640
Income tax
(600)
Profit for the year
20,040
Other comprehensive income
Revaluation surplus
2,000
Total comprehensive income for the year
22,040
292
II. STATEMENT OF COMPREHENSIVE INCOME
2. Preparing statement of comprehensive income
We shall follow 3 steps below to prepare the statement of comprehensive income from the
trial balance:
Open up profit or loss account for statement of comprehensive income.
PROFIT OR LOSS ACCOUNT
Step 1
Identify which ledger accounts relate to income and expense, and
transfer their balance to the profit or loss account. (*)
PROFIT OR LOSS ACCOUNT
Step 2
EXPENSE ACCOUNTS
Total incurred
at Debit side
Step 3
Dr Profit or loss
Cr Expense
PROFIT ACCOUNTS
Dr Profit
Cr Profit or loss
Total incurred
at Credit side
Draw up the Statement of comprehensive income
293
II. STATEMENT OF COMPREHENSIVE INCOME
2. Preparing statement of comprehensive income
Example 2: Preparing statement of comprehensive income
During the year end at 20X7, Ron knuckle Co has the trial balance below:
RON KNUCKLE’S TRIAL BALANCE
Account
Cash at bank
Debit
Credit
$
$
6,500
Capital
7,000
Bank loan
Purchases
Trade account payable
1,000
5,000
-
Rent
3,500
Equipment
2,000
Sales
Trade account receivable
12,500
-
Bank loan interest
100
Other expenses
1,900
Drawings
-
-
1,500
20,500
20,500
294
II. STATEMENT OF COMPREHENSIVE INCOME
2. Preparing statement of comprehensive income
Example 2: Preparing statement of comprehensive income
The statement of comprehensive income will be prepared by following 3 steps:
Step 1: Open up profit or loss account.
PROFIT OR LOSS ACCOUNT
Step 2: Identify which ledger accounts relate to income and expense, and transfer them
to the profit or loss account.
Profit accounts: Sales
Expense accounts: Purchases, rent, bank loan interest, other expenses
Transfer the balancing figures of these accounts to Profit or loss account:
Purchases
Rent
Bank loan interest
Other expenses
Profit for the year (c/d)
PROFIT OR LOSS ACCOUNT
$
5,000 Sales
3,500
100
1,900
2,000
12,500
Profit or loss account shows the profit for the year of $2,000
-> RON KNUCKLE is profitable in 20X7.
$
12,500
12,500
295
II. STATEMENT OF COMPREHENSIVE INCOME
2. Preparing statement of comprehensive income
Example 2: Preparing statement of comprehensive income
Step 3: Draw up statement of comprehensive income.
RON KNUCKLE’S STATEMENT OF COMPREHENSIVE INCOME
$
$
Revenue (= Sales)
12,500
Cost of sales (= Purchase)
(5,000)
Gross profit
7,500
Expenses
Rent
3,500
Bank loan interest
100
Other expenses
1,900
(5,500)
Profit for the year
2,000
296
II. STATEMENT OF COMPREHENSIVE INCOME
2. Preparing statement of comprehensive income
Example 3: Preparing statement of comprehensive income
The following totals appear in the day books for December 20X9
$
120,000
60,000
6,000
12,000
Sales day book
Purchases day book
Returns inward day book
Returns outward day book
Opening and closing inventories are both $9,000.
What is the gross profit for December 20X9?
A. $66,000
B. $54,000
C. $78,000
D.$44,000
Guidance:
Step 1: Open up profit or loss account
PROFIT OR LOSS ACCOUNT
Step 2: Identify which ledger accounts relate to income and expense, and transfer them
the profit or loss account.
We can calculate gross profit in this step.
297
II. STATEMENT OF COMPREHENSIVE INCOME
2. Preparing statement of comprehensive income
Example 3: Preparing statement of comprehensive income
Answer: A
Note: COGS = Opening Inventory + Purchases – Closing inventory
Opening inventory = Closing inventory = $9,000 -> COGS = Purchases
Step 1: Open up Profit of loss account
PROFIT OR LOSS ACCOUNT
Step 2: Identify which ledger accounts relate to income and expense, and transfer them
the profit or loss account.
•
Sales account:
SALES
$
Returns inward
Balancing figure
$
6,000 Receivables
114,000
120,000
298
II. STATEMENT OF COMPREHENSIVE INCOME
2. Preparing statement of comprehensive income
Example 3: Preparing statement of comprehensive income
•
Expense account:
PURCHASES
Payables
•
$
$
60,000 Returns outward
12,000
Balancing figure
48,000
Transfer the balancing figures of these accounts to Profit or loss account:
PROFIT OR LOSS ACCOUNT
$
Purchases
48,000 Sales
Gross profit c/d
66,000
-> The correct answer is $66,000.
$
114,000
299
III. STATEMENT OF FINANCIAL POSITION
1. Accounting equation & Business equation
1.1
Common concepts
There are some common concepts that should be memorized:
Stocks / Inventories
Account receivables (AR)
Account payables (AP)
Unsold goods.
Amounts owed to the
business
by
its
customers.
Amount owed by the
business to its suppliers.
Retained earnings (RE)
Drawings
Return inwards
Profit generated from
operation by a business
but not yet distributed
to its owners.
Amounts of money or
assets taken out of a
business by its owners.
Goods returned to the
business.
Return outwards
Gross profit
Net profit
Goods returned by the
business.
Gross profit = Sales – COGS
Net profit = Gross profit –
Expenses
300
III. STATEMENT OF FINANCIAL POSITION
1. Accounting equation & Business equation
1.2
The accounting equation
The accounting equation states that a company's total assets are equal to the sum of its
liabilities and its shareholders' equity. The accounting equation and its expanded one are
shown below:
Assets
Liabilities
Assets
Liabilities
Equity
Introduced
capital
Earning
profit
Drawings
301
III. STATEMENT OF FINANCIAL POSITION
1. Accounting equation & Business equation
1.2
The accounting equation
Example 4: The accounting equation
Liza Doolittle purchases a market stall from Len Turnip, who is retiring from his fruit and
vegetable business. The cost of the stall is $1,800.
She also purchases some flowers and potted plants from a trader in the wholesale
market, at a cost of $650. This leaves $50 in cash, after paying for the stall and goods for
resale, out of the original of $2,500.
The assets and liabilities of the business have now altered and, on 3 July before trading
begins, the state of business is as follows:
Asset
=
Equity
+
Liabilities
$
Stall
1800
Flower and plants
650
Cash
$
$
50
2500
=
2500
+
0
302
III. STATEMENT OF FINANCIAL POSITION
1. Accounting equation & Business equation
1.2
The accounting equation
Example 5: (Continue with example 4)
On 3 July Liza has a very successful day. She sells all of her flowers and plants for $900
cash. Since Liza has sold goods costing $650 to earn revenue of $900, we can say that
she has earned a profit of $250 on the day's trading.
The state of business is as follows:
Asset
=
$
Stall
Introduced
+
capital
$
Earned
profits
-
$
Drawings
+
$
Liabilities
$
1800
Flower and plants
0
Cash
950
2750
=
2500
+
250
-
0
+
0
303
III. STATEMENT OF FINANCIAL POSITION
1. Accounting equation & Business equation
1.3
The business equation
The total amount of net assets is exactly the same as the stockholders' equity of a business.
It is calculated using the fomulas:
Net assets
Assets
Liabilities
Change in net assets
Introduced
capital
Earning
profit
Drawings
Example 6: The business equation
The net assets of Altese, a sole trader, on 1 January 20X2 amounted to $128,000. During
the year to 31 December, 20X2 Altese introduced a further $50,000 of capital and made
drawings of $48,000. On 31 December 20X2 Altese’s net assets totaled $184,000.
What is Altese’s total profit or loss for the year ended 31 December 20X2?
Answer:
Increase in net assets
184,000 – 128,000
= Introduced capital + Profit – Drawings
= 50,000 + profit – 48,000
-> Profit = 56,000 – 50,000 + 48,000 = $54,000.
304
III. STATEMENT OF FINANCIAL POSITION
2. Preparing statement of financial position
Besides, statement of financial position shall be prepared from trial balance by following 3
steps below:
Step 1
Identify which ledger accounts relate to Assets, Capital and
Liabilities from the trial balance
Step 2
Adjust ledger accounts which need to be modified.
Step 3
Draw up the Statement of financial position.
305
III. STATEMENT OF FINANCIAL POSITION
2. Preparing statement of financial position
Example 7: Prepare statement of financial position
We are going to drawing up SOFP of Ron Knuckle based on its trial balance at 31
December 20X2:
Account name
Cash at bank
Debit
Credit
$
$
13,000
Capital
14,000
Bank loan
Purchases
Trade account payable
2,000
10,000
-
Rent
7,000
Equipment
4,000
Sales
Trade account receivable
25,000
-
Bank loan interest
200
Other expenses
3,800
Drawings
-
-
3,000
41,000
41,000
306
III. STATEMENT OF FINANCIAL POSITION
2. Preparing statement of financial position
Example 7: Prepare statement of financial position
Step 1: Identify which ledger accounts relate to Assets, Capital and Liabilities.
• Assets:
o Non-current asset: Equipment
o Current asset: Cash at bank
• Capital: Capital, Profit or loss account
• Liabilities: Bank loan
Step 2: Adjust ledger accounts which need to be modified.
PROFIT OR LOSS ACCOUNT
$
$
Purchases
10,000 Sales
25,000
Gross profit c/d
15,000
Rent
25,000
25,000
7,000 Gross profit b/d
15,000
Bank loan interest
200
Other expense
3,800
Capital account
4,000
15,000
15,000
307
III. STATEMENT OF FINANCIAL POSITION
2. Preparing statement of financial position
Example 7: Prepare statement of financial position
CAPITAL
$
Drawings
Balance c/d
Balance b/d
3,000 P/L account
15,000
18,000
$
14,000
4,000
18,000
Step 3: Draw up statement of financial position
RON KNUCKLE’S STATEMENT OF FINANCIAL POSITION AS AT 31 DECEMBER 20X2
$
Assets
Non-current assets
Equipment
4,000
Current assets
Cash at bank
13,000
Total assets
17,000
Capital and liabilities
Capital
15,000
Non-current liabilities
Bank loan
2,000
Total capital and liabilities
17,000
308
III. STATEMENT OF FINANCIAL POSITION
2. Preparing statement of financial position
Example 8: Prepare statement of financial position
Drink Co has the following opening balances on its ledger accounts
$
Fixtures
20,000
Trade accounts receivable
8,000
Bank account
2,000
Loan
6,000
What is the opening figure for capital?
A.
$30,000
B.
$22,000
C.
$24,000
D.
$56,000
Answer: C
Assets
Assets
Liabilities
= Capital + Liabilities
= Fixtures + Trade accounts receivable + Bank account
= 20,000 + 8,000 + 2,000 = 30,000
= Loan = 6,000 -> Capital = 30,000 – 6,000 = 24,000
309
CHAPTER 15: CONTROL
ACCOUNT
310
OVERVIEW
What will you learn?
Control account
I. Introduction
II. Operating
III. Reconciliation
Definition
Receivables
control account
Individual
balances
Purposes
Payables
control account
Supplier
statement
Relationship
between
personal
&
control
accounts
Discounts,
contra entries,
and returns
311
I. INTRODUCTION
1. Definition
•
•
A control account is an account in the nominal ledger in which a record is kept of
the total value of a number of similar but individual items.
It is an impersonal account which is part of the double entry system.
Control accounts can be kept for many items (inventories, wages and salaries, cash…).
However, they are used mainly in accounting for receivables and payables.
Receivables control account
Payables control account
• Record all receivables in total.
• Record all payables in total.
• The balance on the receivables
• The
control account at any time will
be the total amount of
receivables due to the business
at that time.
balance on payables
control account at any time will
be the total amount of
payables owed by the business
at that time.
312
I. INTRODUCTION
2. Purpose of control accounts
Control accounts have various purposes including:
Assist in the location of errors
Compare the control account to
the individual balances in the
receivables/payables ledger
every week or day.
Check on the accuracy of entries
made in the personal accounts
Compare total balance on the
control account with total of
individual balances on the personal
accounts.
Quickly provide total receivables
and payables balances for
producing a trial balance SOFP
A single balance on a control
xxxxaccount is obviously extracted
xxxxx more simply and quickly than
txxxxx many individual balances in
xxxx
the receivables or payables
xxxx ledger.
Internal check where there is
a separation of bookkeeping
duties
The person posting entries to
the control accounts will check on a
different person(s) who post
entries to the receivables and
payables ledger accounts.
313
I. INTRODUCTION
3. Relationship between personal accounts and control accounts
3.1
•
•
3.2
Personal accounts
The personal accounts of individual customers/suppliers are kept in the ledger
account.
They are not part of the double entry system.
Relationship between personal accounts and control accounts
At any times, the balance on the control account should be equal to the sum of the
individual balances on the personal accounts in the ledger account.
Control accounts in
general ledger
Account balances
are available on
2 places
Reconcile
Personal accounts in
specific ledgers
314
I. INTRODUCTION
3. Relationship between personal account and control account
3.2
Relationship between personal account and control account
The relation between accounts shown in the flow chart below when sales transactions
occur:
Record personal accounts
in receivables ledger
Book of prime entry
Date
A
Sales day book
Net
Sales
total
tax
x
x
B
x
x
x
C
x
x
x
Invoice
A
Gross
total
B
Invoice $
x
C
Invoice $Payment
x
Invoice Payment
x
X
Payment
$
x
(x)
(x)
(x)
General ledger account
Receivables control account
DR
X
Receivables ledger
DR
CR
A
x
x
B
x
x
C
x
x
CR
Reconcile
X
315
I. INTRODUCTION
3. Relationship between personal account and control account
3.2
Relationship between personal account and control account
And likewise relation between accounts shown in the flow chart below when purchases
transactions occur:
Record personal accounts
in payables ledger
Book of prime entry
Date
A
Purchases day book
Net
Sales
total
tax
x
x
B
x
x
x
C
x
x
x
A
Gross
total
Invoice
B
Invoice $
x
C
Invoice $Payment
x
Invoice Payment
x
X
Payment
$
x
(x)
(x)
(x)
General ledger account
Payables control account
DR
Payables ledger
DR
CR
A
x
x
B
x
x
C
x
CR
X
Reconcile
x
X
316
I. INTRODUCTION
3. Relationship between personal account and control account
3.2
Relationship between personal account and control account
Example: Sales transactions
317
I. INTRODUCTION
3. Relationship between personal account and control account
3.2
Relationship between personal account and control account
Example: Purchases transactions
Account payable ledger/Personal
accounts
•
Supplier A:
Dr Payables
$175
Cr Payables
$400
→ Credit balance: $400 - $175 = $225
•
Supplier B:
Dr Payables
$70
Cr Payables
$200
→ Credit balance: $200 - $70 = $130
Total credit balance = $225 + $130 = $355
318
II. OPERATION OF CONTROL ACCOUNT
1. Receivables control account
Here are the format of receivables ledger control account and related sales transactions
shown in the corresponding ledger:
Receivables ledger control account
Balance b/f
X
Balance b/f
X
Credit sales (Sales Day Book)
X
Sales returns (Sales Returns Day Book)
X
Bank (Cash Book) dishonoured cheques
X
Bank (Cash Book)
X
Bank (Cash Book) refunds of credit
balances
X
Irrecoverable debts (Journal)
X
Interest charged
X
Contra with PLCA
X
Balance c/f
X
Balance c/f
X
X
Balance b/f
X
X
Balance b/f
X
319
II. OPERATION OF CONTROL ACCOUNT
2. Payables control account
Here are the format of payables ledger control account and related purchases transactions
shown in the corresponding ledger:
Payables ledger control account
Balance b/f
X
Balance b/f
X
Purchase returns (Purchases Return Day
Book)
X
Credit purchase (Purchase Day Book)
X
Bank (Cash Book)
X
Bank (Cash Book) refunds of debit
balances
X
Discounts received
X
Contra with RCLA
X
Balance c/f
X
Balance c/f
X
X
Balance b/f
X
X
Balance b/f
X
320
II. OPERATION OF CONTROL ACCOUNT
3. Discounts, contra entries, and returns
3.1
Discounts
Clearly, the discount must be recorded in:
1
The individual account in the Payables/Receivables Ledger
2
The Payables/Receivables Ledger Control Account in the General Ledger
Note: The treatment for discount was explained in Chapter 7: Sales tax.
321
II. OPERATION OF CONTROL ACCOUNT
3. Discounts, contra entries, and returns
3.2
Contra entries
Contra entry is an entry which is recorded to reverse or offset an entry on the other
side of an account.
• Contra may arise where a customer is also a supplier. Instead of both owing each other
money, it may be agreed that the balances are contra.
• The double entry for this type of contra is:
Debit
Credit
Payables ledger control account
Receivables ledger control account
• The individual receivable and payable memorandum accounts must also be updated to
reflect this
322
II. OPERATION OF CONTROL ACCOUNT
3. Discounts, contra entries, and returns
3.2
Contra entries
Example 1: Contra entries
Khalin Co has a number of trucks to provide product delivery services to Chipi Co.
However, Khalin also purchases lubricants oils from Chipi Co for running the trucks.
Khalin Co always performs debt offsetting before making any payment to its supplier
and at every month end. As end December 20X9, the following transactions are still
outstanding on Khalin’s accounts.
Receivables ledger – Receivable from Chipi Co
$
$
1 Dec
Balance b/f
5 Dec
SDB – 1127
325 31 Dec
7 Dec
SDB – 2404
573
6 Dec
31 Dec
Journal
Payables ledger – Payable to Chipi Co
$
Bank
695 1 Dec
Balance b/f
Journal
898 15 Dec
PDB – 0611
29 Dec
PDB – 0709
Show contra entries that Khalin Co has done in Dec 20X9.
898
$
1,020
898
1,324
323
II. OPERATION OF CONTROL ACCOUNT
3. Discounts, contra entries, and returns
3.2
Contra entries
Example 1: Contra entries
Answer:
In the general ledger:
Debit
Payables control account
Credit
Receivables control account
In the payables ledger:
Debit
Payables to company Chipi Co
In the receivables ledger:
Credit
Receivables from company Chipi Co
$898
$898
$898
$898
324
II. OPERATION OF CONTROL ACCOUNT
3. Discounts, contra entries, and returns
3.3
•
Returns
Sometimes, the receivables ledger control account may show an opening credit
balance, i.e. we owe the customer money. These amounts are usually small and arise
when:
The customer has overpaid
Credit notes have been issued for fully-paid-for goods
Payment is received in advance of raising invoices
•
The payables ledger control account may show an opening debit balance for similar
reasons.
•
Technically such balances should not exist and should be transferred to the correct
account. Thus, a credit in a receivable account should be adjusted as follows:
Debit
Credit
Receivables
Payables
Note: Debit/Credit balances in the Payables/Receivables ledger will be adjusted using
exactly the same double entry.
325
II. OPERATION OF CONTROL ACCOUNT
3. Discounts, contra entries, and returns
3.3
Returns
Example 2: Return
Suppose we sell goods for $1,100 on credit to Mr X. A week later, Mr X returns half the
goods to us (and we accept the return).
Make treatment for the return.
Answer:
The double entry is as follows.
Debit
Sales return
Credit
Receivables control
$550 (1,100/2)
$550
326
III. CONTROL ACCOUNT RECONCILIATION
1. Preparing control account reconciliation
The format of receivables ledger control account when preparing reconciliation:
Receivables ledger control account
$
$
Uncorrected balance b/d
X Adjustments for errors
X
Adjustments for errors
X Revised balance c/f
X
X
X
Reconciliation of individual receivables balances with control account balance:
$
Uncorrected balance of individual ledger account
Adjustments for errors
Revised total agreeing with balance c/f on control account
X
X/(X)
X
327
III. CONTROL ACCOUNT RECONCILIATION
1. Preparing control account reconciliation
Example 3: Preparing control account reconciliation
SAP’s payables ledger control account is part of the double entry system. Individual
ledger account balances are listed and casted on a monthly basis, and reconciled to the
control account balance. Information for the month of May is as follows:
1) Individual ledger account balances at 31 May have been totaled $19,766.
2) The payables ledger control account balance at 31 May is $21,832.
3) On further examination the following errors are discovered:
• The total of discount received for the month, amounting to $1,715, has not been
entered in the control account but has been entered in the individual ledger accounts.
• On listing-out, an individual credit balance of $205 has been incorrectly treated as a
debit.
• A petty cash payment to a supplier amounting to $63 has been correctly treated in the
control account, but no entry has been made in the supplier’s individual ledger account.
• The purchases day book total for March has been undercast (understated) by $2,000.
• Contras (set-offs) with the receivables ledger, amounting in total to $2,004, have been
correctly treated in the individual ledger accounts but no entry has been made in the
control account.
(i) Prepare the part of the payables ledger control account reflecting the above
information.
(ii) Prepare a statement reconciling the original total of the individual balances with
the corrected balance on the control account.
328
III. CONTROL ACCOUNT RECONCILIATION
1. Preparing control account reconciliation
Example 3: Preparing control account reconciliation
Guidance:
(i) Prepare a corrected control account
Step 1: Determine the uncorrected balance of the control account
Step 2: Make adjustments to errors having affect on the control account
First we should identify the affects of errors on the control account
Then, we are making adjustments to these errors
Step 3: Prepare a corrected control account
Put uncorrected balance (step 1), adjustments (step 2) on the control account and
calculate the corrected balance.
(We are following the format mentioned in Section III.1)
(ii) Prepare a statement reconciling of individual receivables balances with control
account balance
Step 1: Determine the uncorrected individual balance
Step 2: Make adjustments to errors having affect on the individual balance
First we should identify the affects of errors on the individual balance
Then, we are making adjustments to these errors
Step 3: Prepare a statement reconciling
Put uncorrected balance (step 1), adjustments (step 2) on the statement reconciling and
calculate the corrected balance.
(We are following the format mentioned in Section III.1)
329
III. CONTROL ACCOUNT RECONCILIATION
1. Preparing control account reconciliation
Example 3: Preparing control account reconciliation
Answer:
(i) Prepare the part of the payables ledger control account reflecting the above
information.
Step 1: Determine the uncorrected balance of the payables control account
The uncorrected balance of the payables control account is $21,832.
Step 2: Make adjustments to errors having affect on the control account
Errors
Effect on payables control account
Adjustments
Discount
received of
$1,715 has not been
entered in the control
account
Discount received is debited to
the payables ledger control
account.
Debit side of payables control
account is understated $1,715
Debit to the
payables control
account $1,715
An
individual
credit
balance of $205 has been
incorrectly treated as a
debit.
Does not affect on payables
control account
No adjustment
needed
Cash payment to a
supplier of $63 has not
been entered in individual
ledger account
Does not affect on payables
control account
No adjustment
needed
330
III. CONTROL ACCOUNT RECONCILIATION
1. Preparing control account reconciliation
Example 3: Preparing control account reconciliation
Answer:
(i) Prepare the part of the payables ledger control account reflecting the above
information.
Step 2: Make adjustments to errors having affect on the control account
Errors
Effect on payables control account
Adjustments
Purchases day book total
$2,000
has
been
undercast
The total of the purchases day
book is posted by crediting
payables
Debit side of payables control
account is understated $2,000
Credit to the
payables control
account $2,000
Contras (set-offs) with the
receivables ledger of
$2,004 has not been
entered in the control
account
The contras is debited to the
payables control account
Debit side of payables control
account is understated $2,004
Debit to the
payables control
account $2,004
331
III. CONTROL ACCOUNT RECONCILIATION
1. Preparing control account reconciliation
Example 3: Preparing control account reconciliation
(i)
Prepare the part of the payables ledger control account reflecting the above
information.
Step 3: Prepare a corrected control account
Payables ledger control account
$
$
Uncorrected balance b/f
Discount received
1,715 Purchases
Contra
2,004
Corrected balance c/f
20,113
23,832
21,832
2,000
23,832
(ii) Prepare a statement reconciling the original total of the individual balances with
the corrected balance on the control account
Step 1: Determine the uncorrected individual balance
The uncorrected individual balance is $19,766.
332
III. CONTROL ACCOUNT RECONCILIATION
1. Preparing control account reconciliation
Example 3: Preparing control account reconciliation
(ii) Prepare a statement reconciling the original total of the individual balances with
the corrected balance on the control account
Step 2: Make adjustments to errors having an effect on the individual balance
Effect on individual balance
Adjustments
Discount received of $1,715
has not been entered in the
control account
Errors
Does not effect on individual balance
No adjustment
needed
An individual credit balance
of $205 has been incorrectly
treated as a debit.
Credit balance is understated of $205
The individual balance is understated $205
Debit balance is overstated of $205
The individual balance is understated $205
The individual is understated $205 x2 = $410
Increase the
individual
balance of
$410
Cash payment to a supplier
of $63 has not been entered
in individual ledger account
Debit balance is understated of $63
The individual balance is overstated $63
Reduce the
individual
balance of $63
Purchases day book total
$2,000 has been undercast
Does not affect the individual balance
No adjustment
needed
Contras (set-offs) with the
receivables ledger of $2,004
has not been entered in the
control account
Does not affect the individual balance
No adjustment
needed
333
III. CONTROL ACCOUNT RECONCILIATION
1. Preparing control account reconciliation
Example 3: Preparing control account reconciliation
(ii) Prepare a statement reconciling the original total of the individual balances with
the corrected balance on the control account
Step 3: Prepare a statement reconciling
Reconciliation of individual balances with control account balance
Cr
$
Balance as extracted
19,766
Credit balance incorrectly treated (2 x $205)
410
Petty cash payment
(63)
Net total agreeing with control account
20,113
334
III. CONTROL ACCOUNT RECONCILIATION
2. Supplier statement reconciliations
2.1
Definition
• A supplier will usually send a monthly statement showing invoices issued, credit
notes, payments received and discounts given.
• These statements are compared to the supplier's personal account in the payables
ledger.
• Any discrepancies need to be identified and any errors corrected.
335
III. CONTROL ACCOUNT RECONCILIATION
2. Supplier statement reconciliations
2.2
Reconciliation
Purposes of supplier statement reconciliation:
Before any payments are made to suppliers it is important to ensure that the
suppliers statement is correct – or else over or under payments could be made.
Each invoice and credit note listed on the statement should be checked to the
original documentation for accuracy.
When accuracy has been established, it is then possible to decide which invoices
need paying and when by.
Process to prepare supplier statement reconciliation:
Identify differences
04
03
Allocate payments to
invoices after allowing
for any credit notes.
Tick off the item which
appear
in
both
the
statement and the payables
ledger.
STEP
02
01
Agree the opening balance on
the supplier's statement
invoice and credit note listed
on the statement.
336
CHAPTER 16:
BANK RECONCILIATIONS
337
OVERVIEW
What will you learn?
If there are any
differences
Cash book
adjustments
Should be agreed
Reconciliations
If there still are
differences
Cash book balance
(Internal records)
Re-Reconciliations
Reconciliation
report
Bank statement
balance
(External records)
If there are any
differences
Bank statement
adjustments
338
I. THE BANK RECONCILIATION
1. Bank statement and cash book
Cash book: the record of all
transactions with the bank
Should be the
same, on the
same date
Difference
prepared by the business
Bank
statement:
the
record of all the bank’s
transactions
with
the
business
prepared by the bank
Bank reconciliation
(frequently manner)
- Make changes to the
accounting records
- Resolve any discrepancies
- Identify fraudulent
transactions
A bank reconciliation is a comparison of a bank statement (sent monthly, weekly or
even daily by the bank) with the cash book.
Any difference between the balance on the bank statement and in the cash book
should be identified and satisfactorily explained.
339
I. THE BANK RECONCILIATION
2. Bank reconciliation
Example 1: Bank reconciliation
A Co sold goods valued $8,000, which was paid into the bank.
The transaction should be recorded as below:
BUSINESS VIEW
A’s Cash sales
$8,000
A’s Cash book
BANK VIEW
A’s bank account
(Extracted from bank statement)
$8,000
$8,000
RECONCILE
Payable
substance
to
business
Notes:
In bank statements, debits and credits are reversed because the bank will be
recording the transaction from its point of view, in accordance with the business
entity concept.
For example, if a customer has money in their bank account, the bank owes them that
money  the amount is a payable of the bank.
 According to the business view, if the bank credits the business’s bank account, it
means the transaction will increase the account balance and vice versa.
340
II. DIFFERENCES BETWEEN THE BANK STATEMENT
AND THE CASH BOOK
3. Causes of differences and explanation
Cash book adjustments
Differences between the cash book and the bank statement arise for three reasons:
errors, omissions, timing differences.
Bank
interest/charges
Charges not yet entered the
cash book
Unrecorded/
omitted items
Dishonoured
cheques
Cheques received & paid into
the bank, but the drawee
refused to pay
 Recorded in
bank statement
but not recorded
in cash book
Standing orders/
direct debit
Business’s instruction for the
bank to withdraw from an
account
Credit transfers
Money
received
from
customers paying by credit or
debit cards
Business errors
 Mistakes
made by the
business in the
cash book
Errors in calculation,
recording income &
payments
341
II. DIFFERENCES BETWEEN THE BANK STATEMENT
AND THE CASH BOOK
3. Causes of differences and explanation
Bank statement adjustments
Timing
differences
 Recorded in
cash book but
not recorded in
bank statement
Outstanding/
unpresented
cheques
Cheques sent to suppliers by
not yet cleared by the bank
Outstanding/
uncleared
lodgements
Cheques received by the
business but not yet cleared
by the bank
Bank errors
 Mistakes
made by the
bank in the bank
statement
Errors in
recording
transaction
342
II. DIFFERENCES BETWEEN THE BANK STATEMENT
AND THE CASH BOOK
4. Proforma of bank reconciliation
Adjustments to the cash book and bank statement balance should be computed as
below:
ADJUSTED CASH BOOK
$
Cash book balance b/f
X
Add:
Bank interest
Direct credits
…
Less:
Bank charges
Direct debits/standing
orders
X
X
(X)
ADJUSTED BANK
STATEMENT
Balance per bank
statement
Add:
Outstanding lodgements
…
Less:
Outstanding cheques
…
$
X
X
(X)
(X)
Dishonoured cheques
(X)
…
Adjusted bank statement
balance
RECONCILE
X
After adjusting the balances as per the cash book and as per the bank statement, the
Adjusted cash book
adjusted amounts should be the same.X
balance
Repeat the process of
reconciliation again
No
Are
they
equal?
Yes
Prepare journal entries
for the adjustments to
the balance per books
343
II. DIFFERENCES BETWEEN THE BANK STATEMENT
AND THE CASH BOOK
4. Proforma of bank reconciliation
Example 2: Bank statement and cash book
In preparing an entity’s bank reconciliation statement, the accountant finds that the
following items are causing a difference between the cash book balance and bank
statement balance:
1. Direct debit $320.
2. Lodgements not credited $3,740.
3. Outstanding cheques $866.
4. Cheque paid in by the entity and dishonoured $556.
5. Error by bank $8,240 (cheque incorrectly credited to the account).
6. Bank charges $1,000.
Which of these items will require an entry in the cash book?
A.
2, 4 and 6
B.
1, 4 and 6
C.
2, 5 and 6
D.
1, 2 and 4
Answer: B
• Items 1, 4, 6 are the differences arise from the business mismatching with the bank,
which need adjustments in the cash book.
• Item 2, 3, 5 are the differences arise from the bank clearing process, which need
adjustments in the bank statement.
344
II. DIFFERENCES BETWEEN THE BANK STATEMENT
AND THE CASH BOOK
4. Proforma of bank reconciliation
Example 3: Bank statement and cash book
On which side of the cash book should the following unrecorded items be posted?
•
•
•
•
•
Bank charges
Direct debits/standing orders
Direct credits
Dishonoured cheques received from customers
Bank interest received.
Answer:
• Bank charges, direct debits/standing orders/dishonoured cheques will withdraw
money from the entity  credited to the cash book.
• Bank interest and direct credits will deposit money into the entity  debited to the
cash book.
345
III. WORKED EXAMPLES
1. Type 1: Simple bank reconciliation
Example 4: Question
At 31 December 20X0, the balance in the cash book of Pedro Co was $1,610 debit. A
bank statement on 31 December 20X0 showed Pedro Co to be in credit by $2,224.
On investigation of the difference between the two sums, it was established that:
1) The cash book had been undercast by $180 on the debit site
2) Cheques paid in not yet credited by the bank amounted to $416, called outstanding
lodgements
3) Cheques drawn not yet presented to the bank amounted to $850 called unpresented
cheques
Requirement:
Prepare a statement reconciling the balance per bank statement to the balance per cash
book.
346
III. WORKED EXAMPLES
1. Type 1: Simple bank reconciliation
Example 4: Answer
ADJUSTED CASH BOOK
(a)
$
Cash book balance b/f
1,610 Balance per bank statement
Add:
ADJUSTED
STATEMENT (b)
BANK
$
2,224
Add:
Correction of undercast
180 Outstanding lodgements
416
Less:
Outstanding cheques
Adjusted
balance
cash
book
1,790
Adjusted
balance
bank
(850)
statement
1,790
Notes:
Casting (in accountant’s term) means adding up.
Undercast means the total figure included on the debit side of the cash book was
$180 lower than it should have been.
347
III. WORKED EXAMPLES
2. Type 2: Reverse bank reconciliation
Example 5: Question
The cash book of Madrid Co shows a debit balance of $10,940. Cheques of $2,800 have
been written to suppliers but not yet cleared the bank; uncleared lodgements amount to
$3,880. The bank has accidentally credited Madrid Co’s account with interest of $600
due to another customer. A standing order of $2,600 has not been accounted for in the
general ledger.
Requirement:
What is the balance on the bank statement?
A.
$7,860 Cr
B.
$7,860 Dr
C.
$13,060 Cr
D.
$13,060 Dr
348
CHAPTER 17:
CORRECTION OF ERRORS
349
OVERVIEW
What will you learn?
1. Errors where the trial
balance still balanced
2. Errors where the trial
balance is not balanced
Use a suspense account
Correcting journal entries
Impact of correcting
journal on profit
I.
TYPES OF
ERROR
II.
CORRECTION
OF ERRORS
III.
ADJUSTMENT
TO PROFIT
350
I. TYPES OF ERROR
Review on the trial balance
Reference: Chapter 6: From trial balance to financial statement.
A trial balance (TB) is a list of ledger balances, shown in debit and credit columns
Example 1: The trial balance
TRIAL BALANCE AS AT 1.1.20X0
Dr
Cr
$
$
Revenue
X
Inventory
X
Purchases
X
Non-current assets
X
Trade receivables
X
Cash
X
Share capital
X
Share premium
X
Loans
X
Trade payables
X
Bank overdraft
X
X
should be
agreed
X
351
I. TYPES OF ERROR
Does balance of TB guarantee accuracy of Financial statements?
In the trial balance, theoretically the balances shown in the debit and credit column
should agree.
If not, any discrepancy must be investigated and corrected.
However, a balanced trial balance does not guarantee the accuracy of the financial
statements, as there are errors that make the trial balance still balanced.
Notes:
Is
the trial balance
balanced?
No
Yes
100% incorrect
not sure to be
correct
352
I. TYPES OF ERROR
Types of error
A. Errors where the trial balance still balanced
There are 2 types of error:
A. Errors where the trial balance still balanced
B. Errors where the trial balance is not balanced
1. Error of
omission
A transaction has been completely omitted from the
accounting records
2. Error of
commission
A transaction has been recorded in the wrong account, but
same type of account
3. Error of
principle
A transaction has conceptually been recorded incorrectly,
with different type of account
4. Compensating
error
Two different errors have been made which cancel each
other out
5. Error of
original entry
The correct double entry has been made but with the wrong
amount
6. Reversal of
entries
The correct amount has been posted to the correct accounts
but on the wrong side
353
I. TYPES OF ERROR
B. Errors where the trial balance is not balanced
2 Types of error
7.
Single sided
entry
A debit entry has been made but no corresponding credit
entry or vice versa
8.
Entries at
different values
Debit and credit entries have been made but at different
values
9.
Two
debits/credits
Two debit or two credit entries have been posted
10.
Incorrect
addition
An incorrect addition in any individual account
11.
Extraction
error
The balance in the trial balance is different/or placed in
wrong column from the balance in the relevant account
354
I. TYPES OF ERROR
1. Errors where the trial balance still balanced
Below are a few errors where trial balance still balanced:
IMPACTS ON TRIAL BALANCE
1. Error of
omission:
A cash sale of
$100 was not
recorded
Dr
Cr
+$0
Sales
+$0
Cash
Overall
impact
+$0
CORRECT TRIAL BALANCE
Dr
+$100
Cash
+$0
Cr
+$100
Sales
Overall
impact
+$100
+$100
Dr
Cr
Same impact on
trial balance
2. Error of
commission: A
cash sales which
cash on hand of
$500 has been
debited to the
cash at bank
account in error
Dr
Cr
Cash on hand
+$0
Cash on hand
+$500
Cash at bank
+$500
Cash at bank
+$0
Revenue
Overall
impact
+$500
+$500
+$500
Revenue
Overall
impact
Same impact on
trial balance
+$500
+$500
+$500
355
I. TYPES OF ERROR
1. Errors where the trial balance still balanced
IMPACTS ON TRIAL BALANCE
3. Error of
principle :
A non-current
asset purchase of
$900 has been
debited to the
repair expense
account rather
than an asset
account
Dr
CORRECT TRIAL BALANCE
Cr
Dr
Assets
+$0
Assets
+$900
Repair expense
+$900
Repair expense
+$0
Cash
+$900
Overall
impact
+$900
+$900
Cash
Cr
+$900
Overall
impact
Same impact on
trial balance
+$900
+$900
356
I. TYPES OF ERROR
2. Errors where the trial balance is not balanced
Below are a few errors where trial balance is not balanced:
IMPACTS ON TRIAL BALANCE
7. Single sided
entry:
Sales made for
$400 but no
entry has been
made to the cash
account
Dr
Cr
+$400
Sales
+$0
Cash
Overall
impact
+$0
CORRECT TRIAL BALANCE
Dr
+$400
Sales
+$400
Cash
+$400
Cr
Overall
impact
+$400
+$400
Imbalanced (less debited)
8. Entries at
different values:
Sales made for
$570 but debited
to cash account
for $750
Dr
+$570
Sales
+$750
Cash
Overall
impact
Cr
+$750
Dr
+$570
Sales
+$570
Cash
+$570
Overall
impact
Cr
+$570
Imbalanced (over debited)
+$570
357
I. TYPES OF ERROR
2. Errors where the trial balance is not balanced
IMPACTS ON TRIAL BALANCE
9. Two
debits/credits:
Salary of $500
paid has been
debited to
Salary Account
twice by
mistake
Dr
CORRECT TRIAL BALANCE
Cr
Dr
Salary account
+$500
Salary account
Salary account
+$500
Cash
+$500
+$500
+$500
Cash
Overall
impact
Cr
+$1,000
+$500
Overall
impact
+$500
Imbalanced (over debited)
+$500
358
II. CORRECTION OF ERRORS
Applied methods
There are two methods can be used to correct errors from trial balance:
1. With errors where the trial balance still balanced 🡪 Use journal entries
2. With errors where the trial balance is not balanced 🡪 Use a suspense account first,
and later clear the suspense account by a journal entry
1. Errors where the trial
balance still balanced
2. Errors where the trial
balance is not balanced
Use a suspense account
Correcting journal entries
359
II. CORRECTION OF ERRORS
1. Correcting journal entries
A correcting entry is a journal entry that is made to fix errors in transactions which had
previously been recorded in the general ledger.
The format of a journey entry is shown below:
Dr
Account to be debited
Account to be credited
Cr
X
X
When correcting errors from trial balance using journal entries, a good approach is to
answer below questions step by step:
Step 11
Step
What should the double entry have been?
(‘should do’)
Step 12
Step
What was the double entry?
(‘did do’)
Step 13
Step
Therefore, what correction is required?
(‘to correct’)
360
II. CORRECTION OF ERRORS
1. Correcting journal entries
Example 2: Correcting journal entries
A school principal accidentally posts a bill for $1,500 to the local taxes account instead
of to the electricity account.
Answer:
What should the double entry have been? (‘should
do’)
Step 11
Step
Dr Electricity
$1,500
Cr Cash
$1,500
What was the double entry? (‘did do’)
Step 12
Step
Dr Local taxes
$1,500
Cr Cash
$1,500
Therefore, what correction is required? (‘to correct’)
Step 13
Step
Dr Electricity
$1,500
Cr Local taxes
$1,500
361
II. CORRECTION OF ERRORS
1. Correcting journal entries
Example 3: Question
Requirement:
Write out the journal entries which would correct below errors
1. A business receives an invoice for $900 from a supplier which was omitted from the
books entirely.
2. Repairs worth $100 were incorrectly debited to the non-current asset (machinery)
account instead of the repairs account.
3. The bookkeeper of a business reduces cash sales by $8,500 because they were not
sure what the amount represented. In fact, it was a withdrawal on account of profit.
4. Telephone expenses of $2,240 were incorrectly debited to the electricity account.
5. A page in the sales day book has been added up to $56,850 instead of $27,650.
362
II. CORRECTION OF ERRORS
1. Correcting journal entries
Example 3: Answer
Step 1
What should the double
entry have been?
(‘should do’)
Dr Purchase
Step 2
What was the double
entry?
(‘did do’)
$900
1
Step 3
Therefore, what
correction is required?
(‘to correct’)
Dr Purchase
$900
Cr Payables
$900
No recognition
Cr Payables
$900
Dr Repairs
$100
Dr Machinery
$100
Dr Repairs
$100
Cr Cash
$100
Cr Cash
$100
Cr Machinery
$100
Dr Withdrawal
$8,500
Dr Sales
$8,500
Dr Withdrawal
$8,500
Cr Cash
$8,500
Cr Cash
$8,500
Cr Sales
$8,500
$2,240
$2,240
2
3
4
Dr Telephone
expenses
$2,240
Dr Electricity
$2,240
Dr Telephone
expenses
Cr Cash
$2,240
Cr Cash
$2,240
Dr Electricity
Dr Receivables
$27,650 Dr Receivables
$56,850 Dr Sales
Cr Sales
$27,650 Cr Sales
$56,850 Cr Receivables $29,200
$29,200
5
363
II. CORRECTION OF ERRORS
2. Suspense account
A suspense account is a temporary account, showing a balance equal to the difference
in a trial balance.
The suspense account should be cleared as the mysteries and errors must be corrected
at the year end
There are two main reasons to open a suspense account:
A trial balance does not balance 🡪 the
difference is put to a suspense account
The bookkeeper is not sure where to post
one side of an double entry 🡪 When the
mystery is solved, the suspense account is
closed, and the amount is correctly posted
Example
A cash payment might be made and must obviously be credited to cash. But the
bookkeeper may not know which account to debit.
Dr
Cr
Suspense
Cash
X
X
364
II. CORRECTION OF ERRORS
2. Suspense account
When correcting errors from trial balance using suspense account, a good approach is
to answer below questions step by step:
Step 1
Equalize the trial balance by making an entry for the
suspense account so that the debits and credits agree
(without the corresponding entries elsewhere)
Step 2
What should the double entry have been?
(‘should do’)
Step 3
Step 4
3.1 What was the double entry? (‘did do’)
3.2 Recognize the difference from that double entry for
later clearance on the suspense account
Therefore, what correction is required? (‘to correct’)
Clear the suspense account when the final correct entries
are determined
365
II. CORRECTION OF ERRORS
2. Suspense account
2.1
Using suspense account when the trial balance does not balance
Consider an example: The purchase of a non-current asset costing $190 has been
recorded by debiting $109 to the non-current assets account and crediting $190 to cash.
Step 1
Step 2
Step 3
Step 4
Equalize the trial balance:
• Total debits = $109
• Total credits = $190
🡪 Post a debit of $81 to the suspense account to equalize
trial balance:
Debit Suspense account
$81
What should the double entry be? (‘should do’)
Debit Non-current assets
Credit Cash
$190
$190
3.1 What was the double entry? (‘did do’)
Debit Non-current assets
Credit Cash
$109
$190
3.2 Recognize the difference (less debited):
$81
Therefore, what correction is required? (‘to correct’)
Debit Non-current assets
$81
Credit Suspense account
$81
366
II. CORRECTION OF ERRORS
2. Suspense account
2.1
Using suspense account when the trial balance does not balance
Example 4: Question
Using suspense account when the trial balance does not balance
A trial balance shows a total of debits of $695,600 and a total of credits of $724,700.
1. A credit sale of $7,340 was incorrectly entered in the sales day book as $7,520.
2. A non‐current asset with a carrying amount of $15,780 was disposed of for $18,000.
The only accounting entry was to debit cash.
3. The allowance for receivables was increased from $17,800 to $20,400. The allowance
account was debited in error.
After adjusting for the errors above, what is the balance on the suspense account?
A.
B.
C.
D.
$52,300 debit
$52,120 debit
$52,480 debit
$52,480 credit
367
II. CORRECTION OF ERRORS
2. Suspense account
2.1
Using suspense account when the trial balance does not balance
Example 4: Answer
A is correct.
Step 1
Equalize the trial balance by making an entry for the suspense account so
that the debits and credits agree
• Total debits = $695,600
• Total credits = $724,700
Post a debit of $29,100 to the suspense account to equalize trial balance
Dr
Suspense account
$29,100
368
II. CORRECTION OF ERRORS
2. Suspense account
2.1
Using suspense account when the trial balance does not balance
Example 4: Answer
Step 2
What should the double
entry have been?
(‘should do’)
Dr Receivables $7,340
Step 3
What was the double
entry? (‘did do’)
Dr Receivables $7,520
Dr Sales
$180
$180
1
Cr Sales
$7,340
Cr Sales
$7,520
Cr
Receivables
Dr Cash
$18,00
0
Dr Cash
$18,00
0
Dr Suspense
account (2)
$18,00
0
Cr Disposals
$18,00
0
Cr Suspense
account (β)
$18,00
0
Cr Disposals
$18,00
0
Dr
Irrecoverable
debt expense
$2,600
Dr Allowances
$2,600
for Receivables
Dr Suspense
account (3)
$5,200
Dr
Irrecoverable
debt expense
Cr Suspense
account (β)
Cr Allowances
$5,200
for
Receivables
2
3
Step 4
Therefore, what
correction is required?
(‘to correct’)
Cr Allowances
$2,600
for Receivables
$2,600
$5,200
369
II. CORRECTION OF ERRORS
2. Suspense account
2.1
Using suspense account when the trial balance does not balance
Example 4: Answer
The suspense account balance after adjusting the errors is:
SUSPENSE ACCOUNT
Imbalance on trial balance
(1)
$29,100
Disposals (2)
$18,000
Allowance for receivables
(3)
$5,200
$52,300
Balance b/f
$52,300
Balance c/f (β)
$52,300
$52,300
370
II. CORRECTION OF ERRORS
2. Suspense account
2.2
Using suspense account when not knowing where to post a transaction
Example 5:
Question:
P&M Co received a cheque in a post for $1,160. The name on the cheque is N. D.
England, but P&M have no idea who this person is, nor why they should be sending
$1,160. The bookkeeper decides to open a suspense account.
Answer:
Step 1
Equalize the trial balance:
• Total debits = $1,160 (Cash)
• Total credits = $0
(Yet known where to make an entry
on)
🡪 Post a credit of $1,160 to the suspense account to
equalize trial balance
Credit
Suspense account
$1,160
What should the double entry be? (‘should do’)
Step 2
Debit
Cash
$1,160
Credit
Receivables
$1,160
371
II. CORRECTION OF ERRORS
2. Suspense account
2.2
Using suspense account when not knowing where to post a transaction
Example 5:
3.1 What was the double entry? (‘did do’)
Step 3
Credit
Cash $1,160
3.2 Recognize the difference (less credited):
$1,160
Therefore, what correction is required? (‘to correct’)
Step 4
Debit
Suspense account
$1,160
Credit
Receivables
$1,160
372
III. ADJUSTMENT TO PROFIT
Effect on profit
After correcting errors from trial balance, it may result in a change in profit, depending
on whether the journal debits or credits the statement of profit or loss.
Correcting journal entries
Impact of correcting journal
on profit
373
III. ADJUSTMENT TO PROFIT
1. Impacts on profit using the journal entries
When measuring impacts on profit using journal entries, a good approach is to answer
below questions step by step:
Step 1
Step 2
Step 3
Step 4
What should the double entry be?
(‘should do’)
What was the double entry?
(‘did do’)
Therefore, what correction is required?
(‘to correct’)
Does the correction affect statement of profit or loss
(SOPL)? And how? (*)
374
III. ADJUSTMENT TO PROFIT
1. Impacts on profit using the journal entries
(*) Affection on SOPL: compare to prior profit
If any entry credits the SOPL
Profit increases
If any entry does nothing the SOPL
Profit remains unchanged
If any entry debits the SOPL
Profit decreases
375
III. ADJUSTMENT TO PROFIT
1. Impacts on profit using the journal entries
Consider an example: A school principal accidentally posts a bill for $1,500 to the local
taxes account instead of to the electricity account.
Step 1
Step 2
What should the double entry be?
Dr Electricity
$1,500
Cr Cash
$1,500
What was the double entry?
Dr Local taxes
$1,500
Cr Cash
$1,500
Step 3
Therefore, what correction is required?
Dr Electricity
$1,500
Cr Local taxes
$1,500
Step 4
Entry of Electricity debits the SOPL $1,500
Entry of Local taxes credits the SOPL$1,500
🡪 Profit remains unchanged compared to prior profit
376
III. ADJUSTMENT TO PROFIT
1. Impacts on profit using the journal entries
Consider another example: A page in the sales day book has been added up to $28,425
instead of $28,825.
Step 1
Step 2
Step 3
Step 4
What should the double entry be?
Dr Receivables
$28,825
Cr Sales
$28,825
What was the double entry?
Dr Receivables
$28,425
Cr Sales
$28,425
Therefore, what correction is required?
Dr Receivables
$400
Cr Sales
$400
Entry of Receivables does nothing to the SOPL
Entry of Sales credits the SOPL $400
🡪 Profit increases $400 compared to prior profit
377
III. ADJUSTMENT TO PROFIT
2. Impacts on profit using the suspense account
When correcting errors from trial balance using suspense account, a good approach is
to answer below questions step by step:
Step
01
Equalize the trial balance by making an entry for the suspense account
so that the debits and credits agree
(without the corresponding entries elsewhere)
Step
02
What should the double entry be?
(‘should do’)
Step
03
Step
04
Step
05
What was the double entry? (‘did do’)
Recognize the difference from that double entry for later clearance on
the suspense account
Therefore, what correction is required? (‘to correct’)
Clear the suspense account when the final correct entries are
determined
Does the correction affect statement of profit or loss (SOPL)?
And how? (*)
378
III. ADJUSTMENT TO PROFIT
2. Impacts on profit using the suspense account
(*) Affection on SOPL: compare to prior profit
If any entry credits the SOPL
Profit increases
If any entry does nothing the SOPL
Profit remains unchanged
If any entry debits the SOPL
Profit decreases
379
III. ADJUSTMENT TO PROFIT
2. Impacts on profit using the suspense account
Consider an example: Sales of $380 has been recorded by debiting $380 to the Cash
account and crediting $218 to Revenue.
Step
01
•
Total debits
= $380
•
Total credits
= $218
Post a credit of $162 to the suspense account to equalize trial balance
Credit
Suspense account
$162
Step
02
What should the double entry have been? (‘should do’)
Debit
Cash
$380
Credit
Revenue
$380
Step
03
3.1 What was the double entry? (‘did do’)
Debit
Cash
Credit
Revenue
3.2 Recognize the difference
Step
04
Step
05
$380
$218
= $162 less credited
Therefore, what correction is required? (‘to correct’)
Debit
Credit
Suspense account
Revenue
$162
$162
Entry of Suspenst account does nothing to the SOPL
Entry of Revenue credits the SOPL $162
🡪 Profit increases $162 compared to prior profit
380
III. ADJUSTMENT TO PROFIT
2. Impacts on profit using the suspense account
Example 6: Question
The draft financial statements of B Co for the year ended 31 August 20X5 show a profit
of $211,340 prior to the correction of the following errors:
1.
Cash drawings of $3,430 have not been accounted for.
2.
Debts amounting to $1,140, which were provided against in full during the year,
should have been written off as irrecoverable.
3.
Rental income of $1,400 has been classified as interest receivable.
4.
On the last day of the accounting period, $4,000 in cash was received from a
customer, but no bookkeeping entries have been made.
What is the correct profit of B Co for the year ended 31 August 20X5?
A.
$207,160
B.
$207,660
C.
$211,340
D.
$215,660
381
III. ADJUSTMENT TO PROFIT
2. Impacts on profit using the suspense account
Example 6: Answer
C is correct.
Before
Statement of
Profit or Loss
Statement of
Financial Position
N/A
N/A
1
Effects
on profit
No effect
After
$3,430
Cr Cash
$3,430
Cr Provision for
irrecoverable
debts
$1,140
Cr Receivables
$1,140
N/A
Dr Provision
expense
$1,140
Before
2
After
Dr Drawings
Dr Irrecoverable
debt
No effect
$1,140
382
III. ADJUSTMENT TO PROFIT
2. Impacts on profit using the suspense account
Example 6: Answer
Statement of
Profit or Loss
Before
Dr Rental
income
Cr Interest
Receivables
Dr Interest
Receivables
After
Cr Rental income
Effects
on profit
$1,400
3
Before
Statement of
Financial Position
$1,400
No effect
$1,400
$1,400
N/A
N/A
4
No effect
After
Dr Cash
$4,000
Cr Receivables
$4,000
N/A
383
CHAPTER 18:
INCOMPLETE RECORDS
384
OVERVIEW
What will you learn?
V. Profit Ratios –
Markup & Margin
II.
The Accounting
& Business Equation
Method
I.
INCOMPLETE
RECORDS
IV. Cash/Banking
Data
III.
The Ledger Account
/Balancing Figure
Approach
385
I. INCOMPLETE RECORDS
Why do they occur?
Those reasons might be one of the following:
1. The proprietor of the
business does not keep a
full set of accounts
2. Some of the business
accounts are accidentally
lost or destroyed
In this case, the business will have to use the best available information to estimate any
missing figures in different ways, such as using:
Accounting & business
equation method
Cash/banking data
Ledger account/
Balancing figure approach
1
2
4
3
Profit ratios – markup &
margin
386
II. THE ACCOUNTING
& BUSINESS EQUATION METHOD
1. The accounting equation method
If a business entity has recorded very little information of its transactions, it may still be
possible to calculate net profit of the year, using the accounting equation.
First, remind of the accounting equation:
Liabilities
Share capital
Other reserves
Assets
Opening RE
Equity
Closing
Retained
Earnings (RE)
+ Revenue
- Expenses
- Dividends
Only RE is directly related to the profit or
loss of the year
(which equals to net income less dividends
from the statement of profit or loss)
387
II. THE ACCOUNTING
& BUSINESS EQUATION METHOD
1. The accounting equation method
To calculate profit or loss from RE, follow the two steps below:
Compute closing RE using the accounting equation
Step 1
Closing RE
= Closing Assets – Closing Liabilities – Closing Share
capital – Closing Other reserves
Calculate profit/loss from closing RE
Step 2
Profit/Loss of the year
= Closing RE – Opening RE + Dividends
388
II. THE ACCOUNTING
& BUSINESS EQUATION METHOD
1. The accounting equation method
Example 1: Question
The statement of A Co at 31 December 20X0 shows the following balances:
1.
2.
3.
4.
5.
Non-current assets:
Current assets:
Share capital:
Non-current liabilities:
Current liabilities:
$30,000
$11,600
$2,000
$11,000
$13,400
The sales, purchases and expense records of A Co has unfortunately been destroyed and
the directors need help estimating the entity net profit for the year so that they can
estimate its tax liability.
The directors have informed you that the retained earnings of the entity at 1 January
20X0 were $21,820.
What was the profit/loss (before tax) made by A Co for the year ended 31 December
20X0?
A.
B.
C.
D.
$6,620
($6,620)
$19,600
($19,600)
389
II. THE ACCOUNTING
& BUSINESS EQUATION METHOD
1. The accounting equation method
Example 1: Answer
B is correct.
Compute closing RE using the accounting equation
Step 1
Closing RE = Closing Assets – Closing Liabilities – Closing
Share capital – Closing Other reserves
Closing RE = (1 + 2) – (4 + 5) – 3
Closing RE = ($30,000 + $11,600) – ($11,000 + $13,400) $2,000 = $15,200
Calculate profit/loss from closing RE
Step 2
Profit/Loss of the year = Closing RE – Opening RE –
Dividends
Profit/Loss of the year = $15,200 – $21,820
Profit/Loss of the year = ($6,620)
390
II. THE ACCOUNTING
& BUSINESS EQUATION METHOD
2. The business equation method
The business equations:
Opening
Capital
Profit
net assets
introduced
(- Loss)
Drawings
Closing
Net assets
Assets
Liabilities
net assets
If the business can establish the trader’s net assets at the beginning and end of the
period, its profit/loss can be computed as follow:
Profit/Loss for
the year
Closing
Opening
Capital
net assets
net assets
introduced
Drawings
391
II. THE ACCOUNTING
& BUSINESS EQUATION METHOD
2. The business equation method
Example 2: Question
David starts up his computer shop on 1.1.20X0, from rented premises, with $20,000
inventory and $10,000 in the bank. All his sales are for cash. He keeps no record of his
takings.
At the end of the year, he has inventory worth $24,800 and $35,600 in the bank. He
owes $6,000 to supplier. He had paid in $29,400 he won on the lottery and drawn out
$21,000 to buy himself a car. The car is not used in the business. He has been taking
drawings of $1,400 per month.
Requirement:
What is his profit at 31.12.20X0?
392
II. THE ACCOUNTING
& BUSINESS EQUATION METHOD
2. The business equation method
Example 2: Answer
$32,800 is correct answer.
Closing
net assets
= Closing Inventory + Closing Cash in bank – Closing
Liabilities
= $24,800 + $35,600 - $6,000 = $54,400
Opening
net assets
= Opening Inventory + Opening Cash in bank
= $20,000 + $10,000 = $30,000
Capital
introduced
= Lottery paid in
= $29,400
Drawings
= Drawings to buy a car + Drawings per month for 12
months
= $21,000 + $1,400 x 12 = $37,800
Profit/Loss
for the year
= $54,400 - $30,000 - $29,400 + $37,800 = $32,800
393
III. THE LEDGER ACCOUNT
/BALANCING FIGURE APPROACH
Ledger account & Examples of missing figures
The balancing figure approach, using ledger accounts, is commonly used with 4
accounts:
Cash in hand
Cash at bank
Eg. Cash sales, Cash stolen
Eg. Drawings, Money stolen
Ledger account
& Examples of missing figures
Receivables
Payables
Eg. Credit sales, Money
received from receivables
Eg. Credit purchases,
Money paid to payables
394
III. THE LEDGER ACCOUNT
/BALANCING FIGURE APPROACH
T-accounts
The accounts should be presented as below:
CASH IN HAND
CASH AT BANK
Balance b/f
X
Cash sales
X
Cash
purchases
X
Sundry
income
X
Sundry
Expenses
X
Banking
X
Money Stolen
Balance c/f
X
Balance b/f
Cash received
from
customer
Banking’s
from cash in
hand
X
X
Cash paid to
suppliers
X
X
Expenses
X
X
Drawings
X
X
Money Stolen
X
X
Balance c/f
X
X
Sundry
income
X
X
395
III. THE LEDGER ACCOUNT
/BALANCING FIGURE APPROACH
T-accounts
You may need to use total receivables and total payables accounts where information
given cannot be split between cash and credit sales and purchases
TOTAL RECEIVABLES
Balance b/f
X
Total sales
X
X
TOTAL PAYABLES
Total cash
received from
sales
X
Total cash paid
for purchases
X
Balance c/f
X
Balance c/f
X
X
X
Balance b/f
X
Total purchases
X
X
The value of the missing figure can usually be derived from working out the balancing
figure from the ledger account’s closing balance, opening balance and fluctuations
during the period.
There are two methods can be used to solve the problems, using T-accounts or
equations.
396
III. THE LEDGER ACCOUNT
/BALANCING FIGURE APPROACH
Example
Example 3: Question
Denis Co business had trade payables of $9,714 on 1.5.20X5 and trade payables of
$4,916 on 30.4.20X6. If payments to trade payables during the year to 30.4.20X6 were
$47,008.
Requirement:
What is Denis Co’ purchases during the year?
Answer:
$42,210 is the correct answer.
Using both T-account and equation to solve the question:
TRADE
PAYABLES
$
Payments paid
47,008
Closing balance
4,916
Less: Opening
balance
(9,714)
Credit purchases
(β)
42,210
TRADE PAYABLES
Payments
paid
$47,008
Opening
Balance
$9,714
Closing
balance
$4,916
Credit
Purchases (β)
42,210
$51,924
$51,924
397
IV. CASH/BANKING DATA
Cash/banking data
The use of bank summaries is similar to the ledger account approach.
This method assumes that, whilst data may be missing from the ledger accounts, a
company can always reconstruct their cash inflows and outflows using either the cash
book or bank statements, or both.
Cash book
Reconstruct:
Figure out:
cash inflows
the missing
figure
& cash outflows
Bank statement
398
IV. CASH/BANKING DATA
Example
Example 4: Question
Puli Co is a sole trader who does not keep proper accounting records.
Puli’s first year of trading was 20X0. From reviewing Puli’s bank statements and the
incomplete records relating to cash maintained, the following summary has been
complied.
Bank and cash summary, Puli, 20X0
$
Cash received from credit customers and paid into the bank
175,200
Expenses paid out of cash received from credit customers
before banking
25,197
Cash sales
53,900
Other information, Puli, 20X0
Irrecoverable debts written off
3,600
Closing balance of Trade receivables
0
Which of the following correctly represents Puli’s sales figure for 20X0?
A. $257,897
B. $107,800
C. $175,200
D. $250,697
399
IV. CASH/BANKING DATA
Example
Example 4: Answer
Step 1: Compute total cash received from credit sales
Total cash received from credit sales
= Cash actually paid into the bank + Expense paid out before banking
= 175,200 + 25,197 = 200,397
Step 2: Find credit sales by posting to the T-account of receivables
TOTAL SALES
Credit sales
203,997
Cash received (step 1)
Irrecoverable debts written off
Balance c/f
203,997
Step 3: Compute total sales from credit sales and cash sales
Total sales = Credit sales (step 2) + Cash sales = 203,997 + 53,900 = 257,897
 A is correct.
200,397
3,600
0
203,997
400
V. PROFIT RATIOS – MARKUP & MARGIN
Markup & Margin
Profit ratios are usually used when inventory, sales or purchases is unknown, by
constructing gross profit to determine the mysterious figures.
Gross profit can be expressed as a percentage of either sales or cost of sales:
Gross profit
margin
=
Mark-up
on cost
Gross profit
= Cost of sales x 100%
Gross profit
= Sales x Margin (%)
Gross profit
x 100%
Sales
Gross profit
= Cost of sales x Markup (%)
For example:
Margin = (1,000/5,000) x 100 = 20%
Sales
Cost
sales
of
Gross profit
Mark-up = (1,000/4,000) x 100 = 25%
$
Ratio
5,000
100%
Sales
(4,000)
80%
Cost
sales
1,000
20%
Gross profit
Gross profit is a percentage of Sales, using margin
of
$
Ratio
5,000
125%
(4,000)
100%
1,000
25%
Gross profit is a percentage of Cost of sales,
using mark-up
401
V. PROFIT RATIOS – MARKUP & MARGIN
Example
Example 5: Question
A fire on 30 September 20X2 destroyed some of a company’s inventory and its inventory
records. The following information is available:
$
Inventory 1 September 20X2
17,000
Sales for September 20X2
150,00
0
Purchases for September 20X2
93,000
Inventory in good condition at 30 September
20X2
6,500
Profit margin on sales is 35%
Based on this information, what is the value of inventory lost?
A.
$5,000
B.
$6,000
C.
$7,000
D.
$9,000
402
V. PROFIT RATIOS – MARKUP & MARGIN
Example
Example 5: Answer
B is correct.
Margin = 35%  Gross profit = 35% of Sales
$
Sales
$
Ratio
150,000
100%
(97,500)
65%
52,500
35%
Cost of sales:
Opening inventory
17,000
Purchases
93,000
Less:
Closing
inventory
Less:
Inventory
lost (β)
Gross profit
(6,500)
(6,000)
403
CHAPTER 19: PREPARATION OF
FINANCIAL STATEMENTS FOR
SOLE TRADERS
404
OVERVIEW
What will you learn?
Preparation of financial statements for
sole traders
Financial statements
of a sole trader
Prepare financial statements
for sole traders
STAGE 1
Transactions recorded in ledger accounts
STAGE 2
Ledger accounts balanced and closed off
STAGE 3
Trial balance extracted
STAGE 4
Year-end adjustments made and ledger
accounts closed off
STAGE 5
Trial balance used to prepare financial
statements
405
I. FINANCIAL STATEMENTS OF A SOLE TRADER
1. Financial statement of a sole trader
Sole traders are people who run their own businesses
The elements of a financial statements of a sole trader:
Financial Statements
Statement of
Financial Position
(SOFP)
Statement of
comprehensive income
(SOCI)
(Business performance)
Note: The financial statements can be produced more often in order to give information to the
sole trader on how the business is progressing
406
I. FINANCIAL STATEMENTS OF A SOLE TRADER
The statement of comprehensive income (SOCI)
Here is the format of the statement of comprehensive income for a sole trader:
STATEMENT OF COMPREHENSIVE INCOME
FOR THE YEAR ENDED 31 DECEMBER 20X0
$
Sales revenue
X
Less: Cost of sales (COGS)
(X)
Gross profit
X
Expenses
(X)
Profit before tax
X
Tax expense
(X)
Net profit for the period
X
407
I. FINANCIAL STATEMENTS OF A SOLE TRADER
The statement of financial position (SOFP)
Here is the format of the statement of financial position for a sole trader:
Non-current assets
Equity
PPE
X
Ordinary share capital
X
Investments
X
Share premium
X
Intangibles
X
Retained earnings
X
X
X
Current assets
Inventories
X
Trade and other
receivables
X
Prepayments
X
Cash
X
Non-current liabilities
Loan notes
x
Current liabilities
Trade and other payables
Accrual
Tax payable
X
X
X
X
Total assets
X
X
Total equity and liabilities
X
408
II. PREPARE THE FINANCIAL STATEMENTS
OF A SOLE TRADER
1. The process of preparing financial statements
The process of preparing financial statements for sole traders and other entity is as below:
STAGE 1
Transactions recorded in ledger accounts
(LA)
STAGE 2
Ledger accounts balanced and closed off
Mentioned in chapter 6-14
STAGE 3
Trial balance extracted
STAGE 4
Year-end adjustments made and ledger
accounts closed off
Mention in Section II.2
STAGE 5
Trial balance used to prepare financial
statements
409
II. PREPARE THE FINANCIAL STATEMENTS
OF A SOLE TRADER
2. Adjustments to trial balance and trial balance used to prepare FSs
Note: Financial statements were prepared based on trial balance. Hence, the adjustments
(mentioned detailedly in previous chapters) need to be made to trial balance.
Here are some common adjustments made to FSs:
Adjusting Entries
Depreciation charged (Chapter 9)
DR Depreciation expense ( SOCI)
CR Accumulated depreciation (SOFP)
Irrecoverable debts (Chapter 12)
DR Irrecoverable debt expense (SOCI)
CR Receivables (SOFP)
Closing inventory (Chapter 8)
DR Inventory (SOFP)
CR Statement of profit or loss / purchase
Purchase (Chapter 8)
DR Cost of good sales
CR Purchase
Allowance for receivables (Chapter 12)
(Increase in allowance)
DR Irrecoverable debt expense (SOCI)
CR Allowance for receivables (SOFP)
Accruals (Chapter 11)
DR Expenses (SOCI)
CR Accrual (Liability – SOFP)
Prepayments (Chapter 11)
DR Prepayment (Current asset – SOFP)
CR Expenses (SOCI)
Tax estimated for the year (Chapter 7)
DR Tax charge (SOCI)
CR Current tax liabilities (SOFP)
410
II. PREPARE THE FINANCIAL STATEMENTS
OF A SOLE TRADER
2. Adjustments to trial balance and trial balance used to prepare FSs
Exam focus: Prepare SOCI or SOFP from trial balance for sole traders
Example 1: Adjustments to initial trial balance:
The following trial balance was extracted from the ledger of Stephen Chee, a sole trader, as at 31
May 20X1 – the end of his financial year.
STEPHEN CHEE
TRIAL BALANCE AT 31 MAY 20X1
Property, at cost
Equipment, at cost
Accumulated depreciation (as at 1 June 20X0)
– on property
– on equipment
Purchases
Sales
Inventory, as at 1 June 20X0
Discounts received
Returns out
Wages and salaries
Irrecoverable debts
Loan interest
Other operating expenses
Trade payables
Trade receivables
Cash in hand
Bank
Drawings
Allowance for receivables
17% long-term loan
Capital, as at 1 June 20X0
DR
$
240,000
160,000
CR
$
40,000
76,000
500,000
804,400
100,000
9,600
30,000
117,600
9,200
10,200
35,400
72,000
76,000
600
38,600
48,000
1,335,600
1,000
60,000
242,600
1,335,600
411
II. PREPARE THE FINANCIAL STATEMENTS
OF A SOLE TRADER
2. Adjustments to trial balance and trial balance used to prepare FSs
The following additional information as at 31 May 20X1 is available:
1. Inventory as at the close of business has been valued at cost at $84,000
2. Wages and salaries need to be accrued by $1,600
3. Other operating expenses are prepaid by $600
4. The allowance for receivables is to be adjusted so that it is 2% of trade receivables
5. Depreciation for the year ended 31 May 20X1 has still to be provided for as follows.
•
Property: 1.5% per annum using the straight line method
•
Equipment: 25% per annum using the reducing balance method
Require: Prepare Stephen Chee’s Statement of profit or loss for the year ended 31 May 20X1
and his statement of financial position as at that date.
412
II. PREPARE THE FINANCIAL STATEMENTS
OF A SOLE TRADER
2. Adjustments to trial balance and trial balance used to prepare FSs
Answer:
Step 1: Adjustment to initial trial balance
DR
• Working 1: Accruals
CR
DR
• Working 2: Prepayment
CR
• Working 3: Allowance for receivables
$
Previous allowance
1,000
New allowance
(2% x 76,000) [Note (4)]
1,520
Increase
520
Per trial balance
9,200
Statement of P/L
(Irrecoverable debt expense)
9,720
Expenses (SOCI)
(Wages + Salaries) [Note (2)]
Accrual (Liability – SOFP)
(Wages + Salaries) [Note (2)]
Prepayment (Current asset – SOFP)
(Other operating expenses) [Note (3)]
Expenses (SOCI)
(Other operating expenses) [Note (3)]
1,600
1,600
600
600
Adjustments
DR Irrecoverable debt expense (SOCI)
CR Allowance for receivables (SOFP)
520
520
413
II. PREPARE THE FINANCIAL STATEMENTS
OF A SOLE TRADER
2. Adjustments to trial balance and trial balance used to prepare FSs
• Working 4: Depreciation
Adjustment
DR
CR
Depreciation expense (SOCI)
Accumulated depreciation (SOFP)
$
Property
Opening accumulated depreciation
40,000
Charge for the year (1.5% x 240,000) [Note (5)]
3,600
Closing accumulated depreciation
43,600
Equipment
Opening accumulated depreciation
76,000
Charge for the year (25% x 84,000) [Note (5)]
21,000
Closing accumulated depreciation
97,000
Total charge in statement of comprehensive income
(3,600 + 21,000) (Depreciation expense)
24,600
24,600
24,600
414
II. PREPARE THE FINANCIAL STATEMENTS
OF A SOLE TRADER
2. Adjustments to trial balance and trial balance used to prepare FSs
Step 2: Prepare final accounts from a trial balance
STEPHEN CHEE
STATEMENT OF COMPREHENSIVE INCOME FOR THE YEAR ENDED 31 MAY 20X1
$
$
Revenue (Trial balance)
Cost of sales
Opening inventory
Purchases
Purchases returns
Closing inventory [Note (1)]
804,400
100,000
500,000
(30,000)
(84,000)
(486,000)
318,400
9,600
328,000
Gross profit
Other income – discounts received (Trial balance)
Expenses
Operating expenses
Wages and salaries (= 117,600 + 1,600 [Working 1])
Irrecoverable debts (= 9,200 + 520 [Working 3])
Loan interest (Trial balance)
Depreciation [Working 4]
Other operating expenses ($35,400 - $600)
($600 Cr in expense) [Working 2]
Profit for the year
119,200
9,720
10,200
24,600
34,800
198,520
129,480
415
II. PREPARE THE FINANCIAL STATEMENTS
OF A SOLE TRADER
2. Adjustments to trial balance and trial balance used to prepare FSs
Step 2: Prepare final accounts from a trial balance
STEPHEN CHEE
STATEMENT OF FINANCIAL POSITION AS AT 31 MAY 20X1
$
Non-current assets
Property [Working 4]
196,400
Equipment [Working 4]
63,000
$
259,400
Current assets
Inventory [Note (1)]
Trade receivables net of allowance for receivables
($76,000 – 1,520 [Working 3])
Prepayments [Working 2]
Bank (Trial balance)
Cash in hand (Trial balance)
84,000
74,480
600
38,600
600
198,280
457,680
Capital
Balance as at 1 June 20X0 (Trial balance)
Profit for the year (SOCI)
Drawings (Trial balance)
242,600
129,480
(48,000)
324,080
Non-current liabilities
17% long-term loan (Trial balance)
Current liabilities
Trade payables (Trial balance)
Accruals [Working 1]
60,000
72,000
1,600
73,600
457,680
416
CHAPTER 20: INTRODUCTION
TO COMPANY ACCOUNTING
417
OVERVIEW
What will you learn?
Ordinary
shares
Characteristics
Owner’s share
capital
Preference
shares
Funding
Loan note
(Loan capital)
I. Limited
liability
company
Reserves
Share
premium
II. Capital
structure
Other reserves
Revaluation
surplus
III. Bonus and
rights issues
Retained
earnings
418
I. LIMITED LIABILITY COMPANY
1. Limited and unlimited liability
•
Unlimited liability means that if the business runs up debts that it is unable to pay, the
proprietors will become personally liable for the unpaid debts and would be required, if
necessary, to sell their private possessions to repay them.
•
Limited liability means that the maximum amount that an owner stands to lose, in the
event that the company becomes insolvent and cannot pay off its debts, is their share of
the capital in the business.
419
I. LIMITED LIABILITY COMPANY
2. Limited liability company
2.1
Characteristics
1
Owners equal to shareholders or
members
Large number of
owners
2
Limited liability
company has
some
characteristics:
4
5
2.2
Owner and manager are
separated
3
Owners receive share of profits in form of
dividends
Owners appoint directors to run business on their
behalf
Funding
Companies might be funded in the following ways:
Owners’ share capital
Funding
sources of a
limited
company
Loan notes
Short-term liabilities (such as trade accounts payable)
Retained profits
420
II. CAPITAL OF LIMITED LIABILITY COMPANY
OVERVIEW
Ordinary shares
Owner’s share
capital
Preference shares
Capital of
limited liability
company
Loan note
(Loan capital)
Reserves
Share premium
Other reserves
Revaluation
surplus
Retained earnings
421
II. CAPITAL OF LIMITED LIABILITY COMPANY
1. Owner’s share capital
1.1
Terminologies
Before taking deep into the lessons, some terminologies should be comprehended:
1
Par value
(or nominal value
/legal value)
Par value:
• is an arbitrary value assigned to a share, which is often
perceived as the share’s minimum value (often $1, 50c, 25c);
• remains fixed, whereas the market value of the shares
fluctuates over time.
2
Issue price
The price of new shares when they are sold for the first time
3
Market value
The value at which the shares are trading on the open market
4
Share premium
Share premium is the difference between the par value of the
shares issued and the issue price.
422
II. CAPITAL OF LIMITED LIABILITY COMPANY
1. Owner’s share capital
1.1
Terminologies
Example 1: Terminologies related to owner’s share capital
A company might issue 100,000 $2.00 shares at $2.40 each, therefore:
•
Subscribers will then pay a total of $240,000.
•
The issued share capital of the company would be shown in its
accounts at par value, $200,000.
•
The excess of $40,000 (= 240,000 – 200,000) is described not as
share capital, but as share premium or capital paid-up over par value.
The par value is: $2.00 per share and $200,000 in total.
The issue price is: $2.40 per share and $240,000 in total.
The share premium is: $240,000 - $200,000 = $40,000.
423
II. CAPITAL OF LIMITED LIABILITY COMPANY
1. Owner’s share capital
1.2
Authorized, issued, called-up and paid-up share capital
A distinction must be made between authorised, issued, called-up and paid-up share capital.
1.
Authorised
capital (or
legal capital)
Definition
Example
• is the maximum amount of
(1) A company’s authorised share
capital might be 10,000,000 ordinary
shares of $1 each. This would then be
the maximum number of shares it could
issue, unless the maximum were to be
changed by agreement.
•
•
share capital that a company
is empowered to issue
varies from company to
company
can change by agreement
• is the par amount of share
2.
Issued capital
capital that has been issued
to shareholders
• The amount of issued capital
cannot exceed the amount of
authorised capital
• When shares are issued or
3.
Called-up
capital
allotted, it might call up only
a part of the issue price and
wait until a later time before
it calls up the remainder
(2) Continuing example 1 (authorised
capital) above, the company with
authorised share capital of 10,000,000
ordinary shares of $1 might have issued
8,000,000 shares. This would leave it the
option to issue 2,000,000 more shares at
some time in the future.
(3) If a company allots 500,000 ordinary
shares of $1, it might call up only, say,
75 cents per share.
The issued share capital would be
$500,000 ($1 × 500,000), but the calledup share capital would only be $375,000
($0.75 × 500,000).
424
II. CAPITAL OF LIMITED LIABILITY COMPANY
1. Owner’s share capital
1.2
Authorized, issued, called-up and paid-up share capital
A distinction must be made between authorised, issued, called-up and paid-up share capital.
Definition
4.
Paid-up
capital
When capital is called up, some
shareholders might delay their
payment (or even default on
payment)
Paid-up capital is the amount of
called-up capital that has been
paid
Example
(4) If a company issues 500,000 ordinary
shares of $1 each, calls up 75 cents per
share and receives payments of
$275,000, we would have:
Issued capital
Called-up capital
Paid-up capital
Capital not yet paid
$500,000
$375,000
$275,000
$100,000
Continuing with (4) (paid-up capital) above, the statement of financial position of the company
would appear as follows.
Assets
$
Called-up capital not paid
100,000
Cash (called-up capital paid)
275,000
375,000
Equity
Called-up share capital
(500,000 ordinary shares of $1, with 75c per share called up)
375,000
425
II. CAPITAL OF LIMITED LIABILITY COMPANY
1. Owner’s share capital
1.3
Ordinary shares
Ordinary shares:
•
Are by far the most common type of share
•
Are not preferred with regard to dividend payment.
•
Thus a holder only receives a dividend after fixed dividends have been paid to preference
shareholders.
Characteristics of ordinary shares:
They carry no right to fixed dividend
They normally carry voting rights
Sometimes referred to as equity shareholders and in many ways more like
payables of the company
426
II. CAPITAL OF LIMITED LIABILITY COMPANY
1. Owner’s share capital
1.4
Preference shares
Preference shares are shares that confer certain preferential rights on their holder.
Typical characteristics of preference shares:
Have a priority right to a return of their capital over ordinary shareholders
if the company goes into liquidation
Do not carry a right to vote
If the preference shares are cumulative, it means that before a company
can pay an ordinary dividend it must not only pay the current year’s
preference dividend but must also make good arrears of preference
dividends unpaid in previous years.
427
II. CAPITAL OF LIMITED LIABILITY COMPANY
1. Owner’s share capital
1.4
Preference shares
Preference shares may be classified in one of two ways: Redeemable and Irredeemable
Redeemable preference shares (RPS)
Redeemable means that the company will redeem
(repay) the nominal value of those shares at a later
date.
• The shares will then be canceled and no further dividends paid;
• RPS, therefore, are treated as loans and included as non-current
liabilities in the SOFP;
• Dividends paid on RPS are treated like interest paid on loans and are
included in financial costs in the SOPL.
Irredeemable preference shares (IPS)
Irredeemable preference shares
• Are treated just like other shares;
• They form part of equity;
• Their dividends are treated as appropriations of profit.
428
II. CAPITAL OF LIMITED LIABILITY COMPANY
1. Owner’s share capital
1.5
Example
Example 2: Dividends on ordinary shares and preference shares
G Co has issued 100,000 ordinary shares of $1.50 each and 40,000 7% preference shares of
$2.00 each. Its profits after taxation for the year to 30 September 20X3 were $33,600. The
management board has decided to pay an ordinary dividend (i.e. a dividend on ordinary shares)
which is 50% of profits after tax and a preference dividend.
Show the amount in total of dividends and of retained profits, and calculate the dividend per
share on ordinary shares.
Answer:
$
$
Profit after tax
33,600
Preference dividend (7% of $2.00 × 40,000)
(5,600)
Earnings (profit after tax and preference dividend)
28,000
Ordinary dividend (50% of earnings)
(14,000)
Retained earnings (also 50% of earnings)
14,000
The ordinary dividend is 14 cents per share ($14,000 ÷ 100,000 ordinary shares).
The appropriation of profit would be as follows.
Profit after tax
Dividends: Preference
Ordinary
Retained earnings
33,600
(5,600)
(14,000)
(19,600)
14,000
As we will see later, appropriations of profit do not appear in the SOPL but are shown as
movements on reserves.
429
II. CAPITAL OF LIMITED LIABILITY COMPANY
1. Owner’s share capital
1.6
The market value of shares
Market value is the price at which someone is prepared to purchase shares in the company
from an existing shareholder.
Example
If Mr. T owns 2,000 $1 shares in D Co. He may sell them to Mr. Q for $1.3 each.
•
Par value = $1
•
Market value = $1.3
D Co is not included in the share sale transaction between Mr. T and Mr. Q, therefore:
•
This transfer of existing shares does not affect D Co’s financial position;
•
There are certainly no accounting entries to be made for the share sale.
That means apart from changing the register of members, D Co does not have to bother with
the sale by Mr. T to Mr. Q at all.
Characteristics of the market value:
Often being hard to estimate as the shares in private companies do not change
hands very often;
When companies listed on a stock exchange are quoted, ie it is the market value
of the shares which is quoted.
430
II. CAPITAL OF LIMITED LIABILITY COMPANY
1. Owner’s share capital
1.6
The market value of shares
Example 3: Owners’ capital
TUS company made an issue for cash of 10,000 $1.50 shares at a premium of $0.30 per share.
Which one of the following entries correctly records the issue?
Dr
Cr
$
$
A. Share capital
15,000
Share premium
3,000
Bank
18,000
B. Bank
Share capital
Share premium
18,000
C. Bank
Share capital
Share premium
23,000
D. Share capital
Share premium
Bank
23,000
15,000
3,000
20,000
3,000
3,000
20,000
431
II. CAPITAL OF LIMITED LIABILITY COMPANY
1. Owner’s share capital
1.6
The market value of shares
Example 3: Owners’ capital
Answer: B
Share capital = 10,000 x $1.5 = $15,000
Share premium = 10,000 x $0.3 = $3,000
The correct entry for issuing shares for cash:
Dr Bank
$18,000
Cr Share capital
$15,000
Cr Share premium
$3,000
432
II. CAPITAL OF LIMITED LIABILITY COMPANY
2. Loan note (Loan capital)
2.1
Definition
Loan note simply refers to the document that is evidence of the debt, often a certificate that is
issued to the lender.
Loan notes are long-term liabilities. In some countries, they are described as loan capital because
they are one of the means of raising finance.
Similar to shares, the loan note will have a set nominal value.
Individuals or organisations can buy the loan notes at an agreed price (this can be any value; it
does not have to be the same as the nominal value).
433
II. CAPITAL OF LIMITED LIABILITY COMPANY
2. Loan note (Loan capital)
2.2
Characteristics
Loan capital is different from share capital in the following ways:
Providers
Share capital
Loan capital
• Shareholders are members of a
• Providers of loan capital are
company.
• Shareholders receive dividends
Holders’
benefits
(appropriations of profit).
• Shareholders cannot enforce
Legal action
Security
the payment of dividends.
• Shares are not secured.
creditors.
• Holders of loan capital are
entitled to a fixed rate of
interest.
• Loan note holders can take
legal action against a company
if their interest is not paid when
due.
• Loan notes are often secured
on company assets.
The holder of loan capital is therefore generally in a less risky position than the shareholder. They
have greater security, although their income is fixed and cannot grow, unlike ordinary dividends.
434
II. CAPITAL OF LIMITED LIABILITY COMPANY
2. Loan note (Loan capital)
2.3
Interest of loan notes
Interest is calculated on the par or legal value of loan capital, regardless of its market value.
Example 4: Interest of loan note
If a company has $300,000 (par value) 12% loan notes in issue, the interest of $36,000
($300,000 × 12%) will be charged in the statement of profit or loss per year.
Interest is usually paid half-yearly; examination questions often require an accrual to be made
for interest due at the year end.
435
II. CAPITAL OF LIMITED LIABILITY COMPANY
2. Loan note (Loan capital)
2.3
Interest of loan notes
Example 5: Loan note
Blue, a limited liability company, had $1,000,000 8% loan note in issue at 30 June 20X5. The
interest of loan note being paid half-yearly on 30 June and 31 December.
On 30 September 20X5, Blue Co redeemed $250,000 of these loan notes at par, paying interest
due to that date.
What is the amount of interest payable shown in the Statement of profit or loss at 31
December 20X5?
A.
$20,000
B.
$25,000
C.
$40,000
D.
$35,000
Answer: D
Interest payable for 3 months from 1 Jul to 30 Sep is: $1,000,000 x 8% x 3/12 = $20,000
After 30 Sep 20X5, the company redeemed $250,000 of $1,000,000 loan note
-> The company had $750,000 8% loan note remaining.
Interest payable for 3 months from 1 Oct to 31 Dec is: $750,000 x 8% x 3/12 = $15,000
The amount of interest payable shown in the Statement of profit or loss at 31 Dec 20X5 is
$35,000 ($20,000 + $15,000).
436
II. CAPITAL OF LIMITED LIABILITY COMPANY
OVERVIEW
Share capital
Reserves
Share premium
Capital of limited
liability company
Other reserves
Revaluation surplus
Retained earnings
Note:
Share capital
The par value of
issued capital
Any amounts not yet
called up on issued
shares
437
II. CAPITAL OF LIMITED LIABILITY COMPANY
3. Reserves
3.1
Reserves
Reserves are part of profits or gain that has been allotted for a specific purpose (buy fixed
assets, pay bonuses, pay an expected legal settlement, pay for repairs & maintenance and pay
off debt) or not (called general reserves).
Reserves are classified into 2 sources:
Capital reserves
Reserves
Revenue reserves
• Established
• Established
out
of
capital
profits;
• Normally not allocated as
Characteristics
dividends.
Gain on revaluation of fixed
assets, Share premium, …
Example
out of gain
acquired
from
operating
activities.
• Retained for the purpose of
expanding its business or to
meet out contingencies in the
future.
Retained Earnings,
revaluation, …
Gain
on
438
II. CAPITAL OF LIMITED LIABILITY COMPANY
3. Reserves
3.1
Reserves
In most countries, a distinction must be made between the following.
• Statutory reserves are capital reserves which a company is required to set up by law, and which
are not available for the distribution of dividends, i.e. share premium, revaluation.
• Non-statutory reserves are revenue reserves consisting of profits that are distributable as
dividends if the company wishes.
• Dividends to shareholders.
Example 6: Reserves
Profits are transferred to these reserves by making an appropriation out of profits, usually
profits for the year. Typically, you might come across the following.
$
Profit after taxation
Appropriations of profit
Dividend
(120,000)
Transfer to general reserve
(20,000)
$
200,000
(140,000)
Retained earnings for the year
Retained earnings b/f
Retained earnings c/f
60,000
500,000
560,000
439
II. CAPITAL OF LIMITED LIABILITY COMPANY
3. Reserves
3.1
Reserves
Dividends represent the distribution of profits to shareholders.
Typical characteristics of dividends:
Dividends which have been
paid are shown in the
Statement of changes in
equity.
The proposed dividend does
not appear in the accounts
but will be disclosed in the
notes
Not shown in the Statement
of profit or loss.
Are deducted from retained
earnings in the Statement of
financial position.
The terminology of dividend payments can be confusing, since they may be expressed either in the
form, of ‘x cent per share’ or ‘of y%’. In the latter case, the meaning is always ‘y% of the par value
of the shares in issue’.
440
II. CAPITAL OF LIMITED LIABILITY COMPANY
3. Reserves
3.1
Reserves
Example 7: Dividends
Suppose a company’s issued share capital consists of 200,000 75c ordinary shares which were
issued at a premium of 10c per share. The company’s statement of financial position would
include the following.
$
Ordinary shares
200,000
75c ordinary shares
150,000
Share premium account
(200,000 × 10c)
20,000
If the managers wish to pay a dividend of $15,000, they may propose either of the following.
(a) A dividend of 7.5c per share (200,000 × 7.5c = $15,000)
(b) A dividend of 10% (10% × $150,000 = $15,000)
Not all profits are distributed as dividends; some will be retained in the business to finance
future projects.
441
II. CAPITAL OF LIMITED LIABILITY COMPANY
3. Reserves
3.2
The share premium account
The share premium account is an account into which sums received as payment for shares in
excess of their nominal value must be placed.
Characteristics of share premium account:
Increase in value if and when new shares are issued at a price above their
par value
Decrease in value – only certain very limited ways that we will look at in
F7 (Financial Reporting), such as to ‘finance’ the issue of bonus shares
442
II. CAPITAL OF LIMITED LIABILITY COMPANY
3. Reserves
3.2
The share premium account
Example 8: Share premium account
If Tree Co issues 4,000 $1 ordinary shares at $2.50 each the book entry will be:
DR
Cash
CR
Ordinary shares
CR
Share premium account
$10,000
$4,000
$6,000
Note:
The market price has no bearing at all on the company’s accounts. Therefore, if the market price
goes up or down, the share premium account would remain unaltered.
The share premium account cannot be distributed as a dividend under any circumstances. The
reason for this is to maintain the capital of the company. This capital ‘base’ provides some
security for the company’s creditors.
443
II. CAPITAL OF LIMITED LIABILITY COMPANY
3. Reserves
3.3
Revaluation surplus
A revaluation surplus is the result of an upward revaluation of a non-current asset.
Characteristics of revaluation surplus:
Revaluation
surplus
is
nondistributable, as it represents
unrealized profits on the revalued
assets. It is another capital reserve.
The revaluation surplus may fall if
an asset which had previously
been revalued upwards suffered a
fall in value in the next
revaluation.
The relevant part of a revaluation
surplus can only become realized if
the asset in question is sold, thus
realising the gain.
444
II. CAPITAL OF LIMITED LIABILITY COMPANY
3. Reserves
3.4
Retained earnings
Retained earnings
This is the most significant reserve, and is variously described as revenue reserve, retained
earnings, accumulated profits, undistributed profits, unappropriated profits:
•
Are profits earned by the company;
•
Not appropriated by dividends, taxation or transfer to another reserve account.
Reasons for retaining some profit each year are:
To pay dividends even when profits are low (or non-existent);
To overcome shortage of cash;
Very occasionally, to come across a debit balance. This would
indicate that the company has accumulated losses.
445
III. BONUS AND RIGHTS ISSUES
Introduction
A company can increase its share capital by means of a bonus issue or a rights issue.
Purpose
Definition
Advantages
Bonus issue
Rights issue
• Bonus issue helps a company to
reclassify some of its reserves
(share premium, retained earnings)
as share capital
• Troubled companies typically use
rights issues to pay down debt,
especially when they are unable to
borrow more money.
• A company may wish to increase its
share capital without wishing to
raise additional finance by issuing
new shares
• Companies with healthy BS might
also raise money to acquire a
competitor or open new facilities.
• Are accumulated earnings which are
not given out as dividends, but are
converted into free shares.
• Is an issue of shares for cash to raise
additional capital
• Is the issue of new shares to existing
shareholders in proportion to their
existing shareholding. No cash is
received from making a bonus issue
of shares.
• Increases capital without diluting
current shareholders’ holdings
• Capitalises reserves, so they cannot
be paid as dividends.
• Does not raise any cash
Dis-advantages
• Could jeopardize payment of future
dividends if profits fall
• Are the ‘rights’ offered to existing
shareholders, who can sell them if
they wish.
• Shareholders can buy new shares at a
discount price compared to the
market price for a certain period.
• Raises cash for the company
• Keeps reserves available for future
dividends.
• Dilutes shareholders’ holdings if they
do not take up rights issue.
• As more shares are issued to the
market, the stock price is diluted and
will likely go down.
446
III. BONUS AND RIGHTS ISSUES
Example
Example 9: Bonus and right issues
Tree Co has the following information:
$’000
Shareholders’ equity
Share capital
Reserves
Retained Earnings
$1 ordinary shares (fully paid)
Share premium
$’000
20,000
10,000
40,000
50,000
70,000
1)
2)
Tree Co decided to make a ‘6 for 3’ bonus issues.
Tree Co decided to make a right issue, shortly after the bonus issue (1). The terms are
‘1 for 5 at $1.50 ’.
It is assumed that all shareholders take up their rights.
447
III. BONUS AND RIGHTS ISSUES
Example
Example 9: Bonus and right issues
Answer:
1) Tree Co decided to make a ‘6 for 3’ bonus issues (shareholders are given 6 shares for every 3
they hold before the issue)
Dr Share premium
Dr Retained earnings
Cr Ordinary share capital ($20,000 x 6/3)
$10,000
$30,000
$40,000
Note: Share premium is a priority in making bonus issues, then retained earnings can be used.
2) Tree Co decided to make the right issue, shortly after the bonus issue (1). The terms are ‘1
for 5 at $1.50’. (It means 1 new share for every 5 already held at $1.50.)
Because making right issue is after the bonus issues, there are $60,000 ($20,000 + $40,000)
shares in share capital.
Dr Cash [($60,000/5) x 1.5)]
$18,000
Cr Ordinary share capital [($60,000/5) x 1]
$12,000
Cr Share premium [($60,000/5) x 0.5]
$6,000
448
III. BONUS AND RIGHTS ISSUES
Example
Example 10: Bonus and right issues
NQD Co had a capital structure at 1/1/X4 as follow:
$
Ordinary share capital
200,000 shares of $1.5 each
300,000
Share premium
720,000
In 20X4, company decided to make a ‘1 for 2’ bonus issues, using the share premium
account for this purpose.
Then, NQD Co issued for cash another 120,000 shares at $1.8 each.
What is NQD Co’s capital structure for the accounting year ended 31 Dec 20X4?
Ordinary share capital
$
A. 480,000
B. 630,000
C. 450,000
D. 630,000
Share premium account
$
606,000
906,000
570,000
606,000
449
III. BONUS AND RIGHTS ISSUES
Example
Example 10: Bonus and rights issues
Answer: D
During 20X4:
1) Make bonus issues by using share premium:
Dr Share premium
Cr Ordinary shares ($300,000 x ½)
$150,000
$150,000
2) Issuing for cash 120,000 shares at 1.8$ each:
Dr Bank
$216,000
Cr Ordinary share (120,000 x $1.5)
$180,000
Cr Share premium [120,000 x (1.8 – 1.5)]
$36,000
Capital structure at 31/12/20X4:
Ordinary share = $300,000 + $150,000 (1) + $180,000 (2) = $630,000.
Share premium account = $720,000 - $150,000 (1) + $36,000 (2) = $606,000.
450
CHAPTER 21: EVENTS AFTER
REPORTING DATE (IAS 10)
451
IAS 10: EVENTS AFTER REPORTING PERIOD
What will you learn?
Events after reporting period
I. Definition
II. Types of events
Adjusting
events
Adjust
Non-adjusting
events
Do nothing
III. Disclosure
452
IAS 10: EVENTS AFTER REPORTING PERIOD
I. Definition
Events after the reporting period are ‘those events which could be favourable or unfavourable,
that occurs between the reporting period and the date that the financial statements are
authorised for issue.' (IAS 10, para.3)
The statement is demonstrated by the following diagram:
Start of the
reporting
period
End of the
reporting
period
FSs are
authorized
for issue
Events after the
reporting period
covered by IAS 10
Information
made public
Shareholder
meeting
Events after the reporting
period NOT covered by IAS 10
453
IAS 10: EVENTS AFTER REPORTING PERIOD
II. Type of events
ADJUSTING EVENTS
NON-ADJUSTING EVENTS
Definition
Events that provide additional evidence
of conditions existing at the reporting
date.
Events that are indicative of conditions
arising after the reporting period;
They do not affect the situation at the
reporting date.
Example
31/12/X1 (year-end):
• Cost of inventory = $30/unit
• 5/1/X2 (after year-end and before FS
are authorized for issue)
• NRV calculated = $20/unit
• Decrease in value of inventory in
previous year but after the reporting
date company obtain evidence about
it ➞ Need to adjust in FSs of X1.
The destruction of assets after the
reporting date by fire or flood
➞ Do not affect the situation at the
reporting date.
Accounting treatment
Change the figure in FSs if material
either an adjusting events or the going
concern concept no longer appropriates.
Disclosure if material by way of a note
to the FSs.
Do nothing if not material.
454
IAS 10: EVENTS AFTER REPORTING PERIOD
II. Type of events
Example 1: Classification events after reporting period
The table below are some examples of adjusting and non-adjusting events you should know:
Adjusting events
Non-adjusting events
• The settlement of a court case which
• Announcing a plan to discontinue an
confirms a year end obligation.
• The receipt of information that indicates
that an asset was impaired at the
reporting date.
• The bankruptcy of a customer that
confirms that a year-end debt is
irrecoverable.
• The sale of inventories at a price lower
than cost
• The discovery of fraud or errors showing
that the financial statements are
incorrect.
operation.
• Major purchases of assets.
• The destruction of assets after the
reporting date by fire or flood.
• Entering into significant commitments
or contingent liabilities.
• Commencing a court case arising out of
events after the reporting date.
455
IAS 10: EVENTS AFTER REPORTING PERIOD
II. Type of events
Example 2: Classification events after reporting period
Which one of the following lists of such events consists only of items that, according to IAS 10,
should normally be classified as non-adjusting?
A. Insolvency of an account receivable which was outstanding at the end of the reporting
period, issue of shares or loan notes, a litigation commenced after the end of the reporting
period
B. Issue of shares or loan notes, changes in foreign exchange rates, major purchases of noncurrent assets
C. An acquisition of another company, destruction of a major non-current asset by fire,
discovery of fraud or error which shows that the financial statements were incorrect
D. Sale of inventory which gives evidence about its value at the end of the reporting period,
issue of shares or loan notes, destruction of a major non-current asset by fire
Guidance:
Candidates can use definition of adjusting and non-adjusting events as a guidance to classify
events after reporting period:
• Events that provide additional evidence of conditions existing at the reporting date
➞ Adjusting events
• Events that do not affect the situation at the reporting date
➞ Non-adjusting events
456
IAS 10: EVENTS AFTER REPORTING PERIOD
II. Type of events
Example 1: Classification events after reporting period
Answer: Option B
•
Insolvency of an account receivable which was outstanding at the
end of the reporting period ➞ provide additional evidence of
insolvency of a client which process exist at least from previous year
instead of occurring instantly ➞ need irrecoverable debts for that
insolvency in FSs at the reporting date ➞ Adjusting events.
•
Issue of shares or loan notes ➞ do not affect the situation at the
reporting date ➞ Non-adjusting events.
•
A litigation commenced after the end of the reporting period ➞ do
not affect the situation at the reporting date ➞ Non-adjusting
events.
•
Issue of shares or
(Refer to option A).
•
Changes in foreign exchange rates ➞ do not affect the situation at
the reporting date ➞ Non-adjusting events.
•
Major purchases of non-current assets ➞ do not affect the situation
at the reporting date ➞ Non-adjusting events.
Option A
Option B
loan notes ➞
Non-adjusting
events
457
IAS 10: EVENTS AFTER REPORTING PERIOD
II. Type of events
Example 1: Classification events after reporting period
Option C
Option D
•
An acquisition of another company ➞ do not affect the situation at
the reporting date ➞ Non-adjusting events.
•
Destruction of a major non-current asset by fire ➞ do not affect the
situation at the reporting date ➞ Non-adjusting events.
•
Discovery of fraud or error which shows that the financial statements
were incorrect ➞ fraud or error occur in previous year but discover
after
reporting date
➞
need
to
adjust in
FSs
➞ Adjusting events.
•
Sale of inventory which gives evidence about its value at the end of
the reporting period ➞ sale of inventory occur in previous year but
company obtain evidence about it after the reporting date ➞ need
to adjust to FSs of previous year ➞ Adjusting events.
•
Issue of shares or
(Refer to option B).
•
Destruction of a major non-current asset by fire ➞ Non-adjusting
events (Refer to option C).
loan
notes
➞
Non-adjusting
events
458
IAS 10: EVENTS AFTER REPORTING PERIOD
III. Disclosure
The information should be provided when disclosure of identified and material non-adjusting
events:
The nature of the event
An estimate of the financial effect,
or a statement that such an estimate
cannot be made.
459
IAS 10: EVENTS AFTER REPORTING PERIOD
III. Disclosure
Example 2: Disclosures
During March 2020, in response to significant decreases in demand amidst the COVID-19
outbreak, the Group announced its intention to temporarily reduce its workforce by 130
positions by the end of April 2020, by means of either reduction in hours or temporary leave.
(The nature of the event).
The Group expects the reduction in positions to reduce salaries and benefits expense in 2020 by
a net amount between CU25,000 and CU20,000 per month (An estimate of financial effect).
Note:
Dividends proposed or declared after the end of the reporting period but before the financial
statements are authorized will:
• Not recognised as a liability in the accounts at the reporting date; and
• Disclosed in the notes to the accounts.
460
CHAPTER 22: STATEMENT OF
CASH FLOW (IAS 7)
461
OVERVIEW
What will you learn?
Statement of cash flows
The need of
cash flows statements
Definition
Operating activities
Investing activities
Classification of activities
in cash flows
Preparing a cash flow
statement
Financing activities
Direct method
Indirect method
Advantage and disadvantages
of cash flows
462
I. THE NEED OF STATEMENT OF CASH FLOW
Profit versus cash flow
The diagram below shows the difference between 'Profit' and 'Cash flow':
Cash in
Cash in
Sales
Receivables
(non-cash)
Cash out
Cash out
AP (non-cash)
Expenses
Depreciation
(non-cash)
…
Profit
≠
Cash flow
Profit, including both cash and non-cash sale and expense, is not the same
as cash flow => In some cases, although a business entity makes profits, it
has insufficient cash available to pay its suppliers and shareholders
A misconception by some that if a company makes profits, it can afford to
pay higher wages next year. The ability to pay ways depends on the
availability of cash, not profit.
It seems that a company's performance and prospects depends more realistically on liquidity or
cash flows. Profits does not always give a useful or meaningful picture of a company's operations,
because:
463
II. DEFINITION
Terminologies
Terminologies
Statement of
cash flows
• An additional statement to the FSs
• Concentrate on the sources and users of cash
• A useful indicator of a company’s liquidity and solvency
Cash
Comprises
• Cash on hand
• Demand deposits
Cash
equivalents
Short-term, highly liquid investments that are readily
convertible to cash with insignificant risk of changes in value
Cash flows
Inflows and outflows of cash and cash equivalents.
Operating
activities
The principal revenue-producing activities of the entity and
other activities that are not investing or financing activities.
Investing
activities
The acquisition and disposal of long term assets and other
investments not included in cash equivalents
Financing
activities
Activities that result in changes in the size and composition of
the contributed equity capital and borrowings of the entity.
464
III. CLASSIFICATION OF ACTIVITIES
IN STATEMENT OF CASH FLOWS
1. Structure of a statement of cash flows
The statement of cash flows shall report cash flows during the period classified by
operating, investing and financing activities.
Operating activities
Investing activities
Financing activities
are
the
principal
revenue-producing
activities of the entity
and other activities that
are not investing or
financing activities.
are the acquisition and
disposal of long-term
assets
and
other
investments
not
included
in
cash
equivalents.
are activities that result
in changes in the size
and composition of the
contributed equity and
borrowings
of
the
entity.
Examples:
• Cash receipts from sale
of goods and rendering
of services;
• Cash receipts from
royalties,
fees,
commissions and other
revenue;
• Cash
payments
to
suppliers for goods and
services.
Examples:
• Cash
payments
to
acquire
non-current
assets;
• Cash receipts from sales
of non-current assets;
• Cash
payments
to
acquire shares or loan
notes of other entities.
Examples:
• Cash proceeds from
issuing shares or other
equity instruments;
• Cash
payments
to
owners to acquire or
redeem entity’s shares;
• Cash proceeds from
issuing loans, notes,
bonds, etc.
465
III. CLASSIFICATION OF ACTIVITIES
IN STATEMENT OF CASH FLOWS
2. Presentation of some special items
Interest and dividends
Cash flows from interest and dividends received and paid shall each be disclosed
separately. Each shall be classified in a consistent manner from period to period as
either operating, investing or financing activities.
Interest and dividends received may be
classified as:
• an operating cash flow; or
• an investing cash flow.
Interest and dividends paid may be
classified as:
• an operating cash flow; or
• a financing cash flow.
Taxes on income
Cash flows arising from taxes on income shall be separately disclosed as part of
operating activities unless they can be specifically identified with financing and investing
activities.
466
III. CLASSIFICATION OF ACTIVITIES
IN STATEMENT OF CASH FLOWS
3. Examples
Example 1: Classification of activities in statement of cash flows
Operating
Investing
Financing
Operating or Operating or
Financing
Investing
1. Tax paid
2. Equity dividend paid
3. Process of sales of
short-term investment
4. Payment of staff wages
5. Cash payment to
reduce a lease liability
6. Repayment of bank loan
7. Interest received
8. Cash loan made to a
supplier
Require: Classify the above activities into three types of activities including Operating activities,
Investing activities, and Financing activities.
467
III. CLASSIFICATION OF ACTIVITIES
IN STATEMENT OF CASH FLOWS
3. Examples
Example 1: Classification of activities in statement of cash flows
Answer:
Operating
1. Tax paid
Cash payment paid to tax
authorities when company
sells goods (main revenue producing activities)
2. Equity dividend paid
• Classify as financing cash
flow activities as it is the cost
of
obtaining
financial
recource; or
• Classify as operating cash
flow activities in order to
assist users to assess the
entity’s ability to pay
dividends out of operating
cash flows (IAS 7)
3. Process of sales of short term investment
Disposal
of
short-term
investment
4. Payment of staff wages
Cash payment paid to staffs
when selling goods main
revenue-producing activities
Investing
Financing
Operating or Operating or
Financing
Investing
x
x
x
x
468
III. CLASSIFICATION OF ACTIVITIES
IN STATEMENT OF CASH FLOWS
3. Examples
Example 1: Classification of activities in statement of cash flows
Answer:
Operating
5. Cash payment to reduce a
lease liability
Cash paid as result of
borrowings of the entity
6. Repayment of bank loan
Cash paid as result of
borrowings of the entity
7. Interest received
• With financial institution,
their model is based around
generating
receipts
of
interest and dividends →
interest received shows
income from their main
revenue - producing activities
• With entity other than
financial institution, interest
received shows return on
investment
->
Financial
activities
8. Cash loan made to a
supplier
Cash paid as an investment
to other entity
Investing
Financing
Operating or Operating or
Financing
Investing
x
x
x
x
469
IV. PREPARING A STATEMENT OF CASH FLOW
Method to prepare SOCF
Statement of cash flow
Operating activities
Direct
method
Indirect
method
(Refer to
section
IV.1)
(Refer to
section
IV.1)
Investing activities
Financing activities
Prepared in direct method
(Refer to section IV.2, IV.3)
Notes:
In exams, candidates often required to prepare an extract or the whole statement of cash
flow in the multi task questions, or answer OT question.
The indirect method is more commonly examined. Steps to prepare a statement of cash
flows using indirect method are described in example below.
470
IV. PREPARING A STATEMENT OF CASH FLOW
1. Reporting cash flows from operating activities
Direct method
Indirect method
Disclose major classes of gross cash
receipts and gross cash payments
Net profit or loss is adjusted for the
effects of transactions of a non-cash
nature, any deferrals or accruals of past
or future operating cash receipts or
payments, and items of income or
expense associated with investing or
financing cash flows



Less likely to wrongly calculate as
there is no need for adjustment
More time to prepare


More likely to wrongly calculate
because of adjustment
Less time to prepare
More widely used
471
IV. PREPARING A STATEMENT OF CASH FLOW
1. Reporting cash flows from operating activities
Direct method
Indirect method
Step 1
Create a proforma for the direct
method
Step 1
Create a proforma for the indirect
method
Step 2
Fill proforma using information
from
FS
and
additional
information in the scenario
Step 2
Adjust for the change in
depreciation, investment income
and interest expense (if any)
Step 3
Adjust for the changes during the
period in inventories, operating
receivables and payables
Step 4
Adjust for the changes in interest
paid and income tax paid
Step 5
Fill proforma using calculation
from step 2 to 4
472
IV. PREPARING A STATEMENT OF CASH FLOW
1. Reporting cash flows from operating activities
Direct method
Indirect method
$
$
Cash flow from operating activities
Cash flow from operating activities
Cash receipts from customers (1)
Cash paid to suppliers and employees
(2)
Other operating payments (3)
Cash generated from operations
(4) = (1) + (2) + (3)
Interest paid (5)
Income taxes paid (6)
X
(X
)
(X
)
X
(X
)
(X
)
Net cash from operating activities
X
(7) = (4) + (5) + (6)
Note:
Your FA exam is a CBE, so you will be given the
statement of cash flows pro-forma and you
just have to fill in the numbers and state
whether they are added to or deleted from
cash flows.
Profit before tax (P/L) (1)
X
Adjustment for:
Depreciation (2)
X
Investment income (3)
(X)
Interest expense (4)
Operating profit before working capital
changes (5) = (1) + (2) – (3) + (4)
(Increase)/decrease in trade and other
receivables (6)
(Increase)/decrease in inventories (7)
Increase/(decrease) in trade payables
(8)
Cash generated from operations
(9) = (5) ± (6) ± (7) ± (8)
Interest paid (10)
X
Income taxes paid (11)
Net cash from operating activities
(12) = (9) – (10) – (11)
(X)/X
(X)/X
X/(X)
X
(X)
(X)
X
473
IV. PREPARING A STATEMENT OF CASH FLOW
1. Reporting cash flows from operating activities
Example 2: Preparing statement of cash flows
Statement of profit or loss
Operating profit
Investment income
Finance costs
Profit before tax
Tax
Profit for the year
Other comprehensive income
Revaluation gain
Total comprehensive income
$
48,000
7,200
(6,000)
49,200
(19,200)
Statement of financial position
Closing
Opening
balance
balance
$
$
Current asset
Inventory
18,000
15,000
Receivables
12,000
15,600
Current liabilities
Trade payables
8,400
6,600
30,000
24,000
54,000
Additional information:
(i) During the year depreciation of $30,000 and amortization of $24,000 was charged to profit.
(ii) Receipts from customers, combined with cash sales, were $480,000, payments to suppliers of
raw materials $240,000, other operating cash payments were $60,000 and cash paid on
behalf and to employees was $75,600.
(iii) Interest paid is $7,200 and taxation paid is $7,800.
Required: Using the direct method and indirect methods to prepare the operating activities
section of the statement of cash flows.
474
IV. PREPARING A STATEMENT OF CASH FLOW
1. Reporting cash flows from operating activities
Example 2: Preparing statement of cash flows
(1) Solution - Prepare SOCF using direct method
Guidance:
Step1: Create a proforma for the direct method as given below:
Cash flow from operating activities
$
Cash receipts from customers (1)
X
Cash paid to suppliers and employees (2)
(X)
Other operating payments (3)
(X)
Cash generated from operations (4) = (1) + (2) + (3)
X
Interest paid (5)
(X)
Income taxes paid (6)
(X)
Net cash from operating activities (7) = (4) + (5) + (6)
$
X
Operating activities have positive value or negative value depend on their affect to cash flow:
• Cash inflow -> Positive value (Normally come from cash receipts)
• Cash outflow -> Negative value (Normally come from cash payments)
Step 2: Fill proforma using information from FSs and additional information in the scenario
475
IV. PREPARING A STATEMENT OF CASH FLOW
1. Reporting cash flows from operating activities
Example 2: Preparing statement of cash flows
(1) Solution - Prepare SOCF using direct method
Answer:
$
$
Cash flow from operating activities
Cash receipts from customers (1)
480,000
[(Additional information (ii)])
Cash paid to suppliers and employees (2) (= 240,000 + 75,600)
(315,600)
[(Additional information (ii))]
Other operating payments (3)
(60,000)
([Additional information (ii))]
Cash generated from operations (4) = (1) + (2) + (3)
104,400
(= 480,000 – 315,600 – 60,000)
Interest paid (5)
(7,200)
([Additional information (iii)])
Income taxes paid (6)
(7,800)
([Additional information (iii)])
Net cash from operating activities (7) = (4) + (5) + (6)
(= 104,400 – 7,200 – 7,800)
89,400
476
IV. PREPARING A STATEMENT OF CASH FLOW
1. Reporting cash flows from operating activities
Example 2: Preparing statement of cash flows
(2) Solution - Prepare SOCF using indirect method
Guidance: In direct method, we have to adjust the net profit or loss
Step1: Create a proforma for indirect method
$
Cash flows from operating activities
Profit before tax (statement of profit or loss) (1)
$
X
Adjustment for
Depreciation (2)
X
Investment income (3)
(X)
Interest expense (4)
X
Operating profit before working capital changes
(5) = (1) + (2) – (3) + (4)
X
(Increase)/decrease in trade and other receivables (6)
(X)/X
(Increase)/decrease in inventories (7)
(X)/X
Increase/(decrease) in trade payables (8)
X/(X)
Cash generated from operations (9) = (5) ± (6) ± (7) ± (8)
X
Interest paid (10)
(X)
Income taxes paid (11)
(X)
Net cash from operating activities (12) = (9) – (10) – (11)
Step 2
Step 3
Step 4
X
477
IV. PREPARING A STATEMENT OF CASH FLOW
1. Reporting cash flows from operating activities
Example 2: Preparing statement of cash flows
(2) Solution - Prepare SOCF using indirect method
Guidance: In direct method, we have to adjust the net profit or loss
Step 2: Adjust for the change in depreciation, investment income and interest expense (if any)
You need to add depreciation and interest expense and subtract investment income. But it is very
important to understand why certain items are added and other subtracted. General principles:
Cash in
Sales
Expenses
Cash in
Receivables
(non-cash)
Cash out
AP (non-cash)
Depreciation
(non-cash)
Cash out
…
•
•
•
•
•
Adjust to
Profit
Cash flow
Subtract non-cash sales because: non-cash sales make sale greater than cash in  profit is
greater than cash flow  to adjust profit to cash flow we need to subtract them from profit
Add back non-cash expenses because: non-cash expenses make expense greater than cash
out  profit is greater than cash flow  to adjust profit to cash flow we need to add them
to profit
Depreciation is added back to profit before tax because it is a non-cash expense
Investment income is subtracted from profit before tax because it is an income which is
not part of cash generated from operations.
Interest expense is added back to profit before tax to eliminate its effect to operating
activities as interest expense include both cash and non-cash (the cash payment will be
deducted in “interest paid” figure).
478
IV. PREPARING A STATEMENT OF CASH FLOW
1. Reporting cash flows from operating activities
Example 2: Preparing statement of cash flows
(2) Solution - Prepare SOCF using indirect method
Guidance: In direct method, we have to adjust the net profit or loss
Step 3: Adjust for the changes during the period in inventories, operating receivables and
payables, see the table below: (You can get information from statement of financial position)
If the account
balance increases
Current Assets
Accounts Receivable (money from customers)
A decrease in receivables is added to profit before tax as it
represents a cash inflow as more cash has been collected
from receivables.
An increase in trade receivables is therefore subtracted from
profit before tax
Inventory (buy or pay for inventory)
A decrease in inventory is added to profit before tax as it
represents a cash inflow from disposing of inventory.
An increase in inventory is subtracted from profit before tax
as it represents a cash outflow to pay for the additional
inventory.
Current Liabilities
Accounts Payable (pay your bills)
A decrease in trade payables is subtracted from profit before
tax as it represents a cash outflow as more payables have
been paid off.
An increase in trade payables is added to profit before tax as
company is holding money from customers.
If the account
balance decreases
Subtract
Add
Subtract
Add
Add
Subtract
Step 4: Adjust for the changes in interest paid and income tax paid: Interest paid and income tax
paid are subtract from profit before tax because they are cash expenses.
Step 5: Fill proforma of indirect method base on calculation from step 2 to 4
479
IV. PREPARING A STATEMENT OF CASH FLOW
1. Reporting cash flows from operating activities
Example 2: Preparing statement of cash flows
(2) Solution - Prepare SOCF using indirect method
Answer:
After creating a proforma [(step 1)] adjust all non-cash items or accruals-based figures ([step 24)], you can fill proforma ([step 5)] as below:
$
$
Cash flows from operating activities
Profit before tax (statement of profit or loss) (1)
49,200
Adjustment for
Depreciation (2)
30,000
Armotization (3)
24,000
Investment income (4)
(7,200)
Interest expense (5)
6,000
Operating profit before working capital changes
(6) = (2) + (3) + (4) + (5)
(Increase)/decrease in trade and other receivables (7)
102,000
(Increase)/decrease in inventories (8)
(3,000)
Increase/(decrease) in trade payables (9)
1,800
Step 2
3,600
Step 3
Cash generated from operations (10) = (6) + (7) + (8) + (9)
104,400
Interest paid (11)
(7,200)
Income taxes paid (12)
(7,800)
Net cash from operating activities
(13) = (10) + (11) + (12)
Step 4
89,400
480
IV. PREPARING A STATEMENT OF CASH FLOW
2. Reporting cash flows from investing activities
The investing cash flows of the statement of cash flows would appear something like this:
$
Interest received
X
Dividends received
X
Proceeds of sale of non-current assets
X
Purchase of property, plant and equipment
(X)
Net cash from investing activities
X
Note: Normally you can use information from statement of financial position (SOFP)
and statement of profit or loss (SOPL) to fill these proforma.
But sometime information are not shown in both SOFP and SOPL and required you
to calculate. Common cash flow calculations include the payment to buy PPE and
receipts from sales PPE. You can use T account to calculate them.
481
IV. PREPARING A STATEMENT OF CASH FLOW
3. Reporting cash flows from financing activities
The financing cash flows of the statement of cash flows would appear something like this:
$
Proceeds of the issue of shares
X
Proceeds of receipt of loans/debentures
X
Repayment of loans/debentures
(X)
Dividends paid
(X)
Interest paid
(X)
Net cash from investing activities
X
Note: Same as investing activities, you can use information from SOFP, SOPL or
calculate them using T-account.
482
IV. PREPARING A STATEMENT OF CASH FLOW
4. Preparing a statement of cash flows
Here is an example of statement of cash flows (using direct method)
STATEMENT OF CASH FLOWS
(DIRECT METHOD)
YEAR ENDED 20X1
$m
$m
Cash flows from operating activities
Cash receipts from customers
Cash paid to suppliers and employees
Cash generated from operations
Interest paid
Income taxes paid
Net cash from operating activities
45,450
(41,355)
4,095
(405)
(1,350)
Cash flows from investing activities
Purchase of property, plant and equipment
Interest received
Dividends received
Net cash used in investing activities
(1,350)
330
300
Cash flows from financing activities
Proceeds from long-term borrowings
Dividends paid
Net cash used in financing activities
Net increase in cash and cash equivalents
Cash and cash equivalents at beginning of period
Cash and cash equivalents at end of period
2,340
(720)
750
(1,935)
(1,185)
435
180
615
483
IV. PREPARING A STATEMENT OF CASH FLOW
4. Preparing a statement of cash flows
Here is an example of statement of cash flows (using indirect method)
STATEMENT OF CASH FLOWS YEAR ENDED 20X1
(INDIRECT METHOD)
$m
Cash flows from operating activities
Net profit before taxation
Adjustments for:
Depreciation
Investment income
Interest expense
Operating profit before working capital changes
Increase in trade and other receivables
Decrease in inventories
Decrease 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
Interest received
Dividends received
Net cash used in investing activities
Cash flows from financing activities
Proceeds from long-term borrowings
Dividends paid
Net cash used in financing activities
Net increase in cash and cash equivalents
Cash and cash equivalents at beginning of period
Cash and cash equivalents at end of period
$m
5,355
675
(750)
600
5,880
(750)
1,575
(2,610)
4,095
(405)
(1,350)
2,340
(1,350)
330
300
(720)
750
(1,935)
(1,185)
435
180
615
484
IV. PREPARING A STATEMENT OF CASH FLOW
4. Prepare a statement of cash flows
Exam focus: Preparing statement of cash flows
Colin Co has statement of profit or loss and statement of financial position for the year ended
31/12/20X2
• During the year, the company paid $90,000 for a new piece of machinery.
• Dividends paid during 20X2 totaled $66,000 and interest paid was $28,000.
Required: Prepare SOCF using the indirect method.
STATEMENT OF PROFIT OR LOSS
$’000
Revenue
Raw material consumed
Staff costs
Depreciation
Loss on disposal of non-current asset
$’000
720
70
94
118
18
(300)
420
Interest payable
Profit before tax
Taxation
Profit for the year
(28)
392
(124)
268
485
IV. PREPARING A STATEMENT OF CASH FLOW
2. Prepare a statement of cash flows
Exam focus: Preparing statement of cash flows
Colin Co has statement financial position as at 31/12/20X2 (cont')
STATEMENT OF FINANCIAL POSITION
20X2
$’000
$’000
Non-current assets
Property, plant and equipment
Cost
Depreciation
1,596
318
20X1
$’000
1,560
224
1,278
Current assets
Inventory
Trade receivables
Bank
24
76
48
Equity
Capital and reserves
Share capital
Share premium
Retained earnings
Non-current liabilities
Non-current loans
Current liabilities
Trade payables
Taxation
Total equity and liabilities
1,336
20
58
56
148
1,426
Total assets
$’000
360
36
716
134
1,470
340
24
514
1,112
878
200
500
12
102
6
86
114
1,426
92
1,470
486
IV. PREPARING A STATEMENT OF CASH FLOW
2. Prepare a statement of cash flows
Exam focus: Preparing statement of cash flows
Answer: After 3 working, we can create statement of cash flow as follow:
$
Net cash flows from operating activities
Profit before tax
Depreciation charges
Loss on sale of property, plant and equipment
Interest expense
Increase in inventories
Increase in receivables
Increase in payables
Cash generated from operations
Interest paid
Dividends paid
Tax paid
Net cash flows from operating activities
392
118
18
28
(4)
(18)
6
540
(28)
(66)
(108)
Cash flows from investing activities
Payment to acquire property, plant and equipment
Receipts from sale property, plant and equipment
Net cash flows from investing activities
(90)
12
Cash flows from financing activities
Issues of share capital (360 + 36 – 340 – 24)
Long-term loans repaid (500 – 200)
Net cash flows from financing activities
Decrease in cash and cash equivalents
Cash and cash equivalent at 1/1/20X2
Cash and cash equivalent at 31/12/20X2
$
338
(78)
32
(300)
(268)
(8)
56
48
487
IV. PREPARING A STATEMENT OF CASH FLOW
2. Prepare a statement of cash flows
Exam focus: Preparing statement of cash flows
Answer:
[Working 1]: Prepare operating activities sections
Step 1 + 5:
$
Net cash flows from operating activities
Profit before tax
Depreciation charges
Loss on sale of property, plant and equipment
Interest expense
Increase in inventories
Increase in receivables
Increase in payables
Cash generated from operations
Interest paid
Dividends paid
Tax paid
Net cash flows from operating activities
Step 2: Adjust for Depreciation and loss on sale of PPE
•
Depreciation charges = 118  Add 118
•
Loss on sale of property, plant and equipment = 18
decrease on sales  profit < cash flow)
$
392
118
18
28
(4)
(18)
6
540
(28)
(66)
(108)
338
Add 18 (because loss on sales on PPE
488
IV. PREPARING A STATEMENT OF CASH FLOW
2. Prepare a statement of cash flows
Exam focus: Preparing statement of cash flows
Answer:
[Working 1]: Prepare operating activities sections
Step 3: Adjust for the changes during the period in inventories, operating receivables and
payables
•
Inventories
Opening balance = 20
Closing balance = 24 > 20 -> Subtract 24 – 20 = 4
•
Receivables
Opening balance = 58
Closing balance = 76 > 58 -> Subtract 76 – 58 = 18
•
Payables
Opening balance = 6
Closing balance = 12 > 6 -> Add 12 – 6 = 6
Step 4: Adjust for the changes during the period in interest expense and income tax paid
o
Interest expense = 28 -> Add 28
o
Income tax paid: Using T account as below
TAXATION
$’000
At 1/1/20X2
$’000
86
Income tax paid (bal figure)
Taxation occurred
(= 124 + 86 – 102)
At 31/12/20X2
=> Income tax paid = 108
108
102
124
489
IV. PREPARING A STATEMENT OF CASH FLOW
2. Prepare a statement of cash flows
Exam focus: Preparing statement of cash flows
Answer:
[Working 2]: Prepare investing activities sections
Cash flows from investing activities
Payment to acquire property, plant and equipment
(90)
[Additional information]
Receipts from sale property, plant and equipment [Note 1]
12
Net cash flows from investing activities
(78)
Note 1:
Receipts from sale PPE = Carrying value of disposal - Net loss reported [SOPL]
= (Cost of Disposal Asset - Depreciation on disposals) - Net loss reported
=> Receipts from sale PPE = (54-24) - 18 = 12
Calculate Cost of Disposal Asset and depreciation on disposals: Using T account as below
COST
$’000
1,560 At 31/12/20X2
90 Disposal (balance)
1,650
At 1/1/20X2
Purchases
At 1/1/20X2
Depreciation
(balance)
on
ACCUMULATED DEPRECIATION
$’000
318 At 31/12/20X2
disposals
Charge for the year
24
342
$’000
1,596
54
1,650
$’000
1,596
118
342
490
IV. PREPARING A STATEMENT OF CASH FLOW
2. Prepare a statement of cash flows
Exam focus: Preparing statement of cash flows
Answer:
[Working 3]: Prepare financing activities sections
Cash flows from financing activities
Issues of share capital (360 + 36 – 340 – 24) (SOFP)
Long-term loans repaid (500 – 200) (SOFP)
Net cash flows from financing activities
32
(300)
(268)
Note:
In exam, candidates often required to prepare an extract or the whole statement of cash flow in
the multi task question, or answer OT question.
The indirect method is more commonly examined. Steps to prepare a statement of cash flows
using indirect method are detaily described in the above example.
491
V. ADVANTAGE AND DISADVANTAGE OF CASH FLOWS
Advantages and disadvantages of cash flows
Advantages
Demonstrate
generate cash
ability
Disadvantages
to
Cash flow is more objective
than profit
More comparability between
entities
Better basis
making
for
decision
Easy to understand, prepare
and audit.
Basically the opposite of
advantages
of
accruals
accounting
Example
Cash flow does not match
income and expenditure in the
income statement.
492
CHAPTER 23: INTRODUCTION
TO CONSOLIDATED FINANCIAL
STATEMENTS
493
OVERVIEW
What will you learn?
Introduction to consolidated
financial statement
II. Consolidated
financial statements
I. Introduction to groups
Definition
Types of
investment
Requirement
Basic
principles
Content
494
I. INTRODUCTION TO GROUPS
1. Definition
A group exists where one entity, the parent (referred to as 'the investor'), has control
over another entity, the subsidiary (referred to as 'the investee').
A parent is an entity that controls one or more entities.
To reflect the financial performance and position of the group, consolidated financial
statements are prepared. We will describe it more detail in Section II.
495
I. INTRODUCTION TO GROUPS
2. Types of investment
There are three types of investments: Subsidiaries, Associates, Trade investments.
Subsidiaries
Control
Associates
Significant
influence
Trade
investments
Other
• More than 50% of ordinary (equity) shares
• Less than 50% and the parent has power to:
O Govern the financial and operating policies of the entity
O Appoint or remove a majority of members of BOD
O Cast a majority of votes at meeting of BOD
• More than 20% of ordinary (equity) shares
• Less than 20% and the parent:
O Represent on the BOD of the investee participate in the
policy-making process
O Had material transactions with investee
O Had interchanged of management personnel
O Had provision of essential technical information.
Other than control and significant influence (Normally less
than 20%)
496
I. INTRODUCTION TO GROUPS
2. Types of investment
Example 1: Classification types of investment
Black Co owns the following investments in other companies:
Red Co
Blue Co
Yellow Co
Green Co
Orange Co
Equity shares
75%
30%
45%
18%
10%
Non-equity shares held
Nil
80%
30%
Nil
30%
Black Co also has appointed five of the seven places on the board of directors of Yellow
Co.
Directors of Black Co having two of the five places on the board of Green Co.
Classifying each company as subsidiary, associates or trade investments.
Subsidiary
Red Co
Blue Co
Yellow Co
Green Co
Orange Co
Associates
Trade investments
497
I. INTRODUCTION TO GROUPS
2. Types of investment
Example 1: Classification types of investment
Guidance:
Start from the percentages of equity share hold by investor, you can identify possible
types of investment and then classify base on the differences of each types identified.
Percentages of
equity share
hold by
investor
Type of investment
How to classify
>50%
Subsidiary
Subsidiary
20-50%
Subsidiary or associate
Company has control power or not(or
significant influence)
•
•
<20%
Associate or Trade
investment
Control power 🡪 Subsidiary
No control power/ significant
influence 🡪 Associate
Company has significant influence
power or not.
•
Significant influence 🡪 Associate
•
No significant influence 🡪 Trade
investment
498
I. INTRODUCTION TO GROUPS
2. Types of investment
Example 1: Classification types of investment
Answer:
Red Co
Blue Co
Yellow Co
Green Co
Orange Co
Subsidiary
✓
Associates
Trade investments
✓
✓
✓
✓
Red Co
Black Co has 75% of the equity shares of Red Co, which is more than 50%. This gives
them control 🡪 Red Co is a subsidiary.
Blue Co
Black Co has 30% of equity shares of Blue Co, and there is no sign of control power
of Black Co 🡪 Blue Co is an associate.
Yellow Co
Black Co has 45% of the equity shares of Yellow Co.
The fact that Black Co also has appointed five of the seven directors of Yellow Co 🡪
They have power to appoint or remove a majority of members of the board of
directors. 🡪 Yellow Co is a subsidiary.
Green Co
Black Co has 18% of the equity shares of Green Co
Black Co has 2 out of 5 places on board 🡪 Black Co has significant influence to
Green Co 🡪 Green Co is an associate.
Orange Co
Black Co has 10% of the equity shares of Orange Co 🡪
investment.
Black Co is a trade
499
I. INTRODUCTION TO GROUPS
2. Types of investment
2.1
Subsidiaries
A subsidiary is an entity controlled by another entity.
IFRS 10 requires accounting treatment of subsidiaries in consolidated financial statements
as follows:
The accounts of the parent and
subsidiaries are combined and
presented as a single entity
ACCOUNTING
TREATMENT
Consolidated financial statements
ignore the legal boundaries
We will consider the mechanics of preparing consolidated accounts in chapter 24: The
consolidated statement of financial position and chapter 25: The consolidated statement of
comprehensive income.
500
I. INTRODUCTION TO GROUPS
2. Types of investment
2.2
Associates
Associate is an entity over which the investor has significant influence. This is the power to
participate in the financial and operating policy decisions of the investee but which is not
control or joint control of those policies.
Accounting treatment: Equity method
Consolidated Statement of
comprehensive income - SOCI
Consolidated Statement of
financial position – SOFP
Associate’s sales revenue, cost of
sales... are not amalgamated with the
group
Only the group share of associates’
profit after tax is added to the group
profit
Record the investment at cost at the
acquisition
DR Investment in associate (at cost)
CR Cash
Subsequently adjust the amount each period
for the investor’s proportionate share of the
earnings (losses)
DR Investment in associate
CR Profit from investment
Subsequently adjust the amount each period
for the investor’s proportionate share of the
dividends received by the investor.
DR Cash
CR Investment
501
I. INTRODUCTION TO GROUPS
2. Types of investment
2.2
Associates
Example 2: Equity method
A Co acquires 30,000 of the 120,000 1$ ordinary shares in B Co for $36,000 paid by cash
on 1 January 20X1. In the year to 31 December 20X1, B Co earns profits after tax of
$14,400, from which it pays a dividend of $3,600 by cash
How will B Co's results be accounted for in the consolidated accounts of A Co for the
year ended 31 December 20X1?
502
I. INTRODUCTION TO GROUPS
2. Types of investment
2.2
Associates
Example 2: Equity method
Answer:
A Co has 30,000/120,000 = 25% of the ordinary shares in B Co 🡪 B Co is an Associate 🡪
A Co has to apply equity method in preparing Consolidated financial statements.
(1) Consolidated Statement of profit or loss
Only the group share of associates’ profit after tax which is 25% x $14,400 = $3,600 is
added to the group profit.
(2) Consolidated Statement of financial position
• Record the investment at cost at the acquisition = $36,000
DEBIT
Cost of investment in associate
36,000
CREDIT
Cash
36,000
• Subsequently adjust the amount each period for the investor’s proportionate share of
the earnings (losses) = 25% x 14,400 = $3,600
DEBIT
Cost of investment in associate
3,600
CREDIT
Share of post-acquisition profits
3,600
• Subsequently adjust the amount each period for the investor’s proportionate share of
the dividends received by the investor = 25% x 3,600 = $900
DEBIT
Cash
900
CREDIT
Cost of investment in associate
900
503
I. INTRODUCTION TO GROUPS
2. Types of investment
2.2
Associates
Example 2: Equity method
Answer:
The consolidated statement of financial position will include the asset 'Investment in
associate', calculated as follows:
$
Cost of investment in associate
36,000
Add: Share of B’s profit for the year
3,600
Less: dividend received
(900)
Investment in associate
38,700
504
I. INTRODUCTION TO GROUPS
2. Types of investment
2.3
Trade investments
A trade investment is:
• a simple investment in the shares of another entity, that is held for the accretion of
wealth, and is not an associate or a subsidiary; and
• shown as investments under non-current assets in the consolidated statement of
financial position of the group.
Note: F3 (FA) syllabus only requires you to define and describe a trade investment. To get
deeper.
505
II. CONSOLIDATED FINANCIAL STATEMENTS
1. Requirement to prepare consolidated financial statements
If one entity controls another, company is required to prepare consolidated financial
statements (consolidated FS) to reflect the financial performance and position of the group
as one combined entity.
To be more specific, revenues, expenses, assets and liabilities of the parent and
subsidiaries are combined for ease of understanding and analysis. It helps shareholders
make decision about their investment.
506
II. CONSOLIDATED FINANCIAL STATEMENTS
2. The basic principles of preparing
a consolidated statement of financial position
For the preparation of consolidated financial position, entities must observe the following
basic principles:
Consolidation means adding together.
Consolidate as if you owned
everything then show the
extent to which you do not
own everything.
Consolidation means cancellation
of like items to the group.
Explanation of these basic principles are described in the next example.
507
II. CONSOLIDATED FINANCIAL STATEMENTS
2. The basic principles of preparing
a consolidated statement of financial position
Example 3: Basic principles of preparing a consolidated statement of financial
position
There are two companies, Lens and Sweet.
• Lens owns 80% of the shares in Sweet.
• Lens has a head office building worth $300,000. Sweet has a factory worth $240,000.
• Lens has receivables of $120,000 and Sweet has receivables of $90,000. Included in the
receivables of Lens is $10,000 owed by Sweet.
• Lens has payables of $150,000 and Sweet has payables of $135,000.
Apply Basic principles in preparing consolidated financial statement:
(1) Adding together: Revenues, expenses, assets and liabilities are added together
You add together the values of the head office building and the factory to get an asset,
land and buildings, in the group accounts of $300,000 + $240,000 = $540,000.
But it is not just simply like that, especially when there are transactions within the
group. If we just added the figures together, we would not reflect the financial
performance and position of the group as one combined entity.
Therefore, we have second principles - cancellation of like items to the group.
508
II. CONSOLIDATED FINANCIAL STATEMENTS
2. The basic principles of preparing
a consolidated statement of financial position
Example 3: Basic principles of preparing a consolidated statement of financial
position
(2) Cancellation of like items to the group
To arrive at a fair picture, we eliminate both the receivable of $10,000 in Lens's books
and the payable of $10,000 in Sweet's books. Only then do we consolidate by adding
together.
Consolidated receivables = $120,000 + $90,000 - $10,000
= $200,000
Consolidated payables = $150,000 + 135,000 - $10,000
= $275,000
(3) Consolidate as if you owned everything then show the extent to which you do not
own everything
• Consolidate as if you owned everything
Lens have 80% of shares of Sweet 🡪 Lens controls Sweet, including Sweet’s entire asset,
not just 80% of it. Therefore, in order to reflex group as one combined entity, the figure
for consolidated land and buildings is $300,000 + $240,000 = $540,000 as stated above,
not $300,000 + 80% x $240,000 = $492,000.
• Show the extent to which you do not own everything
There may well be one or more shareholders who own the remaining 20% of the shares
in Sweet Ltd. These shareholders cannot visit 20% of the factory or tell 20% of the
workforce what to do, but they do have an interest in 20% of the net assets of Sweet,
called “non-control interest”. Therefore, we have to show this non-controlling interest
in the equity section of the consolidated statement of financial position.
509
II. CONSOLIDATED FINANCIAL STATEMENTS
3. Content of consolidated financial statements
Package of financial statements presented by parent companies includes:
1
Parent company financial statements, which will
include 'investments in subsidiary undertakings' as an
asset in the statement of financial position, and
income from subsidiaries (dividends) in the statement
of profit or loss and other comprehensive income
2
Consolidated statement of financial position
3
Consolidated statement of comprehensive income
4
Consolidated statement of cash flows
Additional set
of financial
statements
(this is beyond the scope of the FFA/FA syllabus)
Note: In chapter 24 and 25 we will describe how to prepare a simple consolidated
statement of financial position and consolidated statement of comprehensive income.
510
CHAPTER 24: THE
CONSOLIDATED STATEMENT OF
FINANCIAL POSITION
511
OVERVIEW
What will you learn?
The consolidated
statement of financial
position
I. The mechanics of
consolidation
II. Effect of intragroup trading and
mid-year acquisition
Apply basic principles
Consolidation means
adding together
Consolidation means
cancellation of like items
to the group
Adjust:
Assets & liabilities
are added together
• Fair value adjustment
on the PPE
• Intra-group trading
Consolidate as if you
owned everything then
show the extent to
which you do not own
everything
The non - controlling
interest in the
subsidiary’s net asset is
separately reported as a
part of equity
512
I. THE MECHANICS OF CONSOLIDATION
Basic principles
Apply 3 basic principles (mentioned in section II.2 of chapter 23) in preparing consolidated
statement of financial position (consolidated SOFP):
Basic principles
Consolidation means
adding together
Consolidation means
cancellation of like items
to the group.
Adjust:
Assets & liabilities are
added together
• Fair value adjustment
on the PPE
• Intra-group trading
Consolidate as if you
owned everything then
show the extent to
which you do not own
everything.
The non-controlling
interest in the
subsidiary’s net asset is
separately reported as
a part of equity
513
I. THE MECHANICS OF CONSOLIDATION
Basic principles
The proforma of consolidated SOFP is describe as below:
Assets are Adjust fair-value
added together
$
on PPE
Non-current asset
Goodwill
Working 4
X
PPE
Parent + Subsidiaries + Fair value adjustment on the PPE X
Current assets
Inventory
Parent + Subsidiaries - Intra-group trading related
X
Receivables
Parent + Subsidiaries - Intra-group trading related
X
Cash
Parent + Subsidiaries
X
X
NCI is removed from
group’s equity
Equity
Share capital
Share premium
Group retained earning
Non-controlling interest
Non-current liabilities
Current liabilities
Payables
Liabilities are
added together
Parent only
Parent only
Working 5
Working 6
Parent + Subsidiaries
Assets are
added together
Deduct intragroup trading
NCI are separately
reported as part of
equity
Parent + Subsidiaries – intra-groups items related
X
X
X
X
X
X
X
Deduct intra
group trading
514
I. THE MECHANICS OF CONSOLIDATION
Calculation
Normally, you need to calculate goodwill, non-controlling interest and group retained earnings to
complete the consolidated SOFP. Follow process below to calculate them.
Working 1: Establish the group structure
and acquisition time (Refer to section I.1)
Working 2: Calculate consideration
transferred (Refer to section I.2)
Working 3: Calculate net assets of
subsidiary (Refer to section I.3)
Working 4: Calculate goodwill
(Refer to section I.4)
Working 5: Calculate group retained
earnings (Refer to section I.5)
Working 6: Calculate non-controlling
interest (Refer to section I.6)
515
I. THE MECHANICS OF CONSOLIDATION
1. Working 1: Establish the group structure
1
Working 1: Establish the group structure
You need to:
• Identify the percentage shareholding of the parent and the non-controlling interest and the
date the shares were acquired. It helps you calculating in next workings.
• Establish whether there is a parent-subsidiary relationship.
Group structure:
P
Date of
acquisition
X%
S
This indicates that P owns X% of
the ordinary shares of S and when
they were acquired
516
I. THE MECHANICS OF CONSOLIDATION
1. Working 1: Establish the group structure
Example 1: Prepare consolidated statement of financial position
(This example will be used to present the mechanics of consolidation in whole of this chapter)
At 1 January 20X8 P Co paid $120,000 for a controlling interest of 80% in the S Co’s equity when
the retained earnings were $40,000. At the date of acquisition, the fair value of the noncontrolling interest of S Co was measured at $25,000.
The summarized statement of financial positions at 31 December 20X8 are as follows:
P Co
$
S Co
$
Investment in S Co
120,000
Property plant & equipment
170,000
36,000
Current assets
320,000
168,000
610,000
204,000
Shares capital
130,000
40,000
Share premium
70,000
20,000
Retained earnings
140,000
50,000
340,000
110,000
Liabilities
270,000
94,000
610,000
204,000
Required: Prepare the P Co group statement of financial position.
517
I. THE MECHANICS OF CONSOLIDATION
1. Working 1: Establish the group structure
Example 1: Prepare consolidated statement of financial position
Answer:
Working 1: Establish the group structure and acquisition time
Group structure
P
1/1/20X8
P Co controls 80% of S Co
S
🡪 80% of S belongs to P; the rest of 20% belongs to NCI.
Acquisition time
Post-acquisition
1/1/20X7
Pre-acquisition
1/1/20X8
31/12/20X8
P purchased 80% of the issued share capital of S at 1/1/20X8 🡪 all of S’s profit in 20X8 should
be added when consolidate.
Note: When a parent acquires a subsidiary part way through the year (mid-year acquisitions),
only post-acquisition profits are included in the group's consolidated SOFP (Refer to Section
II.2).
518
I. THE MECHANICS OF CONSOLIDATION
2. Working 2: Calculate consideration transferred
2
Working 2: Calculate consideration transferred
The consideration paid by investors for shares of the investee
Consideration transferred
Fair value of consideration paid
Amount parent paid for shares of the
subsidiary at the date of acquisition
• Pay by cash: amount of cash paid
• Pay by shares: their market price on the
date of acquisition
• Pay by both cash and shares
Note: With large entities, shares are
often purchased for cash or shares plus
deferred payments (Calculation of
deferred payments will be described in
F7)
Fair value of non-controlling interest
(NCI) at acquisition
Amount NCI paid for shares of the
subsidiary at the date of acquisition
519
I. THE MECHANICS OF CONSOLIDATION
2. Working 2: Calculate consideration transferred
Example 1 (continued):
Working 2: Calculate consideration transferred
$
Fair value (FV) of consideration paid
120,000
FV of non-controlling interest (NCI) at acquisition
25,000
145,000
520
I. THE MECHANICS OF CONSOLIDATION
2. Working 2: Calculate consideration transferred
Example 2: Calculate consideration transferred
P Co has acquired 80% share capital of S Co (100,000 $1 share). At the date of acquisition, the
fair value of the non-controlling interest of S Co was measured at $25,000.
Calculate consideration transferred if P co acquired by:
i. $200,000
ii. Issuing 5 of its own $1 shares for every 2 shares in S Co. The market value of P Co's shares
was $1.5 at the date of acquisition
Answer:
i. Consideration transferred = Fair value of consideration paid + Fair value of NCI at acquisition
= $200,000 + $25,000 = $225,000
ii. We have to use market price on the date of acquisition ($1.5) instead of face value of shares
($1)
Consideration transferred = Fair value of consideration paid + Fair value of NCI at acquisition
= 80% x 100,000 x 5/2 x $1.5 + $25,000= $325,000
521
I. THE MECHANICS OF CONSOLIDATION
3. Working 3: Calculate fair value of net assets of subsidiary
Working 3: Calculate fair value of net assets of subsidiary
3
FV of net assets of subsidiary is the net assets of subsidiary at the acquisition.
Reason to calculate
•
•
The cost of net assets to the group is the fair value at the date of acquisition
Fair value of net assets is a key figure for the calculation of goodwill in working 4
How to calculate
Calculate equity of subsidiary instead of FV of net assets (as Net assets = Assets – Liabilities =
Equity). Details are described in working 3 below
Calculation fair value of net assets of subsidiary
At date of acquisition
Share capital
Share premium
X
X
Revaluation surplus
X
Retained earnings
Fair value of net assets adjustments
X
X
X
522
I. THE MECHANICS OF CONSOLIDATION
3. Working 3: Calculate fair value of net assets of subsidiary
Example 1 (continued):
Working 3: Calculate fair value of net assets of subsidiary
At date of
acquisition
$
Share capital
(No issue shares in 20X8 🡪 share capital at the date of
acquisition and reporting date are equal)
40,000
Share premium
(No issue shares in 20X8 🡪 share capital at the date of
acquisition and reporting date are equal)
20,000
Retained earnings (Information from scenario)
40,000
100,000
523
I. THE MECHANICS OF CONSOLIDATION
4. Working 4: Calculate goodwill
4
Working 4: Calculate goodwill
Goodwill is recorded as intangible assets in consolidated statement of financial position.
Goodwill can be negative (<0) – as known as bargain purchase. Negative goodwill is credited
directly to the statement of profit or loss
Fair value of net assets of subsidiary
≠
Consideration transferred
OR
Goodwill
Consideration transferred
Goodwill
Calculation goodwill
$
FV of Consideration transferred [Working 2]
Less:
X
FV of net assets at acquisition [Working 3]
(X)
Goodwill on acquisition
X
524
I. THE MECHANICS OF CONSOLIDATION
4. Working 4: Calculate goodwill
Example 1 (continued):
Working 4: Calculate Goodwill
$
FV of Consideration transferred [Working 2]
145,000
Less:
FV of net assets at acquisition [Working 3]
Goodwill on acquisition
(100,000)
45,000
525
I. THE MECHANICS OF CONSOLIDATION
5. Working 5: Calculate group retained earnings
5
Working 5: Calculate group retained earnings
Calculation group retained earnings
$
P's retained earnings (100%)
X
P's % of sub's post-acquisition retained earnings
Note: pre-acquisition retained earnings belong to
previous shareholders so the new parent must exclude
them from group retained earnings.
X
X
526
I. THE MECHANICS OF CONSOLIDATION
5. Working 5: Calculate group retained earnings
Example 1 (continued):
Working 5: Calculate group retained earnings
$
P's retained earnings (100%)
P's % of sub's post-acquisition retained earnings
(= Parent% x (RE at the reporting date – RE date of acquisition
[Working 3])
= 80% × ($50,000 – $40,000))
140,000
8,000
148,000
527
I. THE MECHANICS OF CONSOLIDATION
6. Working 6: Calculate non-controlling interest
6
Working 6: Calculate non-controlling interest
Non-controlling interest (NCI) is part of equity (the ownership) of the group and so the opening
balance at the date of acquisition will increase with its share of any profits and decrease with
any share of losses.
Calculation non-controlling interest
$
Opening balance (FV of NCI at acquisition) [Working 2]
X
Plus: NCI% of post-acquisition profit [Working 3]
X
NCI at reporting date
X
528
I. THE MECHANICS OF CONSOLIDATION
6. Working 6: Calculate non-controlling interest
Example 1 (continued):
Working 6: Calculate non-controlling interest
$
Opening balance (FV of NCI at acquisition) [Working 2]
25,000
Plus: NCI% of post-acquisition profit
(=NCI% x (RE at the reporting date – RE at date of acquisition
[Working 3]) = 20% x (50,000 – 40,000))
2,000
27,000
Now you can prepare the consolidated statement of financial position using the information from
the scenario and the calculation in 6 working above.
529
I. THE MECHANICS OF CONSOLIDATION
6. Working 6: Calculate non-controlling interest
Example 1 (result): Prepare consolidated SOFP
$
45,000
Goodwill
Working 4
PPE
Parent + Subsidiaries + fair value adjustment on the
PPE(170,000 + 36,000)
206,000
Current assets
Parent + Subsidiaries – intra-group trading related
(320,000 + 168,000)
488,000
739,000
Equity
Share capital
Parent only
Share premium
Parent only
130,000
70,000
Group retained earning
Working 5
148,000
NCI
Working 6
27,000
375,000
Current liabilities
Parent + Subsidiaries – intra-groups trading related
(270,000 + 94,000)
364,000
739,000
530
II. EFFECT OF INTRA-GROUP TRADING AND MIDYEAR ACQUISITION TO CONSOLIDATED FINANCIAL
STATEMENT
1. Intra-group transactions
Intra-group trading is trading between parent and subsidiaries. Intra-group balance
must be cancelled in consolidation.
Intra-group
balances
Receivables and payables in P and S that effectively cancel each
other out
Dr Payables
Cr Receivables
2
Intra-group
dividends
Dividends paid by the subsidiary recognised as income by the
parent.
•
Dividend paid: net effect to the group is zero
•
Unpaid dividend: need to eliminate Intra-group
receivables/ payables balance
(Refer to chapter 25)
3
Intra-group
trading
1
Where goods are still held by one entity at the reporting date,
any unrealised profit must be cancelled.
URP = Profit x % unsold at year end
P sells to S
S sells to P
Dr Group RE
Cr Group Inventory (= URP)
Dr Subsidiary RE
Cr Group Inventory (= URP)
Alternative:
Dr Group RE
Dr NCI
Cr Group Inventory (= URP)
531
II. EFFECT OF INTRA-GROUP TRADING AND MIDYEAR ACQUISITION TO CONSOLIDATED FINANCIAL
STATEMENT
1. Intra-group transactions
Example 3: Intra-group trading
Parent owns 80% of Subsidiary.
During the current accounting period, Parent transferred goods to Subsidiary for $8,000,
which gave Parent a profit of $2,000. These goods were included in the inventory of
Subsidiary at the end of the reporting period.
Show the adjustment to eliminate unrealised profits in the consolidation workings for
Parent.
Answer:
Parent transfers goods to subsidiary and goods were still in the inventory of Subsidiary
at the end of the reporting period 🡪 Need to decrease in groups retained earnings and
decrease in group inventory to avoid recording twice.
Adjustment:
DEBIT
CREDIT
Retained Earnings
Group inventory
2,000
2,000
532
II. EFFECT OF INTRA-GROUP TRADING AND MIDYEAR ACQUISITION TO CONSOLIDATED FINANCIAL
STATEMENT
1. Intra-group transactions
Example 4: Intra-group trading
Parent owns 80% of Subsidiary.
During the current accounting period, Subsidiary sold goods to Parent for $36,000,
which gave Subsidiary a profit of $12,000. At the end of the reporting period, half of
these goods are included in Parent's inventory.
Show the adjustment to eliminate unrealised profits in the consolidation workings for
Parent.
Answer:
Subsidiary transfer goods to parent 🡪 Adjustment:
DEBIT
Subsidiary Retained Earnings (1/2 x 12,000)
CREDIT
Group inventory
6,000
6,000
Note: This method still needs to account for the allocation of the adjustment for
unrealised profit between the parent and subsidiary. This will be achieved when
accounting for the respective group and non-controlling interest share of the
movement in net assets.
Alternative:
DEBIT
Group retained Earnings (80%)
4,800
DEBIT
Non-controlling interest (20%)
1,200
CREDIT
Group inventory
6,000
533
II. EFFECT OF INTRA-GROUP TRADING AND MIDYEAR ACQUISITION TO CONSOLIDATED FINANCIAL
STATEMENT
1. Intra-group transactions
From example above, we can see that:
Effect on RE of groups
Subsidiaries sell goods to parent
• Only partially affected base on P%
• The rest affects to NCI
Parent sell goods to subsidiaries
Fully affected
534
II. EFFECT OF INTRA-GROUP TRADING AND MIDYEAR ACQUISITION TO CONSOLIDATED FINANCIAL
STATEMENT
2. Mid-year acquisitions
Mid-year acquisition occurs when a parent acquires a subsidiary part way through the year.
If a parent entity acquires a subsidiary mid-year, the profits for the period need to be apportioned
between pre- and post-acquisition. Only post-acquisition profits are included in the group's
consolidated statement of financial position.
To calculate this, it is normally assumed that S’s profit after tax has accrued evenly throughout the
year. Then we can take the profit for the year and calculate the pre- and post-acquisition profits
based on the number of months the parent has owned the subsidiary.
535
II. EFFECT OF INTRA-GROUP TRADING AND MIDYEAR ACQUISITION TO CONSOLIDATED FINANCIAL
STATEMENT
2. Mid-year acquisitions
Example 5: Mid-year acquisitions
On 1 May 20X7 K acquired 60% of S, paying $152,000 cash. The summarized statements of
financial position of the two entities at 30 November 20X7 were:
K
S
PPE
276,000
230,000
Investment
196,000
Non-current assets
Current assets
Inventory
30,000
50,000
Receivables
38,000
24,000
Cash
4,000
-
544,000
304,000
Equity
Share capital of $1 each
100,000
80,000
Retained earnings
378,000
138,000
Current liabilities
66,000
86,000
544,000
304,000
536
II. EFFECT OF INTRA-GROUP TRADING AND MIDYEAR ACQUISITION TO CONSOLIDATED FINANCIAL
STATEMENT
2. Mid-year acquisitions
Example 5: Mid-year acquisitions
The following information is relevant:
• At 30 November 20X7, the inventory of S included goods purchased at a cost of $16,000 from
K at cost plus 25%. None of the goods had been sold on by S by the reporting date.
• The K Group values the non-controlling interest using the fair value method. At the date of
acquisition, the fair value of the 40% non-controlling interest was $100,000.
• S earned a profit after tax for the year of $18,000 in the year ended 30 November 20X7.
Required: Calculate group retained earnings of K Group as at 30 November 20X7.
537
II. EFFECT OF INTRA-GROUP TRADING AND MIDYEAR ACQUISITION TO CONSOLIDATED FINANCIAL
STATEMENT
2. Mid-year acquisitions
Example 5: Mid-year acquisitions
Answer:
Calculate group retained earning [Working 5]
$
100% K's retained earnings
378,000
Adjustment intra-group trading
(Parent transfer goods to subsidiary 🡪 Adjustment profit
= 25/125 × $16,000 = $3,200)
(3,200)
60% S post-acquisition profit (= 60% × $10,500 [Note 1])
6,300
381,100
538
II. EFFECT OF INTRA-GROUP TRADING AND MIDYEAR ACQUISITION TO CONSOLIDATED FINANCIAL
STATEMENT
2. Mid-year acquisitions
Example 5: Mid-year acquisitions
Note 1: Post-acquisition profit
Profit after tax for the year ended 30/11/20X7 is $18,000
→ Post-acquisition profit (7 months from 1/5/20X7 – 30/11/20X7)= $18,000 x 7/12 = $10,500
Year beginning
1/12/X6
Acq date
1/5/X7
Pre-acq ($7,500)
Year end
30/11/X7
Post-acq ($10,500)
Profit = $18,000
539
II. EFFECT OF INTRA-GROUP TRADING AND MIDYEAR ACQUISITION TO CONSOLIDATED FINANCIAL
STATEMENT
2. Mid-year acquisitions
Example 6: Prepare consolidated statement of financial position:
Guidance: You can use section II.1-6 as a guidance to prepare a consolidated SOFP. You will not
be required to show workings, but understand all workings is an essential part of this question.
Detail about all workings which is described in Section II. Let’s practice with example 6:
Two years ago, Singapore paid $90,000 for a controlling interest of 80% in the Marina Bay’s
equity when the retained earnings were $25,000. The summarized statement of financial
positions at the reporting date are as follows:
Singapore
Marina Bay
$
$
Investment in Marina Bay
Property plant & equipment
Current assets
90,000
30,000
30,000
150,000
30,000
30,000
60,000
Equity shares
Retained earnings
25,000
100,000
125,000
25,000
150,000
15,000
40,000
55,000
5,000
60,000
Current liabilities
540
II. EFFECT OF INTRA-GROUP TRADING AND MIDYEAR ACQUISITION TO CONSOLIDATED FINANCIAL
STATEMENT
2. Mid-year acquisitions
Example 6: Prepare consolidated statement of financial position:
Additional information
(i) At the date of acquisition, the fair value of the NCI of Marina Bay was measured at $20,000
(ii) For consolidation purposes at the date of acquisition the fair value of the non-depreciable
land of Marina Bay exceeded its carrying value by $25,000. Marina Bay has not incorporated
this fair value adjustment into its individual financial statements.
(iii) At the reporting date Singapore is owed $5,000 by Marina Bay.
Required: Prepare the Singapore group statement of financial position.
541
II. EFFECT OF INTRA-GROUP TRADING AND MIDYEAR ACQUISITION TO CONSOLIDATED FINANCIAL
STATEMENT
2. Mid-year acquisitions
Example 6: Prepare consolidated statement of financial position:
Answer:
Singapore group statement of financial position’s proforma:
$
Assets
Goodwill
PPE
Working 4
Parent + Subsidiaries + fair value adjustment on the PPE
X
X
Current assets
Parent + Subsidiaries – intra-group trading related
X
X
Equity
Equity shares
Group retained
earning
Parent only
Working 5
X
X
NCI
Working 6
X
X
X
Current liabilities Parent + Subsidiaries – intra-groups trading related
X
542
II. EFFECT OF INTRA-GROUP TRADING AND MIDYEAR ACQUISITION TO CONSOLIDATED FINANCIAL
STATEMENT
2. Mid-year acquisitions
Example 6: Prepare consolidated statement of financial position:
Working:
• Working 1: Establish the group structure and acquisition time
Group structure
Singapore (the parent)
Two years ago
80% 🡪 S Co is a subsidiary of P Co
Marina Bay
(The subsidiary)
80% of S belongs to P; the rest of 20% belongs to NCI
Acquisition time
P purchased 80% of the issued share capital of S two year ago 🡪 all of S’s profit should be
added when consolidate.
543
II. EFFECT OF INTRA-GROUP TRADING AND MIDYEAR ACQUISITION TO CONSOLIDATED FINANCIAL
STATEMENT
2. Mid-year acquisitions
Example 6: Prepare consolidated statement of financial position:
Working:
• Working 2: Calculate consideration transferred
$
Fair value (FV) of consideration paid
FV of non-controlling interest (NCI) at acquisition
90,000
20,000
110,000
• Working 3: Calculate net assets of subsidiary
At date of
acquisition
$
Equity shares
(No issue shares in post-acquisition 🡪 share capital at the date of
acquisition and reporting date are equal)
15,000
Retained earnings
25,000
Fair value adjustment on PPE
25,000
Fair value of the net assets
65,000
544
II. EFFECT OF INTRA-GROUP TRADING AND MIDYEAR ACQUISITION TO CONSOLIDATED FINANCIAL
STATEMENT
2. Mid-year acquisitions
Example 6: Prepare consolidated statement of financial position:
Working:
• Working 4: Calculate goodwill
$
Consideration transferred [Working 2]
110,000
Less:
FV of net assets at acquisition [Working 3]
(65,000)
Goodwill on acquisition
45,000
• Working 5: Calculate group retained earnings
$
P's retained earnings (100%)
100,000
P's % of sub's post-acquisition retained earnings
(80% × $(40,000-25,000))
12,000
112,000
545
II. EFFECT OF INTRA-GROUP TRADING AND MIDYEAR ACQUISITION TO CONSOLIDATED FINANCIAL
STATEMENT
2. Mid-year acquisitions
Example 6: Prepare consolidated statement of financial position:
Working:
• Working 6: Calculate non-controlling interest
$
Opening balance (FV of NCI at acquisition) [Working 2]
20,000
Plus NCI% of post-acquisition profit
(20% x $(40,000-25,000))
3,000
23,000
546
II. EFFECT OF INTRA-GROUP TRADING AND MIDYEAR ACQUISITION TO CONSOLIDATED FINANCIAL
STATEMENT
2. Mid-year acquisitions
Example 6: Prepare consolidated statement of financial position:
Answer:
Singapore group statement of financial position:
Assets
Goodwill
PPE
Current assets
$
Working 4
Parent + Subsidiaries + fair value adjustment on the PPE
(30,000 + 30,000 + 25,000)
45,000
85,000
Parent + Subsidiaries – intra-group trading related
(30,000 + 30,000 – 5,000)
55,000
185,000
Equity
Equity shares
Group retained
earning
Parent only
Working 5
25,000
112,000
NCI
Working 6
23,000
160,000
25,000
Current liabilities Parent + Subsidiaries – intra-groups trading related
(25,000 + 5,000 - 5000)
185,000
547
CHAPTER 25: THE
CONSOLIDATED STATEMENT OF
COMPREHENSIVE INCOME
548
OVERVIEW
What will you learn?
The consolidated statement
of comprehensive income
I. The mechanics of
consolidation
II. Effect of mid-year
acquisition
Apply basic principles
Consolidation means
adding together
Consolidation means
cancellation of like items
to the group
Revenue and
expenses are added
together
• Intra-group trading
• Unrealised profit
Eliminate:
Consolidate as if you
owned everything then
show the extent to
which you do not own
everything
Profits attributable to
the owners of the
parent and NCI
549
I. THE MECHANICS OF CONSOLIDATION
1. Basic principles
Apply 3 basic principles (mentioned in section II.2 of chapter 23) in preparing consolidated
statement of comprehensive income (Consolidate SOCI).
Basic principles
Consolidation means
adding together
Consolidation means
cancellation of like items
to the group.
Revenue & expenses
are added together
• Intra-group trading
• Unrealised profit
Eliminate:
Consolidate as if you
owned everything then
show the extent to
which you do not own
everything.
Profits attributable to
the owners of the
parent and NCI
550
I. THE MECHANICS OF CONSOLIDATION
1. Basic principles
The proforma of consolidated SOCI is describe as below:
Eliminate intragroup trading
$
Revenue (1)
Parent + Subsidiaries
– intra-group sales [Working 2]
X
Cost of sales (COS) (2)
Parent + Subsidiaries
– intra-group purchases [Working 2]
+ unrealised profits (*) [Working 3]
(X)
(3) = (2) – (1)
X
Gross profit (3)
Eliminate intragroup trading
Eliminate
unrealised profit
Distribution costs (4)
Parent + Subsidiaries
Administrative expenses (5)
Parent + Subsidiaries
(X)
(X)
Finance costs (6)
Parent + Subsidiaries
(X)
Profit before tax (7)
= (3) – (4) – (5) – (6)
X
Income tax expense (8)
Parent + Subsidiaries
(X)
Profit for the year (9)
= (7) – (8)
X
551
I. THE MECHANICS OF CONSOLIDATION
1. Basic principles
The proforma of consolidated SOCI is describe as below:
$
Profit attributable to:
Eliminate
unrealised profit
Non-controlling interests (10)
Profit of subsidiaries x NCI%
- unrealized profits (*) [Working 3] x NCI%
(If S sells to P)
X
Owners of the parent (11)
(11) = (9) – (10)
X
= Owners of the parent (11)
X
Movement on retained earnings:
Group profit for year (11)
Retained earnings brought forward Parent + (Subsidiaries’s retained earnings b/f –
(**) (12)
Subsidiaries at acquisition date) x P%
X
Retained earnings carried forward
(13)
X
= (11) + (12)
552
I. THE MECHANICS OF CONSOLIDATION
1. Basic principles
(*) We can eliminate unrealised profit by:
The effect of intragroup trading must be eliminated from the consolidated statement of profit or loss.
Consolidated
revenue
P’s revenue + S’s revenue – intra group sale
Consolidated
COGS
P’s COS + S’s COS – intra-group sale + URP
Consolidated
profit
P’s profit + S’s profit – URP
Eliminate URP’s effect on NCI:
Effect on NCI profit
S sell goods to P
Profit charges to profit of subsidiary
🡪 Profit of NCI is partly effected base on NCI%
🡪 Subtract unrealized profits x NCI% from profit of NCI
P sell goods to S
Profit charges to profit of parent which NCI do not have any
right
🡪 No adjustment on NCI
(**) With the first acquisition of subsidiary, retained earnings brought forward just includes
Parent’s retained earnings brought forward.
553
I. THE MECHANICS OF CONSOLIDATION
2. Calculation
Normally, you need to calculate intra-group trading (include both intra-group sales and purchases)
and unrealised profits. Follow process below to calculate them.
Working 1: Establish the group structure and acquisition time
Working 2: Calculate intra-group sales and purchases
Working 3: Calculate unrealised profits
554
I. THE MECHANICS OF CONSOLIDATION
3. Example
Example 1: Prepare consolidated comprehensive income
Lancer Co acquired 80% of the ordinary shares of Franky Co on that company's
incorporation on 1 Jan 20X1.
The summarised statements of profit or loss of the two companies for the year ending
31 December 20X5 are set out below.
Revenue
Cost of sales
Gross profit
Administrative expenses
Profit before tax
Income taxes
Profit for the years
Note: Movement on retained earnings
Retained earnings brought forward
Profit for the years
Retained earnings carried forward
Lancer Co
$’000
3,300
(1,890)
1,410
(315)
1,095
(195)
900
Franky Co
$’000
1,500
(900)
600
(450)
150
(30)
120
1,380
900
2,280
318
120
438
Additional information:
Franky Co had recorded sales of $200,000 at a gross margin of 40% to Lancer Co during
the year 20X5. 50% of the goods remained in P Co's inventories at 31 December 20X5.
Required: Prepare the consolidated statement of comprehensive income and the
movement on retained earnings for the Lancer group for the year to 31 December
20X5.
555
I. THE MECHANICS OF CONSOLIDATION
3. Example
Example 1: Prepare consolidated comprehensive income
Answer
$
Revenue (1)
Cost of sales (COS) (2)
Parent + Subsidiaries
= 3300 + 1500 – 200
– intra-group sales [Working 2]
Parent + Subsidiaries
= 1890 + 900 – 200 +
– intra-group purchases
[Working 2]
40
+ unrealised profits [Working 3]
Gross profit (3)
= (2) – (1)
Administrative expenses (4)
Parent + Subsidiaries
Profit before tax (5)
= (3) – (4)
Income tax expense (6)
Parent + Subsidiaries
Profit for the year (7)
= (6) – (5)
4,600
(2,630)
1,970
= 315 + 450
(765)
1,205
= 195 + 30
(225)
980
Profit attributable to:
Non-controlling interests (8)
Profit of subsidiaries x NCI%
- unrealised profits x NCI%
= 120 x 20% - 40 x
20%
Owners of the parent (9)
= (7) – (8)
964
Group profit for year (9)
= Owners of the parent (9)
964
Retained earnings brought
forward (10)
Parent + (Subsidiaries’s
retained earnings b/f –
= 1,380 + 318 x 80%
Subsidiaries at acquisition date)
x P%
1,634.4
Retained earnings carried
forward (11)
= (9) + (10)
2,598.4
16
Movement on retained earnings
556
I. THE MECHANICS OF CONSOLIDATION
3. Example
Example 1: Prepare consolidated comprehensive income
To prepare consolidated SOCI, you should follow 3 working below:
•
Working 1: Establish the group structure and acquisition time
Group structure:
Lancer (P)
1/1/20X1
Lancer (P) controls 80% of Franky (S)
Franky (S)
�
�
80% of S belongs to P; the rest of 20% belongs to NCI
Split SOCI to P and NCI according to % control
Acquisition time:
1/1/20X0
1/1/20X1
Pre-acquisition
31/12/20X5
Post-acquisition
P purchased 80% of the issued share capital of S at 1/1/20X1 🡪 all of S’s income and expenses
should be added when consolidate.
557
I. THE MECHANICS OF CONSOLIDATION
3. Example
Example 1: Prepare consolidated comprehensive income
•
Working 2: Calculate intra-group sales and purchases
During the year Franky Co had recorded sales of $200,000 to Lancer Co and it is an intra-group
trading 🡪 deduct sales of groups by $200,000 and COS by $200,000.
•
Working 3: Calculate unrealised profits
$’000
Sale price
200
80
Unrealised profit (= 80 x 50%)
Gross profit x Remained goods
Unrealised profit attributable to NCI (= 40 x 20%)
40
8
Unrealised profit x %NCI’s shares
558
II. EFFECT OF MID-YEAR ACQUISITION TO
CONSOLIDATED STATEMENT OF
COMPREHENSIVE INCOME
Example
Same as consolidated SOFP. The profits for the period need to be apportioned between pre- and
post-acquisition. Only post-acquisition profits are included in the group's consolidated SOCI.
Exam focus: Prepare a consolidated statement of comprehensive income
You can use section I as a guidance to prepare a consolidated SOCI.
You will not be required to show workings, but understand all workings is an essential part of this
question. Details about all workings are describe in Section I.
Example 2:
Prepare consolidated SOCI where a subsidiary was acquired part way through the year.
Violet Co acquired 60% of the equity of Red Co on 1 April 20X1. The statements of
comprehensive income of the two companies for the year ended 31 December 20X1 are
set out below.
559
II. EFFECT OF MID-YEAR ACQUISITION TO
CONSOLIDATED STATEMENT OF
COMPREHENSIVE INCOME
Example
Example 2: Prepare consolidated SOCI where a subsidiary was acquired part way
through the year.
Violet Co
$
Revenue
Cost of sales
Gross profit
Administrative expenses
Profit before tax
Income taxes
Profit for the year
Note:
Retained earnings brought forward
Retained earnings carried forward
Red Co
$
255,000
97,500
157,500
64,500
93,000
34,500
58,500
120,000
54,000
66,000
18,000
48,000
12,000
36,000
121,000
179,500
60,000
96,000
Red Co (9/12)
$
90,000
40,500
49,500
13,500
36,000
9,000
27,000
During the year, Violet sold goods which cost $20,000 to Red at a margin of 20%. At the year
end, all of these goods remained in inventory.
Required:
Prepare the consolidated statement of comprehensive income and movements on retained
earnings.
560
II. EFFECT OF MID-YEAR ACQUISITION TO
CONSOLIDATED STATEMENT OF
COMPREHENSIVE INCOME
Example
Example 2: Prepare consolidated SOCI where a subsidiary was acquired part way
through the year.
Answer:
$
Revenue (1)
Parent + Subsidiaries
– intra-group sales [Working 2]
= 255,000 + 90,000
– 20,000
Cost of sales (COS) (2)
Parent + Subsidiaries
= 97,500 + 40,500 –
– intra-group purchases [Working 2] 20,000 + 4,000
+ unrealised profits [Working 3]
Gross profit (3)
Administrative expenses (4)
Profit before tax (5)
Income tax expense (6)
Profit for the year (7)
= (2) – (1)
Parent + Subsidiaries
= (3) – (4)
Parent + Subsidiaries
= (6) – (5)
= 64,500 + 13,500
= 34,500 + 9,000
325,000
(122,000)
203,000
(78,000)
125,000
(43,500)
81,500
561
II. EFFECT OF MID-YEAR ACQUISITION TO
CONSOLIDATED STATEMENT OF
COMPREHENSIVE INCOME
Example
Example 2: Prepare consolidated SOCI where a subsidiary was acquired part way
through the year.
Answer: (continued)
$
Profit attributable to:
Non-controlling interests (8)
Owners of the parent (9)
Profit of subsidiaries x NCI%
= (7) – (8)
Movement on retained earnings
Group profit for year (9)
= Owners of the parent (9)
Retained earnings brought
forward (10)
Parent + (Subsidiaries’s retained
earnings b/f – Subsidiaries at
acquisition date) x P% (*)
Retained earnings carried
forward (11)
= (9) + (10)
= 27,000 x 40%
10,800
70,700
70,700
121,000
191,700
(*) All of Red Co's retained earnings brought forward are pre-acquisition. So, we only calculate
with Violet Co’s retained earnings brought forward.
562
II. EFFECT OF MID-YEAR ACQUISITION TO
CONSOLIDATED STATEMENT OF
COMPREHENSIVE INCOME
Example
Example 2: Prepare consolidated SOCI where a subsidiary was acquired part way
through the year.
Working
•
Working 1: Establish group structure and acquisition time
Group structure
Violet (P)
1/4/20X1
Violet (P) controls 60% of Red (S)
Red (S)
�
Split SOCI to Violet and NCI according to % control
Acquisition time:
1/1/20X0
1/4/20X1
Pre-acquisition
31/12/20X1
Post-acquisition
Violet purchased 60% of the issued share capital of S at 1/4/20X1 🡪 Only 9 months (1/4/20X112/31/20X1) of Red Co’s income and expenses should be added when consolidate.
563
II. EFFECT OF MID-YEAR ACQUISITION TO
CONSOLIDATED STATEMENT OF
COMPREHENSIVE INCOME
Example
Example 2: Prepare consolidated SOCI where a subsidiary was acquired part way
through the year.
•
Working 2: Calculate intra-group sales and purchases
During the year Violet Co had recorded sales of $20,000 to Red Co and it is an intra-group
trading 🡪 Deduct Sales of groups by $20,000 and COS by $20,000.
•
Working 3: Calculate unrealised profits
$’000
Sale
20,000
Cost of sale (= 20,000 x 80%)
16,000
Gross profit (Sale – Cost of sale)
4,000
Unrealised profit (= gross profit x % remained goods)
(= 4,000 x 100%)
4,000
564
CHAPTER 26: INTERPRETATION
OF FINANCIAL STATEMENTS
565
OVERVIEW
What will you learn?
Interpretation of
financial statements
I. Importance and purpose
of analysis of financial
statements
Profitability
ratios
II. Analysis of financial
statements using ratio
analysis
Liquidity
ratios
Efficiency
ratios
Financial
position
ratios
566
I. IMPORTANCE AND PURPOSE
OF ANALYSIS OF FINANCIAL STATEMENTS
1. Overview
The bare figures of the accounts of a business are not particularly useful in providing
information to users about its performance and financial position and it is only through
comparisons that their significance can be established.
The table below describe user groups and their purposes when using comparisons:
User groups
Purpose
Management
Use comparisons to ensure the business is performing
efficiently and according to plan.
Employees
Need information to be able to assess the employer’s
ability to provide remuneration and benefits.
Governments
Need information to assess taxation and regulate
industries and for statistical purposes.
Investors
Need information on risk and return on investment,
the ability of the entity to pays dividends.
Lenders and suppliers
Information to assess whether loans, related interest
and invoices will be paid when due.
Customers
Information to judge whether the company will
continue in existence (long-term contract of products
supplies...).
There are various ways to comparisons. In FA exam, we focus on ratio analysis.
567
II. ANALYSIS OF FINANCIAL
STATEMENTS USING RATIO ANALYSIS
1. Overview
Ratios use simple calculations based upon the interactions in sets of data. For example,
changes in costs of sale are directly linked to changes in sales activity. Changes in sales
activity also have an effect upon wages and salaries, receivables, inventory levels etc.
Ratios allow us to see those interactions in a simple, concise format.
The key to obtaining meaningful information from ratio analysis is comparison. This may
involve:
Comparing ratios over time within the same business to establish whether things
are improving or declining
Comparing ratios between similar businesses to see whether the company you are
analysing is better or worse than average within its specific business sector.
Ratio analysis have their own limitations:
The information
used is sometimes
out of date.
Comparative
information is not
always available.
The exercise is subjective, for
example, not all companies use
the same accounting policies.
Interpretation requires thought
and analysis. Ratios should not
be considered in isolation.
Ratios are not
defined in standard
form.
568
II. ANALYSIS OF FINANCIAL
STATEMENTS USING RATIO ANALYSIS
1. Overview
Below is the key accounting ratios:
Key accounting ratios
Profitability
Liquidity
Efficiency
Financial
position
Gross profit
margin
Current ratio
Inventory
turnover
period
Debt ratio
Operating
profit margin
Quick ratio
Receivables
collection
period
Gearing
Payables
payment
period
Leverage
Asset
turnover
Return on
capital
employed
Interest
cover
569
II. ANALYSIS OF FINANCIAL
STATEMENTS USING RATIO ANALYSIS
2. Profitability ratios
Profitability ratios are a class of ratio analysis that are used to:
Assess a company's ability to earn profits from its sales or operations, balance
sheet assets, or shareholders' equity.
Indicate how efficiently a company generates profit and value for shareholders.
Profitability ratios includes:
1
Gross profit margin
2
Operating profit margin (net profit margin)
3
Asset turnover
4
Return on capital employed (ROCE)
570
II. ANALYSIS OF FINANCIAL
STATEMENTS USING RATIO ANALYSIS
2. Profitability ratios
2.1
Gross profit margin
On a unit basis the gross profit represents the difference between the unit sales price and
the direct cost per unit. The margin works this out on an average basis across all sales for
the year.
Revenue − Cost of goods sold
×100%
Revenue
Revenue − Cost of goods sold = Gross profit
Gross profit
→ Gross profit margin =
×100%
Revenue
Gross profit margin =
Purpose
•
•
•
Reflect the amount of gross profit generated for every $1 revenue in the business;
In comparing gross profit over time, if the gross profit has not increased in line with
sales revenue, the discrepancy is due to:
o Increased ‘purchase’ costs
o Inventory write-offs
o Other costs being allocated to cost of sales, e.g. R&D expenditure
To compare business entities within the same sector, inter-company comparison of
gross margin is especially important
o Low margins usually suggest poor performance but may be due to expansion
costs or trying to increase market share
o Above-average margins are usually a sign of good management although
unusually high margins may make the competition keen to join in
571
II. ANALYSIS OF FINANCIAL
STATEMENTS USING RATIO ANALYSIS
2. Profitability ratios
2.1
Gross profit margin
Example:
X Co
Year 1
$
Year 2
$
Revenue
210,000
300,000
Cost of sales
126,000
165,000
Gross profit
84,000
135,000
Profit for the year
21,000
30,000
Year 1:
Gross profit margin =
Gross profit
84,000
× 100% =
x 100% = 40%
Revenue
210,000
Gross profit margin =
Gross profit
135,000
× 100% =
x 100% = 45%
Revenue
300,000
Year 2:
Comment:
Gross profit margin year 2 (45%) > year 1 (40%)  better management in controlling
costs involve in the production.
572
II. ANALYSIS OF FINANCIAL
STATEMENTS USING RATIO ANALYSIS
2. Profitability ratios
2.2
Operating profit margin (net profit margin)
Operating profit margin is calculated by:
Operating profit margin=
Profit before interest and tax (PBIT)
×100%
Revenue
Purpose
• Reflect the amount of profits before interest and tax generated for every $1 revenue in
the business;
• Measure of how effectively the business manages/ administers the process of producing
and selling its products;
• Low margins usually suggest that the business is managing/ administering that process
ineffectively. Reasons of low gross profit margins:
o
o
o
o
o
o
More employees expense
More depreciation due to large acquisitions or disposals
Increase significant provision for long-outstanding trade receivables
Changes in rental agreements
Significant investments in advertising
Rapidly increase fuel costs.
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2. Profitability ratios
2.2
Operating profit margin (net profit margin)
Example
Y Co
Year 1
$
Year 2
$
Revenue
240,000
300,000
Cost of sales
126,000
165,000
Gross profit
114,000
135,000
Operating expenses
54,000
105,000
Profit before interest and tax
60,000
30,000
Year 1:
Operating profit margin=
PBIT
60,000
×100%=
x 100%=25%
Revenue
240,000
Operating profit margin=
PBIT
30,000
×100%=
x 100%=10%
Revenue
300,000
Year 2:
Comment:
Operating profit margin year 1 > year 2  the business manages and administers the
process of producing and selling its products ineffectively.
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2. Profitability ratios
2.3
The relation between gross profit margin and operating profit margin
The operating margin is an expansion of the gross margin because it includes more items
such as selling and distribution costs and administration costs.
Users often calculate both gross profit margin and operating profit margin to analyse cost
control of managements.
Example 1
Year 1
$
Year 2
$
Revenue
140,000
200,000
Cost of sales
84,000
110,000
Gross profit
56,000
90,000
Operating expenses
42,000
70,000
Profit before interest and tax
14,000
20,000
Calculate gross profit margin and operating profit margin for the years.
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2. Profitability ratios
2.3
The relation between gross profit margin and operating profit margin
Example
Answer:
Year 1
56,000
= 40%
140,000
14,000
Operating profit %=
= 10%
140,000
Gross profit %=
Year 2
90,000
= 45%
200,000
20,000
Operating profit %=
= 10%
200,000
Gross profit %=
Comment:
Operating profit margin remain the same between year 1 and year 2 but gross profit
margin increases 🡪 selling and administrative process are ineffective, which lead to
expense increase from 42,000 to 70,000.
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2. Profitability ratios
2.4
Return on capital employed (ROCE)
Return on capital employed is calculated by:
ROCE =
PBIT
×100%
Capital employed
Capital employed = Shareholders′ equity+ long-term liabilities
(or total assets - current liabilities)
Capital employed refer to the value of all sources used by a company to generate earnings,
including shareholders’ equity (Investment from shareholders) and long-term liabilities
(normally used by a company to make profits)
Purpose
• Measure of how much profit the business generates for every $1 capital invested in it;
• The ratio also shows how efficiently a business is using its resources. Low ROCE mean
that business use its resources inefficiently. Reason of low ROCE:
o Increased costs or decreased sales
o Have many unprofitable or unnecessary assets e.g. machinery that has outlived
its useful life
o Increased debt
o Lack of inventory management.
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2. Profitability ratios
2.4
Return on capital employed (ROCE)
Example
Year 1
$’000
Year 2
$’000
Capital employed
2,000
2,000
PBIT
1,000
800
Year 1
ROCE =
1,000
= 50%
2000
Year 2
ROCE =
800
= 40%
2000
Comment:
ROCE of year 2 is lower than year 1 because business resources are inefficiently used in
year 2.
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2. Profitability ratios
2.5
Asset turnover
The asset turnover is:
Purpose
•
To measure of how well the assets of a business are being used (equal to capital
employed because assets are usually bought by capital employed) to generate revenue
during a period
•
The higher the ratio the more efficient the business is
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2. Profitability ratios
2.6
Relationship between operating profit margin and asset turnover ratios
ROCE can be subdivided into operating profit margin and asset turnover:
• Asset turnover: a measure of how intensively the assets are worked or how efficiently
they are used to generate revenue
• Operating profit margin: a ratio to measure of how much profit a company can generate
in each time company use asset.
• Profit margin and asset turnover together explain the ROCE and if the ROCE is the
primary profitability ratio, these other two are the secondary ratios.
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2. Profitability ratios
2.6
Relationship between operating profit margin and asset turnover ratios
Example
Company A
$’000
Company B
$’000
Sale revenue
2,000
8,000
Capital employed
2,000
2,000
400
400
PBIT
Company A
Company B
*OPM: Operating profit margin
Comment:
Although both companies have same ROCE (20%) but different characteristic:
• A uses asset to generate revenue ineffectively but make more profit from each dollar of
revenue.
• B uses asset to generate revenue more effectively but make less profit from each dollar of
revenue.
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3. Liquidity ratios
Liquidity is the amount of cash as company can put its hand on quickly to settle its debt/or
unforeseen demands for cash payments
Current ratio and Quick ratio assess the liquidity/solvency of a business (i.e. the ability to
meet debt obligations)
The ‘standard’ test of liquidity is the current ratio, is calculated by:
Purpose
• Measures the adequacy of current assets to meet liabilities as they fail due;
• A high or increasing figure may appear safe but should be regarded with suspicion as it
may be due to:
O High levels of inventory and receivables (this could mean inventory is unsaleable or
that credit control is weak)
O High cash levels which could be put to better use. (e.g. by investing in non-current
assets).
Note: Current ratio may vary depending upon the market sector so it is very hard to
identify ideal ratio. Traditionally, a current ratio of between 1.5 and 2 are appropriate for
most business.
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3. Liquidity ratios
Quick ratio eliminate inventory from current assets to determine whether the company
has sufficient liquid resources (inventory is the least liquidity assets) to settle its liabilities.
Purpose
• Indicates the extent to which the company could pay current liabilities without relying on
the sale of inventory;
• The higher the ratio result, the better a company's liquidity and financial health.
Traditionally a ratio of 1 is appropriate.
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3. Liquidity ratios
Example
Year 1
$’000
Year 2
$’000
Cash
168
196
Account Receivables
330
376
Inventory
786
844
1,284
1,416
Current assets
Total
Current liabilities
Account payables
1,086
1,080
Total
1,086
1,080
Year 1
Year 2
Comment:
The company improved its liquidity position from Year 1 to Year 2, as indicated by all two
metrics. The quick ratio shows that the company has to sell inventory to meet its current debt
obligations, but the quick ratio is also improving.
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4. Efficiency ratios
Efficiency ratios, also known as activity ratios, are used by analysts to measure the
performance of a company's short-term or current performance.
Efficiency ratios include:
1
Inventory turnover period
2
Receivables collection period
3
Payables payment period
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4. Efficiency ratios
4.1
Inventory turnover period
Inventory turnover period is calculated by:
Purpose
• Indicates the average length of time that stock spends in business before it is sold;
• An increasing number of days implies that management are holding onto inventory for
longer. It could be due to:
o Lack of demand or poor inventory control
o Buying bulk to take advantage of trade discounts
o An expected increase in orders
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4. Efficiency ratios
4.2
Receivables collection period
Receivables collection period is calculated by:
Purpose
• Indicates the average length of time to collect cash from credit customers once they have
purchased goods;
• Increasing accounts receivables collection period is usually a bad sign suggesting lack of
proper credit control, which may lead to irrecoverable debts. It may, however, be due to:
o a deliberate policy to attract more trade, or
o a major new customer being allowed different terms.
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II. ANALYSIS OF FINANCIAL
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4. Efficiency ratios
4.3
Payables payment period
Payables payment periodis calculated by:
Purpose
• Indicates the average length of time of the credit period taken by the company from its
suppliers;
• If the credit period is long:
o the company may develop a poor reputation as a slow payer and may not be able
to find new suppliers
o existing suppliers may decide to discontinue supplies
o
the company may be losing out on worthwhile cash discounts.
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4. Efficiency ratios
Example 2: Liquidity and working capital ratios
Calculate liquidity and working capital ratios from the accounts of BIT Co, a business
provides service support for customers worldwide:
20X7
$m
20X6
$m
Revenue (*)
4,352.4
4,689.6
Cost of sales (**)
(3,318)
(3,463)
Gross profit
Current assets
Inventories
1,034.4
1,226.6
85.4
156.0
Receivables (Note 1)
757.8
862.8
Short-term deposits and cash
410.4
290.0
1,253.6
1,308.8
Current liabilities
Loans and overdrafts
64.8
162.2
Tax on profits
Dividend
Payables (Note 2)
135.6
23.4
974.4
153.4
34.4
934.4
1,198.2
55.4
1,284.4
24.4
Net current assets
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II. ANALYSIS OF FINANCIAL
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4. Efficiency ratios
Example 2: Liquidity and working capital ratios
Note:
20X7
$m
757.8
590.4
167.4
20X6
$m
862.8
671
191.8
1. Receivables
- Trade receivables
- Advance to employees
(*) All revenues are credit
(**) All costs are out-source purchases
2. Payables
- Trade payables
- Payables to employees
20X7
$m
974.4
381.6
592.8
20X6
$m
934.3
376.1
558.2
Answer:
Ratio
Current ratio
Receivables
collection period
20X7
1,253.6/1,198.2 = 1.05
(1,253.6 – 85.4)/1,198.2
= 0.97
(590.4/4,352.4) x 365
= 49.51 days
20X6
1,308.8/1,284.4 = 1.02
(1,308.8 – 156)/1,284.4
= 0.9
(671/4,689.6) x 365
= 52.23 days
Inventory
turnover period
(85.4/3,318) x 365
= 9.39 days
(156/3,463) x 365
= 16.44 days
Payables
payment period
(381.6/3,318) x 365
= 41.98 days
(376.1/3,463) x 365
= 39.64 days
Quick ratio
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II. ANALYSIS OF FINANCIAL
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5. Financial position ratios
When it comes to financial position ratios, there are some ratios that are particularly worth
looking at:
Financial position ratio includes:
1
Debt ratio
2
Gearing ratio
3
Leverage ratio
4
Interest cover
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5. Financial position ratios
5.1
Debt ratios
Debt ratio is calculated by:
Purpose
• Measures how much the company owes in relation to its size;
• When a company is heavily in debt (ie. debt ratio is ≥ 50%), potential lenders may be
unwilling to advance further funds.
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5. Financial position ratios
5.2
Gearing ratio
Gearing ratio is calculated by:
Purpose
• Measures the proportion of assets invested in a business that are financed by
borrowings;
• The higher the level of gearing, the higher are the risks to a business.
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5. Financial position ratios
5.3
Leverage ratio
Leverage ratio is calculated by:
Purpose
• Leverage ratio is the converse of gearing.
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II. ANALYSIS OF FINANCIAL
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5. Financial position ratios
5.4
Interest cover
Interest cover is calculated by:
Purpose
•
Indicates the ability of an entity to pay interest out of profits generated:
o low interest cover indicates to shareholders that their dividends are at risk and
o the entity may have difficulty financing its debts if its profits fall
o interest cover of less than 2 is usually considered unsatisfactory
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5. Financial position ratios
Example 3: Determine purpose of specific ratio
Which of the following is a ratio which is used to measure how effectively the
business manages/ administers the process of producing and selling its product?
A.
Operating profit margin
B.
Gross profit margin
C.
Gearing
D.
Interest cover
Answer: A
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5. Financial position ratios
Example 4: Calculate ratio
From the following information regarding the year to 31 August 20X6, what is the
accountants’ payables payment period?
You should calculate the ratio using purchases as the denominator.
Sales
Cost of sales
Opening inventory
Closing inventory
Trade accounts payable at 31 August 20X6
A.
B.
C.
D.
40 days
50 days
53 days
57 days
Answer: D
Purchases = $(65,000 – 12,000 + 7,600) = $60,600
Accounts payable payment period = (9,500/60,600) x 365 = 57 days
$
86,000
65,000
12,000
7,600
9,500