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_______________
STUDYNOTES
20222023
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Weekday
Weekend
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Paced
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Foreword
Table of Contents
Foreword....................................................................................................................................... 3
Overview ..................................................................................................................................... 11
Syllabus Area A: .............................................................................................................................. 12
The context and purpose of financial reporting ............................................................................ 12
Syllabus Area B: .............................................................................................................................. 31
Qualitative characteristics of financial information ...................................................................... 31
Syllabus Area C: .............................................................................................................................. 41
The use of double-entry and accounting systems ........................................................................... 41
Double Entry System of Bookkeeping .......................................................................................... 42
The Ledger................................................................................................................................... 50
Syllabus Area D: .............................................................................................................................. 56
Recording transactions and events ................................................................................................. 56
Sales, Purchases & Discounts ....................................................................................................... 57
Inventory ..................................................................................................................................... 62
Sales Tax...................................................................................................................................... 70
Accrual and Prepayments ............................................................................................................ 76
Receivables and Irrecoverable Debts ........................................................................................... 84
Non-Current Assets and Depreciation ........................................................................................ 103
Revaluation and Disposals ......................................................................................................... 111
Intangible Non-Current Assets and Amortization ....................................................................... 118
Syllabus Area E: ............................................................................................................................ 119
Preparing a trial balance ............................................................................................................... 119
Control Accounts ....................................................................................................................... 120
Bank Reconciliation ................................................................................................................... 127
Trial Balance .............................................................................................................................. 133
Suspense Account...................................................................................................................... 142
Syllabus Area F:............................................................................................................................. 145
Preparing basic financial statements ............................................................................................ 145
Incomplete records.................................................................................................................... 146
Capital Structure, Finance costs and taxation ............................................................................. 154
Preparing basic financial statements .......................................................................................... 165
IAS 10 and IFRS 15 ..................................................................................................................... 172
1
Foreword
Syllabus Area H: ............................................................................................................................ 176
Interpretation of financial statements .......................................................................................... 176
Interpretation of Financial Statements ...................................................................................... 177
Syllabus Area G: ............................................................................................................................ 189
Preparing simple consolidated financial statements .................................................................... 189
Consolidated statements of Financial Position ........................................................................... 190
Consolidated Statement of Profit and Loss and Accounting for Associates ................................. 204
Statement of Cash flows ............................................................................................................ 210
2
Foreword
Foreword
‘By the ACCA, for the ACCA’
These notes are designed with a simple mission, to fill the gap for Indian students who don’t find
comfort in studying from notes that are framed in a complex manner. Our priority at Zell is to improve
the results our students achieve by providing all that they need, be it quality education, state of the
art infrastructure and techniques or the next step, the content that perfectly fits in making the trifecta
or the winning formula.
Here at Zell, we don’t worry about the background, prior knowledge or preferences someone has. The
aim is simple, by the time a student is done with a paper, they are on the same page as anyone else
and that for us, should be enough knowledge to be able to call them a professional truly.
Keeping all this in mind, we bring to you these notes, created by us, for you, to truly help make the
difference and turn your journey of ACCA into an even better one. This is just the beginning; there is
more in store.
Thank you
Credits
Authored By:
Jash Ramani
Saim Fakih
Designed By:
Mehak Sethi
Harshita Shah
Last updated: March 2022
3
Foreword
Best way to study
Planning how to study
Before starting the preparation for any paper, you should always make a macro level plan on how to
go about preparing for the exam. Understand what is expected of you to be able to clear the exam
with high scores. It is important to set targets and stick to them, to ensure that you stay on track and
progress in your ACCA journey.
Have a plan from the beginning about where you want to be at the end of the month or two months,
then work backwards and understand what you must do to stay on track. Then, at the start of every
week, make a brief plan about how much needs to be covered every day, resulting in the timely
completion of the exam.
Break your macro plan intro studying along with the professor/recordings, examination month and
final revision. Plan how many hours can you give every day and make a schedule accordingly. Ensure
that you can give quality hours without distractions. The quantity of hours doesn’t matter.
How to approach the exam
Knowing how much importance ACCA places on application-based learning is important. You must
understand that rote learning in any exam for any concept will mostly amount to zero marks being
scored.
Further, students tend to take many days after the classes conclude for their self-preparation phase,
which tends to work negatively. The maximum time you should take after completing the classes is
21 days, after which, while you might practice more, the retention of the vast range of topics
covered in class will become faint.
The ideal approach is to watch/attend lectures and keep up with the pace, practising 40% of the
question bank alongside, to cement conceptual understanding. Once classes conclude, ensure the
remaining 60% of the question bank is solved, followed by at least three mock examinations before
attempting the main exam.
Exam month
•
•
•
•
•
In the exam month, ensure that you finish the portion as soon as possible and shift all focus
to completing the question bank. Remember, completing the textbook alone is not enough,
whereas completing the question bank gives you a higher chance of clearing the exam.
If you are done with your question bank, repeat the question bank or key questions you
marked before the exam. Only 40% of your total time should be allocated to building a
conceptual understanding, the remaining 60% to solve questions.
Ensure you do not get into the habit of reading a question and then reading the answer. This
approach will make you seek answers in the exam and not seek solutions on your own. Read
a question, solve it on your own, check the answer. If it is incorrect, solve the question again
to get another answer, rather than reading the explanation to understand what you did
wrong. That should always be the last resort.
Familiarise yourself with the scientific calculator, the CBE exam platform and other tools to
ensure you are comfortable with the same in the actual exam.
Ensure you complete 100% of the portion. Do not skip anything as the exam will test you on
a range of interconnected topics, and leaving parts of the portion will guarantee you are
losing certain marks.
4
Foreword
Exam strategy
There are certain things to be kept in mind before attempting the main exam.
1. Remain calm before the exam. Do not study at the last moment, as going into the exam with
a fresh mind will allow you to tackle the questions more easily.
2. There is no negative marketing in the exams. Ensure that you attempt 100% of the paper to
ensure that some of your educated guesses score some marks even in the worst case.
3. The examination is 2 hours long, which means you have 120 minutes for 100 marks, or
simply 1.2 minutes per mark. Ensure you don’t get overboard with the time you take to solve
a question at hand.
4. Ensure you read the question very carefully. Please don’t assume that you faced a similar
question in the past and jump to solving it as the requirements can vary even in small
concepts causing you to lose easy marks.
5. The options are set up so that even answers derived using the wrong steps are available as
options. Please do not jump to the conclusion that your answer has to be correct because it
is available as an option.
6. If there is a tricky question that you can’t solve, make an educated guess by eliminating the
one’s you know are wrong, flag the question and move ahead. If you finish the paper and
have remaining time, revisit the flag questions to score full marks.
7. Do not sit and recalculate the answer you got more than twice, as you are likely to calculate
it in the same way you did previously, by repeating the same mistake if any. This is a massive
waste of your crucial time. Rather move faster and revisit key questions at the end,
recalculating your answers at that point will possibly reveal mistakes and allow you to rectify
them, thus scoring more marks.
5
Foreword
Elements
Syllabus wise study material
The study material is curated in a manner where the syllabus provided by ACCA has been covered in
vast depth, and the order is set in a way that the flow of concepts within the material suits a
student.
Apply Your Knowledge
Various AYK style questions test the student on their ability to remember and understand concepts
thoroughly before moving to analytical questions.
Quiz
Further, there are primarily application-based quiz questions, introducing the student to analytical
and evaluative questions to bring the student one step closer to actual exam-style questions.
Recap
After the end of every main chapter, there is a recap page summarising all the important topics,
formulae etc., to enable ease of revision for the student.
Mind Maps
Mind maps are flowcharts that summarise the information visually, making it more likely for a
student to retain the knowledge and build upon it. These are present at the end of the book to
enable last-minute revision by simply spending time on those pages.
6
Foreword
Nimbus™ Preparation tools
Interactive notes with gamification
The articulated version of the notes is available on the platform, allowing students to get fully
immersed in their learning and complete more in less or equivalent time they spend reading the
book.
Case studies
Case studies are specifically tailored to address the audience commonly using these notes. Having
interesting case studies based on current affairs, covering key organisations etc., contribute to
further professional development.
Technical articles
ACCA’s technical articles are placed strategically in the material, allowing students to understand
when to go through these all-important technical articles.
Exam experience
The system mimics the exam experience to ensure that the student has conceptually and technically
mastered the paper before appearing for the exam. This includes various objective questions, live
spreadsheets and word processors to practice typing, presentation and most importantly, time
management.
Question Bank & Test Series
The students have access to unit tests, half portion tests, progressive tests, mock tests and unlimited
practice tests with all performance data allowing them to know where they stand, the
improvements required before the exam day arrives.
Flashcards and Interactive mind maps for revision
Flashcards help students quiz themselves, which is more effective as a revision technique than
simply reading through pages. Interactive mind maps allow the student the power to take a detailed
glance through a whole chapter or large concept in minutes while revising at the same time.
Check the last page of this book for more information on Nimbus™ LMS by Zell
7
Foreword
ACCA support
Examining team guidance/Exam technique & reports
The examiners’ reports are an essential study resource. Read them to learn about mistakes that
students commonly make in exams and how to avoid them.
Practice tests
Practice Tests are an interactive study support resource that will replicate the format of all the
exams available as on-demand computer-based exams (CBEs). They will help you to identify your
strengths and weaknesses before you take an exam.
As well as giving you an insight into a live exam experience, Practice Tests will also provide feedback
on your performance. Once you complete the test, you will receive a personalised feedback diagram
showing how you have performed across the different areas of the syllabus.
Specimen exams
The specimen exam indicates how the exam will be assessed, structured and the likely style and
range of questions that could be asked. Any student preparing to take this exam should familiarise
themselves with the exam style.
Technical articles
There is a range of technical articles available on ACCAs website under ‘Study support resources’.
These include a range of simplified articles on complex topics, study support videos, articles on exam
technique etc. making it an important tool to be practised when nearing the exam.
FAQs
Various commonly asked questions about the style of the examination, the coverage, computer-based
exam setup etc., are covered here to allow a student to stay up to date and ensure their understanding
is aligned with that of the ACCA body.
8
Foreword
Syllabus
Introduction to the syllabus
The syllabus for Financial Accounting (FA)/FFA introduces the candidate to the fundamentals of the
regulatory framework relating to accounts preparation and to the qualitative characteristics of useful
information. The syllabus then covers drafting financial statements and the principles of accounts
preparation. The syllabus then concentrates in depth on recording, processing, and reporting business
transactions and events. The syllabus then covers the use of the trial balance and how to identify and
correct errors, and then the preparation of financial statements for incorporated and unincorporated
entities. The syllabus then moves in two directions, firstly requiring candidates to be able to conduct
a basic interpretation of financial statements; and secondly requiring the preparation of simple
consolidated financial statements from the individual financial statements of group incorporated
entities.
Main capabilities
On successful completion of this exam, candidates should be able to:
A.
B.
C.
D.
E.
F.
G.
H.
Explain the context and purpose of financial reporting
Define the qualitative characteristics of financial information
Demonstrate the use of double-entry and accounting systems
Record transactions and events
Prepare a trial balance (including identifying and correcting errors)
Prepare basic financial statements for incorporated and unincorporated entities.
Prepare simple consolidated financial statements
Interpretation of financial statements
Performance Objectives
Objectives
Chapter in Text
PO1 Ethics and professionalism
Qualitative characteristics of financial
information
PO6 Record and process transactions and events
Intangible Non-Current Assets and
Amortization
PO7 Prepare external financial reports
IAS 10 and IFRS 15
PO8 Analyse and interpret financial reports
Interpretation of Financial Statements
9
Foreword
Exam Structure
The syllabus is assessed by a two-hour computer-based examination. Questions will assess all parts of
the syllabus and will test knowledge and some comprehension or application of this knowledge. The
examination will consist of two sections. Section A will contain 35 two-mark objective test questions.
Section B will contain 2 fifteen-mark multi-task questions. These will test consolidations and accounts
preparation. The consolidation question could include a small amount of interpretation and the
accounts preparation question could be set in the context of a sole trader or a limited company.
10
Overview
Overview
Before starting this paper, one must go through the basics of the accounting module as it is critical
to understand the basics and application of accounting concepts to crack the F3 Exam!
Also, for most of the students, F3 might be the first ACCA exam they will appear for. It is crucial to
understand the importance of the exam kit (Kaplan and BPP Both) alongside these notes as ACCA
tests your application of the knowledge you have read about, and that will only truly be tested by
practicing more and more questions.
It is also important to note that it is important to read ALL THE ANSWERS of the questions you solve
in the exam kit, easy and difficult questions, provided at the back of the exam kit thoroughly as it
serves the purpose of enhancing your knowledge and making your concepts extremely strong.
11
The context and purpose of financial reporting
Syllabus Area A:
The context and purpose of financial reporting
12
Introduction to Financial Reporting
13
Introduction to Financial Reporting
Syllabus area A1a, A1e
- Define financial reporting – recording, analysing and summarising financial data.
- Understand the nature, principles and scope of financial reporting.
Financial Reporting involves the recording of business transactions in a systematic manner and
producing financial statements from them for the use of external stakeholders.
The financial statements are prepared in the following ways:
Data
Sources
• Business documents such as invoices and debit notes are made for
all transactions
• Example: An invoice for a sale of Nike shoes of Rs. 5000
• By using business documents, initial entries in the books of
accounts are made
Books of
Prime Entry • Example: Recording the sale of Nike shoes in the sales journal
Ledger
Accounts
Trial
Balance
Financial
Statements
• Corresponding entries in the ledger accounts are recorded
• Example: Crediting the Sales account and debiting the bank
account by Rs. 5000
• Ledger accounts are closed and a list of balances are drawn
• Financial statements (statement of financial position and the
statement of profit and loss) are made from the trial balance
Introduction to Financial Reporting
Financial Statements are prepared in accordance with relevant standards of the country (E.g. IAS,
IFRS) for external users based on historical information.
However, the management of a company needs more detailed information to make decisions
relating to the future of the company, which the financial statements do not provide.
14
Introduction to Financial Reporting
15
Syllabus area A1b-c-d
- Identify and define types of business entity – sole trader, partnership, Limited Liability
Company.
- Recognise the legal differences between a sole trader, partnership and a limited liability
company.
- Identify the advantages and disadvantages of operating as a limited liability company, sole
trader or partnership.
Types of Businesses
Sole Trader
Partnership
Ownership
Legal Entity
Sole owner
Owner and business are
one and the same
2 or more partners
Same entity unless it’s a
Limited Liability Partnership
(LLP)
Liability *
Unlimited
Generally unlimited unless it is
an LLP
Limited
Existence
Dependent on sole trader
A partnership is dissolved
Perpetual existence
Examples
A local general store
Accountancy or law firms
Reliance Limited
Advantages
1) Entitled to all profits
2) Limited compliance
3) Complete control
4) Flexible operations
5) Confidentiality of trade
secrets
1) Additional capital and
resources available
2) Division of responsibility
3) Losses are shared
4) Financial accounts need not
be made public (unless it is an
LLP)
1) Limited and liability
2) Owners and management
are different
3) Easy to raise funds
4) Perpetual existence
5) Tax advantages as the
company is taxed at a lower
rate than an individual
6) Transferability of shares
1) Disagreement between
partners is likely
2) Partners are jointly liable for
actions of another partner
3) Profits needed to be shared
4) Limited growth compared to
an LLC
1) Financial Statements
need to be made public by
law
2) Stringent compliances
3) Audit of financial
statements is mandatory
4) Expensive to incorporate
Disadvantages 1) Unlimited Liability
2) Limited funds and
knowledge
3) Personal stress as it’s a
‘one man-show’
4) The business ceases in
the event of death of a sole
trader
Limited Liability Company
(LLC)
Shareholders
Shareholders and LLC are
separate legal entities
Introduction to Financial Reporting
* Liability of the owners means the extent to which they are liable to pay the debts of the business.
With unlimited liability, the owner may have to sell his/her personal assets to repay loans of the
business, but in the case of limited liability, the risk exposure is to the extent of money invested only.
At the ACCA F3 level, we will be more focused on preparing the financial statements of an LLC.
What is a relative advantage of forming a Limited Liability Company over a partnership?
A.
B.
C.
D.
The owners will have unlimited liability
It will be easy to operate as lesser rules will apply
The business will continue for the foreseeable future
It will be cheap to incorporate a company
Answer: C
16
Introduction to Financial Reporting
17
Syllabus area A2a
- Identify the users of financial statements and state and differentiate between their
information needs.
The financial statements are used by a variety of users (stakeholders) for different reasons to make
informed decisions. Their needs are summarised in the table below –
User
Owners / Shareholders /
Potential Investors
Type of user
Needs of the user
Internal
Owners want to evaluate how profitable the company is and will be
in the future. They would want to know how efficiently their money
is being used in the business and if they are earning sufficient
returns or not.
Management / Board of
Directors
They need detailed financial information to check if the business is
on track to achieve its short-term and long-term targets, and if the
company is not, then to take corrective measures periodically.
Employees and Trade
Unions
As the future of an employee’s career depends on the existence
and growth of the company, an employee would have a keen
interest in knowing about the survivability of the company.
For example, before Jet Airways fell, if the employees and
management knew about its working capital problems, they would
have taken corrective measures or started finding jobs elsewhere
earlier on.
Suppliers
External
The suppliers need to know if the company will be able to pay its
credit dues on a timely basis or not
Customers
Customers need to know if the company will be able to continue to
provide products and services for the foreseeable future or not.
Lenders (Banks)
Lenders are most concerned with the solvency and
creditworthiness of a business. They are also interested in the
assets a company has as it may be secured against long term loans.
Government
The government needs to know if the company is following the
reporting standards and law or not, and if the correct amount of tax
is being paid.
The Public
A business operates within the society, and the public has the right
to know about the impact it is creating on the environment and
society as a whole.
For example, if the company is running adequate corporate social
responsibility (CSR) activities or not.
Introduction to Financial Reporting
This is not an exhaustive list of users of the financial statements, and various other kinds of
stakeholders may be interested in the financial statements for various needs.
18
Introduction to Financial Reporting
Syllabus area A3a-b
- Define and identify assets, liabilities, equity, revenue and expenses.
- Understand and identify the purpose of each of the main financial statements.
In your previous studies, it is most likely you would have prepared financial statements of sole
traders and partnerships. However, at the ACCA level, we will be looking at financial statements of
limited companies in more depth.
Financial Statements consist primarily of 5 statements –
1) The Statement of Profit and Loss and Other Comprehensive Income (SOPLOCI)
The SOPL section records the revenues and expenses of a business for a particular accounting
period. Revenue less expenses will give us the profit (or loss) for the period.
Revenue is the income for a period. It is the gross inflow of economic benefits (cash, receivables,
other assets) arising from the ordinary operating activities of an enterprise (such as sales of goods,
sales of services, interest, royalties, and dividends).
Expenses are decreases in economic benefits during the accounting period in the form of outflows or
depletions of assets or incurrences of liabilities. Examples include wages and salaries, electricity, etc.
The Other Comprehensive Section of the SOPLOCI consists of gains not yet realised by the business.
For example, the revaluation of an asset which is not yet sold by the business, hence the gain on
revaluation is still unrealised.
The vertical format of the SOPLOCI is as follows –
Statement of profit or loss and other comprehensive income
for the year ended 31 December 20XX
Particulars
$
Revenue
X
Cost of Sales
(X)
Gross profit (loss)
X/(X)
Distribution costs
(X)
Administration and selling expenses
(X)
Operating profit (loss)
X/(X)
Finance costs
(X)
Profit before tax (PBT)
X/(X)
Income tax
(X)
Profit (loss) for the year
X/(X)
Other comprehensive income:
Revaluation surplus
Total comprehensive income for the year
X
X
19
Introduction to Financial Reporting
2) The Statement of Financial Position (SOFP)
The SOFP shows the assets, liabilities and capital/equity balance of the business at any given date. It
shows the accumulated balances of these items from the incorporation of the business.
Assets
Key Definition
An asset is a resource controlled by the entity as a result of past events from which future economic
benefits are expected to flow to the entity.
In other words, an asset is anything owned by the business or owed to the business. For example, a
car purchased by the business will be its asset.
Assets are classified into two categories, and it is VERY IMPORTANT from the exam perspective to
know this distinction:
1) Non-current assets – These are assets which are used for a long term in the business to generate
revenue. It is not meant to be resold in the normal course of business activities. It can be difficult to
sell non-current assets as they are highly illiquid.
Examples – land and buildings and plant and machinery.
2) Current assets – These are assets held for the short-term. It is usually sold/recovered within a
year. They are relatively very liquid (can be turned into cash easily) compared to non-current assets.
Example – inventory, trade receivables and cash.
It is important to note that assets in the SOFP are to be written in the increasing order of liquidity,
i.e. the asset which is hardest to sell should appear first.
20
Introduction to Financial Reporting
Liabilities
Key Definition
A liability is a present obligation to transfer economic benefit as a result of past transactions or
events.
In other words, a liability is anything owed by the business to someone else. For example, a loan
which is to be repaid to the bank.
Liabilities are also classified into two categories1) Non-current liabilities - They are long-term liabilities which are to be repaid after 12 months of
the reporting date of the SOFP.
Example – Long term loan is taken from a bank.
2) Current liabilities – Short-term liabilities which are due for payment within 12 months of the
reporting date.
Example – Bank overdraft and trade payables (creditors).
Equity (or capital in case of sole trader and partnerships)
Capital is the amount invested by the owners of the business, and the business owes that amount
back to its owners. In Limited Liability Companies, this amount of investment is divided into
transferable shares, which form the share capital.
Key Definition
The conceptual framework (discussed later) defines equity as Equity is the residual interest in a business and represents what is left when the business is
wound up, all the assets sold and all the outstanding liabilities paid.
If the business stops its operations today, it is effectively what the owners/shareholders of the
company would receive after all liabilities are paid, and assets are sold.
Hence, the accounting equation which forms is –
Capital/Equity = Assets – Liabilities
OR
Assets = Capital/Equity + Liabilities
21
Introduction to Financial Reporting
It is this accounting equation which holds true in case of the SOFP and that the assets (resources of
the business) should equal to the capital plus liabilities (from where these resources are
funded/bought) at any given point in time.
From the perspective of the exam, it is very important to know the format of the SOFP and SOPL.
The vertical format of SOFP is as follows –
Statement of Financial Position at 31 December 20XX
Particulars
Assets
Non-Current Assets
Property, Plant and Equipment
Motor Vehicle
$
$
X
X
X
Current Assets
Inventory
Trade Receivables
Bank
Cash
X
X
X
X
X
Total Assets
Equity and Liabilities
Equity
Share Capital
Share Premium
Revaluation Surplus
Retained Earnings
Total Equity
XX
X
X
X
X
X
Non-Current Liabilities
Bank Loan
Current Liabilities
Trade Payables
Bank Overdraft
Total Equity and Liabilities
X
X
X
X
XX
We will be reviewing most of these SOFP items in depth as to how their values are arrived at in
different chapters as part of the F3 Syllabus.
Remember, in the vertical format of SOFP and SOPLOCI, there is no debit and credit side. Only
addition and subtraction happens.
22
Introduction to Financial Reporting
3) The Statement of Cash Flows
This statement shows the cash inflows and outflows of a business, i.e. the amount it has paid and
received throughout the reporting period. The cash flow statement will be explored in depth in a
later chapter.
23
Introduction to Financial Reporting
4) The Statement of Changes in Equity (SOCIE)
This statement is only prepared by limited liability companies as it shows the movements in the
balances of the 4 primary items of the ‘Equity section’ of the SOFP.
Any issue of new shares or payment of dividends to shareholders will be recorded in this statement.
The format is as follows –
Particulars
Balance at start of
the year
Profit for the year
Dividend Paid
Revaluation
Issue of shares
Closing Balance at
year end
Equity Share
Capital
($)
X
Share
Premium
($)
X
Revaluation
Surplus
($)
X
Retained
Earnings ($)
X
X / (X)
(X)
X
X
XX
X
XX
XX
XX
Total
($)
XX
X / (X)
(X)
X
XX
XXX
5) Notes to Financial Statements
They provide important and detailed information to the users of the financial statements, which is
not available in the face of the SOPLOCI, SOFP, etc. The notes provide the break-up of the values on
the face of the main financial statements.
Significant accounting policies, estimates and judgements of the management in preparation of the
financial statements are all included, and many such key disclosures required by the applicable
standards and laws are included in the notes to financial statements.
24
Introduction to Financial Reporting
Dividends paid are recorded in which of these financial statements?
A.
B.
C.
D.
Statement of Financial Position
Statement of Profit and Loss
Notes to Accounts
Statement of changes in Equity
Answer: D
25
Introduction to Financial Reporting
Syllabus area A4a-b
-
-
Understand the role of the regulatory system, including the roles of the IFRS Foundation
(IFRSF), the International Accounting Standards Board (IASB®), the IFRS Advisory Council
(IFRS AC) and the IFRS Interpretations Committee (IFRIC®).
Understand the role of International Financial Reporting Standards.
It is important to understand the fact that the preparation of financial statements needs a lot of
application of judgement and are based on assumptions.
To overcome this issue, accounting standards were developed by the different national legislative
bodies of respective countries (for example, the Institute of Chartered Accountants of India, i.e. ICAI
is the governing body in India). These are the guiding principles for preparing the financial
statements, so the users are not misguided.
However, the issues which arose with these were that the financial statements of a company in two
countries, let’s say USA and India, were presented differently and prepared on the basis of different
laws and assumptions. Hence, it became of utmost priority to follow global accounting standards,
and that’s where the International Accounting Standards Board (IASB) stepped in and developed the
International Accounting Standards (IASs) and the International Financial Reporting Standards
(IFRSs).
As of 2020, there are 28 IASs and 17 IFRSs in issue and you shall learn about most of them in depth
over the course of your ACCA studies. These global standards enable better financial reporting,
consistency and comparability among companies globally, leading to the global harmonization of
accounting standards.
It is important to note that IFRSs are not compulsory by law to follow in any country, except if a
particular country has made it a mandate to follow these reporting standards. For example, all
entities in the European Union (EU) must report their accounts using the IASs and IFRSs.
The regulatory system, bodies and their roles are summarized in the following flowchart –
26
Introduction to Financial Reporting
The IFRS Foundation (The Foundation)
IFRS Foundation is an independent private body that oversees the IASB. Its aims include improving
the standards of financial reporting globally and leading the world to adopt global accounting
standards while implementing the shift from national accounting standards.
International Accounting Standards Board (IASB)
The main role of IASB is to develop and implement the relevant IASs and IFRSs. The process by which
it develops this is –
Process of developing an IFRS
1. The IASB appoints an advisory committee to oversee developing of new standards.
2. A discussion paper is discussed within the committee and made open to public comments
3. An exposure draft is made available to the public to receive their comments
4. The final standard is reviewed and published if more than 50% votes are casted in favour of
it in the committee.
IFRS Advisory Council (IFRS AC)
As the name suggests, this body advises the IASB. It consults with the outside world and takes the
opinions of other national and international accounting bodies as to what issues they are facing and
consider any suggestions they have, and advice it to the IASB.
IFRS Interpretations Committee (IFRS IC)
The main role of the IFRS IC is to interpret the standards made by the IASB and see if a different
meaning of it can be inferred or any lapses are there in them. Its role also extends to clarifying to the
public if any conflicting interpretations have been made with any previously issued IAS or IFRS.
27
Introduction to Financial Reporting
Syllabus area A5a-b
- Explain what is meant by governance specifically in the context of the preparation of
financial statements.
- Describe the duties and responsibilities of directors and other parties covering the
preparation of the financial statements.
Corporate Governance is the system and methods by which companies are directed and controlled.
It is crucial to understand that shareholders are the owners of a company, and they do not run or
manage the business. The Board of Directors, i.e. the management of the company, look after the
day to day operations of the business on behalf of the shareholders.
Thus, it is the responsibility of the directors to follow good corporate governance practices, and it is
their fiduciary responsibility to act within the best interests of the company first.
The main goal of a good corporate governance system should be to increase shareholder wealth,
transparency and accountability.
The UK Companies Act sets out seven statutory duties of directors.
Directors should:
1. Act within their powers
2. Promote the success of the company
3. Exercise independent judgement
4. Exercise reasonable skill, care and diligence
5. Avoid conflicts of interest
6. Not accept benefits from third parties
7. Declare an interest in a proposed transaction or arrangement
Thus, before taking any decisions, directors should consider the impact of its actions and keep the
best interests of all its stakeholders in mind (employees, suppliers, customers, owners, society, etc.)
It is important to note that it is the responsibility of the directors to ensure that the financial
statements are made in accordance with relevant laws and applicable standards (IFRS, IAS, etc.).
They should take full responsibility for the same and disclose it in the notes to financial statements.
The directors should make sure internal controls are in place within the company to prevent and
detect frauds and manipulation of financial statements on purpose.
Therefore, to oversee this, the owners, i.e. the shareholders, appoint external auditors to review the
financial statements and comment on the fact that if the management have carried out their
fiduciary responsibility properly or not and that the financial statements show a true and fair view of
the performance of the business.
28
Introduction to Financial Reporting
In case of a company, the responsibility of preparation of financial statements is of:
A.
B.
C.
D.
The Shareholders
The Directors
Employees
Government
Answer: B
29
31
Syllabus Area B:
Qualitative characteristics of financial information
Qualitative characteristics of financial information
Syllabus area B1a
-
Define, understand and apply qualitative characteristics of Relevance, Faithful
representation, Comparability, Verifiability, Timeliness, Understandability
The IASB also develops The Conceptual Framework which forms the basis on which IFRSs are
formulated. Also often referred to as ‘The Framework’, it is not an accounting standard like IAS or
IFRS, but it acts as a set of guiding principles which assist in the preparation of financial statements.
The Framework states the qualitative characteristics which financial information should have and
splits them into two categories:1. Fundamental Qualities
a. Relevance
b. Faithful Representation
2. Enhancing Qualities
a. Comparability
b. Verifiability
c. Timeliness
d. Understandability
From the exam perspective, it is important to know which characteristic falls under the fundamental
and enhancing categories, respectively.
Fundamental Qualities
1. Relevance
According to the Framework, information is relevant if it can make a difference to the
decision of the user.
In order to be able to influence decisions, financial information should have predictive
and/or confirmatory value, that is, the financial information of the previous years should aid
in predicting the future performance of a company.
Another key concept to note here is regarding materiality. Any information if omitted or
misstated, if knowing the correct information can change the decision of a user will be
considered material.
It is a very subjective concept, and an item or amount which is material for one company
might not be material for another. For example, for a company like Reliance Ltd, Rs.
1,00,000 wrongly written as Rs. 10,000, it will not make a huge impact on their financials.
However, if the same mistake is done for a small local general store, it is a material
misstatement.
32
Qualitative characteristics of financial information
2. Faithful Representation
In simple words, faithful representation means that financial information should be fairly
presented and reported in accordance with all relevant rules and regulations.
The three key words to note here are:i.
Complete – Information should contain all the necessary details required, and
nothing should be omitted.
ii.
Neutral – Information should not be manipulated and presented without any
subjective bias.
iii.
Free from error – This means errors should be avoided at all costs, but it does not
mean that inaccuracies cannot arise
Another key concept to note here is economic substance over legal form, which is implied in this
characteristic. This means that any accounting treatment should be done in accordance with the
nature of the transaction than what it might be on paper or legally.
For example, let’s say Company X is an agent of Company Y and sells goods of Company Y on behalf
of them. Let’s say Company X sold goods worth $100,000 and is entitled to a commission of 10%.
Over here, legally, Company X is selling goods and collecting revenue from the customer. But, the
substance of the transaction is that the revenue belongs to Company Y and not Company X. The
commission part of the transaction is the revenue for Company X. Hence, Company X will record
revenue only to the extent of $10,000 (10% of 100,000).
33
Qualitative characteristics of financial information
Enhancing Qualities
1. Comparability
Financial information should be comparable with other companies as well as with the figures
from previous years (trend analysis). It should be stated side by side in the financial
statements.
This does not mean that all companies should follow the same accounting policies so they
can be compared. The companies can choose their own policies, but the consistency of
those policies year on year is of utmost importance. If any change is made, it should be
appropriately disclosed in the notes to accounts.
2. Verifiability
This means that figures in the financial information should be independently checked by a
third party. This usually done through an audit.
For example, an auditor can count the number of items in the inventory and apply the
appropriate rate to check the value of inventory stated in the SOFP.
3. Timeliness
Timeliness means that financial information should be available to the users before their
decision is to be made; otherwise, that information is useless to them.
However, care must be taken in order to produce the information quickly and on time. If this
is not done, its reliability is lost.
4. Understandability
In simple words, if the information reported is not understandable by the users, it is
worthless. Hence, financial information should be classified, characterized and presented
clearly and concisely in order to be understandable.
However, this does not mean that complex information is omitted from the financial
statements, as it is assumed that users have reasonable knowledge of finance and accounts.
34
Qualitative characteristics of financial information
35
Qualitative characteristics of financial information
Syllabus area B1b
- Define, understand and apply accounting concepts of materiality, substance over form,
going concern, business entity concept, accruals, prudence, consistency
The concepts of materiality and substance over form were discussed above within the fundamental
qualitative characteristics.
1. Going Concern
Going concern states that the financial statements are prepared with the assumption that
the business will continue to operate indefinitely and that there is no intention of shutting
the business down or reducing its size significantly.
This is the reason why non-current assets are shown at the original cost that they are bought
in the SOFP, and not at their fair value or current market value.
Going concern is the main underlying assumption of the financial statements. If it is not
followed, it should be disclosed why with the reasons of not following the going concern
assumption.
2. Business Entity Concept
Under the eyes of the law, the owner(s) of the business and the business itself are
considered two different entities, and personal transactions of the owners should not be
shown in the books of the company. Everything should be recorded from the view of the
business.
36
Qualitative characteristics of financial information
This is the reason why in sole trader and partnership, we make an owner’s capital account
which shows the amount the business owes to the owner(s).
3. Accruals
The accruals principle is also called as the matching principle. The reason for this is that the
revenue and costs of an accounting period should be matched with each other, i.e. ONLY the
revenues and costs and relating to the current financial year should be included in the
SOPLOCI.
This principle gives rise to prepaid and outstanding incomes and expenses (looked at in
detail in a chapter later)
The SOPLOCI is made on the accrual principle and thus the timing of when cash is received or
paid is irrelevant.
4. Prudence
It is important that the financial statements show a realistic picture about the business.
Profits and assets should not be overstated, and losses and liabilities should not be
understated.
37
Qualitative characteristics of financial information
The prudence concept says that ‘never anticipate future profits, but always provide for all
possible future losses’. This means that revenue should not be recognised until the goods
have changed hands and ownership has been transferred.
Due to the prudence concept, we also create allowances for receivables (provision for
doubtful debts) to predict that a percentage of trade receivables will not pay the amount
due and that the business would have to bear its loss.
5. Fair Presentation
Financial statements should be presented fairly in all aspects and comply with relevant IASs
and IFRSs. IAS 1 Presentation of Financial Statements is an extension to this principle which
states that information should be presented in a neat and concise manner with the
information being relevant, reliable and understandable.
6. Consistency
The accounting policies used and the presentation of information should remain the same
from year to year unless a specific change is required by an updated IAS or IFRS. This ensures
the performance of a company can be analysed over time (time series analysis).
38
Qualitative characteristics of financial information
State whether the following questions are true or false?
1. If a change in any accounting treatment is required by a new IFRS, the consistency principle
says that the change should not be made
2. In a sole trader business, drawings are recorded separately because of the business entity
concept
A.
B.
C.
D.
Both are true
Both are False
Statement 1 is True and statement 2 is false
Statement 2 is true and statement 1 is false
Answer: D
39
Qualitative characteristics of financial information
PO1 – ETHICS AND PROFESSIONALISM
Description
The fundamental principles of ethical behaviour mean you should always act in the wider public
interest. You need to take into account all relevant information and use professional judgement, your
personal values and scepticism to evaluate data and make decisions. You should identify right from
wrong and escalate anything of concern. You also need to make sure that your skills, knowledge and
behaviour are up-to-date and allow you to be effective in your role.
Elements
a. Act diligently and honestly, following codes of conduct, taking into account – and keeping upto-date with – legislation.
b. Act with integrity, objectivity, professional competence and due care and confidentiality. You
should raise concerns about non-compliance.
c. Develop a commitment to your personal and professional knowledge and development. You
should become a life-long learner and continuous improver, seeking feedback and reflect on
your contribution and skills.
d. Identify, extract, interrogate and evaluate complex data to make reliable, informed decisions.
e. Interrogate, critically analyse and assess data and other information with professional
scepticism. You should challenge opinion and facts through corroboration and robust testing.
Example activities
•
•
•
•
•
•
•
•
•
•
Applying legislation appropriately to client needs.
Continually reviewing legislation and regulation that affects your working environment.
Briefing a team on a new standard and how to apply it.
Keeping sensitive information confidential and disclosing it only to those who need it or when
disclosure is legally required.
Recognising unethical behaviour and telling your line manager about what you have seen.
Avoiding situations where there may be any threat to your professional independence.
Deciding what information is important and reliable, using it to support your decision making.
Completing the code of conduct and/or professional ethics training provided by your
organisation.
Checking transactions and supporting documents to verify the accuracy of accounting records.
Use digital technology responsibly to analyse and evaluate data from a variety of sources,
ensuring the integrity and security of this data.
40
Qualitative characteristics of financial information
Syllabus Area C:
The use of double-entry and accounting systems
41
Double Entry System of Bookkeeping
Double Entry System of Bookkeeping
The double entry system of booking basically forms the building blocks of accounting and financial
reporting. It includes your ledgers and applies the duality concept learned earlier, that is every
transaction has a debit side and an equal and opposite credit side.
The practical aspect of the F3 chapter starts from here. LEARN TO READ, UNDERSTAND AND
INTERPRET EXAM QUESTIONS VERY WELL. It is an important skill many lack which can be the
difference between a pass and fail. Develop it by practicing as many questions as humanly possible
before the paper!
Memorising journal entries is simply not going to cut it for F3. One needs to logically
understand when to debit and when to credit a ledger account. That should be your primary
focus area while learning and reading the syllabus area C of the F3 paper; to make your
basics strong. If the foundation is not strong, you might face difficulties in the future ACCA
papers, hence make sure that does not happen!
42
Double Entry System of Bookkeeping
43
Syllabus Area C1a-b
-
Identify and explain the function of the main data sources in an accounting system. [K]
Outline the contents and purpose of different types of business documentation, including:
quotation, sales order, purchase order, goods received note, goods despatched note,
invoice, statement, credit note, debit note, remittance advice, receipt. [K]
Recall this diagram from the syllabus area A –
Data
Sources
• Business documents such as invoices and debit notes are made for
all transactions
• Example: An invoice for a sale of Nike shoes of Rs. 5000
• By using business documents, initial entries in the books of
accounts are made
Books of
Prime Entry • Example: Recording the sale of Nike shoes in the sales journal
Ledger
Accounts
Trial
Balance
Financial
Statements
• Corresponding entries in the ledger accounts are recorded
• Example: Crediting the Sales account and debiting the bank
account by Rs. 5000
• Ledger accounts are closed and a list of balances are drawn
• Financial statements (statement of financial position and the
statement of profit and loss) are made from the trial balance
We shall look at each stage of the accounting cycle one by one in detail now–
Double Entry System of Bookkeeping
44
Data sources and business documents
For manufacturing concerns, typical documents, but not limited to these only, are summarized
below:
Contents
Purpose
1)
Quotation
Quantity/description/details of goods
required.
To get the price from various suppliers
2)
Purchase Order (P.O.)
Details of supplier, e.g. name,
address, quantity/ description/details
of goods required and price.
Made by the buyer requesting the
supplier to provide him with the goods
listed in the purchase order
3)
Sales Order
Quantity/description/details of goods
required and price
Cross-checked with purchase order and
made by the supplier
4)
Goods Dispatched
Note(GDN)
Details of supplier, e.g. name and
address, quantity
and description of goods
Made by supplier to check with P.O.
while dispatching goods
5)
Goods Received Note
(GRN)
Quantity and description of goods
The buyer makes this as confirmation
that he has received the delivery of
goods
6)
Invoice
Name and address of supplier and
customer; details of goods, e.g.
quantity, price, value, sales tax, terms
of credit, etc.
Made by supplier to request for
payment in return for goods/ service
provided
7)
Statement
Details of supplier, e.g. name and
address. Has details of date, invoice
numbers and values, payments made,
refunds, amount owing.
Summary of transactions to confirm the
amount owed by the buyer
8)
Debit Note
Details of supplier, e.g. name and
address. Contains details of goods
returned, e.g. quantity, price, value,
sales tax, terms of credit, etc
Issued by the buyer when he wants to
return goods
9)
Credit Note
Details of supplier, e.g. name and
address. Contains details of goods
returned, e.g. quantity, price, value,
sales tax, terms of credit, etc
Issued by seller to confirm that he will
accept the returned goods
10)
Remittance advice
Method of payment, invoice number,
account number, date, etc.
An intimation of payment
11)
Receipt
Details of payment received
Issued by seller to show payment has
been received
Double Entry System of Bookkeeping
Debit notes – Record purchase returns (issued by buyer)
Credit notes – Record sales returns (issued by seller)
Which of the following documents should accompany a return of goods to a supplier?
A.
B.
C.
D.
Debit note
Remittance advice
Purchase invoice
Credit note
Answer: A
Return of goods to supplier means purchases returns. Hence, a debit note is the corresponding
document the buyer will issue for the same.
45
31
31
Syllabus Area C2a, D2a, D2b
- Identify the main types of ledger accounts and books of prime entry, and understand their
nature and function. [K]
Record cash transactions in ledger accounts. [S]
- Understand the need for a record of petty cash transactions. [K]
Books of Prime Entry
Books of prime entry are books in which the first, initial entry is made in the books of accounts.
These books are required so that entries in the ledgers reduce.
The 7 books of prime entry are –
Book of prime entry
Sales day book
Purchase day book
Sales returns day book
Purchases returns day book
Cash book
Petty cash book
The journal
1)
2)
3)
4)
5)
6)
7)
Transaction Type
Credit sales
Credit purchases
Sales Returns for goods sold on credit
Purchases returns for goods sold on credit
All cash and bank transactions
All small cash transactions
All transactions not recorded in either of the
other books of prime entries
Credit transactions are the ones which do not need immediate payment.
Example: If Mr. A sells goods to Mr. B on credit, that means Mr. B will receive the goods today, but
he will pay Mr. A for those goods later (per say after 1 month hypothetically).
ONLY transactions done on credit are recorded in the first 4 books of prime entries. A typical format
for the first 4 books of prime entry is as follows –
Date
Invoice Number
Name of Supplier / Customer
Total
$
XXX
The TOTALS at the end of the books are what are transferred to the ledger account by passing the
following journal entries –
1. Sales Day Book
Dr Trade Receivables Control A/c (See in later chapter what is control A/c)
Cr Sales A/c
2. Purchases Day Book
Double Entry System of Bookkeeping
Dr Purchases A/c
Cr Trade Payables Control A/c
3. Sales Returns Day Book
Dr Sales Returns A/c
Cr Trade Receivables Control A/c
4. Purchases Returns Day Book
Dr Trade Payables Control A/c
Cr Purchases Returns A/c
32
Double Entry System of Bookkeeping
Sales returns and purchases returns are the exact opposites of sales and purchases. Hence, it
can be concluded that –
Sales (credited), therefore sales returns are debited
Purchases (debited), therefore purchases returns are credited
Cash Book and Petty Cash Book
The cash book records all bank and cash transactions. It will have a debit side (receipts side) and a
credit side (payments side) where it will record the cash payments and receipts.
However, a large business will probably have millions of bank transactions in a month, and it would
become too cumbersome to record everything in one book. Hence, the petty cash book is
maintained where transactions below a certain amount, i.e. small amount transactions are
maintained.
Petty Cash vouchers are the supporting documents for the same, which are used to issue any
payments from the allotted amount of petty cash float, which is the maximum amount of petty cash
allowed to use per month. This is known as following the imprest system, where the amount of
petty cash is restored to the float amount by transferring the money from the bank by the following
journal entry Dr Petty Cash A/c
Cr Bank A/c
33
Double Entry System of Bookkeeping
Syllabus Area C1c-d-e-f, C2b-c
- Understand and apply the concept of double-entry accounting and the duality concept. [K]
- Understand and apply the accounting equation. [S]
- Understand how the accounting system contributes to providing useful accounting
information and complies with organisational policies and deadlines. [K]
- Identify the main types of business transactions, e.g. sales, purchases, payments, receipts. [K]
- Understand and illustrate the uses of journals and the posting of journal entries into ledger
accounts. [S]
- Identify correct journals from the given narrative. [S]
The Journal
The last but probably the most important book of prime entry is the journal, where everything else is
recorded which does not fit in the other books of prime entry. Few examples include –
•
•
•
•
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
Acquisitions and disposals of non-current assets
Opening balances for a statement of financial position items
Correction of errors.
The concept of duality is what is used in recording journals and then to record those journals in the
ledger.
The concept of duality states every transaction in a business will have two aspects to it, i.e. one debit
effect and one credit effect. A debit effect is usually something receiving or gaining in value, and a
credit effect is the opposite of it, i.e. when something is giving or losing value.
For example, let’s say ABC Company bought furniture worth $3,000 and paid it by cash. Over here,
the furniture account is what is gaining in value, so it will be debited, and cash is what is going out of
your business or losing value hence will be credited.
Recording this transaction in a systematic way along with a descriptive narrative explaining what
transaction is occurring is what is called as a journal entry.
The above example written in the typical format of a journal is as follows–
34
Double Entry System of Bookkeeping
Particulars
Furniture A/c
Cash A/c
(Furniture worth $3,000 bought and paid cash)
Debit ($)
3,000
Credit ($)
3,000
There is no need to use the word ‘Being’ before the start of the narrative nor write ‘To’ in front of
the credit effect.
The Accounting Equation
Recall the accounting equation we learnt about in syllabus area A when we saw the SOFP –
Capital/Equity = Assets – Liabilities
OR
Assets = Capital/Equity + Liabilities
The accounting equation shows that assets (resources of the business) should equal to capital plus
liabilities (from where these resources are funded/bought) at any given point in time.
35
Double Entry System of Bookkeeping
36
Apply Your Knowledge
April 1 – John started a business and opened a bank account in which he transferred $30,000 of his
own money
April 2 – The business bought premises worth $20,000 and paid by cheque
April 3 – The business bought goods on credit worth $5,000
April 4 – The business sold goods costing $2,000 on cost price on credit
Show the Accounting equation holds true after every transaction
Solution:
Date
Assets
April 1
Bank
$30,000
$30,000
-
April 2
Premises
Bank
$20,000
$10,000
$30,000
-
Premises
Bank
Inventory
$20,000
$10,000
$5,000
$30,000
Trade Payables
$35,000
Premises
Bank
Inventory
Trade Receivable
$20,000
$10,000
$3,000
$2,000
$30,000
Trade Payables
$35,000
April 3
April 4
=
Capital
+
Liabilities
As seen above, the assets are ALWAYS equal to the capital plus the liabilities. This equation is which
holds true in the balance sheet, i.e. the Statement of Financial Position.
50
The Ledger
A further detailed part of the accounting cycle can be shown as –
This is the part where proper recording and accounting in the ledgers of the business becomes of
utmost importance.
The journal entries in ‘The Journal’ (Book of prime entry) are then entered into what is called a
ledger account.
The ledger account is in the ‘T’ Format, as when it is drawn in rough, it looks like the alphabet ‘T’ (as
seen below by the bold lines). Remember, every transaction has 2 effects, so it must be entered into
2 different accounts, and this system is what is known as the double entry system of bookkeeping.
The format of a ledger is shown below –
Date
Particulars
Name of Account
$
Date
Particulars
$
As seen above, the ledger has two distinctive sides; the left side is called the debit side (Dr), and the
right side is called the credit side (Cr). The date is recorded as to when the transaction occurs. In the
particular column, the name of the account where the other half of the entry can be found is
written.
The Ledger
If we were to take our earlier example of ABC Co. buying furniture and were to put in a ledger, it
would look like this –
Particulars
Cash A/c
Particulars
Furniture Account
$
3,000
Particulars
Cash Account
$
Particulars
Furniture A/c
$
$
3,000
Note – It is common to leave out the date column sometimes if it is not given in the question
When you say you want to debit the cash account, THE AMOUNT of the transaction should
go on the DEBIT SIDE of the account.
It should not be confused with particulars column where the name of the other account is
written
Types of Ledger Accounts
We should understand why and when an account is debited or credited, and before that we need to
know what kind of ledger accounts exist.
As seen above, assets, liabilities and capital form the accounting equation, and each asset/liability
will have its own separate ledger account. As a general rule, all asset accounts are always debited,
and liability accounts are credited.
Other types of accounts which exist are of incomes and expenses. Income accounts include any
money received by the business by carrying out its regular activities, and expenses accounts are the
exact opposite. Examples of incomes include revenue (sales), and of expenses include rent paid.
51
The Ledger
52
As a general rule, income is always credited, and expenses are always debited.
Drawings is any value (cash or goods) taken out of the business by its owners. The drawings account
is always debited with the amount of goods or cash withdrawn by the owner.
Important mnemonics which will help you remember when to debit an account and when to credit
are as follows: –
PEA
RLS
P = Purchases
E = Expenses
A = Assets
R = Revenue/Income
L = Liabilities
S = Sales
This is known as ‘PEARLS’. As seen above, the left side, i.e. the debit side, indicates items to be
debited, and the right side, i.e. the credit side, indicates accounts to be credited.
Another helpful mnemonic is ‘DEAD CLIC’
D
E
A
D
Debtors (Trade Receivables)
Expenses
Assets
Drawings
C
L
I
C
Creditors (Trade Payables)
Liabilities
Incomes
Capital
The first part, ‘DEAD’ indicates the types of accounts to be debited, and the ‘CLIC’ shows the types of
accounts to be credited.
The asset, liability and capital accounts are known as the SOFP A/c. They are NOT closed at the yearend and have a balance c/d and balance b/d always.
The incomes and expenses accounts are known as the SOPL A/c. Their total for the year is transferred
to the SOPL statement and hence the account is closed with no balance at the year-end.
The Ledger
Syllabus Area C2d
- Illustrate how to balance and close a ledger account. [S]
Steps to Balance / Close ledger accounts
1.
2.
3.
4.
Total both sides of the ledger (debit side and credit side)
Write the larger total at the end of both sides of the ledger and double underline it
Find out the difference between the larger and smaller total
Write down the amount of difference on the side which is falling short. Therefore, the debit
side will then equal the credit side
5. Relating to the above step, two scenarios are possible –
a. If it is a SOFP A/c, the difference will become balance c/d, and the balance b/d will
be formed on the diagonally opposite side on the date of the next year
b. If it is a SOPL A/c, this difference will be transferred to the SOPL, and the account will
be closed (write SOPL is particulars column). New entries will be written in the next
year, and the same process followed then.
Messi had receivables of $45,000 at the start of 20X8. During the year, he made credit sales of
$450,000 and received cash of $465,000 from credit customers.
What is the balance on the receivables account at 31 December 20X8?
A.
B.
C.
D.
$60,000 Dr
$60,000 Cr
$30,000 Dr
$30,000 Cr
Answer: C
$30,000 Dr
Since balance b/d is on the debit side, the answer is option C
Balance b/d
Credit Sales
Receivables Account
$
Particulars
45,000
Cash
450,000 Balance c/d (Bal fig)
Balance b/d
495,000
30,000
Particulars
$
465,000
30,000
495,000
53
The Ledger
Apply Your Knowledge
Consider the following transactions: 1. John started a business and opened a bank account in which he transferred $30,000 of his
own money
2. The business bought premises worth $20,000 and paid by cheque
3. The business bought goods on credit worth $5,000 from ABC Ltd.
4. The business sold goods worth $3,000 to XYZ Ltd, half on credit and the half amount
received by cheque
5. John receives bank interest income worth $250
Record these transactions in the nominal ledger of John. Balance only the bank account.
Solution:
Record each transaction one by one. Write down the debit and credit effect, i.e. the journal entry in
rough, and then one by one start plotting it in the ledger accounts as follows –
Particulars
Capital A/c (1)
Sales A/c (4)
Bank Interest Income (5)
Balance b/d
Particulars
Particulars
Bank A/c (2)
Bank Account
$
Particulars
30,000
Premises A/c (2)
1,500
Balance c/d (Bal Fig)
250
31,750
11,750
Capital Account
$
Particulars
Bank A/c (1)
Premises Account
$
20,000
Particulars
$
20,000
11,750
31,750
$
30,000
$
54
The Ledger
Particulars
ABC Ltd. A/c (3)
Particulars
Particulars
Purchases Account
$
5,000
Particulars
ABC Ltd. Account (Trade Payable)
$
Particulars
Purchases A/c (3)
$
5,000
Sales Account
$
Particulars
XYZ Ltd. A/c (4)
Bank A/c (4)
$
1,500
1,500
Particulars
XYZ Ltd. Account (Trade Receivable)
$
Particulars
1,500
Particulars
Bank Interest Income Account (SOPL A/c)
$
Particulars
Bank A/c (5)
Sales A/c (4)
$
$
$
250
Note: - The sales, purchases and bank interest income account values would all be transferred to
the SOPL at the end of the year and the accounts closed.
The remaining accounts would have a balance b/d at the year end and will be shown in the SOFP.
55
The Ledger
Syllabus Area D:
Recording transactions and events
56
Sales, Purchases and Discounts
Sales, Purchases and Discounts
Syllabus Area D1a-b
- Record sale and purchase transactions in ledger accounts. [S]
- Understand and record sales and purchase returns. [S]
Sales, Purchases and Returns
It is normal for customers to return goods if they are faulty, damaged or not as per what they ordered.
Following journal entries are passed in the books of accounts –
In the books of seller:
When goods are sold
1) Dr Trade Receivables (credit sale) / Cash (cash sale)
Cr Sales A/c
When goods are returned, the original entry is reversed
2) Dr Sales A/c
Cr Trade Receivables (credit sale) / Cash (cash sale)
In the books of buyer:
When goods are bought
1) Dr Purchases A/c
Cr Trade Payables (credit sale) / Cash (cash sale)
Again, when goods are returned, the original entry is reversed
2) Dr Trade Payables (credit sale) / Cash (cash sale)
Cr Purchases A/c
57
Sales, Purchases and Discounts
Syllabus Area D1e-f
- Account for discounts allowed. [S]
- Account for discounts received. [S]
Trade Discount and Cash/Settlement Discount
Trade discounts are given by suppliers to encourage bulk buying, i.e. buying in large quantities. For
example, you get a discount for buying 1000 units at one time. From an accounting view, trade
discounts are NOT recorded in the books of accounts. The net amount is recorded, i.e. the original
amount – trade discount.
Cash discounts are given to customers to encourage prompt (early) payments to improve cash flow.
For example, a 5% discount is to be given if the customer pays within 15 days of the date of invoice.
This 5% is effectively a loss of revenue for the seller.
1) When you receive discount from supplier – discount received – shown as other income
2) When you give discount to customer – discount allowed – shown as reduction in revenue
The issue with cash discounts, unlike trade discount, is that at the point of sale, one does not know if
the customer will avail the discount or not and thus what amount the invoice should be made at.
Remember, the INTENTION / EXPECTATION of the customer to avail the cash discount at the date of
sale is what matters the most in such questions.
Seller perspective of recording cash discount
Consider the situation where a company which sold goods to a customer at a price of $100, and the
customer was offered a 5% cash discount for payment within 15 days of the invoice date.
Discount amount = 5% x 100 = $5
Reduced price would become $100 - $5 = $95
Now the question is, should the company make an invoice of $100 or $95? As mentioned above, the
intention of the customer to avail the discount matters. This leads to 4 scenarios being possible,
which are shown in the flowcharts below.
58
Sales, Purchases and Discounts
Note that the invoice would create the following journal entry –
Dr Trade Receivable X
Cr Revenue X
X = $95 or $100 depending on the flowchart used below -
If a discount is not availed, then the additional $5 discount given is effectively treated as cash sales
instead of a credit sale.
Gross amount means amount without discount, and net amount means gross amount less the cash
discount.
59
Sales, Purchases and Discounts
In the above flowchart, if the discount is availed, by debiting revenue by $5, you are effectively
reversing the revenue recognised earlier at the time of sale, i.e. when the invoice was made.
Buyer perspective of recording cash discount
Accounting in the buyer’s books is fairly simple. The initial record is at the gross amount. Continuing
the earlier exampleDr Purchases $100
Cr Trade Payable $100
1) If the discount is not taken
Dr Trade payable
Cr Bank
$100
$100
2) If the discount is taken
Dr Trade payable
$100
Cr Bank
Cr Discount received
$95
$5
60
Sales, Purchases and Discounts
ABC Ltd. sells goods worth $5,000 with a trade discount of 10% and a further 5% cash discount if the
payment is made within 30 days to XYZ Ltd., who is expected to take advantage of this cash discount.
What entries will ABC Ltd. make in its books at the time of sale?
A.
Dr Trade Receivable $4,500
Cr Revenue $4,500
B. Dr Trade Receivable $5,000
Cr Revenue $5,000
C. Dr Trade Receivable $4,275
Cr Revenue $4,275
D. Dr Cash / Bank $4,500
Cr Revenue $4,500
Answer: C
Trade discount is never record in the books. As XYZ Ltd. is expected to avail discount of 5%, the net
amount will be recorded in the invoice and books
5000 x 10% = $500
5000 – 500 = $4,500
4,500 x (100 – 5) % = 4,500 x 95% = $4,275
61
Inventory
Inventory
Syllabus Area D3a-b
- Recognise the need for adjustments for inventory in preparing financial statements. [K]
- Record opening and closing inventory. [S]
Inventory (also called as stock) is a very crucial part of any set of financial statements as it forms a
part of the SOFP as well as the SOPL. Hence, to correctly account for it and ascertain the correct
value of inventory is very important to calculate the correct value of profit as well as net assets.
The topic of inventory covers a range of different sub-topics which provides the examiner lots
of content from which he can ask questions. Thus, this is a very frequently tested part from
the syllabus so make sure you understand the concepts well and mainly know how to apply
them!
Inventory means the goods that remain unsold at the end of the year. This is not necessarily a bad
thing; businesses tend to keep a certain amount of goods in hand to meet unexpected demand in
the future.
Inventory can be come in different forms, including but not limited to –
1. Consumables (like paint which gets consumed to make a car)
2. Raw materials (Steel used to make the body of a car)
3. Work in Progress (WIP) (A car which is not fully assembled)
4. Finished goods (A full manufactured car ready for sale)
5. Goods purchased for resale (A car bought from the manufacturer by a retailer)
Quantity of goods held in closing inventory = Number of goods bought/manufactured - Number of
Goods sold
Inventory forms a part of the Cost of Goods Sold (COGS) / Cost of Sales (COS) formula in the SOPL.
COGS = Opening Inventory + Net Purchases – Closing Inventory
This COGS is then subtracted from the revenue of the company to find the gross profit. As this is in
the top part of the SOPL, it affects all the key items and ratios that follow (net profit and retained
earnings).
Only closing inventory is recorded in the SOFP under current assets.
62
Inventory
The margin / mark-up principle
A business often has a fixed target percentage of profit it wants to earn on any sale. There are two
ways in which a business can determine this gross profit it wants to earn –
1. Gross profit margin
2. Mark-up
% of sales
% of cost of goods sold
You should know that Cost + Profit = Sales. However, the only distinguishing factor between mark up
and margin is on what amount the percentage is applied too, as depicted above.
So, for mark-up and margin problems, the easiest way is to form an equation in terms of 100 as it is
a percentage and then just cross multiply with the actual sales, COGS, profit figure, whichever
maybe provided in the question, to find the rest of the unknowns. Look at the Apply Your Knowledge
below to exactly know how to apply this concept.
Margin is a % of sales, therefore take sales as 100
Mark-up is a % of COGS, there take COGS as 100
Remember this perfectly and you shall never go wrong with mark-up/margin problems. Also,
take note that this is tested in other chapters of F3 as well!
Apply Your Knowledge:
Talia Co operates the business with a margin of 20% on all of its transactions. Find the COGS if sales
in the year 20X9 amounted to $10 million.
Solution:
Margin is a % of sales, therefore we will take sales as 100. We will take whatever we need to find as
xxx in our calculations, in this case, the COGS. We will use the principles of cross-multiplication to
find our answer.
20 is % of profit and will remain the same. The cost of the first equation will simply be a balancing
figure.
Cost
80
+
+
Profit
20
=
=
Sales
100
xxx
+
?
=
10m
63
Inventory
Therefore,
80 x 10m = 100 X xxx
xxx = 10m X 80 / 100
= $8m
COGS = $8m, and profit would therefore be equal to $2m
The following are balances extracted from the ledger accounts of Sunshine Ltd.
Opening inventory
Purchases
Purchase returns
Closing inventory
$10,000
$50,000
$5,000
$15,000
The company sells all its goods on a mark-up of 10%.
What is the gross profit of Sunshine Ltd?
A.
B.
C.
D.
$4,000
$4,444
$4,500
$5,000
Answer: A
COGS = 10,000 + (50,000 – 5,000) – 15,000 = 40,000
$5,000 is deducted from purchases as net purchases are required.
Mark-up means COGS should be 100 in our formula and 10 is equal to the profit percentage.
100 + 10 = 110
40,000 + x = ?
By cross multiplying, x=40,000 X 10 / 100 = $4,000 gross profit and which would lead to a sales value
of $44,000.
64
Inventory
Year-end Inventory adjustments
As inventory is an asset and every asset has its ledger account, so does inventory, but its accounting
is different than other assets. Two basic journal entries are made 1. Dr Opening inventory in COGS (i.e. adding in COGS and a debit to SOPL)
Cr Inventory (asset account)
This basically removes the balance b/d of last year’s inventory from the books of accounts by
crediting the inventory account.
2. Dr Inventory (asset account)
Cr Closing inventory in COGS
(i.e. subtracting in COGS & a credit to SOPL)
This entry effectively creates the closing inventory value at the year-end in the books of account by
debiting the inventory asset account, which will be shown in SOFP and deducted from the COGS
formula in SOPL.
Remember that the closing inventory of the previous year becomes the opening inventory of the
current year.
Remember that in the vertical SOPL, adding any amount (which would reduce profit) is as
good as debiting the SOPL and subtracting any amount (which would increase profits).
COGS as a whole is subtracted therefore it is a debit item but closing inventory, as it reduces
the value of COGS, can be thought of as crediting the SOPL.
65
Inventory
Syllabus Area D3c-d-e
- Identify the alternative methods of valuing inventory. [K]
- Understand and apply the IASB requirements for valuing inventories. [S]
- Recognise which costs should be included in valuing inventories
IAS 2 Inventories is the applicable standard of IASB here. It states that:
An important point to note here is that when calculating NRV, selling costs will include any costs of
further work/re-work done for defective products to bring it back into a saleable condition.
An item is most likely to be valued at NRV when it has become damaged, obsolete, or its market
price fell down drastically due to factors like advancements in technology, the discovery of
substitute, etc.
Inventory is valued at the LOWER of cost or NRV.
Make sure you can recite this even in your sleep!
66
Inventory
Components of Cost
Cost includes 'all costs of purchase, costs of conversion and other costs incurred in bringing the
inventories to their current location and condition'
Costs of purchase include:
1. Raw material costs
2. Import duties
3. Freight and carriage inwards (transport costs in bringing the goods to its present location)
Costs of conversion (cost of turning materials into finished goods) include:
1. Direct costs (direct material, direct labour, etc.)
2. Production overheads (depreciation on factory/machine)
Specific costs to be EXCLUDED are:
1. S – Storage costs
2. A – Abnormal costs and wastage
3. S – Selling and distribution costs
4. A – Administrative overheads
The mnemonic ‘SASA’ can be used to remember the costs to be excluded.
67
Inventory
Carriage inwards is included in cost, but carriage outwards is NOT INCLUDED in cost as it is a
selling and distribution cost.
Also, trade discounts will be deducted from cost as they are NEVER shown in the books of
accounts.
In accordance with IAS 2, which one of the following options consists only of items which form a
part of the cost of the inventory?
A.
B.
C.
D.
Raw Materials, Carriage outwards, supervisor’s salary
Factory depreciation, carriage inwards, storage costs
Carriage Inwards, import duties, direct labour
Carriage inwards, Carriage outwards, Freight
Answer:
C
XYZ Co. sells 3 products; Product A, B and C. The following information is provided
Original Cost
Fair Value
Estimated costs to sell
Units in inventory
A ($)
20
25
100
What is the value of closing inventory?
A.
B.
C.
D.
$18,000
$23,000
$24,500
$19,000
B ($)
30
35
10
200
C ($)
50
45
5
300
68
Inventory
Answer:
D
Inventory is valued at LOWER of cost or NRV.
NRV = Fair value less costs to sell
Original Cost (1)
NRV (2)
Lower of 1 and 2
Units
Value
There, the answer is $19,000
A ($)
20
25
20
100
20 X 100 = 2000
B ($)
30
35 – 10 = 25
25
200
25 X 200 = 5000
C ($)
50
45 – 5 = 40
40
300
40 X 300 = 12000
69
Inventory
Syllabus Area D3f-g
- Understand the use of continuous and period end inventory records. [K]
- Calculate the value of closing inventory using FIFO (first in, first out) and AVCO (average cost) –
both periodic weighted average and continuous weighted average. [S]
Methods of calculating cost of inventory
Till now, what we saw was calculating actual costs of inventory at their purchase price, but this is
only to be used when the items of inventory are distinguishable and of high value (E.g. large steel
bars). However, this is rarely possible in practice, and certain other cost flow methods and
assumptions must be taken for accounting and costing purposes in the valuation of inventory.
These include:
1. First in-First Out (FIFO) – This assumes that the items that entered first are the ones which
will be sold first. Useful for products that have a limited shelf life, i.e. have an expiry date.
E.g. dairy products.
2. Last in-Last out (LIFO) – This assumes the items that were bought or made last are sold first.
3. Average Cost (AVCO) – This takes an average cost either periodically or continuously. Useful
for products who cannot be distinguished from one another. E.g. oil mixed in one huge
barrel before processing.
Take note that IAS 2 Inventories prohibits the use of LIFO accounting. Therefore, we will only study
FIFO and AVCO in depth.
FIFO
The closing inventory is valued at the latest prices as a result of using FIFO method. As the goods
bought first are sold first, the COGS will reflect the prices of earlier months of the years.
70
Inventory
71
In a period of inflation, the value of closing inventory will be HIGHER as the inventory is valued at the
latest (higher) prices.
As closing inventory and gross profits are directly related, in a periods of rising prices FIFO will result in
HIGHER PROFITS.
Understand this logic well as this concept is highly tested in tricky ways in the exam.
Periodic Weighted Average Cost (Periodic AVCO)
This can only be used at the END of an accounting period, when the total value of purchases and
quantities are known. An average cost per unit is calculated, which is used to value the number of
items in the closing inventory Average Cost per unit =
(Total Costs of purchases and inventory)
Total no.of units (Opening inventory+purchases)
Continuous Weighted Average Cost (Continuous AVCO)
In this method, the average cost per unit is calculated every time a purchase is made, and for any
subsequent sale, that average cost is used to remove the items out of inventory.
The average cost in the continuous method needs to be recalculated EVERY TIME A NEW PURCHASE
IS MADE.
Receipts = Purchases (Goods are being received)
Issues = Sales (Goods are being issued/sold)
Inventory
Apply Your Knowledge:
Toretto has closing inventory of 10 units at a cost of $10 each on 31 December 20X6. During the first
week of January 20X7, he entered into the following transactions:
Date
2nd Jan
3rd Jan
5th Jan
Purchase / Sale
Purchase
Sale
Purchase
Units
20
15
5
Unit Cost ($)
11
15
13
Calculate the value of closing inventory at the end of the first week of January and the gross profit
under each of the following methods:
1. FIFO
2. Periodic AVCO
3. Continuous AVCO
Solution:
1) FIFO
The value of closing inventory is the value of the goods in inventory purchases last.
Units in closing inventory = 10 (opening) + 20 (purchase) – 15 (sale) + 5 (purchase) = 20 units
The latest purchases include 5 units purchased 5th Jan and 15 units purchased on 2nd Jan.
Therefore, value of closing inventory = (5 X 13) + (15 X 11) = $230
The gross profit will be Particulars
Revenue (15 X 15)
Less: cost of goods sold
Opening inventory (10 X 10)
Add: purchases (20 X 11) + (5 X 13)
Less: FIFO closing inventory (as calculated above)
Gross profit
$
100
285
(230)
2) Periodic AVCO
Using the formula of average cost per unit, we get the value of closing inventory as
Average Cost per unit =
(Total costs of purchases and inventory)
Total no.of units (opening inventory + purchases)
$
225
(155)
70
72
Inventory
=
(100 + 285)−𝐹𝑟𝑜𝑚 𝐹𝐼𝐹𝑂 𝑐𝑎𝑙𝑐𝑢𝑙𝑎𝑡𝑖𝑜𝑛
10 (opening)+25 (𝑝𝑢𝑟𝑐ℎ𝑎𝑠𝑒𝑠)
= 385 / 35
= 11 / unit
Closing inventory = 20 units X $11 = $220
The gross profit will be Particulars
Revenue (15 X 15)
Less: Cost of goods sold
Opening inventory (10 X 10)
Add: purchases (20 X 11) + (5 X 13)
Less: Closing inventory (as calculated above)
Gross profit
$
100
285
(220)
$
225
(165)
60
Alternatively, the COGS can be derived as: number of goods sold X average cost per unit = 15 X 11 =
$165
3) Continuous AVCO
The average cost per unit needs to be re-calculated after every purchase. The best way to deal with
this problem is to prepare the following table –
Date
Transaction
Jan 1
Jan 2
Total
Opening Inventory
Purchases
Jan 3
Sale (at cost)
Jan 5
Jan 7
Purchase
Closing Inventory
Units
Average Cost per unit ($)
10
20
30
10
11
320 / 30 = 10.67
Total Cost
($)
100
220
320
(15)
15
5
20
10.67
10.67
13
225 / 20 = 11.25
(160)
160
65
225
The sale units will be removed from the inventory at the previously calculated average cost per unit.
Minor rounding errors can occur in calculation using continuous AVCO.
The Gross profit will be:
73
Inventory
Particulars
Revenue (15 X 15)
Less: Cost of Goods Sold
Opening Inventory (10 X 10)
Add: Purchases (20 X 11) + (5 X 13)
Less: Closing Inventory (as calculated above)
Gross Profit
$
100
285
(225)
$
225
(160)
65
Purchase prices are rising, indicating a period of inflation. Therefore, profit using FIFO is higher than
AVCO as explained above in a previous exam tip.
Note that the value of revenue, opening inventory and purchases remain same under all 3
methods. Only the value of closing inventory changes which causes a change in the gross
profit.
Over here the values were small for calculation purposes, but just imagine the impact if the
figures were in $ millions!
74
Inventory
Syllabus Area D3h-i
- Understand the impact of accounting concepts on the valuation of inventory. [K]
- Identify the impact of inventory valuation methods on profit and on assets. [S]
It should be clear from the previous Apply Your Knowledge, that different methods of valuing the
cost of inventory will result in different values of current assets as well as profits. Therefore, it is
crucial to be consistent with the method used every year for comparability between accounting
periods and no manipulation of accounting records.
A higher closing inventory value will lead to:
1. Current asset being overstated in the SOFP
2. Profit being overstated in SOPL (as closing inventory and profits are directly related, higher
closing inventory reduces the value of COGS)
It is crucial to note that this closing inventory value becomes the opening inventory in the
subsequent year and has the reverse impact on profits of the next year, but no impact on the value
of closing inventory.
The same opposite logic is applicable for a lower closing inventory value.
Closing inventory has direct relationship with profits i.e. higher the closing inventory higher
the profits.
Opening inventory has an inverse relationship with profits i.e. higher the opening inventory,
lower the profits (due to COGS being higher, relate with the formula of COGS).
75
Inventory
Jorann Ltd’s closing inventory was understated by $100,000 in the current financial year.
What will be the effect of this error if it is not corrected?
A.
B.
C.
D.
The current year's profit will be overstated and next year's profit will be understated.
The current year's profit will be understated, but there will be no effect on next year's profit.
The current year's profit will be understated and next year's profit will be overstated.
The current year's profit will be overstated, but there will be no effect on next year's profit.
Answer:
C
A lower value of closing inventory will lead to a lower profit figure this year than it should have been
due to the direct relationship between the two.
This error will be carried forward in the next year, and the opening inventory will be understated, as
a result of which the COGS will be lower, and profit will be higher (overstated).
Closing inventory = direct relationship
Opening inventory = Inverse relationship
Remember this!
76
70
Sales Tax
Syllabus Area D1c-d
- Understand the general principles of the operation of a sales tax.
- Calculate sales tax on transactions and record the consequent accounting entries.
Sales Tax
Sales tax is a form of indirect tax which is charged on the final consumer of the product eventually.
Sales tax is comparable to the Goods and Service Tax (GST) in India and Value Added Tax (VAT) in the
United Kingdom.
At each stage of production or the value chain, tax is charged on the final product and also paid on
any materials or inputs used before selling. Hence, each producer effectively only pays taxes on the
amount of value it adds.
Consider the following value chain with sales tax as 10%
Company A
Price = $100
Company B
Bought from A at $110
Tax = $10
Total = $110
Value addition = $40
Sales tax = $15
Selling price to C = $165 (150 + 15 tax)
Company C
Bought from B at $165
Over here, Company C is the final consumer who eventually bears the burden of total sales tax of
$15 charged by Company B.
Sales tax rate will always be given to you in the question.
Gross selling price = Price inclusive of sales tax ($110 for Company A)
Net selling price = Price exclusive of sales tax ($100 for Company A)
We will focus on company B. The tax it pays to company A, i.e. on its purchase of goods of $10, is
input tax for company B. This input tax is set off again the output tax to reduce the tax liability of
the business.
The tax of $15 company B collects on its sale to company C, is the company’s output tax liability
which it needs to pay to the government. Company B is merely collecting taxes on behalf of the
government. The $15 charged on the invoice is not company B’s income.
Sales Tax
Total output tax > total input tax = pay difference of tax amount to the government
Total output tax < total input tax = receive difference of tax amount as refund from the government
Tax payables to authorities = Output Tax – Input Tax
Positive value = tax payable
Negative value = tax refund
Calculation of sales tax amount
You may be given the gross or net amounts in the exams. You should be able to find the amount of
sales tax in both these cases.
In the previous chapter of Inventory, we used the margin and mark-up principle; the same logic of
cross-multiplication applies here as well.
Exclusive price (net amount) + Tax = Inclusive price (gross amount)
First, we need to form an equation in the form of 100.
The exclusive price will be taken as 100 always, and tax will be the % given in the question.
For example, if sales tax rate is 20%, then the equation in the form of 100 will be –
100 + 20 = 120
You can then form a second equation with the actual figure given in the question, cross-multiply and
find any of the remaining figures.
If the net amount is given, simple multiply the tax rate by the amount to find the sales tax
amount. Then, to find gross amount:
Net amount + sales tax = gross amount
71
Sales Tax
Colette purchased goods for $110,000 (exclusive of sales tax) and sells goods for $154,000 (including
sales tax). The sales tax rate is 10%.
What amount of sales tax is ultimately payable to the tax authority based upon this information?
A.
B.
C.
D.
$4,400
$3,000
$26,400
$25,000
Answer:
B
Input tax on purchases = 10% X 110,000 = $11,000 (as exclusive price)
For output tax payable, use the cross-multiplication method.
Exclusive price (net amount) + tax = inclusive price (gross amount)
100 + 10 = 110
? + x = 154,000
By cross multiplying the 2nd and 3rd column items, we can find x as –
110 x = 154,000 X 10
X= 154,000 X (10/110) = $14,000
Tax payable to authorities = output tax – input tax
= 14,000 – 11,000 = $3,000
Accounting for Sales Tax
A sales tax account is made, which shows the tax payable to tax authorities (credit balance b/d) or a
tax refund available from tax authorities (debit balance b/d).
With sales tax, the original sales and purchase entries slightly change.
1) The journal entry for purchases (input tax) is –
Dr Purchases (net amount)
Dr Sales tax A/c (by the amount of sales tax)
Cr Payables / Cash (gross amount)
Sales tax is debited as it is input tax which will be recovered from tax authorities
72
Sales Tax
73
From the previous example, for company B this entry would be –
Dr Purchases $
Dr Sales Tax A/c (by amount of sales tax)
Cr Payables / Cash (gross amount)
2) The journal entry for sales (output tax) is –
Dr Receivables/cash (gross amount)
Cr Sales (net amount)
Cr Sales tax (amount of sales tax)
Sales tax is credited as it is output tax which is payable to tax authorities.
3) When tax is paid to the authorities, the sales tax account is debited against the credit balance b/d
to close the sales tax ledger account.
Dr Sales Tax A/c (amount paid to authorities)
Cr Cash A/c
4) If input tax is more and a refund of tax is available, the sales tax account is credited (opposite logic
of the 3rd journal entry) to close the sales tax account.
Dr Cash A/c (amount received from authorities)
Cr Sales tax A/c
Sales and purchases are recorded net of the tax amount (i.e. tax amount is not included) as sales tax is not
an income or expense so it cannot be shown in SOPL (you are merely collecting sales tax on behalf of tax
authorities).
Trade receivables and payables are recorded at gross amount (i.e. tax amount is included) as the amount of
tax needs to be recovered from receivables and paid to payables as the final total of invoice includes the tax
amount.
In the sales day book and purchases day book (books of prime entry), additional columns are simply
added to show the distinction between the gross and net amount as follows –
Date
Total
Invoice Number
Name of Supplier /
Customer
Gross amount
Sales Tax
Net
Amount
XXX
X
XX
Sales Tax
The total of the net amount column goes to the sales and purchases A/C.
The total of the gross amount column goes to the trade receivables and payables A/C.
The following sales invoices were issued by Iron Man in October:
Extract from sales day book
Date
Oct 8
Oct 23
Invoice Number
100
101
Name of Customer
Captain America
Thor
The applicable sales tax rate of 20%
What accounting entries are required to record the transactions?
Dr
A. Receivables $3,120
B. Receivables $3,900
Sales tax $780
C. Receivables $3,500
Sales tax $700
D. Receivables $4,200
Answer:
Cr
Sales $3,900
Sales tax $780
Sales $3,120
Sales $4,200
Sales $3,500
Sales tax $700
D
October 8 transaction
2,400 is gross amount
Sales tax = gross amount/(100 + 20)*20 = 2400/120*20 = $400
Net amount = gross amount – sales tax = 2,400 – 400 = $2,000
October 23 transaction
1,500 is net amount.
Sales tax = net amount x sales tax % = 1,500 x 20% = $300
$
2,400 (including sales tax)
1,500 (excluding sales tax)
74
Sales Tax
Gross amount is 1,500 + 300 = $1,800
Journal entry
Trade receivables A/C (2400 + 1800) Dr
To sales (2000 + 1500)
To sales tax (400 + 300)
4200
3500
700
75
Accrual and Prepayments
Accrual and Prepayments
Syllabus Area D7a-b-c-d-e
- Understand how the matching concept applies to accruals and prepayments. [K]
- Identify and calculate the adjustments needed for accruals and prepayments in preparing
financial statements.
- Illustrate the process of adjusting for accruals and prepayments in preparing financial
statements. [S]
- Prepare the journal entries and ledger entries for the creation of an accrual or prepayment. [S]
- Understand and identify the impact on profit and net assets of accruals and prepayments.
Accruals and Prepayments
The accruals concept, i.e. the matching concept is used in preparing the SOPL. The matching concept
says that the revenue of a particular period should be matched against the expenditure of the same
period. This means that ONLY the revenue and expenditure which relate to / belong to the period of
the SOPL should be included. The timing of when the money for the revenue or expense is received
or paid is ignored in the accruals concept.
This accruals concept gives rise to accruals (i.e. accrued expenditure and accrued income) and
prepayments (i.e. prepaid expenditure and prepaid incomes) as at the year end, expenses for the
year may not be fully paid, or they may be paid in advance but that amount cannot be shown in the
SOPL. The same logic applies for incomes.
An accrual is an outstanding amount, i.e. amount not paid or received, and a prepayment is an
amount paid or received in advance.
Therefore, the following 4 scenarios are possible –
1. Accrued Expense – Expense not paid by year end
E.g. Electricity bill not paid by year end, therefore the amount is owed hence it is a current
liability.
2. Prepaid Expense – Expense paid in advance for the next year
E.g. Insurance prepaid for the next year. The insurance owes you a service for the next year
therefore, it becomes your current asset.
3. Accrued Income / Revenue – Income yet to be received by year end
E.g. Interest on loan is outstanding for last 3 months. Money is owed to you. Hence it
becomes your current asset.
76
Accrual and Prepayments
4. Prepaid Income / Revenue – Income which you have received in advance
E.g. Rent received in advance for the next 3 months. You owe the service to the person who
stays on rent therefore it becomes your current liability.
A useful way to remember which of the 4 is a current asset or current liability is with the help of
‘PAPA’ & ‘ALLA’ mnemonics as shown below -
The way this is read is, as each row is matched with each other. For example,
Prepaid – Expense – Asset
Prepaid – Revenue – Liability
So on and so forth…
Accruals and prepayments will ALWAYS be current assets and liabilities as they are expected to be
settled in the next financial year.
77
Accrual and Prepayments
Journal entries
1. Accrued Expenditure
Dr Expenditure A/c (SOPL A/c)
Cr Accrued Expenditure A/c (SOFP A/c – Current Liability)
As SOPL is being debited, profit for the year will decrease
2. Prepaid Expenditure
Dr Prepaid Expenditure A/c (SOFP A/c – Current Asset)
Cr Expenditure A/c (SOPL A/c)
As SOPL is being credit, profit for the year will increase
3. Accrued Income
Dr Accrued Income A/c (SOFP A/c – Current Asset)
Cr Income A/c (SOPL A/c)
As SOPL is being credit, profit for the year will increase
4. Prepaid Income
Dr Income A/c (SOPL A/c)
Cr Prepaid A/c (SOFP A/c – Current Liability)
As SOPL is being debited, profit for the year will decrease
First step is to identify if it is a current asset or current liability and accordingly pass the
corresponding double entry in the respective SOPL A/c.
If SOPL A/c is being debited, profit will reduce (more expense or less income)
If SOPL A/c is being credited, profit will increase (less expense or more income)
The best possible way to tackle questions on accruals and prepayments is to make ‘T’ ledger
accounts:
78
Accrual and Prepayments
79
Expense Account
Particulars
Balance b/d (Opening prepaid expense i.e.
CA)
Bank (Total paid in the year)
$
X
X
Particulars
Balance b/d (Opening accrued expense i.e.
CL)
$
X
SOPL (Total expense charged to SOPL)
X
Balance c/d (Closing accrued expense)
X
Balance c/d (Closing prepaid expense)
XX
Balance b/d (Opening prepaid expense, i.e.
CA for next year)
X
X
XX
Balance b/d (Opening accrued expense, i.e.
CL for next year)
X
Income Account
Particulars
Balance b/d (Opening accrued income i.e.
CA)
$
Particulars
$
X
Balance b/d (Opening prepaid income i.e. CL)
X
Bank (Total money received)
X
Balance c/d (Closing accrued income)
X
SOPL (Total income transferred to SOPL)
X
Balance c/d (Closing prepaid income)
X
XX
Balance b/d (Opening accrued income, i.e.
CA)
CL = Current Liability
CA = Current Asset
Remember that in a ‘T’ Account
A debit balance b/d = Asset
A credit balance b/d = Liability
X
XX
Balance b/d (Opening prepaid income, i.e.
CL)
X
Accrual and Prepayments
Apply Your Knowledge:
On 1 January 20X7, Mary Jane owed $4,000 in respect of the previous year’s rent. She paid the
following by cheques during the year ended 31 December 20X7:
10 February
7 May
10 August
15 November
$5,600
$6,000
$5,500
$6,200
At 31 December 20X7, Mary calculated that she owed $3,600 in respect of rent for the year 20X7.
What is the rent charge shown in the SOPL?
A.
B.
C.
D.
$3,600
$22,900
$23,300
$26,900
Solution:
Prepare the Rent ‘T’ Account and find the rent transferred to SOPL as the balancing figure
Rent Account
Particulars
Bank (Total of all cheques)
$
23,300
Particulars
Balance b/d
$
4,000
Balance c/d
3,600
SOPL (Bal fig)
22,900
26,900
26,900
Balance b/d
Therefore, the answer B is correct
3,600
80
Accrual and Prepayments
Apply Your Knowledge:
Peter Parker’s draft financial statements for the year to 31 November 20X4 report a loss of $743. He
found that he did not include an accrued expense of $813 and a prepayment of $417.
What is Peter's profit or loss for the year to 31 November 20X4 after the correction of his
mistakes?
A.
B.
C.
D.
A loss of $348
A loss of $1,139
A loss of $1,973
A profit of $904
Solution:
The accrued expense will increase expenses, therefore, increasing the loss (decreasing the profit),
and the prepayment will have the opposite effect.
Therefore, revised profit or loss = -743 – 813 + 417 = $1,139
Remember, as it’s a loss of $743, it will have a negative sign in your calculation
Answer is B
81
84
Receivables and Irrecoverable Debts
Syllabus Area D8a-b-c-d
- Explain and identify examples of receivables and payables. [K]
- Identify the benefits and costs of offering credit facilities to customers. [K]
- Understand the purpose of an aged receivables analysis. [K]
- Understand the purpose of credit limits. [K]
Receivables and Irrecoverable Debts
Now we shall look at another important item in the current assets section of SOFP, trade
receivables. Analyzing the current assets and current liabilities of any business is crucial as they form
part of the working capital. Without a good short-term liquidity position, the business is bound to
fail soon.
Trade receivables forms a major part of this section alongside inventory. Trade receivables are the
debtors of the company or people who owe money to the business. It is crucial to see the trend in
receivables; are they increasing or decreasing relative to the sales growth. Not recovering money
from trade receivables can be bad signs for a business and, even in extreme cases perceived as
revenue manipulation by the management of the company. Thus, thorough knowledge of this item
of SOFP is vital.
Businesses usually make sales on credit, i.e. they sell the goods today but expect the customers to
make the payment at a later date which can be 30 days, 90 days, etc., depending on the policy of the
business. A trade receivable (also called a debtor in some parts of the world) arises due to this.
It will be recorded as follows:
Dr Trade Receivables
Cr Revenue
When the customer eventually pays off the amount of receivable due, then:
Dr Bank account
Cr Trade Receivables
This then clears out the balance due in the customer’s account, i.e. the debit balance created when
the credit sale was made. Note that individual customer accounts who owe money to the business
due to credit sales are what is known as trade receivables.
Offering better credit terms to customers than competitors can lead to increased sales and customer
loyalty. However, the cash flow (see in a later chapter) maybe adversely affected, and there might
be a risk that the money might never be received from the trade receivable, i.e. it may become
irrecoverable (see later in this chapter).
Receivables and Irrecoverable Debts
To improve better credit control we need to ensure that more receivables do not become
irrecoverable. Therefore, tools like aged receivables analysis and credit limits are used.
Aged receivable analysis shows an ordered list of all credit customers with the amount due and for
how long it has been overdue. Credit limits are limits set by the business above which the customer
cannot avail credit facilities. For example, a customer’s trade receivables balance cannot go above
$50,000. If he wants to take benefit of credit sales, he must first pay up the previous remaining dues.
85
Receivables and Irrecoverable Debts
Syllabus Area D8f-g-h-i
- Record an irrecoverable debt recovered. [S]
- Identify the impact of irrecoverable debts on the statement of profit or loss and on the
statement of financial position. [S]
- Prepare the bookkeeping entries to create and adjust an allowance for receivables. [S]
- Illustrate how to include movements in the allowance for receivables in the statement of
profit or loss and how the closing balance of the allowance should appear in the statement of
financial position. [S]
Irrecoverable Debts and Irrecoverable Debts Recovered
Irrecoverable debts are trade receivable amounts which are likely to not be received anymore.
However, the relating revenue might be recorded in the earlier periods. Therefore, these amounts
must be ‘written off’ from the books of accounts, and a loss should be recognised. Irrecoverable
debts are recorded against a particular credit customer. Take note that the revenue recorded earlier
is not to be received.
When it is uncertain that the amount may or may not be received, an allowance for receivables
should be created against those trade receivables. An allowance simply shows that there is a
possibility that some percentage of the trade receivables won’t be received in the future. An
allowance is created against trade receivables as a whole. This is an application of the prudence
concept of accounting.
The prudence concept, in simple terms is ‘playing safe’ while making the books of accounts.
Foreseeable future expenses shall be recognised, but foreseeable future income shall not be
recognised.
In your earlier studies, you may have called irrecoverable debts as bad debts and an allowance for
receivables as provision/reserve for doubtful debts (RDD).
They are effectively the same thing but with a few differences. Take note that you CANNOT call an
allowance for receivables a provision or reserve as it would then represent a liability, which it is not.
86
Receivables and Irrecoverable Debts
For this chapter, you basically need to be well versed with 4 sets of journal entries which are
To record irrecoverable debts
1) Dr Irrecoverable Debts Expense A/c (SOPL A/c)
Cr Trade Receivables A/c (SOFP A/c)
This basically records a loss from the receivables and removes the amount due from the total of the
receivable’s balances.
There is a possibility that after a few years, the debt you previously recorded as irrecoverable will be
fully or partially received by the customer if his/her financial situation improves. Thus, the
irrecoverable debt is recovered (you may have earlier called it bad debts recovered in your previous
studies).
To record irrecoverable debts recovered
2) Dr Bank A/c
Cr Irrecoverable Debt Expense OR Irrecoverable Debt Recovered A/c (SOPL A/c)
In either of the account being credited, the basic effect will be to increase the profit by either
decreasing expenses or increasing the income, respectively.
A company received cash for an irrecoverable debt which was previously written off.
Which of the following is the correct double entry to record this transaction?
A.
B.
C.
D.
Answer:
Debit
Cash
Irrecoverable debt expense
Trade receivables
Cash
Credit
Irrecoverable debt expense
Cash
Irrecoverable debt expense
Trade receivables
A
Cash is received, so it needs to be debited. As the debt was previously written off, it cannot be offset
against a receivable’s as it does not exist, therefore it needs to be credited to the irrecoverable debt
expense.
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Receivables and Irrecoverable Debts
Allowance for Receivables
Accounting for the allowance for receivables can be broken down into 2 categories:
1. At the time of creation of the allowance
2. Recording increases or decreases in the allowance previously created
To create an allowance for receivables 3) Dr Irrecoverable Debts Expense A/c (SOPL A/c)
Cr Allowance for Receivables A/c
The allowance has a credit balance as it is then deducted from the trade receivables amount in the
SOFP, in a similar fashion to the treatment of accumulated depreciation. An extract from the SOFP
would look like this –
Net trade receivables (gross receivables – irrecoverable debts)
Less: allowance for receivables (closing / new balance)
$
X
(X)
XX
In subsequent years, only the MOVEMENT in the allowance is to be recorded. Steps to know how
much to increase/decrease the allowance is shown below –
1.
2.
3.
4.
Calculate net receivables (gross – irrecoverable debts)
Calculate the new amount of allowance needed on net receivables
Compare the new allowance to the allowance of the previous year
If the new allowance > old allowance = debit the irrecoverable debt expense. Therefore,
more expenses are charged to the SOPL
5. If new allowance < old allowance = credit the irrecoverable debt expense. Therefore, less
expenses are charged to the SOPL
6. The new allowance is deducted from net receivables, as shown in the extract above
88
Receivables and Irrecoverable Debts
89
Journal entries to remember are:
To increase an allowance for receivables
4a) Dr Irrecoverable Debts Expense A/c (SOPL A/c)
Cr Allowance for Receivables A/c
To decrease an allowance for receivables
4b) Dr Allowance for Receivables A/c
Cr Irrecoverable Debts Expense A/c (SOPL A/c)
Questions regarding accounting for the movement in the allowance for receivables are very frequently
tested! Remember:
1) Increasing the allowance = charging more expenses to SOPL than before, therefore profit decreases in the
year the allowance increases
2) Decreasing the allowance = charging less expenses to SOPL than before, therefore profit increases in the
year the allowance decreases
Receivables and Irrecoverable Debts
Apply Your Knowledge:
Ronaldo has opening balances at 1 January 20X8 in his trade receivables account and allowance for
receivables account of $100,000 and $5,500, respectively. During the year, he has credit sales of
$450,000 and received $400,000 cash in return.
He decided to write off $2,000 as irrecoverable. $1,000 written off in the year 20X6 was
subsequently recovered this year. The allowance for receivables needs to be adjusted to 5% of the
net receivables.
a) What is the amount charged to Ronaldo’s statement of profit or loss for the irrecoverable
debt expense in the year ended 31 December 20X8?
b) State the final amount of trade receivables to be shown in the SOFP at 31 December 20X8.
Solution:
a) 450,000 – 400,000 = $50,000 is the amount increased in receivables during the year.
$2,000 is to be written off as irrecoverable
Net receivables = 100,000 + 50,000 – 2,000 = $148,000
New allowance = 5% X 148,000 = $7,400
Increase needed in allowance is = 7,400 – 5,500 = $1,900
Amount charged to SOPL = irrecoverable debts + increase (decrease) in allowance – irrecoverable
debts recovered
= 2,000 + 1,900 - 1,000
= $2,900 will be shown as an expense in SOPL which will reduce profit
b)
Net trade receivables (150,000 – 2,000)
Less: allowance for receivables (closing / new balance)
$
148,000
(7,400)
140,600
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Receivables and Irrecoverable Debts
Syllabus Area D8i
- Classify items as current or non-current liabilities in the statement of financial position. [S]
Payables, Provisions and Contingencies
Recall that liabilities are ‘an obligation to transfer economic benefits as a result of past transactions’,
and the obligation should be reliably measured.
The obligation can be either a:
1) Legal Obligation – Arising as a result of a contract or law
2) Constructive Obligation – Arising due to a pattern of past behaviour/actions which is
expected to be repeated in the future.
For example, if an owner of a shop exchanges goods within 30 days, if the customer wants a
different colour, but has never explicitly told this policy but has been following it since years, it
becomes a constructive obligation.
If the goods sold were faulty or defective, it is the legal obligation of the owner to replace it with a
new one
Liabilities are also classified into two categories:
1) Non-Current Liabilities - They are long-term liabilities which are to be repaid after 12 months
of the reporting date of the SOFP.
Examples – Long term loan taken from a bank.
2) Current Liabilities – Short-term liabilities which are due for payment within 12 months of
the reporting date.
Examples – Bank overdraft, trade payables (creditors), short term loan
Like credit sales, businesses make credit purchases in a similar fashion
The double entries for the same are recorded as –
When purchasing on credit
Dr Purchases
Cr Trade Payables
When the payable liability is actually paid
Dr Trade Payables
Cr Bank
When the timing and amount of the liability occurring is uncertain, either a provision or contingent
liability must be recognised, NOT a liability. IAS 37 is the relevant standard dealing with this.
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Receivables and Irrecoverable Debts
Syllabus Area D9a-b-c-d-e-f
-
Understand the definition of “provision”, “contingent liability” and “contingent asset”.[K]
Distinguish between and classify items as provisions, contingent liabilities or contingent
assets.
Identify and illustrate the different methods of accounting for provisions, contingent liabilities
and contingent assets. [K]
Calculate provisions and changes in provisions. [S]
Account for the movement in provisions. [S]
Report provisions in the final accounts. [S]
Provisions and Accounting for Provisions
A provision is defined as 'a liability of uncertain timing or amount.’
Warranties and potential lawsuits which will be lost are the best examples of provisions. The
company knows that it is obligated to pay some amount, but when will it have to pay the amount
and how much is an uncertain matter. Hence, it recognises a provision for such items in the books of
accounts.
Criteria for recognising a provision are –
1. An entity has a present obligation (legal or constructive) as a result of a past event,
2. A reliable estimate can be made of the amount of the obligation, and
3. It is probable that an outflow of resources embodying economic benefits will be required to
settle the obligation
If all these three conditions are not met, no provision shall be recognised
The key word to look out for over here is ‘probable’ outflow of resources. If it is certain that there
will be a payment in future (like in case to a bank against a loan), a liability should be recognised and
not a provision.
Provisions are shown on the face of the SOFP under the heading of either a current or non-current
liability.
Accounting for provisions is similar to that for an allowance for receivables.
To create a provision:
Dr Relevant Expense A/c (SOPL A/c)
Cr Provision A/c (SOFP A/c)
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Receivables and Irrecoverable Debts
To record movements in the provision:
Increase in provision: Dr Relevant expense account
Cr Provision
Decrease in provision: Dr Provision
Cr Relevant expense account
Apply Your Knowledge:
Brent Ltd has a policy of refunding purchases by dissatisfied customers within 1 month, (e.g. if a
customer is not happy about the size, colour, etc.) even though it is under no legal obligation to do
so. Its policy of making refunds is publicised in the store and in advertisements. The year ending is 31
December 20X8.
Should a provision be recognised in the financial statements for the year ended 31 December 20X8
for goods which may be returned in January 20X9?
Solution:
Brent ltd has entertained these returns in the past, and the customers expect the same in the future
too. Thus, this becomes a constructive obligation of the company. It is probable that some of the
goods sold in December might be returned in January.
Hence, if a reliable estimate from past returns can be calculated, a provision MUST be recognised by
Brent Ltd.
Apply Your Knowledge: 3
A hardware store provides a warranty on all its products of one year. The following pattern has been
estimated by past data, which is expected to continue in the future
% of total sales
70
25
5
Defects
None
Minor
Major
Cost of repairs ($m)
0.5
2.0
What amount of warranty provision should the store provide for?
Solution:
The expected value approach should be used here, i.e. the % should be multiplied by the cost
individually then added together. (Column 1 X Column 3)
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Receivables and Irrecoverable Debts
(70% X 0) + (25% X 0.5) + (5% X 2.0) = $0.225m = $225,000 should be recognised as a provision
Contingent Assets and Liabilities
The word contingent means that the existence and occurrence of the asset or liability depends on a
certain event happening or not. Saying that India will win the world cup if Virat Kohli performs is a
contingent event that if Virat performs, India may win. However, this is not a guarantee or certainty
of India winning the world cup.
A contingent asset is defined as '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.’
An example would be when you have sued someone, and it is possible (5-50% chance) of you
winning the lawsuit.
A contingent liability is defined as a) 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
b) A present obligation that arises from past events but is not recognised because:
(i)
(ii)
It is not probable that an outflow of resources embodying economic benefits will be
required to settle the obligation, or
The amount of the obligation cannot be measured with sufficient reliability
In simple words, when an obligation is possible and not probable, it is a contingent liability and
should be disclosed in the notes to accounts.
For example, there is a possibility of losing a lawsuit, however it is not probable that you will lose the
lawsuit.
94
Receivables and Irrecoverable Debts
95
If a liability, i.e. a present obligation is there, but it CANNOT be reliably measured, then a
contingent liability is to be disclosed, a liability cannot be recognized.
A summary table can be shown as
DEGREE OF PROBABILITY
OUTFLOW
INFLOW
PRESENTATION
Virtually certain (> 95%)
Recognise liability
Recognise asset
On the SOFP
Probable (50 - 95%)
Recognise provision
Disclose as a
contingent asset
On the SOFP for the provision and
disclose in notes for asset
Possible (5 - 50%)
Disclose contingent
liability
Ignore
Disclose in the notes to financial
statements below SOFP
Remote (<5%)
Ignore
Ignore
Shown nowhere in financial
statements
This table contains key words and key percentages which is used by the examiner in the question which
provides you with the correct answers.
Make sure you learn this! Both the % and the key word!
Receivables and Irrecoverable Debts
Consider the following cases
1) The company gives warranties on its products. The company’s statistics show that about 5% of
sales give rise to a warranty claim.
2) The company has a possibility of losing a lawsuit filed by an ex-employee as told by the lawyer of
the company.
What is the correct action to be taken in the financial statement for these items?
A.
B.
C.
D.
CASE 1
Create a provision
Disclose by note only
Create a provision
Disclose by note only
Answer:
CASE 2
Disclose by note only
No action
Create a provision
Disclose by note only
A
Identify the key words in the question
Even though only 5% warranties arise, there is still a probable chance of the outflow of money
happening. The timing and amount are not certain therefore, a provision and not a liability is to be
made.
In case 2, the key word is ‘possibility’ which gives us a hint that it is a contingent liability and,
therefore, it will be disclosed by note only.
Non – current assets (NCA) form the major chunk of the SOFP in terms of value. They stay on the
SOFP for a number of years, and their value affects not only affects the SOFP but the SOPL too
(through depreciation) every year. Thus, studying about NCA in depth becomes crucial for any
accountant / financial analyst.
96
Receivables and Irrecoverable Debts
Syllabus Area D4a-b-c-d-j
- Define non-current assets. [K]
- Recognise the difference between current and non-current assets. [K]
- Explain the difference between capital and revenue items. [K]
- Classify expenditure as capital or revenue expenditure. [S]
- Explain the purpose and function of an asset register. [K]
Tangible Non-Current Assets
NonCurrent
Assets
(NCA)
1. They are
long-term
assets
usually with
large values
2. They are
not meant
for resale
Current
Assets (CA)
Short –
terms
assets with
relatively
smaller
values
Usually
meant for
resale
3. They are
relatively
illiquid
(cannot be
sold or
converted
to cash
easily)
Relatively
liquid
4. NCA are
used by the
business to
generate
revenue
and income
Arise from
normal
trading
activities of
the
business
5. Tangible
and
intangible
NCA exist
-
6. NCA are
CA are not
depreciated depreciated
97
Receivables and Irrecoverable Debts
7. Examples:
Property,
Plant and
Equipment
Motor
Vehicles
Land and
Building
Examples:
Inventory
Trade
Receivables
Bank and
Cash
NCA are recorded in the non-current asset register as a measure of internal control. This internal
control means that in case of any theft or mistakes in a ledger, the asset register can be compared
with the ledger to find out any discrepancies.
An NCA register will contain the following details:
1.
2.
3.
4.
5.
Cost
Date of purchase
Location of asset
Depreciation method used (discussed later)
Estimated useful life
This is not an exhaustive list, and any relevant detail related to the asset will be included.
Periodically, all physical NCA should be checked with an updated asset register, and any
discrepancies in either the register or the ledger should be corrected. Errors might occur due to
calculation mistakes or forgetting to record the transaction in either the asset register or the ledger
accounts.
Capital Expenditure
(Capex)
Revenue Expenditure
1. Expenditure done to
acquire NCA
Expenditure done to
run the day to day
activities of the
business, i.e. it creates
current assets
2. Usually, ‘capital’
means a one-time
expenditure
‘Revenue’ means
recurring in nature
3. Includes improving
and increasing the
earning capacity of
NCA.
E.g. An extra rotor
Includes expenditure
done to maintain the
existing earnings
capacity of NCA.
E.g. Repair and
98
Receivables and Irrecoverable Debts
purchased which
increases the output
of a machine from
100 units to 150
units
4. The benefits of such
expenditure are
expected to be
received in many
financial years, i.e.
long-term benefits
and use
maintenance charges
of machinery to
ensure the output of
100 units is
maintained and does
not fall below it
The benefits are
estimated to be
received within the
current financial year,
i.e. in the short-term
benefits and use
5. Recorded in the SOFP Recorded in the SOPL
(i.e. capitalised)
(i.e. expensed)
6. Examples:
i.
Price of an
industrial
machine
ii.
Delivery and
installation
cost of the
machine
iii.
Legal fees
and customs
duty in
acquiring the
machine
iv.
Trials and
test runs are
required to
make the
machine
work before
set-up
v.
Adding extra
engine to
increase the
revenue
generating
capacity of a
machine
vi.
Direct
employee
costs arising
from
construction/
acquisition of
an asset
Examples:
i.
Repairs and
maintenance
of the
machine
ii.
Any
administration
and general
overhead
iii.
Costs of
training
employees on
how to use
the machine
iv.
Repainting
costs after
machine is
used for
sometime
v.
Wages of
machine
operators
An unrelated example
is road tax, which is an
annual charge, which
is paid while
purchasing a car
99
Receivables and Irrecoverable Debts
Another unrelated
but important
example is an
extension of space in
a restaurant as it
increases the seating
capacity and,
therefore, revenue
earning capacity.
100
Receivables and Irrecoverable Debts
101
The distinction between capital expenditure and revenue expenditure is extremely important. Remember
that:
Capital expenditure is capitalized and forms a part of the NCA in the SOFP whereas revenue expenditure
cannot form a part of the SOFP and must be expensed to the SOPL.
Know the examples given in the above table very thoroughly! Again, they are not an exhaustive list of
items, but the reasoning behind their classification should be well understood to crack exam questions.
The purchase of a motor vehicle was wrongly recorded in the motor expenses account. What will be
the effect of this on the profit for the year and the total value of assets?
A.
B.
C.
D.
Answer:
Effect on Profit
Understated
Understated
Overstated
Overstated
Effect on Assets
Undervalued
Overvalued
Undervalued
Overvalued
A
The purchase of a motor vehicle is a capital expenditure which will be recorded in the NCA section in
the SOFP and motor expenses are a revenue expenditure which will be expensed in the SOPL.
By increasing motor expenses, more expenses will be shown in the SOPL, which will reduce the
profit, hence the profit is understated
By not showing the value of motor vehicles in the assets section, assets are undervalued, (as they
should be recorded at a higher value) including the recent purchase of the motor vehicle.
Receivables and Irrecoverable Debts
IAS 16 Property, Plant and Equipment is the relevant standard for non-current assets. It states that:
‘The cost of a non-current asset is any amount incurred to acquire the asset and bring it into
working condition’
If a particular cost is incurred without which the asset cannot work, it MUST be capitalised.
Therefore, the cost of a non-current asset should include ONLY capex and exclude revenue
expenditure. Also, note that every asset will have its separate cost ledger account.
The double entry to record the purchase of an NCA is –
Dr Non-current asset A/c (assets are always debited)
Cr Bank & Cash / Payables A/c
Consider the following information:
Purchase of land
Legal fees related to purchase of land
Purchase of car
Delivery charge of car
Cost of re-painting car to black
Number plate of car
Road tax on invoice of car
$
100,000
500
20,000
100
1000
50
200
What is the correct amount for land and motor vehicles to be shown in the SOFP?
A.
B.
C.
D.
Land
100,000
99,500
100,500
100,500
Motor Vehicles
20,000
21,150
20,150
20,350
Answer: C
Road Tax and cost of re-painting are revenue expenditures and shall not be included in the costs of
the assets
102
Non-Current Assets and Depreciation
103
Non-Current Assets and Depreciation
Syllabus Area D5a-b-c-f
- Understand and explain the purpose of depreciation. [K]
- Calculate the charge for depreciation using straight line and reducing balance methods. [S]
- Identify the circumstances where different methods of depreciation would be appropriate. [K]
- Calculate the adjustments to depreciation necessary if changes are made in the estimated
useful life and/or residual value of a non-current asset. [S]
Depreciation
As noted earlier, NCA are highly valued items on the SOFP which stay there for years until they are
sold or disposed. This means that NCA does have a limited life, and they should eventually be
written off (i.e. charged/debited to the SOPL) at the end. However, if let’s say, a $1m asset is
disposed in the year 20X9, and you charge the full $1m to the SOPL that year, it is likely there will be
a very heavy loss that year.
To avoid this, the concept of depreciation came up. Depreciation spreads the large cost of the asset
across its useful life (which is usually more than 3 years). This is also an application of the matching
principle where revenue generated by the asset is appropriately matched with the expense (i.e.
depreciation) in that year’s SOPL.
Further reasons for depreciating assets include:
1. Physical wear and tear
2. Passage of time
3. Obsolescence of assets due to technology
4. Depletion of an asset (E.g. A mineral ore being full mined)
Depreciation gives rise to two effects in the financial statements:
1. Current year’s depreciation is shown as an expense in SOPL, which reduces profit
2. The value of NCA in the SOFP is reduced by the accumulated depreciation (see later) to show
its carrying amount as on the date of the SOFP.
A key assumption here which you should know is that if an asset is purchased mid-year, depreciation
is pro-rated i.e. find the annual depreciation, divide it by 12 to find monthly depreciation and then
multiply it by the number of months you own the asset in the year (in year of purchase as well as disposal).
If it is mentioned charge a full year’s depreciation in the year of purchase and NO depreciation in the year
of disposal!
Non-Current Assets and Depreciation
Before we move further, here are a few key terms you should familiarize yourself with:
1. Depreciable asset – An asset with a finite useful life which should be depreciated
2. Historical cost of the asset – The cost at which the asset was originally bought
3. Estimated useful life – The expected life of the asset which the business intends to use it for
(E.g. a car can be expected to last for 10 years, but if the business will use it only for 7 years,
then 7 years is the car’s estimated useful life)
4. Residual Value – The estimated value to be received at the end of the asset’s useful life
when it is sold/disposed after deducting any expected costs of disposal
5. Depreciable amount – Historical cost less the residual value; this gives the value of which
the depreciation should be calculated
6. Accumulated depreciation – Depreciation charged on the asset from the year when it was
bought to the current date, i.e. all the depreciation to date (year 1 depreciation + year 2
depreciation + …. so on)
7. Carrying Amount / Written Down Value (WDV) – This is the value at which the asset is
recorded in the SOFP. It is calculated as:
WDV = Historical Cost – Accumulated Depreciation
Methods of Depreciation
The two main methods of depreciation used are –
104
Non-Current Assets and Depreciation
105
Formulas
1) Annual straight-line depreciation =
(Cost−Residual Value)
Estimated Useful Life
This amount will remain the same every year so it need not be re-calculated each year.
2) Reducing Balance Method = % X Carrying Amount
As carrying amount changes every year (reduces), depreciation needs to be calculated every year and
will not be the same as last year.
Consistency is key over here, i.e. the same method should be applied with the same estimates of
useful life and residual value each year.
However, if the business does feel the need to change any of the estimates or the method of
depreciation in the straight-line depreciation method after the asset has been used for a few years,
it should apply the change PROSPECTIVELY, i.e. make the changes in depreciation in the future years
only.
Simply recalculate the new depreciation using the revised residual value and revised REMAINING
useful life figures and charge depreciation.
A key assumption here which you should know is that if an asset is purchased mid-year or disposed of
mid-year, charge a full year’s depreciation in the year of purchase and NO depreciation in the year of
disposal, provided nothing else is mentioned in the question.
If it is mentioned to pro-rata the depreciation, then find the annual depreciation, divide it by 12 to find
monthly depreciation and then multiply it by the number of months you own the asset in the year of
purchase and disposal.
Non-Current Assets and Depreciation
106
Apply Your Knowledge:
Timothy is running a successful manufacturing business. He currently owns the following two
machines, A and B, with the following details:
•
•
Machine A was purchased at a cost of $5,000 on 1st June 20X9 and is depreciated on a
straight-line basis at 10% with an estimated useful life of 10 years and a residual value of
$500
Machine B was purchased on 1st January 20X7 for $10,000 and is depreciated on a reducing
balance basis of 20% with an estimated useful life of 5 years
A full year’s depreciation is charged in the year of purchase and none in the year of disposal.
What is the total depreciation charge for the year ended 31 st December, 20X9 to be shown in the
SOPL?
What is the carrying amount / Written down value (WDV) of machine B as on that date of SOFP?
Solution:
First, it is important to break down the question into two parts and calculation, one for each
machine. It is also important to take note of the year in which we are currently, i.e. 20X9. Let’s start
with machine A.
Machine A is depreciated on a straight-line basis and therefore, its depreciation will remain the same
each year. By applying the formula it is,
Depreciation of machine A = (5000 – 500) / 10 = $450 per year
As a full year’s depreciation is charged in the year of acquisition, the $450 is not pro-rated to 6
months depreciation. Also, note that 10% straight line depreciation is equal to dividing the cost into
10 years, which is what we have done. 10% X $4,500 (i.e. the depreciable amount) will give us the
same result as well.
Machine B is a little tricky. The written down value (WDV) needs to be calculated again each year,
and then the rate of 20% applied to it. In the following way Year
Depreciation calculation
(20% X WDV at the start
of the year i.e. previous
years value)
Depreciation
charge for the
year ($)
Accumulated
depreciation ($)
WDV at year end (original
cost – column 4 value)
20X7
20X8
20X9
20% X 10,000
20% X 8,000
20% X 6,400
2,000
1,600
1,280
2,000
2,000 + 1,600 = 3,600
3,600 + 1,280 = 4,880
10,000 – 2,000 = 8,000
10,000 – 3,600 = 6,400
10,000 – 4,880 = 5,120
As seen above, the depreciation charge for machine B for the year 31st December 20X9 is $1,280,
and the WDV is $5,120.
Therefore, total depreciation charge to SOPL in the year is = 1,280 + 450 = $1,730
Non-Current Assets and Depreciation
Apply Your Knowledge:
Assume it is the year 20Y3. Timothy, from our previous example, on 1st January 20Y3, concluded that
his machine A will have a remaining estimated useful life of only 4 years and no residual value at the
end of its life.
What is the depreciation charge for Machine A in the year 20Y3?
Solution:
First, we need to find the carrying amount as on 1 st January, 20Y3. 4 years have passed since the
purchase of machine A.
Therefore, the WDV would be equal to
5,000 – (4 X 450) = $3,200
Therefore, the new depreciation will be calculated as –
Depreciation = (New WDV – revised residual value) / remaining useful life
= (3,200 – 0) / 4
= $800 annual depreciation till it is used in the business
107
Non-Current Assets and Depreciation
Syllabus Area D5d-g
- -Illustrate how depreciation expense and accumulated depreciation are recorded in ledger
accounts. [S]
- Record depreciation in the statement of profit or loss and statement of financial position. [S]
Ledger accounting for depreciation
Firstly, understand the fact that the ledger accounting you must have learned from your previous
studies might be very different from what you will study in ACCA, mainly due to the concept of
accumulated depreciation. Recall that depreciation affects both the SOPL and the SOFP as well.
The journal entry to record the depreciation every year is –
Dr Depreciation expense (SOPL) X
Cr Accumulated depreciation (SOFP) X
An important point to note here is the fact that each year’s depreciation goes in the SOPL, and
therefore that account is closed. But, the accumulated depreciation has to be shown on the face of
the SOFP, as a reduction to the original cost of the SOFP in the following way –
Non-current asset at cost
Less: accumulated depreciation
Carrying amount of NCA
$
X
(X)
XX
It is crucial to know that the depreciation account is closed each year by transferring its value to the
SOPL for the year (where it is shown as an expense). The accumulated depreciation is never closed
(unless all NCA are sold off) as its value since inception must be stated in the SOFP.
The value in the accumulated depreciation account is carried forward to the next year in the form of
balance b/d.
Depreciation account – ALWAYS debit balance and is a SOPL A/c
Accumulated depreciation account – ALWAYS credit balance and is a SOFP A/c
It does not matter if the straight line or reducing balance method is used, the ledger
treatment under both methods is the same!
108
Non-Current Assets and Depreciation
This might sound confusing at first, but it is in fact, a very simple logical journal entry. Look at the
following Apply Your Knowledge to make sure you understand the accounting treatment perfectly.
Apply Your Knowledge:
James is a huge textile trader who just bought a new office building in London on 1st January 20X1
for $5m. He is going to depreciate the building on a flat 5% straight line basis every year.
Show the relevant ledger account entries in the books of James for the year ended 20X1 and 20X2.
Also, show a relevant extract from the SOPL and SOFP for the year ended 20X2.
Solution:
Depreciation = 5% X 5m = $250,000
Date
20X1
Jan 1
Particulars
Bank / Cash
Building Account (at cost)
$
Date
20X1
5,000,000
Dec 31
Particulars
Balance c/d
5,000,000
20X2
Jan 1
Balance b/d
5,000,000
Particulars
Accumulated
Depreciation
Balance c/d
Accumulated
Depreciation
Depreciation (expense) Account
$
Date
Particulars
20X1
Dec 31
SOPL
250,000
(transfer)
250,000
$
250,000
250,000
20X2
Dec 31
250,000
5,000,000
5,000,000
250,000
20X2
Dec 31
5,000,000
5,000,000
20X2
Dec 31
5,000,000
Date
20X1
Dec 31
$
SOPL
(transfer)
250,000
250,000
109
Non-Current Assets and Depreciation
Date
20X1
Dec 31
Particulars
Balance c/d
Accumulated Depreciation Account
$
Date
Particulars
20X1
250,000
Dec 31
Depreciation
Expense A/c
250,000
Dec 31
Balance c/d
250,000
250,000
20X2
Jan 1
20X2
Dec 31
$
500,000
500,000
Balance b/d
250,000
Depreciation
Expense A/c
250,000
500,000
In reading these accounts, make sure you see the date and find the corresponding double entry in
the other account to understand it perfectly.
Often, the cost account and depreciation account are mixed and presented as a non-current asset at
the carrying amount.
SOPL for the year ended 31st December 20X2 (Extract)
$
Expenses
Depreciation
250,000
SOFP as on 31st December 20X2 (Extract)
Building (at cost)
Less: accumulated depreciation
$
5,000,000
(500,000)
Carrying amount of building
4,500,000
110
Revaluation and Disposals
Revaluation and Disposals
Syllabus Area D4g, D5e
Record the revaluation of a non-current asset in ledger accounts, the statement of profit or
loss and other comprehensive income and in the statement of financial position. [S]
- Calculate depreciation on a revalued non-current asset, including the transfer of excess
depreciation between the revaluation surplus and retained earnings. [S]
Revaluation of Non-Current Assets
Till now, we learnt about the cost model of accounting for NCA, but IAS 16 additionally allows the
use of the revaluation model too. The need for the revaluation model arises because assets with
long useful lives remain on the balance sheet for many years at a historical cost which does not
represent their fair values at most times, especially for appreciating assets like land. It is useful to
value such assets at their current fair values to strengthen the SOFP and show a better and relevant
picture of the business’ assets.
However, it is crucial to note that this revalued amount is the unrealised gain on the value of the
asset, i.e. the increase in value has not been recognised yet as you still own the asset. If the asset is
sold, then the gain (increase in value) is recognised. Until then, you are just presenting the asset at
its increased fair value rather than the original cost. The fair value can decrease in the future as well!
Recall that the SOPL contains an extension to it of Other Comprehensive Income (OCI), which makes
the combined statement as SOPLOCI. The unrealised gain on the upward revaluation of NCA is
shown in the OCI section, not the SOPL section.
A revaluation gain is shown in the OCI section, not the SOPL. Therefore, an upward
revaluation of an asset WILL NOT affect the profit for the year.
The amount of revaluation will be calculated as –
Revaluation gain = Revalued amount (i.e. fair value) – Carrying amount
The journal entry to record this gain is –
Dr Non-current asset
Cr Revaluation surplus
111
Revaluation and Disposals
Revaluation surplus are accumulated revaluations done by the company of all its NCA to date. It is
shown under the equity section of the SOFP, as it increases the value of net assets. Revaluation
surplus also forms part of the Statement of Changes in Equity (SOCIE).
Note that in the OCI, only the current year’s revaluation gain amount is shown, whereas the
revaluation surplus is the accumulated amount shown in the SOFP.
As most NCA are depreciated, to record the revaluation gain, the accumulated depreciation amount
must be transferred to the revaluation surplus when the asset is revalued. Therefore, the journal
entry to record the revaluation of a depreciated asset is –
Dr Accumulated depreciation
Dr Non-current asset – cost
Cr Revaluation surplus
By the depreciation to date
Increase in value (revalued amount –original cost)
Depreciation to date + increase in value
If an item of PPE is revalued, the whole class of PPE of which that asset belongs to shall be revalued.
2 effects of revaluation are:
1) Revaluation gain is recorded in OCI for the year
2) Add it to the revaluation surplus under the equity section of the SOFP
Apply Your Knowledge:
Caleb owns a factory which was purchased on 1 January 20X5 for $500,000, and depreciation is
charged at 2% p.a. on a straight- line basis.
Caleb revalued the factory premises to $800,000 on 1 January 20X7 to reflect its fair market value.
What is the balance on the revaluation surplus after accounting for this transaction? Show the
journal entry to record the revaluation as well.
Solution:
Depreciation = 2% X 500,000 = $10,000
Carrying Amount = 500,000 – (2 X 10,000) = $480,000
Revaluation surplus = Revalued amount – CA = 800,000 – 480,000 = $320,000
Journal entry –
Dr Accumulated depreciation
Dr Factory – cost
Cr Revaluation surplus
$20,000
$300,000 (800,000 – 500,000)
$320,000
112
Revaluation and Disposals
Depreciation & Transfer of excess depreciation for revalued assets
After revaluation, the asset will be depreciated on the revalued amount. Therefore, the depreciation
charged to SOPL each year will increase after revaluation. The new depreciation less the new
depreciation is what is known as excess depreciation.
IAS 16 provides an option to companies to transfer this excess depreciation to retained earnings by
simply passing a journal entry in the equity section of the SOFP by the amount of excess
depreciation Dr Revaluation Surplus
Cr Retained Earnings
The logic behind this is that the gain is still unrealised, and revaluation is the reason behind the
excess depreciation being charged to SOPL, therefore the revaluation surplus shall only bear that
extra expense and therefore is debited which reduces the value of the revaluation surplus.
From the point of view of the F3 exam, this concept is extremely important!
This transfer of excess depreciation is a movement in the equity balances of the SOFP; therefore is it
shown in the SOCIE
Apply Your Knowledge:
Refer to the previous to Apply Your Knowledge.
Caleb takes the option to transfer the excess depreciation from revaluation surplus to retained
earnings. Pass the journal entry for the same
Solution:
New depreciation = 2% X 800,000 = $16,000
Old depreciation = 2% X 500,000 = $10,000
Excess depreciation = 16,000 – 10,000 = $6,000
Dr Revaluation Surplus
Cr Retained Earnings
$6,000
$6,000
113
Revaluation and Disposals
114
Syllabus Area D4e-f-h
- Prepare ledger entries to record the acquisition and disposal of non-current assets. [S]
- Calculate and record profits or losses on disposal of non-current assets in the statement of
profit or loss, including part exchange transactions. [S]
- Calculate the profit or loss on disposal of a revalued asset. [S]
Disposal of Non-Current Assets
In an ideal world, when you sell an asset, you should get the exact amount of its carrying amount.
However, that is almost never the case, and therefore a profit or loss on disposal arises due to which
many accounting entries need to be passed while disposing/derecognizing any asset. A new account,
disposal of NCA account needs to be made to ascertain the profit or loss made.
Proceeds – CA = Profit / loss from disposal of asset
Proceeds from sale of asset > CA at disposal date = Profit
Proceeds from sale of asset < CA at disposal date = Loss
Proceeds from sale of asset = CA at disposal date = Neither profit or loss
Steps to record the disposal of an asset are as follows:
1. Remove the original cost of the asset from the NCA at cost account
Dr Disposal Account
Cr NCA at Cost Account
2. Remove the accumulated depreciation on the asset from the accumulated depreciation account
Dr Accumulated Depreciation Account
Cr Disposal Account
The basic logic is to simply remove any balances (empty the cost and accumulated depreciation accounts)
out of the books of accounts and financial statements. Therefore, the original entries passed during
acquisition simply need to be reversed now with a corresponding entry in the disposal account
3. Pass the journal entries for the proceeds/part exchange of the asset.
Dr Bank/Cash Account
Cr Disposals Account
Revaluation and Disposals
This records the receipt of money in return for the sale/disposal of an asset
In practical life, it is very common to exchange your old asset for the one. A simple example you
can relate to is selling your old phone and buying a new phone. An exchange allowance or
discount will be given in order to return the old phone to the seller. In that case, the journal
entries to pass will become –
Dr NCA at cost account
Cr Disposals Account
Part exchange allowance
Part exchange allowance
Dr NCA at cost account
Additional cash needed to be paid to cover the value of the new asset
Cr Bank / Cash Account
The disposal account shall look like this at the end where the profit/loss on disposal become the
balancing figures –
Disposal Account
Original Cost
Particulars
$
X
Profit on disposal (Bal fig.)
X
Particulars
Accumulated Depreciation
Bank / Cash
Loss on disposal (Bal fig.)
XX
$
X
XX
X
XX
If the asset being disposed has been previously revalued, then this revaluation gain is now realized,
and therefore the gain should be shown in the SOPL. However, as it relates to prior periods, it
cannot be shown in the SOPL of the year in the SOPL.
Hence, the revaluation surplus amount should be directly transferred to retained earnings in the
SOCIE by passing the same journal entry as in excess depreciation Dr Revaluation Surplus
Cr Retained Earnings
(full amount of revaluation of the asset being disposed)
115
Revaluation and Disposals
Apply Your Knowledge:
Jonathan runs a business sewing sports jerseys. When he started business on 1 January 20X7, he
bought a basic sewing machine for $25,000. He depreciates the machine using the straight-line
method at a rate of 20% p.a. and charges a full year of depreciation in the year of acquisition and
none in the year of disposal.
The business has now grown such that he needs a bigger, more advanced machine, for which the
following deal has been finalised on 1st January 20X9:
Part exchange allowance for basic sewing machine
Balance to be paid in cash for new advanced machine
$7,500
$40,000
The new machine will be depreciated exactly in the same way as the old one.
Show the required entries in the ledger accounts of Jonathan for the year ended 31 December
20X9.
Solution:
Sewing Machine (At cost)
Date
20X9
Jan 1
Jan 1
Particulars
$
Balance b/d
New asset part exchange
allowance (disposal A/c)
25,000
Jan 1
Bank A/c
7,500
40,000
72,500
20Y0
Jan 1
Balance b/d
47,500
Date
20X1
Jan 1
Particulars
Dec 31
$
Disposal
25,000
Balance c/d
47,500
72,500
Accumulated Depreciation Account
Date
20X9
Jan 1
Particulars
$
Disposal
10,000
Balance c/d
9,500
Date
20X9
Jan 1
Dec 31
Dec 31
Particulars
$
Balance b/d
10,000*
Depreciation
Expense A/c
9,500**
19,500
*25,000 X 20% X 2 years = $10,000
**47,500 X 20% = $9,500 (this is the current year’s depreciation on the new asset)
19,500
116
Revaluation and Disposals
Disposal Account
Particulars
Sewing machine at cost
$
25,000
Particulars
Accumulated depreciation
Part exchange allowance
Bank / cash
Loss on disposal (Bal fig.)
$
10,000
7,500
7,500
25,000
25,000
Depreciation (Expense) Account
Date
20X9
Dec 31
Particulars
Accumulated
Depreciation
$
9,500
9,500
Therefore, the SOPL will have a total debit of $17,000:
$7,500 – Loss on disposal
$9,500 – depreciation on new machine
Date
20X9
Dec 31
Particulars
SOPL
(transfer)
$
9,500
9,500
117
Intangible Non-Current Assets and Amortization
Intangible Non-Current Assets and Amortization
Syllabus area D6a-b-e-f
- Recognise the difference between tangible and intangible non-current assets. [K]
- Identify types of intangible assets. [K]
- Explain the purpose of amortisation. [K]
- Calculate and account for the charge for amortisation. [S]
Intangible Non-Current Assets and Amortization
Intangible assets are the type of assets which cannot be seen, felt or touched. Examples include
patents, copyrights, licenses, franchises and qualifying developments costs.
IAS 38 Intangible Assets defines an intangible asset as 'an identifiable non - monetary asset without
physical substance'
Key characteristics include:
1. The asset should be controlled by the entity
2. Future economic inflows should be probable
3. It is separately distinguishable from goodwill
Internally generated goodwill i.e. goodwill which the owners think the business has is NOT considered
an asset. Only acquired goodwill (see chapter on consolidation) is allowed to be shown in the SOFP.
Amortization is nothing but the depreciation of intangible assets with finite lives. The accounting, i.e.
the ledger entries and calculation of amortization, is exactly the same as the straight-line method of
depreciation.
118
Intangible Non-Current Assets and Amortization
119
A patent whose estimated value is $100,000 is issued to a pharmaceutical company in January 20X1
for 10 years for its unique formula. What is the carrying value of the patent at the end of 20X5?
A.
B.
C.
D.
100,000
50,000
150,000
60,000
Answer:
B
Amortisation = 100,000 / 10 = $10,000 per year
Accumulated amortisation = 10,000 X 5 years = $50,000
Carrying amount = 100,000 – 50,000 = $50,000
Intangible assets with indefinite useful lives (e.g. patents issued forever) are NOT AMORTISED but they
are tested for impairment (i.e. loss in value) annually
Like tangible NCA, intangible NCA are initially measured at cost, and then subsequent measurement
can be done through the cost model or valuation model.
COST MODEL
Intangible asset
carried at cost
less amortisation
and impairment
losses.
REVALUATION MODEL
• Intangible assets revalued to a carrying amount of fair value less amortisation
and impairment losses.
• Fair value is determined with reference to an active market (market with
identical products, price available to public)
• It can rarely be used for intangible assets
Intangible Non-Current Assets and Amortization
Syllabus area D6c-d
- Identify the definition and treatment of “research costs” and “development costs” in
accordance with IFRS® Standards. [K]
- Calculate amounts to be capitalised as development expenditure or to be expensed from given
information. [S]
Research and Development Costs
IAS 38 contains special provisions for capitalization of research and development (R&D) costs. The
standard treats research costs and development costs separately.
IAS 38 defines research as the 'original and planned investigation undertaken with the prospect of
gaining new scientific or technical knowledge and understanding.'
Development is defined as 'the application of research findings or other knowledge to a plan or
design for the production of new or substantially improved materials, devices, products, processes,
systems or services before the start of commercial production or use.'
Look for key words like design, construct, test, etc., to distinguish development expenditure from
research costs.
Research costs should be expensed to SOPL as they do not guarantee nor is it probable that any
future economic inflows will happen. This is the application of the prudence concept.
Development costs are also expensed unless some specific qualifying criteria are met, in which case
they must be capitalised as intangible assets and shown in the SOFP. The qualifying criteria can be
summarised with the mnemonic ‘PIRATE’ as shown below
P
I
R
A
T
E
Probable flow of future economic benefits from the asset
Intention to complete the intangible asset and use or sell it
Resources are adequate to complete the asset (technical and financial)
Ability to use or sell the intangible asset after completion
Technical feasibility to complete the asset
Expenditure can be reliably measured
ALL of the 6 criteria should be met to capitalize development expenditure. Even if 1 is not
met, it should be expensed to SOPL.
120
Intangible Non-Current Assets and Amortization
If development expenditure is capitalised and has a limited life, it must be amortised like an
intangible asset with a finite useful life.
If development expenditure is recognised as an expense in P/L, then it cannot be recognised as an
asset later. Development expenditure should be amortised over its useful life as soon as commercial
production begins.
Charlie Co had its first financial year in 30 June 20X9 and incurred the following expenditure on
research and development, none of which related to the cost of non-current assets:
$10,000 on successfully devising processes for converting petroleum to oil X, Y and Z
$50,000 on developing a new kind of renewable fuel based on chemical Z.
No commercial uses have yet been discovered for chemicals X and Y. Commercial production and
sales of the new renewable fuel commenced on 1 April 20X9 and are expected to produce steady,
profitable income during a 5-year period before being replaced. Adequate resources exist to achieve
this.
What is the maximum amount of development costs that must be carried forward at 30 June 20X9
under IAS 38 Intangible Assets?
A.
B.
C.
D.
$40,000
$60,000
$50,000
$47,500
Answer:
D
50,000 – 2,500 = $47,500
The $10,000 spent on processes does not meet the recognition criteria for an intangible asset and so
must be recognised as an expense in profit or loss.
The $50,000 relating to developing new renewable energy sources must be capitalised. Amortisation
must start once commercial production begins, and amortisation is $10,000 per year ($50,000 / 5
years). The carrying value at the year-end represents $50,000 less three months' amortisation.
(10,000 X 3/12 = 2,500)
121
Intangible Non-Current Assets and Amortization
Syllabus Area D5i
- Illustrate how non-current asset balances and movements are disclosed in financial
statements. [S]
Disclosure Notes – Tangible and Intangible NCA
Tangible and intangible assets usually have the same related disclosure requirement in the notes to
accounts. The basic logic is to include the total amount on the face of SOPLOCI, SOFP, SOCIE and
provide the break-ups and additional descriptions required in the notes to accounts.
Disclosure notes can and will be tested. Don’t ignore this area of the syllabus
IAS 16 Disclosure requirements for property, plant and equipment (PPE) include –
1. A reconciliation between the carrying amounts of PPE at the start of the year and the end of the
year
a. Additions
b. Disposals
c. Revaluations
d. Depreciation
e. Any other movements in value of carrying amounts
2. An accounting policy note stating the measurement basis used on which depreciation is
calculated along with which method is used
3. For each class of PPE
a. Depreciation method used
b. Useful lives or rate of depreciation
c. Total depreciation charge for the period
d. Gross amount of depreciable assets and the corresponding accumulated depreciation
amounts at the beginning and end of the year
4. For revalued assets
a. Basis used to revalue assets
b. Effective date on which revaluation was done
c. If an independent valuer was used or not
d. Carrying amount of each class of PPE if the class had not been revalued, i.e. value under
the historical cost method
e. Revaluation surplus, indicating the movement for the period and any restriction on
distribution of the surplus to the shareholders.
122
Intangible Non-Current Assets and Amortization
PO6 – RECORD AND PROCESS TRANSACTIONS AND EVENTS
Description
You use the right accounting treatments for transactions and events. These should be both historical
and prospective – and include non-routine transactions.
Elements
a. Implement or operate systems to record and process accounting data using emerging
technology where appropriate or feasible.
b. Gather information for end-of-period accounting entries – and prepare estimates for
adjustments to inter-company accounts.
c. Verify, input and process routine financial accounting data within the accounting system
using emerging technology where appropriate or feasible.
d. Prepare and review reconciliations and other accounting controls.
e. Make sure you’re using accounting standards and policies when you’re processing
transactions and events.
123
119
Syllabus Area E:
Preparing a trial balance
Control Accounts
120
Control Accounts
Syllabus Area E3a-b-c-d-e-f
a) Understand the purpose of control accounts for accounts receivable and accounts payable.[K]
b) Understand how control accounts relate to the double-entry system.[K]
c) Prepare ledger control accounts from given information.[S]
d) Perform control account reconciliations for accounts receivable and accounts payable.[S]
e) Identify errors which would be highlighted by performing a control account reconciliation.[K]
f) Identify and correct errors in control accounts and ledger accounts.[S]
Control Accounts
Control accounts refer to the general ledger account, which summarises the large number of
transactions that take place in the business.
In a double entry book-keeping system, control accounts are mainly used to verify the accuracy in
ledger accounts, i.e. they provide a check on the doubly entry system, much like a trial balance.
Important journal entries:
A. Transfer of total sales into general ledger
Dr Receivables Ledger Control Account
Cr Sales Revenue
B. Transfer of total purchases into general ledger
Dr Purchases
Cr Payables Ledger Control Account
Many businesses also maintain a memorandum which is a list of individual receivables and payables
from the customers and suppliers maintained separately.
A memorandum is mainly a simple list of balances is used as the record by the companies to see how
much is due to an individual supplier and how much is due from an individual customer. Thereby
assisting in credit management and cash flow.
Control Account Formats and Important Journal Entries
Receivables Ledger Control Account Format
Particulars
Balance b/f
Credit Sales [SDB]
Bank [CB] (Dishonoured Cheques)
Bank [CB] (Credit Refund)
Interest Charged
Balance c/f
Balance b/f
Amount [$]
X
X
X
X
X
X
X
X
Particulars
Balance b/f
Sales Returns [SRDB]
Bank [CB]
Irrecoverable Debts [Journal]
Purchase receivables ledger control [Contra]
Balance c/f
Balance b/f
Amount [$]
X
X
X
X
X
X
X
X
Control Accounts
121
Payables Ledger Control Account Format
Particulars
Balance b/f
Bank [CB]
Purchase Return [PRDB]
Discounts Received
Sales receivables ledger control [Contra]
Balance c/f
Balance b/f
Amount [$]
X
X
X
X
X
X
X
X
Particulars
Balance b/f
Credit Purchases [PDB]
Bank [CB] (Refund of Debit Balances)
Amount [$]
X
X
X
Balance c/f
Balance b/f
X
X
X
Note - Any entries in the control account shall also be reflected in the individual receivable and
accounts payable ledger account
Think of the control accounts as TOTAL accounts of trade receivables and payables. Therefore, all
entries you would debit / credit in a debtor’s A/c, the same effect would be given here in the trade
receivables control account
Correcting credit balances on the receivable ledger control account / debit balances of the payables
ledger control account
Dr Receivables
Cr Payables
Contra entry
Dr Payables Ledger Control Account
Cr Receivables Ledger Control Account
Abbreviations / Short Forms
SBD – Sales Day Book
PDB – Purchased Day Book
SRDB – Sales Returns Day Book
PRDB - Purchase Returns Day Book
CB – Cash Book
SOPL – Statement of Profit and Loss
SOFP – Statement of Financial Positions
Recording Credit Balances [credit balances on the receivable ledger control account]
Sometimes in a control account, there might be a credit balance meaning the business owes the
customer money.
Such balances generally arise and are small in size:• Overpayment by the customer
• Advance payment from customers before raising the invoices
• Issuance of credit notes for fully paid goods
Control Accounts
The payables ledger control account may show or debit balance for the similar reasons
Technically, such balances should not exist. If we transfer them to the correct account
thereby of credit in the receivable account or a debit balance in the payables account, it shall be
adjusted using the following double entry:
Dr Receivables Control A/c
Cr Payables Control A/c
Contra Entries
This is an entry passed to avoid clerical paperwork and writing off multiple checks when one of the
businesses suppliers is also a business’s customer; thereby, via passing this entry, the balances are
cancelled. This entry is also selected in the individual receivable and payable memorandum account
Double Entry:
Dr Payables ledger control account
Cr Receivables ledger control account
Basically, a contra entry is passed when a business is your debtor as well as your creditor. Thus, you will
owe money to the other business as well as will be owed. For example, if Janelle owes Shawn $100 and
Shawn owes Janelle $50, this can be netted off by saying that Janelle should pay $50 to Shawn and
Shawn should pay nothing to Janelle.
Apply Your Knowledge:
Ashlyn Co prepares monthly receivables' and payables' ledger control accounts. At 1 October 2010 the
following balances existed in the entity’s records.
Receivables ledger control account
Payables ledger control account
Debit $
55000
500
Credit $
15000
48000
The following information was extracted in October 2010 from the entity's records:
Credit sales
Credit purchases
Cash sales
Cash purchases
Sales returns
Purchases returns
Received from customers
Dishonoured cheques
Payments to suppliers
Cash discount received
Irrecoverable debt
$
3,50,000
95,000
8,000
5500
15000
2500
270000
900
80000
6500
5500
122
Control Accounts
Interest charged to customers
Contra settlements
Increase in allowance for receivables
123
1900
2500
2300
At October 30, 2010, the following balances were extracted in the receivables and payables ledgers:Debit $
?
500
Receivables ledger control account
Payables ledger control account
Credit $
3000
?
Prepare the receivables' ledger control account and the payables' ledger control account for Ashlyn
Co for the month of October 2010 to determine the closing debit and closing credit balances on the
receivables' ledger control account and payables' ledger control account respectively.
Solution:
Ashlyn Co
Receivables Ledger control account
Particulars
Balance b/f
Credit Sales [SDB]
Bank [CB] (Dishonoured Cheques)
Bank [CB] (Credit Refund)
Interest Charged
Balance c/f
Balance b/f
Amount [$]
55000
350000
900
1900
3000
410800
102800
Particulars
Balance b/f
Sales Returns [SRDB]
Bank [CB]
Irrecoverable Debts [Journal]
Purchase receivables ledger control [Contra]
Balance c/f
Amount [$]
15000
15000
270000
5500
2500
102800
410800
3000
Balance b/f
Payables Ledger control account
Particulars
Balance b/f
Bank [CB]
Purchase Return [PRDB]
Discounts Received
Sales receivables ledger control [Contra]
Balance c/f
Balance b/f
Amount [$]
500
80000
2500
6500
2500
51500
143500
500
Particulars
Balance b/f
Credit Purchases [PDB]
Balance c/f
Balance b/f
Amt [$]
48000
95000
500
143500
51500
Control Accounts
Control Account Reconciliations
Particulars
Balance as per examiner
Adjustment for error
Amount [$]
X
X
X
Particulars
Adjustment for error
Revised balance c/f
Amount [$]
X
X
X
Reconciliation of Individual Receivables Balances with Control Account Balance
Particulars
Balance as extracted from list of receivables
Adjustments for errors
Revised total agreeing with balance c/f on the control account
Amount [$]
X
X / (X)
XX
Supplier Statements
A supplier statement is issued by the business’ supplier, which summarises the transactions that
occurred between the business and the supplier and show an outstanding balance at the end of the
period.
The purpose of the supplier statement is to ensure that the total outstanding amount as per the books
of the business and the books of suppliers tally. Thereby, the individual payable ledger account should
agree with the total of the supplier statement. Thereby this provides a means to prove the accuracy
of accounting records.
Apply Your Knowledge:
Fallion Ltd has provided the following information in the month of April 2012:
Individual ledger account balances at the end of the month were 24,544
Final balance on the payables’ ledger control account was 26,564
Upon a further examination of books and the journal entries, the following errors were discovered:
• No entry was made for the total discount received for the month of $2000 in the control
account however it was recorded in the individual ledger account.
• On listing out, an individual credit balance of $450 has been incorrectly categorised as a debit.
• A petty cash payment to a supplier of $80 has not been recorded in the suppliers individual
ledger account, however, it has been correctly recorded in the control account.
• Purchase day book total for April has been understated by $4300
• Contrast or set off with the receivables ledger of $3500 was not recorded in the control
account however, has been accounted for in the individual ledger accounts.
Prepare the following:
• Part of the payables ledger control account to reflect the above information
• Reconciliation statement to reconcile the difference between individual balances and the
corrected control account balance
124
Control Accounts
Solution:
This is one of the comprehensive questions where in a systematic and methodical approach is required
to tackle the question
Here one needs to assess the impact of each error on the payables ledger control account and
individual payables ledger balances
Error 1 – Since an entry has been made into the Individual Ledger Account, however, no entry made
in control accounts, we have to record an entry in payables ledger control account
Error 2 – Individual credit balances are extracted from individual supplier ledgers and does not impact
control accounts
Error 3 - Since an entry has been made into the payables ledger control account, and no entry has
been made in the individual ledger account, we have to record an entry to account for the petty cash
payment
Error 4 – Purchases day book is the source document for payables ledger control accounts, and
individual balances are taken from the individual supplier ledgers
Error 5 - Since an entry has been made into the Individual Ledger Account and no entry is made in
control accounts, we have to record an entry in the payables ledger control account
Payables ledger control account
Particulars
Discounts received
Sales receivables ledger control [contra]
Balance c/f
Amt [$]
2000
3500
25364
30864
Particulars
Balance b/f
Purchases
Amt [$]
26564
4300
Balance b/f
30864
25364
Reconciliation of individual balances with control account balance
Balances as per Payables Ledger Control Account
Incorrect Credit Balance [2 x 450]
Petty Cash Entry
$
24,544
900
(80)
25364
125
Control Accounts
Apply Your Knowledge:
Clyde received a statement from his supplier, Ashwin, which showed a balance of $11,560. Clyde’s
payables ledger of Ashwin showed a balance due of $11,510. An investigation on both sides to
reconcile this discrepancy revealed the following.
(1) Cash paid to Ashwin of $412 has not been recorded by Ashwin
(2) Clyde’s recorded a cash discount of $50, which was not allowed by Ashwin but failed to account
for it in the payables ledger
Compute the difference after allowing for these items
Solution:
Difference
Balance as per the respective parties
Adjustment
Revised Balance
The difference = 11,560 – 11,148
= 412
Clyde
11510
50
11560
Ashwin
11560
(412)
11,148
126
Bank Reconciliation
Bank Reconciliation
Syllabus Area D4a
-
Understand the purpose of bank reconciliations.[K]
Bank Reconciliation
In your earlier studies, you might have learnt bank reconciliation in a very different way. You
may have learnt to go from the cash book balance to the bank statement balance. However,
at the ACCA level, the goal is to find the CORRECT bank balance to be shown in the SOFP.
Keep this in my mind while reading this chapter.
Objective of a bank reconciliation statement:
Reconcile the balance as per the cashbook and bank statement and find the correct revised cash book
balance to be shown in SOFP.
Cashbook
Bank Statement
Bank A/C as per business’s books
Business’s Bank A/C as per bank’s books
The debits and credits in the bank statement will be recorded from the bank’s point of view, i.e.
opposite to what you do in your company’s ledger. Therefore:
1)Any deposit in business’s bank account – Debit in bank A/c and credit in bank statement
2) Any withdrawal in business’s bank account – Credit in bank A/c in ledger and debit in bank
statements
The bank statement will check the most important and vulnerable asset of the business - cash.
However, due to the differences occurring between the bank statement and cash book, it is necessary
to reconcile both these balances, and thereby we prepare a bank reconciliation statement.
The reconciliation is generally carried out monthly and even more frequently in large businesses.
127
Bank Reconciliation
Syllabus Area D4b-c
- Identify the main reasons for differences between the cash book and the bank statement.[K]
- Correct cash book errors and/or omissions.[S]
Differences in the Bank Statement and the Cashbook
There are 3 major differences between the cash book and bank statement:1. Unrecorded items [cashbook adjustments]
2. Timing differences in recording the transactions [bank statements adjustments]
3. Errors made in the cashbook and/or bank statement
Unrecorded Items [Require adjustment in Cashbook]
These items are not recorded in the cash book; however, they are recorded in the bank statement
simply because the business and their accountants are not aware of these transactions until they have
occurred. Thereby an adjustment must be made within the cash book in order to reflect these
unrecorded items.
Examples of unrecorded items include interest, bank charges and dishonoured cheques
Items
Bank charges (money going out)
Direct debits / standing order (money going out)
Dishonoured cheques (reversing earlier debit entry)
Direct credits (money coming in)
Bank interest received (money coming in)
Impact on Cashbook
Credit
Credit
Credit
Debit
Debit
Timing differences in recording the transactions [bank statements adjustments]
These items are recorded in the cash book as when the cheques were issued to suppliers and cheques
were received from customers; however, your timing differences, i.e. meaning clearing process by the
bank, has not been cleared
1. Outstanding / unpresented cheques [cheques sent to suppliers]
This refers to cheques that have been issued to suppliers and recorded in the business’ cash book on
the same day; however, the supplier after receiving the cheque may not have deposited the cheque
immediately into the bank, or maybe the cheque is still in the clearing system and is not reflected in
the bank statement till clearing.
E.g., Business issued a cheque to supplier X on March 20 and recorded it as a payment in the business’s
cashbook; however, they did not deposit the cheque on the same day, and it was not cleared by the
bank till March 26
128
Bank Reconciliation
Thereby the business will record the payment on March 20 in the cashbook, and the bank will record
the payment on March 26, causing a difference in the balances.
2. Outstanding / uncleared lodgements [cheques received from customers]
This refers to cheques that have been received from customers and recorded in the business’s book
on the same day however, it may not be deposited into the bank until a few days later and are not
cleared by the bank immediately thereby causing a difference.
Lodgements are also referred to as deposits.
E.g., Business received a cheque from Customer XYZ on January 2 and recorded it as a receipt in the
business’s cashbook; however, they did not deposit the cheque on the same day, and it was not
cleared by the bank till January 13.
Thereby the business will record the receipt on January 2 in the cashbook, and the bank will record
the receipt on January 13, causing a difference in the balances.
Adjustment for these items
Balance as per bank statement
Less: unpresented cheques [sent to suppliers]
Add: uncleared lodgements [received from suppliers]
Balance as per cash book [revised]
$
X
(X)
X
X
Remember the Bank Reconciliation Statement properly. Also, you may be given the revised
cash book balance and told to find the balance as per bank statement. In that case, you will
go reverse in the statement i.e. less the lodgements from the revised cash book balance and
add the unpresented cheques.
Errors made in the cashbook and/or bank statement
Errors in the cash book may be made by the accountants within the business, and hence an adjustment
will have to be made within the cashbook for these errors.
Errors in the bank statement are made by the banks while recording the transactions, and hence an
adjustment will have to be made within the Bank Reconciliation Statement for these errors.
129
Bank Reconciliation
c) Prepare bank reconciliation statements.[S]
d) Derive bank statement and cash book balances from given information.[S]
e) Identify the bank balance to be reported in the final accounts.[S]
Format of the Bank Reconciliation Statement
Cashbook A/c
Particulars
$
Particulars
Balance b/f
Adjustments
Revised Balance c/f
Balance b/f
Adjustments
Revised Balance c/f
Revised Balance b/f
Revised Balance b/f
$
Bank Reconciliation Statement as at ….
Balance as per bank statement
Less : unpresented cheques [sent to suppliers]
Add : uncleared lodgements [received from suppliers]
Balance as per cash book [revised]
$
X
(X)
X
X
Note – The bank balance on the statement of financial position under current assets as bank and other
equivalent balances is always the revised cash book balance
Notes
1. Positive Balance - Credit in bank statement and debit in cash book
2. Overdrawn balances [negative balance] - debit in bank statement and credit in cash book
3. Do not forget to account for aggregation of deposits in a bank statement
Question Flow –
130
Bank Reconciliation
Type 1 – In these type of questions, you may be asked to prepare a bank reconciliations statement
directly using the given format
Type 2 – In these type of questions, you may be asked to prepare a cash book and then bank
reconciliations statement
Note – In rare case scenarios for Type 1 Questions – The question is made complicated by using a
cashflow and a bank statement given and asked to prepare a revised cashflow and BRS.
Approach :–
Step 1 – Cancel out all the common questions [Pay attention to details in terms of cheque numbers
and amounts]
Step 2 – Highlight all discrepancies of amounts and timing differences
Step 3 – Account for discrepancies like deposit difference amounts, unrecorded items in the cashflow,
and the timing differences items
Step 4 – Prepare the BRS
Apply Your Knowledge:
The following is a summary of Talwar’s cash book in the month of January 2007
Cashbook A/c
Particulars
Receipts
Balance c/f
$
1482
629
Particulars
Balance b/f
Payments
$
759
1352
Balance b/f
2111
629
2111
The company maintains only a cash book account where in all the transactions are recorded.
Note – All transactions are done by cheque.
The following discrepancies were identified by the junior accountant:1. Bank charges of $147 were not recorded in the cash book and only recorded in the bank
statement
2. Cheques drawn amounting to $357 have not been presented to the bank for payment
3. A cheque of $44 had been entered as a receipt in the cash book instead of a payment
4. A cheque drawn for $12 has been entered in the cash book as $120
Compute balance on the bank statement at the end of the month
Solution:
Revised Cash Book
Particulars
Adjustment re cheque [4]
$
108
Particulars
Balance b/f
$
629
131
Bank Reconciliation
Balance c/f
756
864
Bank Charges [1]
147
Adjustment for cheque mistakenly 88
entered as receipts [3]
864
Revised Balance b/f
756
Bank Reconciliation Statement as at 31 January 2007
Balance as per bank statement [calculated figure]
Less: unpresented cheques [2]
Add: uncleared lodgements
Balance as per revised cash book
$
(399)
(357)
0
(756)
Here in the bank reconciliation statement, we had 3 elements out of the total 4 thereby, we did the
reverse calculation in order to compute the balance as per the bank statement, which was a calculated
figure.
Rationale for each of the adjustments :Bank charges are a reduction in the bank balance thereby are reflected on the credit side of the cash
flow account
Unpresented cheques are shown directly in the bank reconciliation statement
•
•
If a check is mistakenly entered as a receipt, the first thing would be to undo that effect by
crediting the cash book by the same amount; also one to account for payment transaction
which was not recorded initially, thereby crediting the cash book by the same amount once
again
As initially $12 were accounted for and only the difference must be accounted for, we have
debited by the cash flow $108
Thereby this was one of the questions wherein first a revised cash book was prepared where in all the
errors made in the cash book and transactions occurred. However, they were only reflected in bank
statement and revised cash book in order to compute the corrected cash book balance which in turn
was used in BRS.
132
133
Trial Balance
Syllabus Area E1a-c-d
-
Identify the purpose of a trial balance.[K]
Prepare extracts of an opening trial balance.[S]
Identify and understand the limitations of a trial balance.[K]
Trial Balance
At the year-end, once all ledger have their balances brought forward, the closing balances of all
accounts are summarised on a long list known as a trial balance. One of the primary rules of accounting
is that the debit total should always equal he credit total which is also applied in the trial balance as
we follow the double entry bookkeeping system. In the event of the debit and credit totals not telling
the difference must be investigated and any necessary changes to make the totals tally. Hence, a trial
balance provides an arithmetical accuracy check on the ledger accounts.
b) Extract ledger balances into a trial balance.[S]
Format of Trial Balance
Trial Balance as at Dec 31, 2020
Particulars
Sales Revenue
Purchases
Expenses
Non-current Assets
Trade Receivables
Cash
Share Capital
Loans
Trade Payables
Debit
$
X
X
X
X
X
XXX
Preparation of financial statements and the process
Step 1 – recording of transactions in the ledger account
Step 2 – balancing of ledger account and computing the closing balances of ledger accounts
Step 3 – using the closing balances of ledger account, creating/extracting the trial balance
Step 4 – making year-end adjustments and closing off the ledger accounts
Step 5 – use of trial balance to prepare the financial statements
Note - Exam Questions will be any specific step of the above process
2. Correction of errors
a) Identify the types of errors which may occur in bookkeeping systems.[K]
b) Identify errors which would be highlighted by the extraction of a trial balance.[K]
c) Prepare journal entries to correct errors.[S]
Credit
$
X
X
X
X
XXX
Trial Balance
Types of Errors
There are two types of errors which occur in the accounting books:1. Errors where the trial balance still tallies – Such type of errors required new corrected or
amended entries to be passed
2. Errors where trial balance doesn’t tally - Such type of errors required a suspense account to
be created in order to make the trial balance tally
Note - The inherent flaw of a trial balance detecting errors by showing that both the debit and credit
totals do not tally is that despite correcting all the mistakes (even if the trial balance tallies [debit =
credit]), the accuracy is still not guaranteed.
Errors where trial balance still tallies
Error of Omission
Error of Commission
Error of principle
Compensating Error
Error of Original Entry
Reversal of Entries
Errors where trial balance doesn’t tally
One sided entry
Debit amount is not equal to the credit amount
Same side entries
Casting error in one of the accounts
Opening balances not included in the calculation
Extraction error
For errors where trial balance tallies, a useful mnemonic to remember is ‘POOR CC’
Error of P - Principle
O – Omission
O – Original Entry
R – Reversal of Entries
C – Commission
C – Compensating Errors
Errors where the trial balance still tallies
1. Error of Omission
This error refers to the omission of a transaction from the accounting records
Example - a cash purchase of $500 isn't recorded in the books
2. Error of Commission
This error refers to transactions recorded in the wrong account
Example - sundry income of $1000 recorded as other income in the books
134
Trial Balance
3. Error of Principle
This error refers to when transactions have been recorded in an incorrect manner
conceptually
Example - purchases of $1500 have been recorded as sales returns in the accounting books.
A non-current asset purchase of $1200 has been debited to the repairs account instead of the
non- current asset account
4. Compensating Error
This error refers to when 2 different errors cancel each other out
Example - a cash purchase of $1500 has been recorded via debiting the purchase account by
$500, and another error has resulted in debiting the purchase account by $1000
5. Error of Original Entry
This error refers to when there has been an error in recording the entry using the wrong
amount
Example - a cash purchase of $400 has been recorded as a cash purchase of $140
6. Reversal of Entries
This error refers to when the entries have been reversed; the correct account, the correct
amounts have been used however, on the wrong side
Example - a cash purchase of $400 has been debited to cash and credited to purchases
Note – Always assume if one side or aspect of a journal entry, (whether it be debit or credit); if part
of the entry is not mentioned, then it has been recorded correctly
Approach to the correcting the above entries
1. What the correct double entry should have been?
2. What double entry was actually done?
3. Pass the correcting entry
Errors where Trial Balance still doesn’t tally
The following are the errors where in the trial balance does not tally:• Single sided entry - no corresponding debit or credit entry has been made
135
Trial Balance
•
•
•
•
•
Both the debit and credit entries made with different values in the same journal
Two debit or credit entries made in the same journal e
Opening balance of that account is not accounted for
Incorrect addition in the individual account
Extraction error - this is when the error occurs in the extraction stage, i.e. the stage where in
ledger balance are extracted to trial balance and the accountant copied the value from the
wrong ledger account or places the value in the wrong column of the trial balance
A suspense account is opened whenever the trial balance doesn’t tally. Correction to account for any
of the above six errors will result in an impact in the suspense account balance
Note – If the debit side of the trial balance is more than the credit side, then we need an entry which
increases the credit side balance with the amount of the difference and vice versa for other scenarios
Apply Your Knowledge:
Debit side is less than the credit side by 1500
Solution:
This means we need to increase the debit side balance by 1500 to make the trial balance tally
Impact of correction journals on profit
Sr No.
1
Particulars
Dr Statement of Profit and Loss A/c
Cr Statement of Profit and Loss A/c
Impact on Profits
No Impact
2
Dr Statement of Profit and Loss A/c
Cr Statement of Profit and Loss A/c
No Impact
3
Dr Statement of Profit and Loss A/c
Cr Statement of Financial Position
Negative Impact on Profit /
Decrease in Profits
136
Trial Balance
4
Dr Statement of Financial Position
Cr Statement of Profit and Loss A/c
Positive Impact on Profit /
Increase in Profits
In the exam, there will be a question where there will be a loss, so use the below Table for the same
Sr No.
1
Particulars
Dr Statement of Profit and Loss A/c
Cr Statement of Profit and Loss A/c
Impact on Profits
No Impact
2
Dr Statement of Profit and Loss A/c
Cr Statement of Profit and Loss A/c
No Impact
3
Dr Statement of Profit and Loss A/c
Cr Statement of Financial Position
Positive Impact on Loss /
Increase in Losses
4
Dr Statement of Financial Position
Cr Statement of Profit and Loss A/c
Negative Impact on Loss /
Decrease in Losses
Note – Here Statements of Profit and Loss refers to any elements appearing in SOPL and Statements
of Financial Position refers to any elements appearing in SOFP
The logic is if there is a negative impact on profits which means profits are falling, thereby the
corresponding impact would be a positive impact on loss, meaning an increase in these losses.
Thereby if there is a positive impact on profits which means profits are rising, thereby the
corresponding impact would be a negative impact on loss, meaning a decrease in these losses.
Another simple way to remember is when there isIncrease in Profits – Add to the Profit/Loss Figure
Decrease in Profits – Subtract from the Profit/Loss Figure
The above tables given are extremely important to know without which you won’t be able to
tackle the exam questions correctly.
137
Trial Balance
Apply Your Knowledge:
The following correction journals have been posted by David Blake, a small business owner:
David’s draft profit figure is $44,000 however is before accounting for the following journal entries.
Compute the revised Profit Figure by taking into account the impact of the below Journal Entries on
Profit and Loss Account
(1) Dr Suspense $400
Cr Rent Received $400
(2) Dr Suspense $3300
Cr Receivables $3300
(3) Dr Loan interest $100
Cr Loan
$100
(4) Dr Sundry Expense $50
Cr Suspense $50
(5) Dr Bank $600
Cr Suspense $600
Note – In Exam, such questions will be MCQs; however, in the initial stages treat all questions in
Textbook as if they aren’t MCQ and try to calculate the Final Answers for Numerical Problems like this
one
Solution:
The first step would be to prepare a simple Table in rough or fair
Increase $
Draft Profit before Journal Entries
Entry 1 – Rent Received
Entry 2 – No Impact
Entry 3 – Loan Interest
Entry 4 – Sundry Expense
Entry 5 – No Impact
Revised Profits
Decrease $
$
44000
400
100
50
400
150
44250
Rationale –
Entry 1 – Income not recorded, so now profits increase
Entry 2 – No Impact as none of the components of the Journal Entry neither Debit nor Credit involve
Profit and Loss Account
Entry 3 – Loan interest not recorded, so profits will decrease
Entry 4 - Sundry Expense not recorded, so now decrease the Profits
Entry 5 – No Impact as none of the components of the Journal Entry neither Debit nor Credit involve
Profit and Loss Account
138
Trial Balance
Errors where the trial balance still balances
Even if the trial balance still balances, there may be errors of posting into the ledger accounts. This
may distort the information presented in the statement of financial position and statement of profit
or loss.
Apply Your Knowledge:
Consider the example of accounting for a cash sale of $2,000 with the following accounting entries
made in the ledgers:
Debit Non-current assets
$2,000
Credit Trade payables
$2,000
An equal value of debits and credits has been posted into the ledgers, and the trial balance will agree,
but the accounting entries are wrong. Consequently, the balances for non-current assets and trade
payables will be overstated by $2,000. In addition, the balances for the bank balance and sales revenue
will be understated by $2,000. This will be corrected by a journal adjustment.
In this example, the net effect is that sales revenue and profit for the year in the statement of profit
or loss has been understated by $2,000. In the statement of financial position, non-current assets and
trade payables have been overstated, and the bank balance has been understated, each by $2,000.
The correcting entries required are as follows:
Debit Cash account $2,000
Credit Non-current assets $2,000
Debit Trade payables $2,000
Credit Sales revenue $2,000
Errors where the trial balance does not balance
If the trial balance does not balance, there will be one or more errors posting into the ledger accounts.
This will distort the information presented in the statement of financial position and statement of
profit or loss.
Apply Your Knowledge:
Consider the example of accounting for a cash sale of $8,000 with the following accounting entry made
in the ledgers:
Debit Cash account $8,000 with no credit entry made.
An unequal value of debits and credits has been posted into the ledgers, and the trial balance will not
agree, which will require creation and clearance of a suspense account in due course.
139
Trial Balance
Initially, sales revenue and therefore profit for the year has been understated. A suspense account will
be created with a credit balance of $8,000.
In this example, the net effect is that sales revenue and profit for the year in the statement of profit
or loss has been understated by $8,000. In the statement of financial position, the suspense account
with a credit balance has been created and will be cleared by a journal adjustment as follows:
Debit Suspense account $8,000
Credit Sales revenue $8,000
140
142
Suspense Account
Syllabus Area 5a-b-c-d
- Understand the purpose of a suspense account.[K]
- Identify errors leading to the creation of a suspense account.[K]
- Record entries in a suspense account.[S]
- Make journal entries to clear a suspense account.[S]
Suspense Account
A suspense account is a temporary account which is created to make the trial balance tally. This is
where the balances are held until connecting entries are passed in order to clear any balance on the
suspense account before the final accounts are prepared. The suspense account should be closed
when and all errors are corrected before publishing final financial statements.
At the end, the suspense A/c will have a nil balance.
In a suspense account, there can be either a debit or credit balance. Also, if there is a trial balance
difference then it is posted as well in the suspense A/c.
Suspense A/c
Particulars
$
XXX
Balance b/f
Particulars
Trial Balance Difference
$
XXX
Assuming a debit balance on suspense account and a trial balance difference wherein the debit total
is greater than credit total; this scenario could be vice versa as well.
Reasons why a suspense account exists:
1. On the extraction of a trial balance the debits are not equal to the credits and the difference
is put to a suspense account.
2. When a bookkeeper performing double entry is not sure where to post one side of an entry
he or she may debit or credit a suspense account and leave the entry there until its ultimate
destination is clarified.
Apply Your Knowledge:
Trial Balance as on 20th March 2020
Particulars
Sales Revenue
Purchases
Expenses
Debit
$
3500
1000
250
Credit
$
10000
Suspense Account
Non-current Assets
Trade Receivables
Cash
Share Capital
Loans
Trade Payables
5500
1500
50
1200
600
750
11750
12550
Debit
$
Credit
$
The trail balance is not tallying; what can be done?
Solution:
Trial Balance as on 20th March 2020
Particulars
Sales Revenue
Purchases
Expenses
Non-current Assets
Trade Receivables
Cash
Share Capital
Loans
Trade Payables
Suspense Account
3500
1000
250
5500
1500
50
800
12550
10000
1200
600
750
12550
Since the trial balance is not tallying, a temporary suspense account will be created with the
difference of the two columns and on the side where the shortfall was, i.e. debit of 800
Approach to Questions
Take the same approach as before
1. What the correct double entry should have been?
2. What double entry was actually done? - Use the suspense account for any missing balances
or shortfalls
3. Pass the correcting entry – reverse the suspense A/c entry
Apply Your Knowledge:
The purchase of a non-current asset costing $100 has been recorded by debiting $10 to the noncurrent assets account and crediting $100 to cash.
What the correct double entry
should have been? [should do]
What double entry was actually done? Pass the correcting entry
[did do]
Debit NCA
Debit NCA 10
100
Debit NCA 90
143
Suspense Account
Credit Cash A/c
100
Debit Suspense A/c 90
[balance figure]
Credit Cash A/c
100
Credit Suspense A/c
Where an opening balance has not been brought down, journal it in and send the opposite entry to
suspense. The correction journal must always include an equal debit and credit.
Approach to questions where suspense account needs to be prepared
Step 1 - Prepare the suspense A/c ledger and input the opening balance and any trial balance
difference
Step 2 – Prepare the table and deal with each of the journal entries one by one [You can choose to
directly pass the correcting entry, but it is not advisable as you will be more prone to errors]
Step 3 – Post the suspense account entries to the suspense A/c ledger
Apply Your Knowledge:
While extracting the Trial Balance of AT & S, the accountant found a Suspense Account with a credit
balance of 500 and credit totals being more than the Debit Totals by 1364.
Upon further investigation, the accountant found the following errors:1 – No entry made for 150 paid to Allionz
2 – A payment to a credit supplier, Daffle of 190, was recorded 90 in the Journal
3 – A debit balance of 180 in the Sundry Expense account had been incorrectly extracted to the list of
balances as a credit balance
4 – A receipt from customer H has been posted to his account however posted to cashflow as 56
instead of 560
Solution:
Step 1 –
Suspense A/c
Particulars
Trial Balance Difference
$
1500
Particulars
$
2500
Balance b/f
Step 2 –
1
2
What should have the entry What was actually done?
been?
Actual Entry
Correct Entry
Dr Allionz
150
None
Cr Cash
150
Dr Daffle
190
Dr Daffle
100
Cr Cash
190
Cr Cash
100
Correcting Journal
Dr Allionz
Cr Cash
Dr Daffle
Cr Cash
150
150
100
100
144
90
Suspense Account
3
Dr Sundry Expense
Cr Cash
180
180
4
Dr Cash
Cr Receivables
560
560
Dr Suspense
360
Cr Sundry Expense 180
Cr Cash
180
Dr Cash
56
Dr Suspense
504
Cr Receivables
560
Dr Sundry Expense 360
Cr Suspense
360
Dr Cash
Cr Suspense
504
504
Step 3 –
Suspense A/c
Particulars
Trial Balance Difference
Balance c/f
$
1364
0
1364
Particulars
Balance b/f
Sundry Expense [3]
Cash [4]
$
500
360
504
1364
145
145
Syllabus Area F:
Preparing basic financial statements
Incomplete records
Incomplete records
Syllabus Area D
- Understand and apply techniques used in incomplete record situations: [S]
- Use of accounting equation
- Use of ledger accounts to calculate missing figures
- Use of cash and/or bank summaries
- Use of profit percentages to calculate missing figures.
Incomplete records
When an accountant is preparing accounting books for the year, it is likely that all of the information
is not available for him to prepare the complete set of financial statements; this is a very common
scenario in small businesses or businesses who have let the accounting function of the business fall
through the crack.
It is possible that in such scenarios then maybe an incomplete ledger or missing journal entries.
If this is the case, one of the ways is to input a rough estimate for the missing figures
There are a number of different ways in which one can calculate the missing and required aspects:
1. Accounting equation method
2. Balancing figure method
3. Use of cash and banking data
4. Profitability ratios - markup and margin
i) Use of accounting equation
1. Accounting equation method
Assets = Equity + Liabilities
Total Assets = Share Capital + Retained Earnings + Other Reserves + Total Liabilities
Assets = Non-current Assets + Current Assets
Equity = Share Capital + Retained Earnings + Other Reserves
Liabilities = Non-current Liabilities + Current Liabilities
Closing Retained Earnings = Prior Year’s Retained Earnings +/- Year’s Profit/Loss - Dividends
Closing Net Assets = Opening Net Assets + Capital Introduced + Profit - Drawings
Imagine the T-accounts for the above and you shall know when to add and when to subtract,
thus you can find any missing value (debits = credits)
146
Incomplete records
Apply Your Knowledge:
The following information is provided for a company:
Non-Current Assets = 15000
Current Assets = 5000
Share Capital = 500
Non-Current Liabilities = 6500
Current Liabilities = 1500
Prior Year Retained Earnings = 5600
Compute the Profit and Loss Figure.
Solution:
Total Assets = Share Capital + Retained Earnings + Other Reserves + Total Liabilities
15000 + 5000 = 500 + Retained Earnings + 0 + 1500 + 6500
Retained Earnings = 11500
Closing Retained Earnings = Prior Year’s Retained Earnings + Year’s Profit
11500 = 5600 + Profit
Profit = 5900
2) Use of ledger accounts to calculate missing figures
1. Balancing figure method [ledger account approach]
Ledger Account
Receivables A/c
Payables A/c
Cash A/c
Bank A/c
Missing values which can be ascertained
Credit Sales, Receipts from Customers
Credit Purchases, Payments to Suppliers
Cash Sales, Theft
Drawings, Theft
Bank A/c
Particulars
Balance b/f
Receipts from Customers
Cash A/c [deposits]
Sundry and other Incomes
Balance b/f
$
Particulars
Payments to Suppliers
Expenses
Bank A/c [withdrawal]
Drawings
Theft
Balance c/f
$
147
Incomplete records
148
Cash A/c
Particulars
Balance b/f
Cash Received from Customers
Sundry and other Incomes [in cash]
Bank A/c [Withdrawal]
$
Particulars
Cash Purchases
Expenses paid in Cash
Bank A/c [Deposits]
Theft [Cash Stolen]
Balance c/f
$
Balance b/f
Note – A negative bank balance implies an overdraft thereby, bank balance can be negative due to
the overdraft facility available by bank. A cash balance can never be negative.
The general practice is to make a separate Bank A/c and Bank Overdraft A/c
Money Deposited [depositing cash into bank]
Dr Bank A/c
Cr Cash A/c
XXX
XXX
Withdrawals [withdrawing cash from the bank]
Dr Cash A/c
Cr Bank A/c
XXX
XXX
For Receivables and payables, one can use the individual or the total receivables and payables A/c
[In the total receivables and payables – no bifurcation between cash and credit sales A/c]
Total Receivables A/c
Particulars
Balance b/f
Total Sales [Cash + Credit]
$
Particulars
Receipts from customers [Cash + Credit]
Balance c/f
$
Balance b/f
Total Payables A/c
Particulars
Payments to Suppliers [Cash + Credit]
Balance c/f
$
Particulars
Balance b/f
Total Purchases [Cash + Credit]
Balance b/f
Apply Your Knowledge:
The following information was given by an employee of XYZ
On October 1
$
Incomplete records
Outstanding electricity
Rent received in advance
149
$1500
$1950
Cash paid and received during the year
Electricity
$5500
Rent received
$6000
On November 30
Outstanding Electricity
Rent received in Advance
$750
$500
What are the charges for electricity and rent in the statement of profit or loss for the year?
Solution:
Here we need to prepare two separate ledgers of Electricity A/c, and Rent Received A/c wherein the
balance b/d will be reflected in SOFP and a charge to SOPL in the ledger itself.
Electricity A/c
Particulars
Cash A/c
Balance c/f
$
5500
750
6250
Particulars
$
1500
4750
6250
750
Particulars
$
1950
6000
7950
500
Balance b/f
SOPL Charge
Balance b/f
Rent Received A/c
Particulars
SOPL Charge
Balance c/f
$
7450
500
7950
Balance b/f
Cash A/c
Balance b/f
Electricity
Rent Received
SOPL
4750
7450
SOFP
750
500
As we have learnt in the previous Chapter Accruals and Pre-payments, there may be similar questions
asked wherein there will be a missing figure like opening or closing balance, amount paid or received or
the prepayment or accrual amount which will need to be calculated using the T Account or the ledger
format of respective Income A/c or Expense A/c
Incomplete records
3) Use of cash and banking data
This effectively is the same as the previous method, but it uses bank statements and the cash book
to find out missing items. As with ledgers, a cash book can be used in a similar fashion to find the
missing cash items (cash inflows as well as outflows)
4) Use of profit percentages to calculate missing figures.
Using margin and mark up calculate the cost of sales
The margin / mark-up principle
A business often has a fixed target percentage of profit it wants to earn on any sale. There are two
ways in which a business can determine this gross profit it wants to earn –
1.
2.
Gross profit margin - % of Sales
Mark-up - % of Cost of Goods Sold
You should know that Cost + Profit = Sales. However, the only distinguishing factor between mark up
and margin is on what amount the percentage is applied too, as depicted above.
So, for mark-up and margin problems, the easiest way is to form an equation in terms of 100 as it is a
percentage and then just cross multiply with the actual sales, COGS, profit figure, whichever maybe
provided in the question, to find the rest of the unknowns. Look at the Apply Your Knowledge below
to exactly know how to apply this concept.
Apply Your Knowledge:
Ryle operates the business with a margin of 20% on all of its transactions. Find the COGS if sales in
the year 20X9 amounted to $10 million.
Solution:
Margin is a % of sales, therefore we will take sales as 100. We will take whatever we need to find x in
our calculations, in this case, the COGS. We will use the principles of cross-multiplication to find our
answer.
20% of profit and the cost part of the first equation will simply be a balancing figure.
Cost
80
+
+
Profit =
20
=
Sales
100
x
+
?
10m
Therefore,
80 X 10m = 100 X x
=
150
Incomplete records
x = 10m X 80 / 100 = $8m
COGS = $8m, and profit would therefore be equal to $2m
Missing Inventory Figures
Prior to the advent of accounting applications and ERP systems, an organization would try to keep a
record of quantities of the various raw materials; however, an accurate record is not always possible,
which is why a year-end reconciliation is prepared using the principles we discussed before and below.
Compute any missing Inventory via inputting figures in the below formula:Cost of Sales = Opening Inventory + Net Purchases– Closing Inventory
[Cost of Sales = Opening Inventory + Purchases – Purchases Returns – Closing Inventory]
Journal Entries
1. Recording Closing Inventory
Dr Inventory [SOFP]
Cr Profit or Loss A/c [SOPL]
XXX
XXX
2. Lost Inventory
Not Insured
Dr Insurance Company [Other Receivables under Current Assets]
Cr Profit or Loss A/c [Cost of Sales A/c]
Insured
Dr Profit or Loss A/c [Expenses A/c]
Cr Profit or Loss A/c [Cost of Sales A/c]
Partly Insured
Dr Insurance Company [Other Receivables under Current Assets]
Dr Profit or Loss A/c [Expenses A/c]
Cr Profit or Loss A/c [Cost of Sales A/c]
XXX
XXX
XXX
XXX
XXX
XXX
XXX
Rationale - A credit to cost of sales in SOPL is made to remove it from the cost of sales and debit the
expenses in SOPL. An insurance company will account for the loss made and the amount claimed.
Apply Your Knowledge:
Talwar’s warehouse was recently robbed, and them being a small business did not keep an accurate
record of the same. Their insurance policy covered 40% of the stolen goods
The following information was provided:Mark up 25%
Sales $5000
Opening inventory $1500
151
Incomplete records
Purchases $5500
Closing inventory $1500
Compute the value of Inventory stolen and the relevant SOPL extracts
Solution:
The first step would be to calculate the Profit and Cost of Sales figure using Mark-up principles
Particulars
Sales
(-) Cost of Sales
Opening Inventory
Purchases
Inventory Lost
Closing Inventory
Gross Profit
$
1500
5500
(1500)
(1500)
$
5000
(4000)
1000
%
125
(100)
25
Inventory lost calculated as a missing figure.
Dr Insurance Company [1500 x 40%]
Dr Profit or Loss A/c [Expenses A/c] [1500 x 60%]
Cr Profit or Loss A/c [Cost of Sales A/c]
600
900
1500
Note – In certain questions, if no closing inventory is mentioned and if said, there has been a theft or
fire, then assume that the entire inventory has been stolen and lost by fire
152
154
Capital Structure, Finance Costs and Taxation
Syllabus Area a-b
- Understand the capital structure of a limited liability company including:
- Ordinary shares
- Preference shares (redeemable and irredeemable)
- Loan notes.
- Record movements in the share capital and share premium accounts.
Capital structure of a limited liability company
All companies require finance regardless of the type of business organization or their size, whether
they are a sole proprietor, partnership, limited company, small business, MNC etc.
Without external financing, they cannot commence and continue their operations.
Finance is the capital invested in the business.
Capital is of little or no use, however it can be employed in the wealth generation process.
Money is also referred to as a form of financial capital which is used to purchase materials, machinery,
land and building, pay labour and employees etc, which in turn helps in the creation of goods and
services which are sold to customers in exchange for money which helps generate wealth for its
owners.
Capital Structure – Comprises of debt and equity
1. Debt - the debt holder is entitled to a mandatory payment in the form of interest, capital repayment
and/or both
2. Equity - Holder is entitled to any form of repayment; however, benefits from the appreciation of the
equity and can also claim the residual assets [remaining net worth after payment to creditors and
other parties] in the event of liquidation.
Classification of whether a source of finance is a debt or equity is quite straightforward and easy;
however, in certain scenarios, it could be unclear whether it is debt or equity, which is why one must
be aware of the following three forms of financial capital and how they are reflected in the final
account/financial statements:
1. Ordinary equity share capital – there shown under the equity section on the SOFP. FHHHHHH
it is at the discretion of directors to decide whether or not to pay shareholders dividends and what
intervals
Ordinary share capital refers to the part ownership of the company based on their shareholding;
however, unlike other types of business organizations here the ordinary share capital holders don't
have any rights to claim the profits or assets of the business while it is going concerned; when the
business liquidates or ceases to exist ordinary share capital holders will receive residual interest in
proportion to the size of their holding
Any changes in ordinary share capital, reserves, Retained Earnings, and Dividend Payments are
reflected in the statement of changes in equity as post to the distribution of profits to the owners of
the business, i.e. ordinary share capital holders
Capital Structure, Finance Costs and Taxation
Dividends are mere appropriation / distribution of profits to ordinary shareholders
They are shown in the SOCIE section of the financial statements, NOT SOFP
2. Loan Notes – Business issues loan notes which require annual interest payment and principal payment
of the entire data fixed point in time as rather than Equity shareholding which dilutes ownership rights
of Promoters
businesses are liable to only pay the Loan note holder as per the terms agreed prior and laid down in
the loan note agreement
The interest payment is treated as a finance charge and shown as an expense in SOPL, while the
principal is a liability on SOFP
3. Preference Shares – These can be either debt or equity depending on the terms, i.e. whether they are
redeemable or irredeemable
In the case of Redeemable Preferences shares, there is an obligation to repay the principal. Thereby,
it is shown as a debt, and the treatment of dividends shall be as finance charges in SO PL and the
redeemable preferences shares will be shown as liabilities in SOFP
In case of Redeemable Preference shares, there is no obligation to repay the shares thereby it is
treated as equity in SOFP & dividends are treated the same way as ordinary dividends in the final
account.
However, it is worth noting that ordinary shareholders are entitled to the residual assets of the
business; however, redeemable preference shares aren't as they are not be part owners of the
business and have no rights over the residual assets in event of a liquidation of the business.
The key characteristics therefore can be summarised as –
1. Ordinary shares – Ownership of company, voting rights, shareholders earn dividends
(no fixed returns)
2. Preference shares – Given preference over ordinary shares in case of dividends and
liquidation of company
a. Redeemable - Liability, dividends are treated as finance charges
155
Capital Structure, Finance Costs and Taxation
Ordinary Share Capital
Ordinary share capital comes under the equity section of the business and is recording in the
Statement of Changes in Equity [SOCIE] section of Statement of Financial Position [SOFP]
Important Terminologies regarding Share Capital
Each share nominal or par value or Face Value often Rs.10, which is a value assigned to share and
referred to as the share’s minimum value. This value is used to calculate dividends to shareholders.
E.g. – A ltd decides to pay a dividend of 100% [FV-10; MPS – 250]
Thereby Dividend per share [DPS] = 100/100 * 10 = Rs.10
Shares are sold by the company at the issue price in the initial listing. This issue price is at least equal
to the nominal value of share; however, in reality is often sold at a premium thereby, it is termed as
an issue at a premium.
Market price of a share is the value at which the share is actively traded at the Stock Exchange and
fluctuates over time. MPS on a particular date is at the end of that day.
The market price of a share is influenced by a lot of factors, including the success, recent actions of
the company and demand and supply factors; however, none of this including the market price of the
share, is included in the financial statements.
Issued Share Capital – this is the share capital that has been issued to the shareholders. The number
of shoot shares are used in the computation of dividends.
Called up Share Capital – this is the amount of nominal value paid by shareholders plus any further
amounts that will be paid by them in the future.
Paid up Share Capital – this is the amount of nominal value which has been paid at the current date.
Journal Entries for Issue of shares
[A] Issue of shares at Nominal Value
Dr Cash
[Issue price x no. of shares]
Cr Share Capital
[Nominal Value x no. of shares]
[B] Issue of shares at Premium
However, in reality, there will be instances when the shares are issued at a price above the nominal
value. Thereby this is termed as an issue of shares at a Premium
Dr Cash
[Issue price x no. of shares]
Cr Share Capital
[Nominal Value x no. of shares]
Cr Share Premium [(Difference between Issue Price and Nominal Value) x No. of shares sold]
The share capital and share premium account are reflected in the Statement of Changes in Equity
[SOCIE] section of SOFP
E.g. – ABC Company issued 5000 Rs 10 shares at Rs 35 each
The Journal Entry for the above transaction would be :Dr Cash
Cr Share Capital [5000 x 10]
Cr Share Premium [5000 x (35-10)]
175000
50000
125000
156
Capital Structure, Finance Costs and Taxation
Loan Notes (Loan Stock)
A Public Limited Company, i.e. company which is listed at the Stock Exchange, is able to raise funds via
the issuance of loan notes which are
Journal Entry –
Recording the Loan as an long term liability and obligation to the lenders [i.e. the Loan note holders]
Dr Cash
XXX
Cr Non-current Liability
XXX
Recording the Finance Charge i.e the interest
Dr Finance Charges
[SOPL]
XXX
Cr Cash/Current Liabilities [SOFP]
XXX
[If interest is paid, then record as a Payment by crediting Cash and if interest isn’t paid, i.e. it is due,
then record as a Current Liability]
Apply Your Knowledge:
ABC issues $100,000 10% loan notes, redeemable in 20 years’ time on March 1 , 2013. Interest is
payable quarterly at the end of June, Sept, Dec and March
What shall be the accounting treatment in Journal and Financial Statements?
March 1 , 2013
Dr Cash
Cr Non-current Liability
100000
June 30 , 2013
Dr Finance Charges
[SOPL]
Cr Interest Accrual [SOFP]
3333
Sept 30 , 2013
Dr Finance Charges
[SOPL]
Cr Interest Accrual [SOFP]
3333
Dec 31 , 2013
Dr Finance Charges
[SOPL]
Cr Interest Accrual [SOFP]
3333
Mar 31 , 2014
Dr Finance Charges
[SOPL]
Cr Interest Accrual [SOFP]
3333
100000
3333
3333
3333
3333
In this question Interest = 100000 x 10% x 4/12 = 3333
Rationale In the first Journal Entry, we have recorded the cash received from the issue of Loan Notes
In the consecutive journal entries, we record the quarterly interest payments
Interest Rate
n
Interest Payments = Principal Amount x
x 12 [It’s just simple interest calculation]
100
N = No.of payments in a year [Annually = 1 ; Half Yearly = 2 ; Quarterly = 4]
Preference Shares
157
Capital Structure, Finance Costs and Taxation
Preference shares, as the term suggest, have preference over ordinary shares in the event of a
liquidation and have no voting rights. They are entitled to a fixed rate of interest
If the preference shares are redeemable in nature, then they are treated the same way loan notes are
accounted for by treating redeemable preference share as a liability in SOFP and dividend payment as
finance charges in SOPL
c) Identify and record the other reserves which may appear in the company statement of financial
position.[S]
Other Reserves
In addition to external sources of finance, whether it be debt or equity, i.e. loan capital or share capital;
Companies also reinvest the internally generated wealth, which is the yearly profits and revaluation
reserve. These are often referred to as reserves or other components of equity which are owned by
the ordinary shareholders of the company.
These reserves are included in SOFP, and any movements in share capital and reserves for the relevant
accounting are disclosed in the Statement of Changes in Equity which forms part of the Statement of
Financial Position
Common constituents of Other Reserves include the following:1. Revaluation Reserve
These are the unrealised gain when Property, Plant and Equipment and any other Non-current asset
is revalued
As this is an unrealised gain, it can’t be paid out as dividends to shareholders
Even share premium CANNOT be used to pay out dividends
2. Retained Earnings
These are the total till date profits/Losses after accumulated and not paid out as dividends to
shareholders
retained earnings are accumulated profits due to the shareholders. However, they are generally not
paid out there by our record as an apart of the companies liability in Equity Section
Movement in retained earnings can be found in the Statement of Changes in Equity
These can be used to pay dividends to shareholders
d) Define a bonus (capitalisation) issue and its advantages and disadvantages.[K]
f) Record and show the effects of a bonus (capitalisation) issue in the statement of financial
position.[S]
158
Capital Structure, Finance Costs and Taxation
Bonus Issue
This is the issue of new shares to the existing shareholders in the ratio of their existing share holding
there is no cash inflow from a bonus issue thereby, the issue is funded from the reserves. Remember,
no cash is received from the issue of bonus shares.
Note – Any reserve could be used to fund the bonus issue; however, it is preferable to use a nondistributable reserve such as the share premium account over the other reserves. However, if the
share premium account is fully exhausted, then the other reserves may also be incorporated in the
same transaction / Journal entry
Advantages
Disadvantages
• The issued share capital gets divided
• Administrative costs of bonus issues are
into a larger no. of shares thereby, the
generally a lot
market price of each share reduces
• No cash is raised by a bonus issue
making it more viable for new share
holders to enter
• Issued share capital is more in line with
the total assets in the company by a
reduction in the reserves and increase
in share capital
• No dilution to current shareholders
Journal Entry of Bonus Issue
Dr Share Premium A/c
Cr Share Capital
[In case of Bonus Issue funded fully from Share Premium A/c]
XXX
XXX
Dr Share Premium A/c
XXX
Dr Any other Reserves A/c
XXX
Cr Share Capital
XXX
[In case of Bonus Issue funded partly from Share Premium A/c and partly from Reserves]
Note – XXX is the Nominal Value
Bonus issue is simply a movement of reserves in the equity section of SOFP. The share
premium account partially / fully becomes share capital to strengthen the SOFP
159
Capital Structure, Finance Costs and Taxation
Apply Your Knowledge:
XYZ Ltd has 10,000 50c shares issued for $1.5, and then 2 years has a bonus issue of 1 for every 5
shares. The share premium account is capitalised and compute the balances on the share capital and
share premium accounts of XYZ Ltd after this transaction.
Solution:
Here for every 5 shares, a new share is issued, and since this is a paper exercise where no funds are
raised, there is no Cash or Bank A/c
New shares issued from Bonus Issue = 10000 x [1/5] = 2000
Journal Entry
Dr Share Premium A/c [2000 x 50 c]
Cr Share Capital
1000
1000
Statement of Financial Position
$
Capital & Reserves :
Share Capital [10000 x 0.5] + 1000
Share Premium [10000 x (1.5-0.5)] - 1000
Accumulated Profit
6000
9000
XXX
e) Define a rights issue and its advantages and disadvantages.[K]
g) Record and show the effects of a rights issue in the statement of financial position.[S]
Rights Issue
This is the offer of new shares to existing shareholders in the ratio of their existing shareholding at a
stated price which is generally below the market price of the share, i.e. shares are offered at a
discount to the market price
•
•
Advantages
Cheapest way to raise finance via
issuing new shares
Rights issue generally hold a greater
chance of success than an issue of
shares to the common public
•
•
Disadvantages
More costly than Debt Issue
May not be successful in raising the
finance it has planned to
Accounting of Rights Issue –
Accounted for in the same manner as a normal share issue and has a similar impact on the Statement
of Financial Position as an issue of the full price
𝑋
No of shares for Right Issue = 𝑌 x No. of shares in the market
[1 for every 6 shares – X=1 ; Y=6 ; 2 for every 3 shares – X=2 ; Y=3]
160
Capital Structure, Finance Costs and Taxation
𝑋
Total no. of shares post Right Issue = 𝑋+ 𝑌 x No. of shares in the market
Apply Your Knowledge:
JRD Ltd issued 1500 $1 shares at nominal value in 2005. Needing further funds, in 2015 made a rights
issue of 1 for 10 at $5. This offer is fully taken up.
Solution :
Dr Cash
Cr Share Capital [1500 x 1]
Dr Cash [150 x 5]
Cr Share Capital [150 x 1 ]
Cr Share Premium [Bal Figure]
1500
1500
750
150
600
For every 10 shares an owner owns; they are entitled to buy one more, and since the offer is fully
taken up
No of shares for Right Issue = 1500 x (1/10) = 150
This will be reflected in SOFP under the Capital Reserves Section :
$
Capital & Reserves :
Share Capital [1500+150]
1650
Share Premium
Accumulated Profit
600
XXX
Rights issue – Money is raised – therefore Net Assets increase
Bonus issue – No money received by company – therefore Net Assets remain same
h) Record dividends in ledger accounts and the financial statements.[S]
Dividends
Dividends are the distribution of profits to their owners, i.e. the shareholders and are expressed as an
amount per share of the nominal value [Face Value]
E.g. – Company A declares dividend of 100% ; CMP is 1500 & FV is 10
100
Then Dividend = 100 x 10 = $ 10
Dividend on preference shares are generally fixed an redetermine, such as 2% of the nominal value of
the shareholding
161
Capital Structure, Finance Costs and Taxation
Ordinary Dividends
A company might choose to pay evidence more than once a year and at different intervals in the same
year.
Dividend paid in middle of the year is known as Interim or Mid Year Dividend
Dividend paid at the end of the year is known as Final Dividend
A large sum of dividend paid on account of extraordinarily good financial results is known as Special
Dividend
All types of dividends must be approved by the shareholders, and until they have been approved, the
business is under no obligation to pay a dividend to its shareholders
E.g. – Common dividend paying stocks in India include Coal India & Bajaj Auto
Note – proposed dividend are not recorded in any of the financial statements, and only dividends due,
i.e. which are approved by the shareholders, are recorded as liabilities at the year end
Journal Entry –
Dr Retained Earnings
Cr Bank
XXX
XXX
Note – In Statement of Changes in Equity Dividend is the summation of all dividends declared in the
Financial Year
So Dividends = Special Dividend + Final Dividend + Interim Dividend
i)
Calculate and record finance costs in ledger accounts and the financial statements.[S]
Income & Corporation Tax
Like individuals, business entities are also liable to pay tax on their incomes, i.e. a tax is levied on their
profits
The taxability of an organization before on the type of the business organization polar-
162
Capital Structure, Finance Costs and Taxation
Sole Trader and Partnership
For a sole trader or partnership, the tax is imposed upon the individual who runs the business as both
the business and individual in the eyes of law are one and the same.
If the Business owners use the business bank account to pay any form of tax liabilities, then in the
businesses books, it will be recorded as drawings made by the business owners
Limited liability companies
For a Limited Liability Companies, the business and the business owners are separate legal entities.
Thereby the tax charge will be reflected as an expense in SOPL, and any tax liability due to the
government or the government bodies will be reflected as liabilities in the SOFP
this is referred to as income tax or Corporation tax [ however, income tax must not be confused with
the income tax of individual employees ]
this charge for income tax is based upon the level of profits on by the company and tax rates at the
time of the calculation as tax rates are often revised annually, and the level of profit determine the
slab in which the companies income falls
companies financial year end and tax year ends do not open match, which is why companies prepare
or a rough estimate of their income tax liability and recorded it as a liability in sosp to present a true
and fair picture of the companies financial statements
Tax Provision - this is the provision for the income taxes due and is recorded as a liability in SOFP, and
any movement in this provision is recorded in the SOPL
Increase in Provision → Have to pay more taxes → Higher Expenses and Lower Profits →
Debit SOPL
Decrease in Provision → Have to pay less taxes → Lower Expenses and Higher Profits → Debit
SOFP
Steps in Computation of Income Tax
Step 1 : Record the Double Entry for estimation of Tax Liability at the Year End
Dr Income Tax Charge [SOPL]
Cr Income Tax Liability [SOFP-Current Liabilities]
XXX
XXX
Step 2 : Computation to Actual Tax Liability and recording the payment of the same
Dr Income Tax Liability
Cr Bank
XXX
XXX
Step 3 : Reconciling the Difference between the estimated and actual amount of Tax
163
Capital Structure, Finance Costs and Taxation
To summarise, the total estimate of Tax Liability at the end of the year should be equal to the income
tax liability on the Statement of Financial Position
Income Tax Charge for SOPL is calculated as follows :Current Tax Estimate
Under / (Over) Provision in prior year
Total Income Tax Charge for the Year
$
X
X / (X)
X
Under Provision - the impact of under provision means we have underestimated the total tax charge
thereby, we need to add the difference to the current tax estimate in order to arrive at the total
income tax charge for the year
Over Provision - the impact of over provision means we have overestimated the total tax charge
thereby, we need to subtract the difference from the current tax estimate in order to arrive at the
total income tax charge for the year
Apply Your Knowledge:
Travista’s estimate of last year’s tax charge was 25200, and they settled with the tax authorities for
24100 due to some discrepancies and timing differences in preparation of Financial Statements
Due to this large difference, this time the accountant took a more cautious approach for the next
year’s tax liability and estimated it to be 27500
How is all of this reflected in SOPL and SOFP?
Solution:
SOFP – 27500 [From Tax Perspective, the estimate of current year’s tax is recorded as a Current
Liability]
SOPL - 26400 (27500 – 1100)
[From Tax Perspective, the estimate of current year’s tax - Overprovision + Under provision]
Here it is an Over provision of 1100 as the estimate was 25200 and actual was 24100
164
Preparing basic financial statements
Preparing basic financial statements
Syllabus Area F1-2
1. Statements of financial position
- Recognise how the accounting equation, accounting treatments (as stipulated within sections
D, E and examinable documents) and business entity concept underlie the statement of
financial position. [K]
- Understand the nature of reserves. [K]
- Identify and report reserves in a company statement of financial position. [S]
- Prepare a statement of financial position or extracts as applicable from given information
using accounting treatments as stipulated within sections D, E and examinable documents. [S]
- Understand why the heading retained earnings appears in a company statement of financial
position. [K]
2. Statements of profit or loss and other comprehensive income
- Prepare a statement of profit or loss and other comprehensive income or extracts as
applicable from given information using accounting treatments as stipulated within section D,
E and examinable documents. [S]
- Understand how accounting concepts apply to revenue and expenses. [K]
- Calculate revenue, cost of sales, gross profit, profit for the year, and total comprehensive
income from given information. [S]
- Disclose items of income and expenditure in the statement of profit or loss. [S]
- Record income tax in the statement of profit or loss of a company, including the under and
overprovision of tax in the prior year. [S]
- Understand the interrelationship between the statement of financial position and the
statement of profit or loss and other comprehensive income. [K]
- Identify items requiring separate disclosure on the face of the statement of profit or loss. [K]
Preparing Basic Financial Statements
Making Financial Statements is the end goal of financial accounting. In this chapter, all of the
knowledge you have learnt till in syllabus area D and E will all be used and consolidated. The
knowledge gained from each chapter, like inventory, non-current assets, etc., will all be used to
make adjustments in the financial statements.
Common adjustments include (but not limited to) 1) Closing Inventory
Dr Inventory (SFP)
Cr Cost of sales (P/L) – i.e. subtract in COGS
2) Depreciation
Dr Depreciation expense (P/L)
Cr Accumulated depreciation (SFP)
165
Preparing basic financial statements
3) Accruals
Dr Expenses (P/L) – i.e. add to relevant expense
Cr Accrual (Liability) (SFP)
4) Prepayments
Dr Prepayment (Current Asset) (SFP)
Cr Expenses (P/L) – i.e. subtract from expense
5) Irrecoverable debts
Dr Irrecoverable debt expense (P/L)
Cr Receivables (SFP) – i.e. subtract from gross trade receivables
6) Allowance for receivables
Increase in allowance
Dr Irrecoverable debt expense (P/L)
Cr Allowance for receivables (SFP)
Decrease in allowance
Dr Allowance for receivables (SFP)
Cr Irrecoverable debt expense (P/L)
7) Tax treatment
Dr Tax charge (P/L)
Cr Current tax liabilities (SFP)
Overprovision in prior year
Dr Current tax provision (SFP)
Cr Tax charge for the year (P/L)
Underprovision in prior year
Dr Tax charge for the year (P/L)
Cr Current tax provision (SFP)
Another important thing is the format of the financial statements as per IAS 1 Presentation of
Financial Statements. Be absolutely thorough with them! Sample formats are given below
with hypothetical numbers for your reference
166
Preparing basic financial statements
Statement of Financial Position at 31 December 20X9
Particulars
Assets
Non-Current Assets
Property, Plant and Equipment
Less: Accumulated Depreciation
Total Non-Current Assets [A]
Current Assets
Inventory
Trade Receivables
Short Term Investments
Bank and Cash
Total Current Assets [B]
Total Assets [A + B]
20X9
($’000)
1,250
(400)
850
100
70
20
50
240
1,090
Equity and Liabilities
Equity
Share Capital
Share Premium
Revaluation Surplus
Retained Earnings
Total Equity [C]
200
100
200
265
765
Non-Current Liabilities
Bank Loan
200
Current Liabilities
Trade Payables
Bank Overdraft
Interest Payable
Taxes Payable
55
25
25
20
Total Liabilities [D]
325
Total Equity and Liabilities [C + D]
1,090
167
Preparing basic financial statements
Statement of profit or loss and other comprehensive income
for the year ended 31 December 20X9
Particulars
$ (‘000)
1100
(675)
425
(100)
(200)
125
(20)
105
(15)
90
Revenue
Cost of Sales
Gross Profit
Distribution Costs
Administration and Selling Expenses
Operating Profit
Finance Costs
Profit Before Tax (PBT)
Income Tax
Profit for the Year
Other Comprehensive Income:
Revaluation Gain
50
Total Comprehensive Income
140
The Statement of Changes in Equity (SOCIE)
This statement is only prepared by limited liability companies as it shows the movements in the
balances of the 4 primary items of the ‘Equity section’ of the SOFP, i.e. share capital, share premium,
revaluation reserves and retained earnings.
Retained earnings are the total accumulated profits and losses of a business to date
Any issue of new shares or payment of dividends to shareholders will be recorded in this
statement.
The format is as follows –
Particulars
Balance at start of
the year
Profit for the year
Dividend Paid
Revaluation
Issue of shares
Closing Balance at
year end
Equity Share
Capital
($)
X
Share
Premium
($)
X
Revaluation
Surplus
($)
X
Retained
Earnings ($)
X
X / (X)
(X)
X
X
XX
X
XX
XX
XX
Total
($)
XX
X / (X)
(X)
X
XX
XXX
Now try out these Apply Your Knowledge to test all your knowledge learned until now combined in
one question!
168
Preparing basic financial statements
Apply Your Knowledge: 1
The trial balance of Talwar Ltd as at 31 December 2019 was as follows:
Particulars
Sales and Purchases
inventory
Distribution cost
Administrative expenses
Trade receivables and trade payables
Reorganization costs
Bank
Ordinary shares 50 cents
10% redeemable preferences of dollar one
10% low notes
Non-Current Assets [at Carrying Value]
share premium
Accumulated profits at Jan one 2018
Loan note interest paid
Preference dividend paid
Interim ordinary dividend paid
Tax
Suspense
Debit ($)
40000
16000
16000
31100
20000
4800
14500
Credit ($)
100000
40000
16000
18000
16000
70000
6000
6000
800
900
1600
219000
1000
16000
219000
Consider the following adjustments:Prepare the Financial Statement of Talwar Ltd for the year ended 31 December 2019
1. Closing inventory valued at $24000
2. Proposed Final ordinary dividend of 20 cents per share
3. Revaluation of Land & Building to $22000 from carrying value of $10000
4. Suspense account balance is due to ordinary share issue of 8000 shares not accounted for
5. Income Tax account overprovisioned in the Trial Balance and current year Tax Liability at
$6000
Solution :
Statement of profit or loss and other comprehensive income
for the year ended 31 December 2019
Particulars
Revenue
Cost of Sales [16000+40000-24000]
Gross Profit
Distribution Costs
Administration Expenses
Operating Profit
Reorganisation Costs
$ (‘000)
100000
(32000)
64000
(16000)
(31100)
20900
(4800)
169
Preparing basic financial statements
Profit Before Tax (PBT)
Finance Charges
Profit before Taxation [PBT]
Taxation [6000-1000]
Profit for the Year [PAT]
Other Comprehensive Income
Revaluation Surplus for the Year
Total Comprehensive Income
16100
(1600)
14500
(5000)
9500
12000
22500
Statement of Financial Position at 31 December 2019
Particulars
Assets
Non-Current Assets
Property, Plant and Equipment
[70000+12000]
Current Assets
Inventory
Trade Receivables
Bank
($’000)
($’000)
82,000
24000
20000
15500
Total Assets
58500
140500
Equity and Liabilities
Equity
Share Capital [16000+4000]
10% Redeemable Preference Share Capital
Share Premium [6000+12000]
Revaluation Surplus
Retained Earnings
10000
18000
18000
12000
10500
Total Equity [C]
40500
Non-Current Liabilities
10% Loan Note
16000
Current Liabilities
Trade Payables
Taxes Payable
40000
6000
46000
Total Equity and Liabilities
140500
140500
170
Preparing basic financial statements
Statement of changes in equity for the year ended 31 December 2019
Particulars
Balance at start
of the year
Profit for the
year
Dividend Paid
[1800+3200]
Revaluation
Issue of shares
Closing Balance
at year end
Equity
Share
Capital
($)
Irredeemable
Pref Share
Share
Premium
($)
Revaluation
Surplus
($)
Retained
Earnings
($)
Total
($)
16000
18000
6000
-
6000
46000
9500
9500
(5000)
(5000)
12000
4000
20000
12000
16000
12000
18000
18000
12000
10500
78500
171
IAS 10 and IFRS 15
IAS 10 and IFRS 15
Syllabus Area F4a-b-c
- Define an event after the reporting period in accordance with IFRS Standards. [K]
- Classify events as adjusting or non-adjusting. [S]
- Distinguish between how adjusting and non-adjusting events are reported in the financial
statements.[K]
Events after Reporting Period [IAS 10]
Events after Reporting period as 'those events, favourable and unfavourable, that occur between the
end of the reporting period and the date when the financial statements are authorized for issue.'
(IAS 10, para 3).
Adjusting Events
An event after the reporting period which provides further evidence of conditions that existed at the
time of reporting/reporting period requiring an adjustment in the final accounts.
Only events after the reporting period which provides additional evidence of conditions existing at
the reporting date require an adjustment in the financial statements
Non-Adjusting Events
An event after the reporting period which provides no evidence of conditions that existed at the time
of reporting/reporting period and doesn’t require an adjustment in final accounts and are only
disclosed in the notes to financial statements.
E.g. - Proposed dividend or declared dividend are only disclosed in notes to financial statements
Events requiring adjustment:
1.
2.
3.
4.
5.
6.
7.
8.
9.
Significant fall in property value at year end - only revaluation
Sale of inventory after reporting period end for less than its carrying value at year end
Deterioration or destruction of inventory
Insolvency declared by a customer
An insolvent customer payback- bad debts recovered
Fall in long term investment prior to year end
Discovery of fraud or errors made in the financial statements
Amounts received or paid in respect of legal or insurance claims in negotiations at year end
Determination after year end of sale or purchase of assets sold or purchase before year end
Events not requiring adjustment:
1.
2.
3.
4.
5.
6.
7.
Acquisition or disposal of a subsidiary after year end
Plans to discontinue an operation
Major purchases or disposal of assets
Destruction of production plant by fire after reporting period end
Announcement or commencing implementation of a major restructuring
Litigation commenced after the end of a reporting period
Fall in value of investment between reporting date and date of financial statements
For disclosure of an event, it is necessary to have –
172
IAS 10 and IFRS 15
173
1. Nature of the event
2. An estimate of the financial impact of the event
Apply Your Knowledge:
The following events occurred after the reporting period ended March 15, 2020 and before the year
end March 31, 2020
1. One of the key business customers declared bankruptcy on March 17, 2020
2. Dividends per share of Rs.15 declared on March 19, 2020
3. One of the direct business competitors introduced a new product line
4. Purchase of year-end inventory on March 22, 2020, is at less than the cost
5. Theft at one of the warehouse occurred on March 18, 2020
Which of the following events require an adjustment, and which ones require a note to accounts?
Adjustment
A. 1,4
B. 1,3,4
C. 2,4
D. 3,4
Answer:
Notes to Accounts
2,3,5
2,5
1,3,5
1,2,5
Option A
Event
1
Type
Adjusting Events
Rationale
declaration of bankruptcy by one of the customers provides evidence
of their inability to pay the debt. Thereby this outstanding amount
should be written off as a bad debt / recoverable date to present a
more realistic picture
2
Non-adjusting Events
Corporate actions does not any how impact the going concern of the
business
3
Non-adjusting Events
Competitor’s actions does not impact the going concern of the
business
4
Adjusting Events
Inventory must be valued at lower cost and NRV.
The post year end purchase carries evidence of the NRV thereby, an
adjustment must be made in the closing inventory to account for the
reduction in value
5
Non-adjusting Events
Since it is at one of the warehouses and (no where it is mentioned that
it is one of the crucial or important warehouses), it will be classified as
an non-adjusting event; however, if it were one of the crucial or
important warehouses, this would be classified as an adjusting event
IAS 10 and IFRS 15
Revenue from Contracts [IFRS 15]
Recognition of revenue is often a topic of debate amongst many accountants globally since decades.
As revenue is perhaps one of the most important components in the financial statements and an
overstatement or an understatement will drastically impact the overall final accounts.
Generally, for manufacturing businesses, it is easy to record revenue as all it has to do is multiply their
sales price with the quantity of goods sold.
However, with the advent of service businesses selling a bundle of goods and services, it is difficult to
identify when and how much revenue should be recorded and recognize in the financial statements.
Revenue is defined as 'income arising in the course of an entity's ordinary activities
IFRS 15, Appendix A
Note - all revenues included in the financial statements are exclusive of sales tax or any other forms
of taxes and also exclude any amount of money collected on behalf of other parties.
E.g. - A stockbroker who has received Rs 100000 from his client for the purchase of shares won’t record
100000 as his sales revenue rather only the commission component of the transaction, which will form
the revenue of the stock broker.
5 Step Approach for Revenue Recognition
1.
2.
3.
4.
5.
I
P
T
P
S
Identify the contract
Identify the separate Performance obligations with the contract
Determine the Transaction price
Allocate the transaction Price to the Performance obligations in the contract
Recognize revenue when [or as] a performance obligation is Satisfied
Know the revenue recognition 5 steps properly!
“Revenue is recognised either at a point in time or over a period of time.”
(IFRS 15, para 32).
As per IFRS 15, one of the following criteria must be met when a business entity is to satisfy its
performance obligations and recognize revenues for the same over a period of time:1. The customers receives and consumes the benefits from the business entity simultaneously
2. The performance of the business entity results in the creation or enhancement of an asset
which is controlled by the customer [example: WIP]
3. The performance of the entity doesn't create an asset with an alternative used to the entity,
and the entity has an enforceable right to payment for performance completed to date
The above criterions are more likely to apply to the provision of services over a period of time
174
IAS 10 and IFRS 15
Control of an asset refers to the ability of direct use and substantially all of the remaining benefits
from the asset, which could be either cash inflows or savings in outflows.
Control also includes the ability to prevent other entities from obtaining the benefits from the asset
via use or sale .
The indicators of transfer of control are as follows:1.
2.
3.
4.
Entity has a present right to payment for the asset
The customer has a legal title to the asset
The entity has transferred the physical position of the asset
The customer has significant risk and rewards of ownership of the asset
Disclosure Requirements
The key disclosure requirements pertaining to revenue recognition in accordance with IFRS 15 are as
follows:1. Disclosure of accounting policy used for revenue recognition
2. Disclosure of the total amount of revenue recognized categorised into different categories
3. Disclosure of any significant amendments made while applying the 5 step approach of IFRS 15
175
IAS 10 and IFRS 15
PO7 – PREPARE EXTERNAL FINANCIAL REPORTS
Description
You take part in preparing and reviewing financial statements and all accompanying information and
you do it in accordance with legal and regulatory requirements.
Elements
a. Contribute to drafting or reviewing primary financial statements according to accounting
standards and legislation.
b. Make sure that your organisational policies are fit for the purpose of preparing external
financial statements.
c. Classify information correctly.
d. Review financial statements and correct for errors and account for – or disclose – events
after the reporting date.
e. Prepare or review narrative and quantitative information to include with financial
statements.
176
176
Syllabus Area H:
Interpretation of financial statements
Interpretation of Financial Statements
Interpretation of Financial Statements
Syllabus Area H1a-b
- Describe how the interpretation and analysis of financial statements is used in a business
environment. [K]
- Explain the purpose of interpretation of ratios. [K]
Interpretation of Financial Statements
We previously learnt how to make the books of accounts, financial statements and the various
adjustments related to it as well. Now, listed companies publish these financial statements to the
general public. The users of the financial statement as described in syllabus area A will use these
financial statements for their respective needs.
However, just getting the SOPL or SOFP of a company is of no use. One must know how to read
them, analyse them, look for interrelationships between the different sets of financial statements,
i.e. between SOPL and SOFP, etc. and hence be able to draw conclusions from them. This is the
primary role of any financial or equity research analyst.
Ratio analysis uses data from financial statements and calculates key figures which help draw these
conclusions. A standalone ratio on its own is useless. If I say that company A has a gross profit
margin of 20%, there is no way for one to tell is good or bad without comparing it with the figure
from last year, target ratios, industry average, trends, etc. A ratio is only meaningful if it is
compared with something.
Ratio calculation is the first step of fundamental analysis of any company and is often called
the primary tool of any financial analyst.
From the exam point of view, knowing just the formula of the ratio is not enough. You
should understand its meaning, its impact, what causes a change in the ratio from one year
to another, be able to tell if the ratio is good or bad, compare ratios amongst 2 or more
companies, find out interdependencies among ratios, etc.
Calculation part is easy; the interpretation part is the tricky area where you need to focus.
The interpretation and commentary based on these ratio calculations only become more and
more important as you move ahead in your ACCA papers.
177
Interpretation of Financial Statements
Syllabus Area H2a-b, H3a-b
- Calculate key accounting ratios: [S]
Profitability
Liquidity
Efficiency
Position
Explain the interrelationships between ratios. [K]
- Calculate and interpret the relationship between the elements of the financial statements
with regard to profitability, liquidity, efficient use of resources and financial position. [S]
- Draw valid conclusions from the information contained within the financial statements and
present these to the appropriate user of the financial statements. [S]
Ratios
Before we start, a few key terminology to know are –
1) Working Capital / Net Current Assets = Current Assets – Current Liabilities
2) Net Assets = Total Assets – Total Liabilities
OR
Total Equity
3) Capital Employed = Non-Current Liabilities + Equity
OR
Total Assets – Current Liability
Ratios are divided into 4 primary categories, and we will look at each one by one –
i) Profitability
ii) Liquidity
iii) Efficiency
iv) Position
Profitability Ratios
Profitability ratio focus on how profitable the company has been relative to the resources it has.
They are key ratios to find out if companies are performing well or not as investors are not likely to
invest in companies which are loss making or relatively less profitable.
1) GROSS PROFIT MARGIN
=
GROSS PROFIT (GP) X 100 %
REVENUE
178
Interpretation of Financial Statements
The GP margin shows how profitable the manufacturing and trading activities of the business have
been.
Causes of changes (not an exhaustive list)
1. Increase in selling price = increase in GP margin
2. Decrease in costs = increase in GP, therefore, increase in GP margin
3. Increase in revenue but no increase in GP = lower GP margin
General rule to find out if the ratio increase or decreases is purely a mathematical exercise.
An increase in the numerator of the ratio will increase it providing other things remain
constant and vice versa.
An increase in the denominator will decrease the ratio and vice versa, provided other things
remain constant. (Inverse relationship)
It is important to compare the GP margin with the industry average. A supermarket chain may
operate on very low margins, even of 2-3%, but if compared to the industry average, it is nearby the
figure, it is okay. Some industries like luxury automobile industries may have extremely higher
margins to compensate for the lower volumes of trade.
Therefore, the conclusion is that one must compare apples to apples, i.e. like with like only.
Generally, the higher the ratio, the better.
2) OPERATING PROFIT MARGIN
=
OPERATING PROFIT(PBIT) X 100 %
REVENUE
It is similar to the GP margin ratios except for the fact that the PBIT will be used in the numerator,
and hence the level of expenses will play a huge role in the determination of the ratio.
Additional Causes of changes other than of GP Margin (not an exhaustive list)
1. Increase in depreciation = decrease in PBIT = Decrease in ratio
2. Increase in irrecoverable debts = same effect as above
3. Decrease in fuel costs = increase in PBIT = Increase in ratio
Generally, the higher the ratio the better.
179
Interpretation of Financial Statements
3) Return on Capital Employed (ROCE)
=
PBIT
X 100 %
CAPITAL EMPLOYED
ROCE is the MOST IMPORTANT of all the profitability ratios. It shows how much profit the company
generates from every $1 invested in it, i.e. it shows the return on your investments. It shows how
efficiently the business is using its resources.
For example, consider –
A Ltd.
PBIT [A]
Capital Employed [B]
$10,000
$100,000`
ROCE [A / B]
10%
B Ltd.
$20,000
$500,000
4%
Though in absolute figures, B Ltd. makes double the profit of A Ltd and which may seem very
attractive, in reality it is not as it uses much more money and resources to generate it. Hence, an
investment in A Ltd. would generate 6% more returns than an investment in B Co.
Causes of changes (not an exhaustive list)
1. Any cause which decreases profits = decrease in ROCE
2. Increase in Assets = Increase in Capital employed = decrease in ROCE
3. Increase in loans = Increase in capital employed = decrease in ROCE
Comparing the ROCE with the previous year’s, the target ROCE set by management at the start of
the financial year and with companies in the same industry is a very useful exercise which must be
done to bring out the true meaning of the ratio.
Generally, higher the ratio, the better.
4) NET ASSET TURNOVER =
REVENUE
(in times)
CAPITAL EMPLOYED
This ratio shows how much revenue the company generates from the resources it has, i.e. the
amount of sales generated with every $1 investment.
Any cause which increases revenue and decreases capital employed (decrease in assets, equity or
non-current liabilities) will increase the asset turnover ratio
Generally, higher the ratio, the better.
180
Interpretation of Financial Statements
Be mindful of the significant purchase of PPE and its impact on ROCE and asset turnover. For
example, imagine that a manufacturing company buys a significant amount of property and plant in
a year with the aim to increasing production and, therefore, sales. The short-term effect is that ROCE
and asset turnover will initially fall, but this does not mean the business is performance has
deteriorated. This may indicate future gains and a rise in ROCE later as revenues and PBIT increase
over the years.
Inter-relationship between ROCE, asset turnover and operating profit (PBIT) margin is –
ROCE = PBIT margin X Asset Turnover
PBIT
=
PBIT
X
Revenue
CAPITAL EMPLOYED
Revenue
Capital Employed
A trade-off often exists between margin and asset turnover that means different businesses can
actually achieve the same ROCE:
Low-margin businesses (e.g. food retailers) often have intensive asset usage (i.e. they produce a high
volume of goods to sell but sell them at low prices).
Higher margin businesses (e.g. luxury jewellery items) produce less goods but sell them at a high
price.
Which of the following transactions would result in an increase in capital employed?
A.
B.
C.
D.
Selling inventory at a profit
Writing off a bad debt
Paying a payable in cash
Increasing the bank overdraft to purchase a non-current asset
181
Interpretation of Financial Statements
Liquidity Ratios
These 2 ratios measure how solvent the company is in the short run and will it be able to meet its
short-term liabilities on time or not.
1) Current Ratio =
Current Assets
Current Liabilities
An ideal ratio would be above 1.5:1, i.e. 1.5 times the current assets to cover the current liabilities.
Causes of changes (not an exhaustive list)
1. Increase in trade receivables = increase in current assets = ratio increases
2. Increase in bank overdraft = increase in current liabilities = ratio decreases
3. Increase in inventory = increase in current assets = ratio increases
The nature of the industry plays a key role here as well. Supermarkets tend to have low current
ratios as most of their dealings are done in cash, and they pay their suppliers later. Therefore, the
numerator is relatively lower, and the denominator is relatively larger, leading to low current ratios,
maybe even lower than 1.5:1. But, that does not mean the supermarket is performing poorly, it
just is the nature of its industry.
A shortcoming of the current ratio is that it includes the inventory in current assets, which is not
considered highly liquid as all of it cannot be sold in a very short span of time. To overcome this, the
quick ratio was developed.
2) Quick Ratio / Acid Test Ratio
=
Current Assets – Inventory
Current Liabilities
Generally, a ratio above 0.7:1 is considered good. Therefore, only quick assets like trade receivables
and cash and cash equivalents are included in the numerator
Any change in inventory levels will not cause a change in the quick ratio as it is excluded from the
calculation.
182
Interpretation of Financial Statements
A Ltd. has a current ratio of 1.5:1 and a quick ratio of 0.7:1. If inventory worth $100 is bought on
credit, what will be the effect on both these ratios?
A.
B.
C.
D.
Both ratios will increase
Current ratio will increase, but quick ratio will decrease
Current ratio will decrease, but quick ratio will increase
Both ratios will decrease
Efficiency Ratios
These ratios deal with how efficiently the working capital of the business is being managed, i.e. the
management of trade receivables, payables and inventory.
1) Inventory Turnover Period =
Year- end Inventory
COGS
X 365 / 12
The answer will be in a number of days if multiplied by 365 and in months if multiplied by 12. An
increasing number of days will mean that inventory is being held in the company for longer, which
may indicate difficulty to sell it due to obsolescence and damage. If inventory stays too long, then
the cost of storing and handling inventory also increases, and too much cash will be tied up in
inventory which is not a good sign.
Even average inventory level, i.e. (opening inventory + closing inventory) / 2, can be used sometimes
as the numerator.
Again, the nature of industry plays a key role in the analysis of inventory turnover; thus, industry
comparison would be more meaningful.
Generally, a trend in the days increasing or decreasing is better. Decreasing number of days is
generally better, however, if days are too low that may mean that enough inventory is not being
held by the business to meet increasing sales.
183
Interpretation of Financial Statements
2) Receivables Collection Period =
Trade Receivables
X 365 / 12
Credit Sales
This ratio shows on average how many days it takes for the company to collect money from its
debtors.
Take note that ONLY CREDIT sales are to be used, not total sales which include cash sales as well.
Generally, increasing receivables days are bad as it shows poor credit control policies as well as
increases risk of these receivables becoming irrecoverable.
Cash based business will have very low receivables days as their value of receivables is only virtually
negligible
The resulting number of days should be compared to the credit policy of the business. If the credit
policy is of 30 days and the receivable days are 40, that means the business is taking 10 days longer
to collect its debts from customers, which is a bad sign.
Identifying the trend with previous years will also give great insights in analysis.
3) Payables Collection Period =
Trade Payables
X 365 / 12
Credit Purchases
This ratio shows how many days does the business take to pay its credit suppliers.
Take note that ONLY CREDIT purchases are to be used, not total purchases which includes cash
transactions as well.
Note:- If purchases figure is not available, COGS can be used as an approximation instead in the
denominator
Generally, increasing payable days are good as it is a free source of finance. However, the following
points shall also be noted if the days are too long–
1. The company may develop a poor reputation as a slow payer and may not be able to find
new suppliers
2. Existing suppliers may decide to discontinue supplies if earlier dues are not paid for a long
period of time
3. The company may be losing out on worthwhile cash discounts
184
Interpretation of Financial Statements
For all 3 ratios in days, do SOFP A/c X 365
SOPL A/c
The ratios can be found in turnover times as well. For that, simply do –
365
to find answer in times p.a.
Inventory / receivables / Payable days
A high inventory turnover in times means inventory is being sold quickly. 10 times would
mean that management needs to order inventory 10 times in a year.
4) Cash Conversion Cycle (CCC) = Inventory days + Receivable days – payable days
The above 3 ratios in days are used to calculate the CCC. The CCC shows how many days cash is tied
up in working capital. Lower the days, the better, as fewer amounts of cash will be tied up as
working capital which can be used elsewhere.
Choose 2 of the following reasons which indicate that the inventory turnover period has increased
from last year?
1 Obsolete Goods
2 Seasonal fluctuations
3 Slowdown in trading
4 Reduce selling prices
A.
B.
C.
D.
2&3
3 and 4
1 and 3
1 and 2
185
Interpretation of Financial Statements
Financial Position Ratios
Financial position ratios assess the capital structure of the business, i.e. the level of debt it uses to
finance its long-term activities as compared with equity. This is known as how geared the company
is.
1) GEARING RATIO =
___DEBT__
EQUITY
OR
___
DEBT_
DEBT+EQUITY (Capital Employed)
X 100
The first answer is given in a ratio form, and the second is in a percentage form. An increase in levels
of debt financing will increase the ratio as well as the percentage
Gearing ratios indicates the degree of risk attached to the company as a highly geared company
(more debt) is more risky to invest as compulsory fixed repayments to debt are required.
Consider the following points 1) Increase in gearing indicates borrowings increasing faster than equity or equity falling more
quickly than borrowings.
2) Redeemable Preference share capital to be included in debt & not equity as it carries the
right to a fixed rate of dividend payable before ordinary shareholders and needs to be repaid
and thus is treated as a liability.
3) Irredeemable preference shares are included in equity along with share capital, share
premium and other reserves (retained earnings + revaluation surplus).
High Gearing
Large proportion of funds are raised through
debt; therefore raising more money from
debt might be difficult
Low Gearing
Provide scope to increased borrowings when
potentially profitable projects are available,
i.e. can borrow more easily when required.
Greater risk of insolvency as failure to pay
debt may lead to it
Risk of insolvency is relatively lower
Cost of raising finance are low as raising debt
finance is cheaper than raising equity finance
Cost of raising the finance may be relatively
higher
Equity returns required also rise as
shareholders needs more return than
debtholders for the added risk they take
-
Generally, ideal gearing ratios are considered to be NOT TOO HIGH, NOR TOO LOW.
186
Interpretation of Financial Statements
2) Interest coverage ratio =
PBIT
Interest Payable
Interest coverage ratio shows the ability of the business to pay out its fixed interest payment using
the profits it generates.
An increase in the use of debt might reduce the ratio as interest expense (denominator) rises.
A low interest coverage ratio might be risky for shareholders as they may not get dividends then as
very less or no amount is left for them.
If profits start falling, then it might become difficult to pay out its fixed interest payment each year
and may need to raise additional finances.
Generally, a ratio greater than 2:1 is considered good
Which of the following 4 options can reduce the gearing of the company?
A.
B.
C.
D.
Making a rights issue of equity shares
Issuing further long-term loan notes
Making a bonus issue of shares
Paying dividends on its equity shares
LIMITATIONS OF RATIO ANALYSIS
1)
2)
3)
4)
Manipulated books which give wrong ratios(creative Accounting; window dressing, etc.)
Different accounting policies & managerial policies
Seasonal trading thus not evenly accrued.
Impact of price change over time caused by inflation leads to trend analysis being
inaccurate over long term
5) Inter firm comparisons could be misleading.
Answers to Quiz Questions
1) A
187
Interpretation of Financial Statements
The profit earned will be added to retained earnings which will increase the amount of equity and
thus increase capital employed
2) D
This kind of questions can be tricky!
First, identify the two effects, i.e. inventory will increase, and trade payables will also increase by
$100
Since current ratio is 1.5:1, take hypothetical numbers like CA = $150 and CL = 100 (Ratio should be
same) to aid your calculation. After the transaction, CA = 150 + 100 = 250 & CL = 100 + 100 = $200.
Recalculate the ratio as 250 / 200 = 1.25:1. Therefore the current ratio will decrease
In the case of a quick ratio, there will be no impact on CA. therefore, an increase in the denominator
(CL) will cause the ratio to decrease
3) C
An increase in inventory turnover period means the average days the inventory is being held in
inventory is increasing, which is a bad sign. If sales volumes are decreasing, it will lead to an
increasing build-up of inventories which will increase turnover days. If inventories are becoming
obsolete, it will be difficult to sell them and hence the increase in inventory days makes sense.
4) A
Making a rights issue will increase the value of equity and thus decrease the value of gearing. Bonus
issue will have no effect on gearings. Issuing loan notes will increase debt, and paying dividends will
reduce reserves, both of which will increase gearing
188
Interpretation of Financial Statements
PO8 – ANALYSE AND INTERPRET FINANCIAL REPORTS
Description
You analyse financial statements to evaluate and assess the financial performance and position of an
entity.
Elements
a. Assess the financial performance and position of an entity based on financial statements and
disclosure notes.
b. Evaluate the effect of chosen accounting policies on the reported performance and position
of an entity.
c. Identify inconsistencies between the information in the financial statements of an entity and
any accompanying narrative reports.
d. Evaluate the effects of fair value measurements and any underlying estimates on the
reported performance and position of an entity.
e. Conclude on the performance and position of an entity identifying relevant factors and make
recommendations to management.
189
189
Syllabus Area G:
Preparing simple consolidated financial statements
Consolidated statements of Financial Position
Consolidated statements of Financial Position
Syllabus Area G1a-b
- Define and describe the following terms in the context of group accounting:
- Parent
- Subsidiary
- Control
- Consolidated or group financial statements
- Non-Controlling Interest
- Trade/Simple Investment
- Identify subsidiaries within a group structure.
Consolidated Financial Statements
Till now, we learnt about the financial statements of a single company. In the further parts of the
syllabus, we will learn about the financial statements of group companies. A group company exists
when a parent (holding/investor company) controls the actions of a subsidiary (an investee
company).
This topic forms a critical part of the F3 exam as it is virtually certain to come in section B for
15 marks! Not only that, it forms a crucial part of further ACCA papers like F7 (Financial
Reporting) and SBR (Strategic Business Reporting) where it comes for roughly 30% of the
paper sometimes!
Hence, make sure you get all the concepts clear very thoroughly and put in time to practice
the questions at the F3 level itself to ace the ACCA exams!
For example, in 2008, the Tata group made an historic acquisition of Jaguar and Land Rover from
Ford Motor companies. With this acquisition, Jaguar and Land Rover became part of the various
companies under the umbrella of Tata Group, and its assets, liabilities, profits, etc., should be
included as a part of the financial statements of Tata Group. This is important because as an
investor, if I were to buy shares of Tata group (i.e. Tata sons), I am concerned with the performance
and financial statements of the WHOLE TATA GROUP and all of its subsidiaries as well.
In a similar way, at the F3 level, we will primarily look at acquisitions that have taken place just
recently and also acquisitions that have taken place a few years ago and how to do the accounting
for the same by making group SOFP and a group SOPL.
IFRS 10 Consolidated Financial Statements uses the following definitions • 'Parent – an entity that controls one or more entities'
• 'Subsidiary – an entity that is controlled by another entity' (known as the parent)
190
Consolidated statements of Financial Position
•
'Control of an investee – an investor controls an investee when the investor is exposed, or
has rights, to variable returns from its involvement with the investee and has the ability to
affect those returns through its power over the investee.'
‘Control is identified by IFRS 10 as the sole basis for consolidation and comprises the following three
elements:
1. Power over the investee (Usually, owning 50% more shares carrying voting rights would
constitute having power)
2. Exposure, or rights, to variable returns from its involvement with the investee (For example,
receive dividends from the subsidiary)
3. The ability to use its power over the investee to affect the amount of the investor's returns
(IFRS 10, para 7).’
Further signs of control apart from more than 50% ownership to look out for in questions are as
follows –
1. Govern the financial and operating policies of the subsidiary
2. Appoint or remove MAJORITY of the Board of Directors
Non-Controlling Interests (NCI), in simple words, is the shareholding not owned by the Parent. So, if
the parent owns 70% of the Company, then 30% is considered as the NCI. They are the minority
shareholders of the company.
A Trade/Simple investment is simply an investment in the equity shares of another company.
Usually, the ownership is of less than 20%. Trade Investments are NOT CONSOLIDATED, they are
simply shown as investments under Non-current assets, and any dividends from them are included
in the group SOPL.
ABC Co. owns 49% shares of XYZ Co. ABC Co. determines how much dividend XYZ Co. gives out in a
financial year and also has major representation on the board of XYZ Co. and decides the tenure of
most board members as well. What is the relationship which exists between the two companies?
A.
B.
C.
D.
ABC has a Non-Controlling Interest in XYZ Co.
Parent – Associate
Parent – Subsidiary
Trade Investment
Answer: C
Although not more than 50% shares are held in XYZ Co., the ability to decide dividends and the
board members in XYZ Co. gives ABC control over XYZ, which is the key point in the determination of
a parent and subsidiary relationship.
191
Consolidated statements of Financial Position
Syllabus Area G1c-d
- Describe the components of and prepare a consolidated statement of financial position or
extracts thereof, including: [S]
- Fair value adjustments at acquisition on land and buildings (excluding depreciation
adjustments)
- Fair value of consideration transferred from cash and shares (excluding deferred and
contingent consideration)
- Elimination of intra-group trading balances (excluding cash and goods in transit)
- Removal of unrealised profit arising on intra-group trading
- Acquisition of subsidiaries part way through the financial year
- Calculate goodwill (excluding impairment of goodwill) using the full goodwill method only as
follows: [S]
Basic principles of Consolidation
1. Consolidation means adding together (Add all FS items on a line by line basis)
2. Consolidation means cancelling of like items internal to the group (E.g. Internal Trade
receivables of the parent are cancelled with the internal trade payables of the subsidiary)
3. Consolidate as if you own everything, then show the extent to which you do not own
everything (Add everything as if you own 100% of the subsidiary, but if you own only 80%,
then show that the remaining 20% value of the firm belongs to the NCI)
4. Adjust Retained Earnings and make it Group Retained Earnings
5. Calculate Goodwill and NCI and show it in the group SOFP
It is crucial to think from the perspective of the group as a whole to apply these principles stated
above and not from the individual view of the Parent or Subsidiary.
The Investment in subsidiary item in the SOFP of the Parent will be cancelled with the share
capital of the subsidiary
In the group Consolidated SOFP, ONLY the share capital and share premium of the Parent
Company will be shown. It will NOT be added with the share capital and share premium of
the subsidiary.
This is the application of the 2nd principle of consolidation
192
Consolidated statements of Financial Position
Which of the following combinations of amounts will be shown on the Group SOFP from the
following extractsP Co. SOFP
S CO. SOFP
Investment in S Co. - $30,000
Cash and Bank - $3,000
Cash and Bank - $5,000
Share Capital - $50,000
Share Capital - $100,000
Share Premium - $5,000
A.
B.
C.
D.
Investment in S Co. – $30,000, Share capital - $150,000, Share Premium - $5,000
Cash and Bank - $8,000, Share Capital - $100,000
Cash and Bank - $8,000, Share Capital - $150,000
Cash and Bank - $5,000, Share Capital - $100,000, Investment in S Co. - $30,000
Answer – B
Remember that only the share capital of the parent will be shown in the group SOFP and that
investment in S Co. won’t be shown in the group SOFP.
The following working notes will be usually made in most consolidation sums 1. Group Structure
2. Net Assets of Subsidiary
3. Goodwill
4. NCI
5. Group Retained Earnings
We will look at the proforma’s of each of the following working notes as follows –
The parent company is referred to as P Co. and the Subsidiary company as S Co.
1) Group Structure
P Co.
Date of Acquisition
S Co.
80% ownership
193
Consolidated statements of Financial Position
2) Net Assets of Subsidiary (S Co.)
Share Capital
Share Premium
Revaluation Surplus
Retained Earnings
Fair Value Adjustment
At Acquisition Date ($)
X
X
X
X
X
XX
At the Reporting Date ($)
X
X
X
X
X
XX
It is important to note that share capital and share premium amounts shall remain unchanged from
the date of acquisition of subsidiary till the reporting date (date when we are making the
consolidated financial statements.)
We know that Net Assets = Total Assets – Total Liabilities. Hence, the net assets or the value of the
business can be ascertained by simply showing the equity section as done above due to the
accounting equation.
Another important point to note is the adjustment regarding the fair value. It is crucial to know that
on the SOFP, the assets are recorded at the price they are bought originally, which can be years ago.
For appreciating assets like land, this is not the correct value of it which is recorded in the SOFP.
Hence, to record the assets at their correct fair value (usually the current market value) is important,
so the right price is paid to acquire the subsidiary company, and goodwill amount is calculated to
correct and not overstated. (See below). Therefore, the difference between the carrying amount and
fair value of the asset is added to net assets in this working
3) Goodwill
Goodwill calculation is the most important part of your working, and this should be expected to be
tested in MCQs as well as section B questions. Goodwill is the excess value of the business above its
net assets. It represents how much extra, i.e. the premium someone is willing to pay to acquire the
business. In layman’s terms, it is the value of the reputation of the business and the premium the
investor is willing to pay to acquire the business.
Goodwill earned in an acquisition is called acquired goodwill which is allowed to present in the
group SOFP, whereas internally generated goodwill (goodwill as per management) is not allowed.
The reason for this is that goodwill should not be recognised unless someone is willing to pay for it.
It is calculated as follows –
194
Consolidated statements of Financial Position
Fair Value (FV) of Consideration Paid (Cash given or MARKET VALUE of shares
transferred
Add: FV of Non-Controlling Interest (NCI) AT ACQUISITION (usually given in the
question)
Less: FV of Net assets AT ACQUISITION (i.e. the first column of working 2)
Goodwill on acquisition
$
X
X
XX
(X)
XX
Goodwill is only calculated AT THE DATE OF ACQUISITION and at no other date after that.
Hence, it is crucial to note that all values used in its calculation shall be of the acquisition
date.
Marvel paid $100m to acquire 60% of DC on 1 st January, 2021. At that date, the share capital of DC
was $50m, retained earnings were $15m, and the fair value of the land it owned was $5m higher
than its book value.
Fair value of NCI on the date of acquisition was $20m.
What is the amount of goodwill to be shown in the group SOFP?
A.
B.
C.
D.
$65m
$30m
$55m
$50m
Answer – D
100+20- (50+15+5)
195
Consolidated statements of Financial Position
4) Non-Controlling Interest (NCI)
As mentioned earlier, NCI represents the part not owned by the Parent of the group. NCI will only
exist if the parent does not own 100% of the subsidiary. It is really simple to calculate as the NCI at
the acquisition date is usually given at F3 level. The share of NCI’s reserves (profits plus any gains on
revaluation) is just added to its value at acquisition.
NCI is shown in the equity section of the Group SOFP.
FV of NCI at acquisition (same amount as in W3)
Add: NCI’s share of post-acquisition reserves [(2nd column of W2 – 1st
Column) X % share]
NCI Value at reporting date to be shown in group SOFP
$
X
X
XX
5) Group Retained Earnings
First thing to be done over here is to distinguish between pre-acquisition retained earnings and postacquisition retained earnings. It is important to know that the Parents company that the new owners
don’t have any rights on the profits earned by the business before the acquisition that is preacquisition retained earnings which is the amount of retained earnings as shown on the date of
acquisition in the SOFP of the subsidiary.
If the subsidiary is not wholly-owned (100% ownership), then the appropriate share of postacquisition reserves should be given to NCI as done in working 4, and only the parent’s share should
be added to the group retained earnings. These same principles of accounting for retained apply to
any increases or decreases in the revaluation surplus.
P Co’s Retained Earnings (100% amount as per individual SOFP)
Add: P Co. share of post-acquisition reserves (2nd column of W2 – 1st Column)
X % share]
Group Retained Earnings at reporting date to be shown in group SOFP
$
X
X
XX
We will see how to calculate group retained earnings with more adjustments later in this topic.
196
Consolidated statements of Financial Position
Apply Your Knowledge: 1
The following statements of financial position have been prepared at 31 st December 20X9.
Non-current assets:
Property, plant & equipment
Investment: Shares in S Co.
Current assets
Total
Equity:
Ordinary $1 shares
Share premium
Retained earnings
Current liabilities
P Co.
$
S Co.
$
85,000
60,000
160,000
305,000
18,000
65,000
35,000
70,000
170,000
20,000
10,000
25,000
55,000
135,000
305,000
47,000
102,000
84,000
102,000
P Co. acquired 15,000 ordinary $1 shares in Jerry on 1 January 20X9, when P Co’s retained earnings
stood at $20,000, and its share premium was $10,000. On this date, the fair value of the 25% noncontrolling shareholding in S Co. was $12,500, and the fair value of PPE was $5,000 higher than its
book value. The P Group uses the fair value method to value the non-controlling interest.
Prepare the consolidated statement of financial position of P Co. as at 31 December 20X9
Solution:
Consolidated Statement of Financial Position for P Group at 31 December 20X9
$
Non-current assets:
Goodwill (W3)
Property, plant & equipment (85 + 18 + 5 (FV adj)
Current assets (160 + 84)
Total
Equity:
Ordinary $1 shares
Share premium
NCI (W4)
Retained earnings (W5)
Current liabilities (135 + 47)
17,500
108,000
244,000
369,500
65,000
35,000
13,750
73,750
187,500
182,000
369,500
197
Consolidated statements of Financial Position
Working Notes:
1) Group Structure
15,000 / 20,000 X 100 = 75% ownership
P Co.
1st Jan 20X9
75% ownership
S Co.
2) Net Assets of Subsidiary (S Co.)
Share Capital
Share Premium
Retained Earnings
Fair Value Adjustment
At Acquisition Date ($)
20,000
10,000
20,000
5,000
55,000
At the Reporting Date ($)
20,000
10,000
25,000
5,000
60,000
3) Goodwill
Fair Value (FV) of Consideration Paid
Add: FV of Non-Controlling Interest (NCI) AT ACQUISITION
Less: FV of Net assets AT ACQUISITION (i.e. the first column of working 2)
Goodwill on acquisition
$
60,000
12,500
72,500
(55,000)
17,500
4) NCI
FV of NCI at acquisition
Add: NCI’s share of post-acquisition reserves [(60,000 – 55,000)X 25%]
$
12,500
1,250
NCI Value at reporting date to be shown in group SOFP
13,750
198
Consolidated statements of Financial Position
5) Group Retained Earnings
P Co’s Retained Earnings (100% amount as per individual SOFP)
Add: P Co. share of post-acquisition reserves [(60,000 – 55,000)X 75%]
$
70,000
3,750
Group Retained Earnings at reporting date to be shown in group SOFP
73,750
Intra-group trading and Unrealised profits
Intra group trading means when the parents and subsidiary buy and sell goods from each other as
well. In this scenario, from the perspective, the following adjustments need to be made –
1. Remove/Subtract the intra-group trade receivable / payables balances owed to each other as
from the point of view of the group, there is nothing owed to each other as the group is one
entity.
2. If one entity sells goods by adding a profit margin and these goods are not yet sold to anyone
outside the group, this profit is unrealised, and a Provision for Unrealised Profit (PURP) will be
created.
3. Inventory will be decreased by the amount of PURP as the inventory should carried at the cost
to the group.
The PURP will be calculated using the margin and mark-up rules as stated in the question. The key
point to note here is who the seller of the goods is as that company has gained a profit on the sale.
If the seller is the parent, the full PURP will be deducted from the group Retained earnings itself.
However, if the seller is the subsidiary, then the share of the profit is to be borne by the NCI
proportionately. The journal entry for the same is as follows Dr Group retained earnings (group %) – W5
Dr Non-controlling interests (NCI %) – W4
Cr Group inventory (100%)
Alternatively, an easier way to calculate the retained earnings in Consolidation questions is as
follows –
199
Consolidated statements of Financial Position
Group Retained Earnings working As per question / Individual SOFP
Less: Pre-acquisition Retained Earnings (R.E)
Less: PURP (If S Co. is seller)
Less: PURP (If P Co. is seller)
Group Share of S Co.’s Post-acquisition R.E.
(% multiplied by XXX)
Group R.E. to be shown in group SOFP
NCI’s Share of S Co.’s Post-acquisition R.E.
(% multiplied by XXX)
P Co.
XX
S Co.
XX
(X)
(X)
XXX
(X)
XX
XXXX
XX
Apply Your Knowledge: 2
Refer back to Apply Your Knowledge 1.
Consider the following additional information –
P Co. owed S Co. $2,000 at the year end. Also, during the year, S Co. sold goods worth $5,000 at a
margin of 20% to P Co., and 50% of these goods were still lying in the inventory of P Co. at the year
end.
Show the effects of these transactions and calculate the revised group retained earnings, NCI
balance, current assets and current liabilities.
Solution:
First, we need to calculate the PURP
A margin of 20% means we need to take sales as 100%
Cost + Profit = Sales
80 + 20 = 100
? + x = 5,000
By cross multiplying, we get x=$1,000 profit (5000 X 20/100)
As only 50% of these goods are not yet sold outside the group,
PURP = $1,000 X 50% = $500
Current Assets = 160,000 + 84,000 – 2,000 (Intra-group receivable) - $500 (Removing PURP from
Group Inventory) = $241,500
Current Liabilities = 135,000 + 47,000 – 2,000 (Intra-group receivable) = $180,000
200
Consolidated statements of Financial Position
Working 5 will be revised and made in this format –
As per question / Individual SOFP
Less: Pre-acquisition Retained Earnings (R.E on 1 Jan 20X9)
Less: PURP (As S Co. is seller)
P Co.
70,000
Group Share of S Co.’s Post-acquisition R.E.
(75% X 4,000)
Group R.E. to be shown in group SOFP
3,000
73,000
NCI’s Share of S Co.’s Post-acquisition R.E.(25% X 4,000)
1,000
S Co.
25,000
(20,000)
(1,000)
4,000
Working 4 will be revised as follows -
FV of NCI at acquisition
Add: NCI’s share of post-acquisition reserves (W5 above)
$
12,500
1,000
NCI Value at reporting date to be shown in group SOFP
13,500
If P Co. was the seller in Apply Your Knowledge 2, the PURP of $1,000 would be deducted
from P Co.’s column (1st column and not S Co.’s column)
By doing this, all of the unrealized profit is allocated to P Co. and NONE to the NCI
Mid-Year acquisitions
If an acquisition is made in between a financial year, it is important to find out the reserves
(Retained earnings and revaluation surplus) as it is required for W2 and W3, respectively. Hence, it is
assumed that the profits accrue evenly over the year, and the starting retained earnings balance is
added to the number of months for which profits have been earned in the current financial year to
get the pre-acquisition retained earnings.
201
Consolidated statements of Financial Position
Apply Your Knowledge: 3
Refer back to Apply Your Knowledge 1 only.
If P Co. acquired S Co. mid-year on 30th June 20X9 and S Co.’s profit for the year is $5,000, which
accrues evenly throughout the year, what would be the changes in the group SOFP?
Solution:
Only the working notes would require changes, otherwise, everything else will be done exactly in the
same way.
Working Notes:
1) Group Structure
15,000 / 20,000 X 100 = 75% ownership
P Co.
1st June 20X9
75% ownership
S Co.
2) Net Assets of Subsidiary (S Co.)
Share Capital
Share Premium
Retained Earnings
Fair Value Adjustment
At Acquisition Date ($)
20,000
10,000
22,500*
5,000
57,500
At the Reporting Date ($)
20,000
10,000
25,000
5,000
60,000
* As the acquisition is made 6 months into the year, 6 months of profits will be included in preacquisition retained earnings.
Therefore, 5,000 X 6 / 12 = 2,500
3) Goodwill
Fair Value (FV) of Consideration Paid
Add: FV of Non-Controlling Interest (NCI) AT ACQUISITION
Less: FV of Net assets AT ACQUISITION (i.e. the first column of working 2)
Goodwill on acquisition
$
60,000
12,500
72,500
(57,500)
15,000
202
Consolidated statements of Financial Position
4) NCI
FV of NCI at acquisition
Add: NCI’s share of post-acquisition reserves [(60,000 – 57,500)X 25%]
$
12,500
625
NCI Value at reporting date to be shown in group SOFP
13,125
5) Group Retained Earnings
P Co’s Retained Earnings (100% amount as per individual SOFP)
Add: P Co. share of post-acquisition reserves [(60,000 – 57,500) X 75%]
$
70,000
1,875
Group Retained Earnings at reporting date to be shown in group SOFP
71,875
203
Consolidated Statement of Profit and Loss and Accounting for Associates
Consolidated Statement of Profit and Loss and Accounting for Associates
Syllabus Area G1e
- Describe the components of and prepare a consolidated statement of profit or loss or extracts
thereof including: [S]
- Elimination of intra-group trading balances (excluding cash and goods in transit)
- Removal of unrealised profit arising on intra-group trading
- Acquisition of subsidiaries part way through the financial year
Consolidated SOPL
The consolidated SOPL follows the same basic principles of consolidation like the consolidated SOFP
and is, in fact, relatively easier to make due to no calculation of goodwill.
Additional points to be taken care of while making a consolidated SOPL are –
1. Revenues and expenses are added in the same manner like assets and liabilities were
2. Instead of eliminating the trade receivables and payables balances, the FULL amount of sales
and purchases are deducted in the group SOPL
3. The PURP is calculated in the same way and ADDED to COGS
4. Dividends (Investment Income from S Co.) are NOT to be consolidated and are to be
excluded completely
The reason for adding the PURP in COGS is to decrease the profit as it is not realised for the group.
Therefore, the consolidated COGS can be calculated by –
P Co’s COGS + S Co.’s COGS – Intra group purchases + PURP
Make sure you learn and understand this formula very well!
Like previously, even here the key is who the seller of the goods is, the parent or the subsidiary.
An additional step is required S Co. is the seller, which is shown by the following flowchart –
204
Consolidated Statement of Profit and Loss and Accounting for Associates
NCI also needs to bear the share of unrealised profits as it owns a stake in the Subsidiary, but it does
not need to bear any share if all of the profits belong to only the parent to whom it is unrelated.
Hence, NCI’s profit share = (NCI % X SUBSIDIARY’s PAT) – (NCI % X PURP)
Let’s take a hypothetical example the group PAT is $100m and the NCI % is 20%, and the PURP is
$5m. S Co.’s profit (will be given in the question) is $30m
Therefore, the following additional extract needs to be prepared after the group profit after tax is
found below the group SOPL to divide the profit appropriately among NCI and the group –
Group Profit after Tax
Attributable to:
Group (Bal fig.)
Non-Controlling Interest [ (20% X 30m) – (20% X 5)
$m
100
95
5
100
The group retained earnings is the amount which is added in the group SOFP and is ALWAYS
calculated as the balancing figure.
The reason for that is the attribution part is merely dividing the group profit respectively to
whom it belongs. Take note of the fact that the total of group + NCI profit add up to 100 only
above and will be the case ALWAYS
Since it is much easier to calculate NCI’s profit share, the group can simply be found as a
balancing figure.
205
Consolidated Statement of Profit and Loss and Accounting for Associates
Apply Your Knowledge: 4
The statements of profit or loss for P Co. & S Co. for the year ended 31st December 20X9 are given
below. P acquired 75% of the ordinary share capital of S many years ago.
Revenue
Cost of Goods Sold
Gross Profit
Investment Income from S
Distribution Costs
Administration Costs
Profit before tax
Income tax expense
Profit for the year
P
$000
2,400
(2,160)
––––––
240
10
(20)
(40)
––––––
190
(40)
––––––
150
––––––
S
$000
800
(720)
––––––
80
(5)
(10)
––––––
65
(25)
––––––
40
––––––
During the year, S Co. sold goods worth $50,000 at a mark-up of 25% to P Co., and half of these
goods were still lying in the inventory of P Co. at the year end.
Prepare the consolidated statement of profit or loss of P Group for the year ended 31 December
20X9
Solution:
Consolidated Statement of Profit and Loss for P Group at 31 December 20X9
Revenue (2,400 + 800 – 50)
Cost of Goods Sold
[2,160 + 720 – 50 + 5 (W2) ]
Gross Profit
Distribution Costs (20 + 5)
Administration Costs (40 + 10)
Profit before tax
Income tax expense (40 + 25)
Group profit for the year
Profit attributable to:
P Co., i.e. the group (Bal. fig.)
Non-Controlling Interest
$000
3,150
(2,835)
––––––
315
(25)
(50)
––––––
240
(65)
––––––
175
––––––
166.25
206
Consolidated Statement of Profit and Loss and Accounting for Associates
[ (25% X 40,000*) – (25% X 5,000)]
8.75
––––––
175
––––––
*40,000 is the profit after tax of S Co. from the question
Working Notes:
1) Group Structure
P Co.
75% ownership
S Co.
2) PURP Calculation
A mark-up of 25% means we need to take Cost as 100%
Cost + Profit = Sales
100 + 25 = 125
? + x = 50,000
By cross multiplying, we get x=$10,000 profit (50,000 X 25/125)
As only 50% of these goods are not yet sold outside the group,
PURP = $10,000 X 50% = $5,000
This needs to be added in the group COGS
Tutorial Note
If P Co. was the seller, the deduction of (25% X 5,000) would not be required in NCI as whole of
PURP is to be borne by the parent
207
Consolidated Statement of Profit and Loss and Accounting for Associates
Mid-Year acquisitions
Again, if the subsidiary is acquired mid-way of the financial year, time apportionment of the
amounts will be needed. However, in an SOPL, all the amounts belong to the incomes and expenses
which accrue throughout the year. Hence, ALL SOPL ITEMS MUST BE TIME APPORTIONED
The easiest way to do this is to time apportion all amounts of the standalone S Co. SOPL and then
add the first and third columns as in a normal consolidation question.
Time apportioning means calculating profits belonging to the group i.e. the number of
months AFTER THE DATE OF ACQUISITION!
Only the Subsidiaries amounts are to be time apportioned, not the Parents!
Apply Your Knowledge:
Refer back to Apply Your Knowledge 4.
If S Co. was acquired on 31st March, 2020 (i.e. 3 months into the financial year), just add an
additional 3rd column in the following way –
Revenue
Cost of Goods Sold
Gross Profit
Investment Income from S
Distribution Costs
Administration Costs
Profit before tax
Income tax expense
Profit for the year
P
$000
2,400
(2,160)
––––––
240
10
(20)
(40)
––––––
190
(40)
––––––
150
S
$000
800
(720)
––––––
80
(5)
(10)
––––––
65
(25)
––––––
40
S (9/12 X S column)
9/12 X 800= 600
(540)
––––––––––––
60
(3.75)
(7.5)
––––––––––––
48.75
(18.75)
––––––––––––
30
After this point, repeat the same steps as done in Apply Your Knowledge 4 with values of the 3rd
column rather than the 2nd column for S Co. to prepare the consolidated SOPL.
208
Consolidated Statement of Profit and Loss and Accounting for Associates
Syllabus Area G2
- Define and identify an associate and significant influence and identify the situations where
significant influence exists. [K]
- Describe the key features of a parent-associate relationship and be able to identify an
associate within a group structure. [K]
- Describe the principle of the equity method of accounting for Associate entities [K]
Associates
An Associate is defined as ‘an entity over which the investor has significant influence’
Significant influence is 'the power to participate in the financial and operating policy decisions of the
investee but is not control or joint control over those policies
Other signs of influence to look out for in questions are as follows –
1. Representation on the Board of Directors (no control to change like in Parent-subsidiary
relationship)
2. Participation in the policy making process
Usually, if a company owns the following % shareholding then it assumed to have –
>50% - Control (Parent - Subsidiary)
20% – 50% - Significant Influence (Parent – Associate)
<20% - No control nor significant influence (Trade Investment)
Make sure to learn this!
A Co. has investments in many other companies. It owns 70% of the shares in B Co., 25% of shares in
C Co. and 40% in D Co. Additionally, it also governs all the major financing and operating decision of
B Co. as well as D Co. Which of the following relationship between A Co. and the other companies
are true?
A.
B.
C.
D.
Solution: A
B Co.
Subsidiary
Subsidiary
Subsidiary
Associate
C Co.
Associate
Subsidiary
Trade Investment
Trade Investment
D Co.
Subsidiary
Associate
Subsidiary
Associate
209
Consolidated Statement of Profit and Loss and Accounting for Associates
Equity Accounting is the method by which associates are accounted for in group financial
statements. This is a fairly straightforward method, unlike the accounting for subsidiaries.
NO LINE-BY-LINE ADDITION is required how it was in accounting for subsidiaries neither in the group
SOFP nor group SOPL.
1. In the group SOPL –
A single line item is just added showing the group’s profit share after tax ( Associate’s PAT for the
year X group %) less any impairment losses of the associate in the year less PURP (only parent’s
share)
Dividends received from associates are not to be shown in the SOPL
2. In the group SOFP –
An additional line item of ‘investment in associate’ is included in the Non-current assets section with
the following format –
Cost of investment
Add: Share of Post-acquisition profits
Less: Impairment losses
Less: Group share of PURP (If P Co. is seller)
Less: Dividends received from associate
Investment in Associate
$
XX
X
(X)
(X)
(X)
XXX
An important point to note here is that impacts of any trading between Parent & Associate should
not be nullified, as the associate is considered outside the group.
However, if PURP exists, the group’s share should be deducted in the SOPL and SOFP, as shown
above.
At the F3 level, no calculations will be required for equity accounting but just a clear understanding
of the method and its principles to tackle the MCQ questions.
210
210
Statement of Cash flows
Syllabus Area F
Syllabus Area F5a-b-c
- Differentiate between profit and cash flow. [K]
- Understand the need for management to control cash flow. [K]
- Recognise the benefits and drawbacks to users of the financial statements of a statement of
cash flows. [K]
Statement of Cash Flows (SCF)
Cash Flow statement shows the net cash received or net cash paid by the business in the year. First,
we need to understand what is exactly meant by cash flow. Cash flow is often called the ‘lifeblood of
a business’. The reason for this is that a loss making company can survive with positive cash flows
(i.e. more cash coming into the business than going out), but a profitable company with negative
cash flows won’t survive in the short as well as long run. The simple reason being you need cash to
pay your creditors, to run daily operations, etc., without which your business cannot run at all. Thus,
cash flow provides a good measure of a company’s liquidity and solvency.
The concept of cash flow is very important in the real world. Some even say that analyzing
the cash flow statement is more meaningful than analyzing the profit from SOPL as it shows
the true position of the business. Cash flows are used in valuations of companies, in present
value calculations, etc. which form the core topics of papers like Financial Management (F9)
and Advanced Financial Management (AFM).
As far as F3 is concerned, don’t be surprised if this is tested for 15 marks in Section B!
Make sure you are thorough with the conceptual logic presented in this chapter.
PROFIT IS NOT THE SAME AS CASH FLOW. This is the first thing that you need to make sure you
know in an absolute sense, as this is where people go wrong. Key differences are highlighted below –
Statement of Cash flows
Profit
Follows accrual concept, i.e. if the
revenue or expense belongs to this year
but cash may or may not be received for
the same, it will still be included
Cash Flow
Follows cash basis, i.e. inclusion are made only
if cash has come in or gone out of the business
2)
Non- cash expenses like depreciation are
included in the calculation of profit
Non-cash items are excluded
3)
Timings of when money is received or
paid is ignored
The timings of receipt/payment of money is the
ONLY thing that matters
4)
Can be manipulated by using different
accounting policies
Cannot be manipulated by different accounting
policies
1)
Advantages and disadvantages of SCF for the users are –
Advantages
Positive cash flows means that the
business is self-sufficient and can most
probably survive in the long run.
Disadvantages
Use historical cash flows, i.e. last year’s cash
flows. Users are more interested in the future
cash flows of the business.
2)
Shows primary activities by which cash is
being generated by the business, i.e. from
operating, investing or financing (see
later)
It is up to the users how to interpret the cash
flows as no interpretation is provided in the
financial statements
3)
Cash flows are objective rather than
subjective, like profit measures which are
easy to manipulate
Important non-cash transactions like bonus
issues or revaluation of assets are not shown in
SCF
1)
In a nutshell, Cash flow is needed for survival. Therefore, it should be a priority task of the
management to generate positive cash flows.
211
Statement of Cash flows
Syllabus Area F5d-e-f-g-h
- Classify the effect of transactions on cash flows. [S]
- Calculate the figures needed for the statement of cash flows including: [S]
- Cash flows from operating activities
- Cash flows from investing activities
- Cash flows from financing activities
- Calculate the cash flow from operating activities using the indirect and direct method. [S]
- Prepare statements of cash flows and extracts from statements of cash flows from given
information. [S]
- Identify the treatment of given transactions in a company’s statement of cash flows. [K]
Direct & Indirect Method of Cash Flow Statement
The cash flow statement is primarily divided into 3 parts –
1. Cash Flow from Operating activities (CFO)
2. Cash Flow from Investing activities (CFI)
3. Cash Flow from Financing activities (CFF)
A positive cash flow figure indicates a cash inflow, i.e. cash has come into the business, whereas a
negative cash flow figure indicates a cash outflow, i.e. cash has gone out of the business.
CFO contains the main parts of the statement. CFO includes an important figure of cash generated
from operations which shows have the core operations, i.e. manufacturing goods for a
manufacturer, have been able to generate positive cash flows for the company or not. Further, the
interest and taxes paid will be deducted from this figure.
Cash Generated from Operations is calculated in two methods –
1. Direct Method – actual cash inflow and outflow figures are used
2. Indirect Method – Profit before Tax (PBT) is used as a starting point, and adjustments are
made to it to arrive at the CFO figure
We will look at this section of the statement in more detail ahead.
CFI contains cash paid to purchase Non-current assets (NCA), proceeds from their sale and income
from other investments
CFF deals with how the company is financed, i.e. transaction between lenders and equity holders of
the company. This includes payments made to pay back loans, proceeds from new loans taken or
proceeds from new shares issued or any rights issues as well.
Following are important definition provide by IAS 7 Cash Flows, the relevant standard applicable
here.
212
Statement of Cash flows
Cash - consists of cash in hand and deposits repayable upon demand, less overdrafts.
Cash equivalents are 'short-term, highly liquid investments that are readily convertible to known
amounts of cash and are subject to an insignificant risk of changes in value'
Hence, Cash & Cash Equivalents = Bank balance + Cash balance + Short-terms investments – Bank
overdrafts
Short term investments are usually considered to mature within 3 months.
Net Cash Flow = CFO + CFI + CFF
At the end of the statement, a reconciliation between the last years cash and cash equivalents and
the current balance is made. This should equal to net cash flow of the company ALWAYS as at the
end of the day, the movement in the cash balances is only the cash generated (or paid) out of the
business. The SCF just depicts what items have caused this positive or negative change.
This reconciliation provides a good check to your cash flow statement. If the reconciliation
does not match, it is most likely you have made some error in your SCF which needs to be
corrected.
All new terms explained above, can simply put into one statement as depicted below in the format –
213
Statement of Cash flows
Format of Cash Flow Statement (Indirect Method)
A] CASHFLOW FROM OPERATING ACTIVITIES
(+)
(+)
(-/+)
(-/+)
(-/+)
(+/-)
Profit before Tax
Finance Cost (from SOPL)
Depreciation (from SOPL)
Profit/loss on disposal of NCA
XX
XX
XX
(X)/X
Profit before Working Capital Changes
XX
Increase/Decrease in Inventories
Increase/Decrease in Trade Receivables
Increase/Decrease in Trade Payables
(X) / X
(X) / X
X / (X)
Cash generated from Operations
XX
(-/+)
(-)
(X) / X
(X)
Interest (Paid) / Received (W1)
Tax Paid (W2)
Net Cashflow from Operating Activities
XX / (XX)
B] Cashflow from Investing Activities
(+)
(-)
(+)
(+)
Proceeds from Sale of NCA
Purchase of NCA (W3)
Interest received
Dividends Received
Net Cashflow from Investing Activities
XX
(XX)
XX
XX
XX / (XX)
C] Cashflow from Financing Activities
(+)
(+)
(-)
(-)
Cash proceeds by issue of Loan Notes
Cash proceeds by issue of shares (W4)
Dividend Paid to NCI (W5)
Repayment of Loan Notes
XX
XX
(XX)
(XX)
Net Cashflow from Financing Activities
XX / (XX)
Net Increase/Decrease in Cash (A+B+C)
Add: Opening balance of Cash & Cash equivalents
Closing Balance of Cash & Cash Equivalents
XX / (XX)
XX_______
XXX / (XXX)
This closing balance of cash and cash equivalents MUST match with the value of cash and cash
equivalents in the closing SOFP. If it doesn’t, there is some error you have made in your SCF.
214
Statement of Cash flows
Working Notes –
1)
Particulars
Cash paid (Bal fig)
Balance c/d
Interest payable Account
$
Particulars
X
Balance b/d
X
Interest charge in SOPL
XX
$
X
X
XX
An interest receivable account can be made in a similar fashion for the working under investing
activities, with the cash received being the balancing figure.
2)
Particulars
Cash paid (Bal fig)
Balance c/d
Tax payable Account
$
Particulars
X
Balance b/d
X
Tax charge in SOPL
XX
$
X
X
XX
3)
NCA at Carrying Amount Account
Particulars
$
Particulars
Balance b/d
X
Depreciation charge (SOPL)
Cash paid to purchase PPE (Bal Fig)
Disposals at CA
X
Profit on Disposal
X
Loss on Disposal
Revaluations of NCA (Closing –
Opening SOFP balances)
X
Balance c/d
XX
$
X
X
X
X
XX
Note that this is at carrying amount. Therefore, it is as good as preparing the NCA Cost A/c and the
Depreciation A/c together. This is the most trickiest part of the SCF.
If Sales proceeds of disposal of an asset are not given, the disposal account may also need to be
prepared to find cash received on disposing of NCA.
215
Statement of Cash flows
Prepare the retained earning account to find the actual cash amount of dividends paid.
4) Cash proceeds from the issue of share capital = (Closing sharing capital + Share premium) –
(Opening share capital + share premium)
5)
Particulars
Dividends paid (Bal fig)
Retained Earnings Account
$
Particulars
X
Balance b/d
Balance c/d
X
Profit from the year (SOPL)
XX
$
X
X
XX
The figures that go in the SOPL are more often than NOT THE SAME as the one’s that go in
the SCF and that’s why actual cash paid / received needs to be found by preparing ledger
accounts and control accounts as presented in the working notes above and cash inflows and
outflows found as balancing figures.
The reason being SOPL figures are accrual based i.e. if they accrue before the year end they
must be included in SOPL, regardless of whether the cash was received/paid before the year
end or not for the same.
Moreover, IAS 7 provides some flexibility while dealing with the treatment of interest paid/received
and dividends paid only.
1. Interest paid – CFO OR CFF (preferably CFO)
2. Dividends paid – CFO OR CFF (preferably CFF)
3. Interest received CFO OR CFI (preferably CFI)
Dividends received will be CFI only always.
216
Statement of Cash flows
Make sure you are absolutely thorough with the format of the indirect method of preparing
the statement as it is most likely a significant amount of questions will be tested on it. More
importantly, try to understand the logic behind why something is added / subtracted from
the profit before tax rather than memorizing it as then you are bound to go wrong. Logic can
never go wrong!
Think of the cash effect simply i.e. if cash will come into the business then add the respective
amount and if cash will go out of the business then subtract that amount from profit.
Which, if any, of the following items would form a part of the cash flow from financing activities in
the Cash Flow Statement?
1 Proceeds of sale of Machinery
2 Dividends received
3 Bonus Issue of shares during the year
A.
B.
C.
D.
1 only
2 only
3 only
None of them
Logic behind the format of Cash Flows
1. The finance cost, previously subtracted, is added back as it is an accrual amount and not the
actual amount of interest paid in cash that year, which is calculated in W1 and deducted
later in SCF
2. Non – cash items like depreciation and profit/loss on disposal of NCA are included while
calculating profit but should not be included in SCF. Therefore, as depreciation and loss on
disposal were previously deducted, it is now added back, and the opposite applies for profit
on disposal.
3. Working Capital Changes
a. An increase in inventory means that more cash has been used to buy up the extra
inventory. Hence, this becomes a cash outflow. If inventory levels decrease, the
opposite logic can be applied
217
Statement of Cash flows
b. An increase in receivables indicates that cash is NOT being collected from your
debtors on time which can be treated as a cash outflow. A decrease in receivables
would mean more cash has been collected, leading to a cash inflow
c. An increase in trade payables shows that you are taking extra credit terms and not
paying suppliers and using their money as a free source of credit, thereby it becomes
a cash inflow. If payables decrease, that means more cash has been paid to them in
the year generating cash outflows.
4. Proceeds = Cash inflows
Payments = Cash outflow
Important!
A shortcut way to remember treatment for working capital changes is –
Increase in Assets – Subtract, i.e. cash outflow
Increase in Payable – Add, i.e. cash inflow
‘AS PA’ is the mnemonic to help you.
Ofcourse the reverse logic applies, i.e. decrease in assets will be added, and a decrease in payables
will be subtracted.
Another way to remember is simply –
For Assets – do Opening value less Closing value. If it’s a positive number, then it’s a cash inflow,
and if it’s a negative number, then it’s a cash outflow.
For Liabilities – do Closing value less Opening value. Again, if positive, it is an inflow and vice versa
218
Statement of Cash flows
Apply Your Knowledge:
Consider the following financial statement for XYZ Co. for the year ended 20X9 –
Statement of Financial Position at 31 December 20X9
Particulars
20X9
($’000)
20X8
($’000)
1,250
(400)
850
1,000
(300)
700
100
70
20
50
240
90
80
25
35
230
1,090
930
Equity and Liabilities
Equity
Share Capital
Share Premium
Revaluation Surplus
Retained Earnings
Total Equity [C]
200
100
200
265
765
150
75
50
230
505
Non-Current Liabilities
Bank Loan
200
300
Current Liabilities
Trade Payables
Bank Overdraft
Interest Payable
Taxes Payable
55
25
25
20
60
20
35
10
Total Liabilities [D]
325
425
1,090
930
Assets
Non-Current Assets
Property, Plant and Equipment
Less: Accumulated Depreciation
Total Non-Current Assets [A]
Current Assets
Inventory
Trade Receivables
Short Term Investments
Bank and Cash
Total Current Assets [B]
Total Assets [A + B]
Total Equity and Liabilities [C + D]
219
Statement of Cash flows
Statement of profit or loss and other comprehensive income
for the year ended 31 December 20X9
Particulars
Revenue
Cost of Sales
Gross Profit
Distribution Costs
Administration and Selling Expenses
Operating Profit
Finance Costs
Profit Before Tax (PBT)
Income Tax
Profit for the Year
$ (‘000)
1100
(675)
425
(100)
(200)
125
(20)
105
(15)
90
Additional information 1. Administration and selling expenses include a loss on disposal of non-current assets of
$10,000 and also depreciation for the year, which is $50,000
2. During the year, an item of plant was disposed of, which originally cost $70,000 and had
accumulated depreciation to the date of disposal of $20,000 was disposed of for $40,000.
Prepare the Statement of Cash Flow using the indirect method.
Solution:
This question may seem daunting at first, with so much data given. However, it is extremely easy and
scoring as long as you know the format and logic thoroughly.
Hence, the first step is to lay down the format and keep filling in the values one by one alongside
preparing working notes where ever required. The key is to compare ALL the SOFP value changes
from 20X8 to 20X9.
A] CASHFLOW FROM OPERATING ACTIVITIES
(+)
(+)
(+)
(-)
(+)
(-)
Profit before Tax
Finance Cost (from SOPL)
Depreciation (from SOPL and notes)
Loss on disposal of NCA (from notes)
$’000
105
20
50
10
Profit before Working Capital Changes
185
Increase in Inventories (90 - 100)
Decrease in Trade Receivables (80 – 70)
Decrease in Trade Payables (55 – 60)
(10)
10
(5)
Cash generated from Operations
180
(-)
(-)
(30)
(5)
Interest Paid (W1)
Tax Paid (W2)
Net Cashflow from Operating Activities
145
220
Statement of Cash flows
B] Cashflow from Investing Activities
(+)
(-)
Proceeds from Sale of NCA (Note 2)
Purchase of NCA (W3)
40
(110)
Net Cashflow from Investing Activities
(70)
C] Cashflow from Financing Activities
(+)
(-)
(-)
Cash proceeds by issue of shares (W4)
Dividend Paid to NCI (W5)
Repayment of Bank Loan (200 – 300)
75
(45)
(100)
Net Cashflow from Financing Activities
(70)
Net Increase in Cash (145 – 70 - 70)
Add: Opening balance of Cash & Cash equivalents
Closing Balance of Cash & Cash Equivalents
5
40
45
*Cash and Cash equivalents = Bank & Cash + Short Investments – Bank overdraft
Opening = 35 + 25 – 20 = 40
Closing = 50 + 20 – 25 = 45
As seen above, the net cash flow leads to a change of $5,000 in the last year’s cash and cash
equivalents and this year’s cash and cash equivalents.
Working Notes –
1)
Particulars
Cash paid (Bal fig)
Balance c/d
Interest payable Account
$
Particulars
30
Balance b/d
25
55
Finance Cost in SOPL
$
35
20
55
221
Statement of Cash flows
2)
Particulars
Cash paid (Bal fig)
Balance c/d
Tax payable Account
$
Particulars
5
Balance b/d
20
Tax charge in SOPL
25
$
10
15
25
3)
NCA at Carrying Amount Account
Particulars
$
Particulars
Balance b/d
700
Depreciation charge (SOPL)
Cash paid to purchase PPE (Bal Fig)
Disposals at CA (70 – 20)
110
Loss on Disposal
Revaluations of NCA (200–50)
150
Balance c/d
960
$
50
50
10
850
960
4) Cash proceeds from the issue of share capital = (Closing sharing capital + Share premium) –
(Opening share capital + share premium)
= (200 + 100) – (150 + 75)
=$75,000
5)
Particulars
Dividends paid (Bal fig)
Balance c/d
Retained Earnings Account
$
Particulars
45
Balance b/d
265
310
Profit from the year (SOPL)
$
230
90
310
222
Statement of Cash flows
As stated earlier, there are 2 methods of calculating the cash generated from operations figure;
Direct and Indirect. All other parts of SCF remain absolutely the same otherwise. Key differences are
-
1)
Direct Method
Provides more details than indirect
method about cash flow
Indirect Method
Provides fewer details
2)
Less widely used in real life
More widely used in practice
3)
Confidential information may be revealed
hence not preferred by management
Chances of sensitive information like amounts
paid to suppliers, etc. are not revealed
Format of Direct method calculation –
$
Cash Received from customers
Cash paid to suppliers
Cash paid to employees
Cash Generated from Operations
Interest paid
Taxes paid
Net Cash from Operating Activities
X
(X)
(X)
XX / (XX)
(X)
(X)
XX / (XX)
The interest paid and taxes paid are found out exactly in the same way as in the indirect method.
The other 3 figures are found by using control accounts of trade receivables, trade payables and
wages payable, respectively, as balancing figures in each of the control accounts.
223
Statement of Cash flows
An extract from the SCF of ABC Co. is shown below with the following observations made $000
Profit before tax
1,300
Loss on disposal
(375)
Increase in receivables (289)
Increase in payables
275
(1) The loss on disposal should have been added, not deducted.
(2) Increase in receivables should have been added, not deducted.
(3) Increase in payables should have been deducted, not added.
A.
B.
C.
D.
1, 2 and 3
1 only
2 and 3 only
None of them
Answers to Quiz Questions
1) D
Proceeds from the sale of machinery will be shown under the heading of investing activities
Dividends received are either operating or financing activities
Bonus issue, although dealing with issuing shares, does not bring any cash flow, and hence it is not
included anywhere in the SCF.
2) B
The loss on disposal is a non-cash item which should not be included. As it was subtracted in the
calculation of profit, it should be added back to profit to nullify its effect
224
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