FA Course notes

Syllabus A: The Context And Purpose Of Financial Reporting ....................3

Syllabus A1. The Scope and Purpose of, Financial Statements ...........................................3
Syllabus A2. Users’ and stakeholders’ needs .................................................................. 11
Syllabus A3. The main elements of financial reports ..........................................................12
Syllabus A4. The regulatory framework ............................................................................18
Syllabus A5. Duties and responsibilities of those charged with governance .........................23
Syllabus B. THE QUALITATIVE CHARACTERISTICS ................................26
Syllabus B1. The qualitative characteristics of financial information ......................................26
Syllabus C. DOUBLE-ENTRY AND ACCOUNTING SYSTEMS .................32
Syllabus C1. Double-entry book-keeping principles ..........................................................32
Syllabus C2. Ledger accounts and books of prime entry ..................................................39
Syllabus D. RECORDING TRANSACTIONS AND EVENTS ......................52
Syllabus D1. Sales and purchases ................................................................................. 52
Syllabus D2. Cash ........................................................................................................56
Syllabus D3. Inventory ................................................................................................... 61
Syllabus D4. Tangible non-current assets ........................................................................ 75
Syllabus D5. Depreciation ..............................................................................................90
Syllabus D6. Intangible non-current assets and amortisation ..............................................96
Syllabus D7. Accruals and prepayments .......................................................................101
Syllabus D8. Receivables and payables ........................................................................107
Syllabus D9. Provisions and contingencies ....................................................................118
Syllabus D10. Capital structure and finance costs .......................................................... 125
Syllabus E. PREPARING A TRIAL BALANCE .........................................141
Syllabus E1. Trial balance ............................................................................................141
Syllabus E2. Correction of errors .................................................................................. 144
Syllabus E3. Control accounts and reconciliations .......................................................... 149
Syllabus E4. Bank reconciliations .................................................................................. 161
Syllabus F. PREPARING BASIC FINANCIAL STATEMENTS ...................166
Syllabus F1. Statements of financial position ..................................................................166
Syllabus F2. Statements of profit or loss and other comprehensive income .......................169
Syllabus F3. Disclosure notes ......................................................................................177
Syllabus F4. Events after the reporting period ................................................................ 178
Syllabus F5. Statements of cash flows (excluding partnerships) .......................................183
Syllabus F6. Incomplete records .................................................................................. 192

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Syllabus G. CONSOLIDATED FINANCIAL STATEMENTS ......................197
Syllabus G1. Subsidiaries ............................................................................................197
Syllabus G2. Associates .............................................................................................204
Syllabus H. INTERPRETATION OF FINANCIAL STATEMENTS ...............205
Syllabus H1. Importance and purpose of analysis of financial statements ..........................205
Syllabus H2. Ratios .....................................................................................................207

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 Syllabus A: The Context And Purpose Of
Financial Reporting

Syllabus A1. The Scope and Purpose of, Financial Statements

A1a) Define financial reporting – recording, analysing and summarising financial data.

Financial Reporting

Financial reporting is a way of recording, analysing and summarising

financial data.

Remember these 3 steps:

1. Transactions are recorded in books of prime entry.

2. The totals of these books of prime entry are posted to the ledger accounts.

3. Finally, transactions are summarised in the financial statements

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 A1b) Identify and define types of business entity – sole trader, partnership, limited liability
company.

Main types of business entity

Businesses exist to make a profit.

There are three main types of business entity:

1. Sole Traders

Sole traders are people who work for themselves.  

Examples include a hairdresser, the local stationer, a plumber.  

A sole trader has unlimited liability, i.e. if the business runs up debts that it is unable to
pay, the proprietor will become personally liable for the unpaid debts and would be
required, if necessary, to sell his private possessions to repay them.  

For example, if a sole trader has some capital in his business, but the business now
owes $50,000 which it cannot repay, the trader might have to sell his house to raise the
money to pay off his business debts.

2. Partnerships

Partnerships occur when two or more people decide to run a business together. 

Examples include an accountancy practice, a legal practice and a medical practice.

In general, the partners have unlimited liability although there may be circumstances
when one or more partners have limited liability.

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 3. Limited Liability Companies

Limited liability companies are incorporated to take advantage of ‘limited liability’ for
their owners (shareholders).

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

In all cases, we apply the separate entity concept, i.e. the business is regarded as
being separate from the owner (or owners) and the accounts are prepared for the
business itself.

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 A1c) Recognise the legal differences between a sole trader, partnership and a limited liability
company.

The legal differences between a sole trader,

partnership and a limited liability company

In law, sole traders and partnerships are not separate entities from their owners.  

A partnership ceases and a new one starts whenever a partner joins or leaves the
partnership.

A limited liability company has a separate legal identity from its shareholders.  In fact, it
can issue contracts in the company’s name.  It continues to exist regardless of the
identity of its owners.

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A1d) Identify the advantages and disadvantages of operating as a limited liability company, sole
trader or partnership.

Advantages of a Limited Company

• Limited Liability

• More capital can be raised as no limit on number of shareholders

• Control of company can not be lost to outsiders – shares only sold if all
shareholders agree

• The business will continue even if one of the owners dies, shares being transferred
to another owner – separate legal identity

Disadvantages of a Limited Company

• Profits have to be shared out amongst a potentially larger number of people

• Detailed legal procedures must be followed to set up the business – consuming

time and money

• Financial statements have to comply with legal and accounting requirements

• Financial information can be inspected by any member of the public once filed
with the Registrar, including competitors

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 Advantages of the Sole Trader

• Personal satisfaction

• Secrecy

• Personal Control

• Enjoyment of all profits

• Absence of legal formalities when establishing business

• Financial advantages in terms of low taxes, longer period to pay taxes and lower
accountancy fees.

Disadvantages of the Sole Trader

• Limited sources of finance

• Restricted growth

• Full personal responsibility for the decisions and due to unlimited liability the debts
of the business

Advantages of a Partnership

• There are no legal formalities to complete when setting up the business

• Each partner can specialize

• Partners can share the workload

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 • Financial advantages in terms of low taxes, longer period to pay taxes and lower
accountancy fees.

Disadvantages of a Partnership

• Partners are jointly and severely liable for the acts and omissions of the other
partners

• Profits have to be shared amongst more owners

• Partners may disagree

• The size of a partnership is limited to a maximum of 20 partners, however there

are exceptions to this general rule

• Any decision made by one partner on behalf of the company is legally binding on
all other partners

• Partnerships are unincorporated, resulting in unlimited liability for the partners,

making them personally liable for the debts of the firm.

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 A1e) Understand the nature, principles and scope of financial reporting.

Reporting the results

Financial accounting is mainly a method of reporting the results and financial position of
a business. It is not primarily concerned with providing information towards the more
efficient running of the business. In fact, financial accounting provides historical (past)
information.

Management need to plan for the future. They require detailed information as they are
responsible to plan and control the resources of the business.   Management (or cost)
accounting analyses data to provide information as a basis for managerial action.

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 Syllabus A2. Users’ and stakeholders’ needs

A2a) Identify the users of financial statements and state and differentiate between their
information needs.

Prepare and Produce

Why do businesses need to prepare and produce financial information?

A business should produce information about its activities because there are various
groups of people who want or need to know that information.

The “Framework for the Preparation and Presentation of Financial Statements” states
that, “the objective of financial statements is to provide information about the financial
position, performance and changes in financial position of an entity that is useful to a
wide range of users in making economic decisions.”

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 Syllabus A3. The main elements of financial reports

A3a) Understand and identify the purpose of each of the main financial statements.

The principle financial statements of a sole trader are the statement of financial position
and the statement of profit or loss.

Statement of Financial Position

The statement of financial position is a list of all the assets owned and the liabilities
owed by a business as at a particular date.  

It is a snapshot of the financial position of the business at a particular moment.

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 Statement of profit or loss

A statement of profit or loss is a record of revenue generated and expenditure incurred

over a given period. 

The statement shows whether the business has had more revenue than expenditure (a
profit) or vice-versa (a loss)

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 A3b) Define and identify assets, liabilities, equity, revenue and expenses.

Assets

An asset is a resource controlled by the entity as a result of past events and from which
future economic benefits are expected to flow to the entity.

Some assets are held and used in operations for a long time.  These are known as non-
current assets.

Other assets are held for only a short time.   They are likely to be realized within the
normal operating cycle or 12 months after the end of the reporting period. These are
classified as current assets.

Liabilities

A liability is a present obligation of the entity arising from past events, the settlement of
which is expected to result in an outflow from the entity of resources embodying
economic benefits.

Some liabilities are due to be settled within the normal operating cycle or 12 months
after the end of the reporting period. These are classified as current liabilities.  

Other liabilities may take some years to repay – non-current liabilities.

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 Capital / Equity

Capital is the amount invested in a business by the owner.  This is the amount the
business owes to the owner.  In the case of a sole trader,

CAPITAL = ASSETS – LIABILITIES

CAPITAL = NET ASSETS

In the case of a limited liability company, capital usually takes the form of shares. Share
capital is known as equity. The Framework defines equity as “the residual interest in the
assets of the entity after deducting all its liabilities.”

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 Revenue

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

Expenses arise in the course of the ordinary activities of the enterprise.  They include,
for example, cost of sales, wages and depreciation.

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 Notes

1. The top part of the statement of profit or loss, i.e. Sales – Cost of Sales = Gross
Profit, is called the Trading Account. It records the trading activities of the
business.

2. Sundry income includes bank interest, rent receivable, income from investments.

3. Carriage inwards is the cost of transport of goods into the firm and is therefore
added to the purchases figure.

4. Carriage outwards is the cost of transport of goods out of the firm to its
customers, it is not part of the firm's expenses in buying the goods and is always
entered as an expense.

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 Syllabus A4. The regulatory framework

A4a) 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 (IFRS IC).

The role of the regulatory systems

Introduction

Limited liability companies are required by law to prepare and publish financial
statements annually. 

The form and content of these accounts are primarily regulated by national legislation. 

They must also comply with International Accounting Standards (IASs) and International
Financial Reporting Standards (IFRSs).

Accounting Standards

International Accounting Standards were issued by the IASC from 1973 to 2000. 

They provide guidance as to how items should be shown in a set of financial statements
both in terms of their monetary value and any other disclosures. 

They are a single set of high quality, understandable and enforceable global standards.

The IASB replaced the IASC in 2001.

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 Since then, the IASB has amended some IASs and has proposed to amend others, has
replaced some IASs with new International Financial Reporting Standards, and has
adopted or proposed certain new IFRSs on topics for which there was no previous IAS. 

Accounting standards were developed for two main reasons

• To reduce subjectivity

• To achieve comparability between different organisations

Financial statements may not be described as complying with IFRSs unless they
comply with all of the requirements of each applicable standard and each applicable
interpretation.

The IFRS Foundation (IFRSF)

The IFRS Foundation is an independent organisation having two main bodies, the
Trustees and the International Accounting Standards Board (IASB), as well as the IFRS
Advisory Council (IFRS AC) and the IFRS Interpretations Committee (IFRS IC). 

The IFRSF is governed by a board of 22 trustees. 

These trustees appoint the members of the IASB, IFRS IC and the IFRS AC. 

They also review annually the strategy of the IFRSF and the IASB and its effectiveness,
including consideration, but not determination, of the IASB's agenda. 

These trustees also raise the funds necessary to support the IFRSF.

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 The International Accounting Standards Board (IASB)

The International Accounting Standards Board (IASB) is an independent, privately-

funded accounting standard-setter based in London, UK. 

There are 14 Board members, each with one vote.

The IASB is committed to developing, in the public interest, a single set of high quality,
understandable and enforceable global accounting standards that require transparent
and comparable information in general purpose financial statements.  

In addition, the IASB co-operates with national accounting standard-setters to achieve

convergence in accounting standards around the world.

How are standards developed?

International Financial Reporting Standards (IFRSs) are developed through an

international consultation process, the "due process” that involves interested individuals
and organisations from around the world.

The due process comprises six stages:

1. IAASB reviews auditing developments and takes suggestions from interested

parties.

2. Planning the project, including forming a 'working group' to advise the IASB and
its staff on the project;

3. Developing and publishing the discussion paper for public comment;

4. Draft standard produced and commented on by interested parties for a period of

120 days (Exposure period).

5. Project task force considers comments and amendments made if appropriate.


If changes significant there may be another exposure period.

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 6. Standard finalised and approved by meeting of IAASB at which there must be a
minimum of 12 members.

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 A4b) Understand the role of International Financial Reporting Standards.

The IFRS Advisory Council (IFRS AC)

The IFRS Advisory Council (IFRS AC) gives advice to the IASB on a range of issues
which includes:

1. input on the IASB’s agenda

2. input on the IASB’s project timetable (work programme) including project priorities,
and consultation on any changes in agenda and priorities

3. advise on projects, with particular emphasis on practical application and

implementation issues

The IFRS AC also supports the IASB in the promotion and adoption of IFRSs
throughout the world.

This may include the publishing of articles supportive of IFRSs and addressing public
meetings on the same subject.

The IFRS Interpretations Committee (IFRS IC)

Reports to the IASB.

The IFRIC reviews the current IFRSs and the IASB Framework, accounting issues.

The interpretations cover both:

• newly identified financial reporting issues not specifically dealt with in IFRSs; or

• issues where unsatisfactory or conflicting interpretations have developed


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Syllabus A5. Duties and responsibilities of those charged with
governance

A5a) Explain what is meant by governance specifically in the context of the preparation of
financial statements.

Corporate governance

Corporate governance was defined by the Cadbury Committee   as: 'The system by
which an organisation is directed and controlled, at its most senior levels, in order to
achieve its objectives and meet the necessary standards of accountability and probity.’

Corporate governance is not solely about introducing systems of control, it is

fundamentally linked to directing the organisation in order to achieve objectives.

This is critical to the success of the organisation and is a central part of the role of the
board of directors.

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 A5b) Describe the duties and responsibilities of directors and other parties covering the
preparation of the financial statements.

Board of Directors

The most prominent group of actors in corporate governance are the company’s
directors. They can be either executive or non-executive directors (NEDs).

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.

Directors' considerations

1. The consequences of decisions in the long term

2. The interests of their employees

3. The need to develop good relationships with customers and suppliers

4. The impact of the company on the local community and the environment

5. The desirability of maintaining high standards of business conduct and good

reputation

6. The need to act fairly between all members of the company

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 Directors’ Responsibility for the Financial Statements

The directors are responsible for preparing the annual financial statements in
accordance with applicable law and regulations. Company law requires the directors to
prepare financial statements for each financial year and such financial statements must
give a true and fair view.  Hence, the directors are required to:

• select suitable accounting policies and then apply them consistently;

• make judgments and estimates that are reasonable and prudent; and;

• state whether they have been prepared in accordance with IFRSs.

Directors are responsible for the internal controls necessary to enable the preparation of
financial statements that are free from material misstatement, whether due to error or
fraud.  They are also responsible for the prevention and detection of fraud.

Financial statements of companies are usually audited.   An audit is an independent

examination of the accounts to ensure that they comply with legal requirements and
accounting standards.  The findings of the audit are reported to the shareholders.

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 Syllabus B. THE QUALITATIVE
CHARACTERISTICS
Syllabus B1. The qualitative characteristics of financial
information

B1a) Define, understand and apply qualitative characteristics:

i) Relevance ii) Faithful representation iii) Comparability
iv) Verifiability v) Timeliness vi) Understandability

The IASB’s Conceptual Framework for Financial

Reporting

The IASB’s Conceptual Framework for Financial Reporting describes the basic
concepts by which financial statements are prepared. 

The main purpose of the Framework is to:

1. assist in the development of future IFRS and the review of existing standards by
 setting out the underlying concepts

2. promote harmonisation of accounting regulation and standards by reducing the

number of permitted alternative accounting treatments

3. assist the preparers of financial statements in the application of IFRS, which would
include dealing with accounting transactions for which there is not (yet) an
accounting standard.

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 Qualitative Characteristics of Financial Information

The revised Framework distinguishes between two types of qualitative characteristics

that are necessary to provide useful financial information:

• Fundamental qualitative characteristics


 

- relevance and 

- faithful representation)

• enhancing qualitative characteristics 

- comparability (including consistency), 


- timeliness, 

- verifiability and 

- understandability).


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 Fundamental Qualitative Characteristics

For information to be useful, it must be both relevant and faithfully represented

1. Relevance

◦ Influences economic decisions of user


Relevant financial information is capable of making a difference in the
decisions made by users

◦ Has predictive value and/or confirmatory value or both


Relevant information assists in the predictive ability of financial
statements. 


That is not to say the financial statements should be predictive in the sense
of forecasts, but that (past) information should be presented in a manner
that assists users to assess an entity’s ability to take advantage of
opportunities and react to adverse situations.

◦ Materiality

Materiality is a threshold or cut-off point for information whose omission or
misstatement could influence the economic decisions of users taken on
the basis of the financial statements.  


This depends on the size of the item or error judged in the particular
circumstances of its omission or misstatement.  


Hence, materiality is not a matter to be considered by standard-setters but

by preparers and their auditors.

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 2. Faithful Representation



General purpose financial reports represent economic phenomena in words and
numbers. 



To be useful, financial information must not only be relevant, it must also represent
faithfully the phenomena it purports to represent. 


Financial statements will generally show a fair presentation when


• They conform with accounting standards

• They conform with the any relevant legal requirements

• They have applied the qualitative characteristics from the Framework.


Financial information that faithfully represents economic phenomena has three

characteristics: -


it is complete

it is neutral

it is free from error

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 Enhancing Qualitative Characteristics

Comparability, verifiability, timeliness and understandability are directed to enhance

both relevant and faithfully represented financial information. 

Those characteristics should be maximised both individually and in combination.

1. Comparability

◦ Users can identify similarities and differences


Comparability is fundamental to assessing the performance of an entity by
using its financial statements. 


Assessing the performance of an entity over time (trend analysis) requires

that the financial statements used have been prepared on a comparable
(consistent) basis.

◦ Consistent application of methods


Comparability is enhanced by the use and disclosure of consistent
accounting policies. 


Users can confirm that comparative information for calculating trends is

comparable. 


The disclosure of accounting policies at least informs users if different

entities use different policies.


Comparability should be distinguished from consistency (the consistent

use of accounting methods).  


It is recognised that there are situations where it is necessary to adopt new

accounting policies (usually through new Standards) if they enhance
relevance and reliability. Consistency and comparability require the
existence and disclosure of accounting policies.

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 2. Verifiability

Financial information is verifiable when it enables knowledgeable and independent
observers to reach a consensus on whether a particular depiction of an event or
transaction is a faithful representation.

3. Timeliness

Timeliness means that information is available to decision-makers in time to be
capable of influencing their decisions.

4. Understandability

Understandability is enhanced when the information is:

◦ classified

◦ characterised

◦ presented clearly and concisely

However, relevant information should not be excluded solely because it may be too
complex and cannot be made easy to understand.

To exclude such information would make financial reports incomplete and potentially
misleading.

Financial reports are prepared for users who have a reasonable knowledge of business
and economic activities and who review and analyse the information with diligence.

The Cost Constraint on Useful Financial Reporting

Cost is a pervasive constraint to financial reporting. Reporting such information imposes

costs and those costs should be justified by the benefits of reporting that information. 

The IASB assesses costs and benefits in relation to financial reporting generally, and not
solely in relation to individual reporting entities. 

The IASB will consider whether different sizes of entities and other factors justify
different reporting requirements in certain situations.


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 Syllabus C. DOUBLE-ENTRY AND
ACCOUNTING SYSTEMS
Syllabus C1. Double-entry book-keeping principles

C1a) Identify and explain the function of the main data sources in an accounting system.

The function of the main data sources in an

accounting system

A business will enter many transactions during the year.

All of these need to be recorded and summarized to produce the entity’s financial
statements.

These business transactions are recorded on source documents.

These documents are the source of all the information recorded by a business.

Examples include sales and purchase orders, invoices and credit notes.

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 C1bf) Outline the contents and purpose of different types of business documentation,
including: quotation, sales order, purchase order, goods received note, goods despatched
note, invoice, statement, credit note, debit note, remittance advice, receipt.
Identify the main types of business transactions e.g. sales, purchases, payments, receipts.

The contents and purpose of different types of

business documentation

Documents used to record business transactions include

• Quotation:

a business makes a written offer to a customer to produce or deliver goods or
services for a certain amount of money

• Sales Order:

a customer writes out or signs an order for goods or services he requires

• Purchase Order:

a business orders from another business goods or services

• Goods received note:


a list of goods that a business has received from a supplier

• Goods despatched note:


a list of goods that a business has sent out to a customer

• Invoice:

An invoice relates to a sales order or a purchase order. When a business sells
goods or services on credit to a customer, it sends out an invoice.   When a
business buys goods or services on credit, it receives an invoice from the supplier.

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 • Statement:

A document sent by a supplier to a customer listing all invoices, credit notes and
payments done by the customer

• Credit note:

a document sent by a supplier to a customer in respect of goods returned or
overpayments made by the customer

• Debit note:

a document sent by a customer to a supplier in respect of goods returned or an
overpayment made. It is a formal request for the supplier to issue a credit note

• Remittance advice:

a document sent with a payment, detailing which invoice are being paid and which
credit notes offset

• Receipt:

a written confirmation that money has been paid.

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C1c) Understand and apply the concept of double- entry accounting and the duality concept.

Books of Prime Entry

As we have seen in the previous chapter, repetitive transactions may initially be

captured in day books (also known as books of prime entry) e.g., all the sales invoices
may be listed in the sales day book. These day books are not part of the double-entry
system but enable the number of double-entries to be reduced by ascertaining an
aggregate

Nominal Ledger

The total of the day book, or the single transaction, is recorded in the double-entry
system by being posted to the nominal accounts in the general/nominal ledger.
Each nominal account (or T account) has two sides, the left hand side of which is called
the debit side (DR) and the right hand side of which is called the credit side (CR).

35
 Nominal accounts are normally opened for each asset and liability (or class thereof), and
one for each type of expense and income. In addition a sole trader will also have an
account for capital. Capital represents the proprietary interest in the net assets of the
business. It is created when the owner introduces resources into the business entity and
increases when the business generates a profit.

As already mentioned, only transactions capable of being measured objectively in

monetary terms can be recorded (this is known as the money measurement concept).

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 Double-entry rules

Rule 1: - The duality rule

Every transaction has two effects, one of which will be recorded as a debit in one
account and the other which will be recorded as a credit in another account. If this rule
is broken, the trial balance will not agree and a suspense account is opened. This will
be discussed later in “Correction of Errors”.

TOTAL DEBITS = TOTAL CREDITS

Rule 2: - The when to DR and CR rule

The rules as to when to debit a T account and when to credit a T account can be
summarized in the following table.

The Debit/Credit Table:

Rule 3: - Debit is on the left and credit is on the right

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 C1d) Understand and apply the accounting equation.

The Accounting Equation

E.g. Statement of Financial Position – M. Stark

Assets = Liabilities

Assets = (Capital + Profit – Drawings) + Payables

Assets – Payables = Capital +Profit – Drawings

Net Assets = Proprietor’s Interest

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 Syllabus C2. Ledger accounts and books of prime entry

C2a) Identify the main types of ledger accounts and books of prime entry, and understand
their nature and function.

Journal Book

The journal keeps a record of unusual movement between accounts. It is used to record
any double entries made which do not arise from the other books of prime entry.
For example, journal entries are made when errors are discovered and need to be
corrected and for period end adjustments (depreciation, bad and doubtful debts,
accruals and prepayments).

The format of a journal entry is

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 Memorandum Ledgers

The main purpose of memorandum ledgers is to know how much is owed by each
particular customer or to a specific supplier at a point in time.

There are two main types of memorandum ledgers

• Receivables Ledger

• Payables Ledger

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 Receivables Ledger

This ledger shows how much is owed to the business by each individual customer

41
 Payables Ledger

This ledger shows how much is owed by the business to each individual supplier.

42
 C2b) Understand and illustrate the uses of journals and the posting of journal entries into
ledger accounts.

43
 Cash Book

The cash book records receipts and payments into and out of the business bank
account. These would include receipts and payments made by bank transfer, standing
order, direct debit and bank interest and charges, directly by the bank.

44


45
 Sales Day Book

The sales day book lists all sales made on credit. It is used to keep a list of all invoices
sent out to customers each day.

46
 Sales Returns Day Book

When customers return goods for some reason, a credit note is raised. All credit notes
are recorded in the sales returns day book.

Purchase Day Book

The purchase day book lists all purchases made on credit, i.e. a list of all invoices it
receives.

47
 Purchase Returns Day Book

The purchase returns day book records credit notes received in respect of goods which
the business sends back to its suppliers.

Petty Cash Book

Most businesses keep a small amount of cash on the premises to make occasional
small payments in cash, e.g. staff refreshments, postage stamps, to pay the office
cleaner, taxi fares, etc. This is often called the cash float or petty cash account.
Therefore, the petty cash book is a cash book for small payments.

Very often these businesses use the imprest system. Under the imprest system, the
petty cash is kept at an agreed sum, so that each topping up is equal to the amount
paid out in the period.

Example

The amount of money in petty cash is kept at an agreed sum of $250.  Expense items
are recorded on vouchers as they occur and the total voucher payments for the period
were $55. Therefore:

The cash payment required from the bank account into petty cash is equal to $55, i.e.
total of the voucher payments since the previous top-up.

48


Keeping cash (even in small amounts) on the premises is a security risk. Therefore a
petty cash system is usually subject to strict controls.

1. Payment is only made in respect of authorised claims.

2. All claims are supported by evidence.

49
 C2d) Illustrate how to balance and close a ledger account.

The totals from the books of prime entry are posted to the nominal accounts in the
nominal ledger through double-entry.

A business will want to know the balance on each account (to add to the Trial Balance).
This is done by 'balancing off' each account.

Steps to balance off a ledger account

1. Add the debit and credit sides separately.

2. Fill in the higher of the two totals on both sides.

3. 'Balance' the account (make the two sides equal) – balance c/d

4. Complete the 'double entry' – balance b/d on the opposite side.

Example 1

In the books of Cows Co:

Year 2016

Jan 1 - Paid $50,000 into a business bank account

Jan 9 - Bought goods for $2,000

Jan 11 - Cash Sales $5,000

Required

Balance off a ledger account (Bank a/c & Cash a/c only) as at 31 Jan 2016.

50
 Solution

51
 Syllabus D. RECORDING TRANSACTIONS
AND EVENTS
Syllabus D1. Sales and purchases

D1c) Understand the general principles of the operation of a sales tax.

Sales tax is an indirect tax on the supply of goods and services which is eventually
borne by the final customer.

Input and Output Tax

1. Output tax

Sales tax charged on goods and services sold by a business is referred to as
output tax.  



e.g. I sell a computer to you and you will pay me a price + output tax (VAT)

2. Input tax

Sales tax paid on goods and services ‘bought in’ by a business is referred to as
input tax.


e.g. If I buy a computer,  I have to pay a price + input tax (VAT)

If output sales tax exceeds input sales tax, the business pays the difference in tax to the
authorities.

If output sales tax is less than input sales tax in a period, the tax authorities will refund
the difference to the business.


52


53
 D1d) Calculate sales tax on transactions and record the consequent accounting entries.

Accounting Treatment

Registered businesses charge output sales tax on sales and suffer input sales tax on
purchases.  

Sales tax does not affect the statement of profit or loss, but is simply being collected on
behalf of the tax authorities to whom a quarterly payment is made.

Therefore, if a business sells goods for $1,000 + 17.5% sales tax, the accounting entries
to record the sale would be: 



Dr Cash/trade receivables(Gross) $1,175

Cr Sales (Net) - P&L  $1,000

Cr Sales tax control account $175

If input sales tax is recoverable, the cost of purchases should exclude the sales tax and
be recorded net of tax. 

Therefore, if a business purchases goods on credit for $500 + 17.5% sales tax, the
accounting entries would be: 

Dr Purchases - P&L $500.00


Dr Sales tax control account $87.50

Cr Cash/trade payables $587.50

54
 Irrecoverable Sales Tax

There are some circumstances in which traders are not allowed to reclaim sales tax paid
on their inputs.  

For e.g. sales tax charged on motor cars, other than for resale, and on certain business
entertaining expenses is irrecoverable. 

In these cases, sales tax must be regarded as part of the cost of the items purchased
and included in the statement of profit or loss charge or in the statement of financial
position as appropriate.

Therefore, the double entry for buying a motor vehicle, where sales tax is irrecoverable,
is: -

Dr Motor Vehicles A/c (cost + sales tax)

Cr Cash A/c (cost + sales tax) 

55
 Syllabus D2. Cash

D2b) Understand the need for a record of petty cash transactions.

56
 Cash Book

The cash book records receipts and payments into and out of the business bank
account. 

These would include receipts and payments made by bank transfer, standing order,
direct debit and bank interest and charges, directly by the bank.

57


Petty Cash Book

Most businesses keep a small amount of cash on the premises to make occasional
small payments in cash, 

e.g. staff refreshments, postage stamps, to pay the office cleaner, taxi fares, etc. 

This is often called the cash float or petty cash account. 

Therefore, the petty cash book is a cash book for small payments.

Very often these businesses use the imprest system. 

58
 Under the imprest system, the petty cash is kept at an agreed sum, so that each
topping up is equal to the amount paid out in the period.

Example

The amount of money in petty cash is kept at an agreed sum of $250.  

Expense items are recorded on vouchers as they occur and the total voucher payments
for the period were $55. 

Therefore:

The cash payment required from the bank account into petty cash is equal to $55, i.e.
total of the voucher payments since the previous top-up.

59


Keeping cash (even in small amounts) on the premises is a security risk.

Therefore a petty cash system is usually subject to strict controls.

1. Payment is only made in respect of authorised claims.

2. All claims are supported by evidence.

60
 Syllabus D3. Inventory

D3a) Recognise the need for adjustments for inventory in preparing financial statements.

Inventories

Inventories are assets:

• held for sale in the ordinary course of business;

• in the process of production for such sale; or

• in the form of materials or supplies to be consumed in the production process or

in the rendering of services.

Inventory can be a significant figure for some businesses, e.g. manufacturing

companies.

It affects the financial statement in two ways:

1. Statement of financial position: it is included as a current asset

2. Statement of profit or loss: 


opening and closing inventory have a direct impact on cost of sales and therefore
profits. 



(The cost of goods sold is calculated as: Opening inventory + Purchases – Closing
inventory).

61
 All businesses must therefore ensure that their financial statements
account for inventory accurately in terms of:

1. the accounting adjustment

2. its valuation

62
 D3b) Record opening and closing inventory.

Inventory is generally accounted for as a year end adjustment via a journal entry.

Opening Inventories

These are the goods held by the business at the beginning of the year. 

However, such goods will normally have been sold during the year. 

They are no longer an asset of the entity but will form part of the costs that should be
matched against sales revenue when determining profit.

Therefore, opening inventories brought forward in the inventory account are transferred
to the trading account. 

The accounting entry is:



Dr Cost of sales (I/S)

Cr Inventories (SOFP)

Closing Inventories

Goods might be unsold at the end of an accounting period and so still be held in
inventory. 

The value of closing inventories is accounted for in the nominal ledger by debiting an
inventory account and crediting the trading account at the end of an accounting period. 

63
 Inventory will therefore have a debit balance at the end of a period, and this balance will
be shown in the statement of financial position as a current asset.

The accounting entry is:



Dr Inventories (SOFP)

Cr Cost of sales (I/S)

64
 D3c) Identify the alternative methods of valuing inventory.

The alternative methods of valuing inventory

The inventories figure is made up of two elements

1. Quantity


The quantity of inventories held at the year end is established by means of a

physical count of inventory in an annual counting exercise, or by a 'continuous'
inventory count.

2. Valuation


The basic rule as per IAS 2 “Inventories” states that: 




Inventories should be measured at the lower of cost and net realisable value



The value of inventories is calculated at the lower of cost and net realisable value
for each separate item or group of items. 


Here, the prudence concept is being applied in presenting financial information.

Other methods

There are other methods which, in theory, might be used for the valuation of inventory

• Inventories might be valued at their expected selling price.

• Inventories might be valued at their expected selling price, less any costs still to
be incurred in getting them ready for sale and then selling them. This amount is
referred to as the net realisable value (NRV) of the inventories.

65
 • Inventories might be valued at their historical cost (ie the cost at which they were
originally bought).

• Inventories might be valued at the amount it would cost to replace them.

This amount is referred to as the current replacement cost of inventories

66
 D3d) Understand and apply the IASB requirements for valuing inventories.

IAS 2

IAS 2 lays out the required accounting treatment for inventories under the historical cost
system.

The major area of contention is the cost value of inventory to be recorded.

This is recognised as an asset of the enterprise until the related revenues are
recognised (i.e. the item is sold) at which point the inventory is recognised as an
expense (i.e. cost of sales).

Part or all of the cost of inventories may also be expensed if a write-down to net
realisable value is necessary.

67
 D3e) Recognise which costs should be included in valuing inventories.

Cost

The cost of inventories will consist of all the following costs

1. Purchase

2. Costs of conversion

3. Other costs incurred in bringing the inventories to their present location and
condition, e.g. carriage inwards

Costs of purchase

IAS 2 lists the following as comprising the costs of purchase of inventories

• Purchase price; plus

• Import duties and other taxes; plus

• Transport, handling and any other cost directly attributable to the acquisition of
finished goods, services and materials; less

• Trade discounts, rebates and other similar amounts

68
 Costs of conversion

Costs of conversion of inventories consist of two main parts

1. Costs directly related to the units of production, e.g. direct materials, direct labour

2. Fixed and variable production overheads that are incurred in converting materials
into finished goods, allocated on a systematic basis.

Fixed production overheads are those indirect costs of production that remain relatively
constant regardless of the volume of production, e.g. the cost of factory management
and administration.

Variable production overheads are those indirect costs of production that vary directly,
or nearly directly, with the volume of production, e.g. indirect materials and labour.
(IAS 2)

69
 Net Realisable Value

The net realisable value of an item is essentially its net selling proceeds after all costs
have been deducted.

It is calculated as:

As a general rule, assets should not be carried at amounts greater than those expected
to be realised from their sale or use.

In the case of inventories this amount could fall below cost when items are damaged or
become obsolete, or where the costs to completion have increased in order to make the
sale.

70
 D3f) Understand the use of continuous and period end inventory records.

Inventories held at the year end

The quantity of inventories held at the year end is established by means of a physical
count of inventory in an annual counting exercise, or by a 'continuous' inventory count.

In simple cases, when a business holds easily counted and relatively small amounts of
inventory, quantities of inventories on hand at the reporting date can be determined by
physically counting them in an inventory count.

In more complicated cases, where a business holds considerable quantities of varied

inventory, an alternative approach to establishing quantities is to maintain continuous
inventory records.

This means that a card is kept for every item of inventory, showing receipts and issues
from the stores, and a running total.

A few inventory items are counted each day to make sure their record cards are correct
– this is called a 'continuous' count because it is spread out over the year rather than
completed in one count at a designated time.

71
D3g) Calculate the value of closing inventory using FIFO (first in, first out) and AVCO (average
cost) – both periodic weighted average and continuous weighted average.

FIFO (first in, first out)

FIFO assumes that materials are issued out of inventory in the order in which they were
delivered into inventory, i.e. issues are priced at the cost of the earliest delivery
remaining in inventory

AVCO (average cost)

AVCO calculates a weighted average price for all units in inventory. Issues are priced at
this average cost, and the balance of inventory remaining would have the same unit
valuation.

A new weighted average price is calculated whenever a new delivery of materials into
store is received. 

LIFO is no longer permitted under IAS 2.

72
 D3h) Understand the impact of accounting concepts on the valuation of inventory.

Accounting assumption of accruals

The fundamental accounting assumption of accrual requires costs to be matched with

associated revenues. In order to achieve this, costs incurred for goods which remain
unsold at the year end must be carried forward in the statement of financial position and
matched against future revenues.

In valuing inventory, we also follow the prudence concept which states that a profit
cannot be anticipated before it is realised.

A. If inventory is expected to be sold at a profit:

(i) value at cost

(ii) do not anticipate profit.

B. If inventory is expected to be sold at a loss:

(i) value at net realisable value

(ii) do provide for the future loss

73
 D3i) Identify the impact of inventory valuation methods on profit and on assets.

Inventory valuation methods

Each method of valuation produces different costs both of closing inventories and also
of material issues.

Since raw material costs affect the cost of production, and the cost of production works
through eventually into the cost of sales, it follows that different methods of inventory
valuation will provide different profit figures.

In times of rising prices, using FIFO method will mean the financial statements show
higher inventory values and higher profit.

74
 Syllabus D4. Tangible non-current assets

D4a) Define non-current assets.

Non-current assets

Non-current assets - all assets other than current assets shall be classified as non-
current assets. They include both tangible and intangible assets.

The accounting treatment of tangible non-current assets is covered by IAS 16: Property,
Plant and Equipment

75
 D4b) Recognise the difference between current and non-current assets.

The difference between current

and non-current assets

Current assets are assets

• realized (sold/consumed) in entities’ normal operating cycle

• which are held for trading

• which include cash and cash equivalent

• are expected to realize within 12 months after the end of the reporting period

76
 D4c) Explain the difference between capital and revenue items.

77
 Capital expenditure results in the appearance of a non-current asset in the statement of
financial position of the business.

Revenue expenditure results in an expense in the statement of profit or loss.

78
 D4d) Classify expenditure as capital or revenue expenditure.

Capital / Revenue Expenditure

Capital expenditure results in the appearance of a non-current asset in the statement of

financial position of the business.

Revenue expenditure results in an expense in the statement of profit or loss.

79
 D4e) Prepare ledger entries to record the acquisition and disposal of non-current assets.

Acquisition of Non Current Assets

When a non-current asset is acquired, the double-entry is: -



Dr Non-Current Asset

Cr Cash/Payables


Tangible non-current assets should initially be recorded at cost.

The cost of an asset includes

1. Purchase price – after deducting trade discounts and rebates and adding duties
and non-refundable taxes

2. Cost directly attributable to bring the asset to its location and to make it available
for its intended use.



These include:

a. Initial delivery and handling costs


b. Installation and assembly costs


c. Costs of testing whether the asset is working properly


d. Professional fees


80
 The following costs may not be included:

a) The cost of maintenance contracts


b) Administration and general overhead costs


c) Staff training costs

3. Dismantling cost – cost of removing old asset from its place in order to put in the
new one

81
 Disposal of non-current assets

When a non-current asset is sold, there is likely to be a profit or loss on disposal. 

This is the difference between the net sale price of the asset and its net book value at
the time of disposal.

If:

Sales proceeds > NBV → profit on disposal

Sales proceeds < NBV → loss on disposal

Accounting Treatment

1. Remove the cost of the asset:



Dr Disposal account

Cr Non-current asset

2. Remove the accumulated depreciation charged to date:


Dr Accumulated depreciation

Cr Disposal account

3. Account for the sales proceeds:


Dr Cash

Cr Disposal account

4. Balance off disposal account to find the profit or loss on disposal.

A profit on disposal is shown in the statement of profit or loss as sundry income, a loss
as an expense in the statement of profit or loss.

82
D4f) Calculate and record profits or losses on disposal of non-current assets in the statement
of profit or loss including part exchange transactions.

Part exchange allowance

Instead of receiving sales proceeds as cash, a part exchange allowance could be

offered against the cost of a replacement asset:



Dr New asset cost

Cr Disposal account


IAS 16 states that the cost of an item obtained through part exchange is the fair value of
the asset received.

The part exchange allowance takes the place of proceeds in the disposals account.

83
D4gh) 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.
Calculate the profit or loss on disposal of a revalued asset.

IAS 16

IAS 16 allows entities the choice of two valuation models for its non-current assets – the
cost model or the revaluation model.

Each model needs to be applied consistently to all non-current assets of the same
‘class’. A class of assets is a grouping of assets that have a similar nature or function
within the business.

For example, properties would typically be one class of assets, and plant and
equipment another.

Additionally, if the revaluation model is chosen, the revaluations need to be kept up to

date, although IAS 16 is not specific as to how often assets need to be revalued.

When the revaluation model is used, assets are carried at their fair value, defined as ‘the
amount for which an asset could be exchanged between knowledgeable, willing parties
in an arm’s length transaction’.

When a revalued asset is disposed of, any revaluation surplus may be transferred
directly to retained earnings, or it may be left in equity under the heading revaluation
surplus.

The transfer to retained earnings should not be made through the statement of profit or
loss

IAS 16 allows (but does not require) entities to make a transfer of the ‘excess
depreciation’ (the extra depreciation which results due to the increased value of the
asset) from the revaluation reserve directly to retained earnings.

84
 Accounting treatment

• Adjust cost account to revalued amount.

• Remove accumulated depreciation charged on the asset to date.

• Put the balance to the revaluation reserve.

The required double-entry is:



Dr Non-current asset cost

Dr Accumulated Depreciation

Cr Revaluation Reserve

85
 D4i) Illustrate how non-current asset balances and movements are disclosed
in financial statements.

For each class of property, plant, and equipment,

disclose

• basis for measuring carrying amount

• depreciation method(s) used

• useful lives or depreciation rates

• gross carrying amount and accumulated depreciation and impairment losses

• reconciliation of the carrying amount at the beginning and the end of the period,
showing

- additions 

- disposals 

- acquisitions through business combinations 

- revaluation increases or decreases 

- impairment losses 

- reversals of impairment losses 

- depreciation 

- net foreign exchange differences on translation 

- other movements


If property, plant, and equipment is stated at revalued amounts, certain additional

disclosures are required

86
 • the effective date of the revaluation

• whether an independent valuer was involved

• the methods and significant assumptions used in estimating fair values

• for each revalued class of property, the carrying amount that would have been
recognised had the assets been carried under the cost model

• the revaluation surplus, including changes during the period and any restrictions
on the distribution of the balance to shareholders

87
 


88
 D4j) Explain the purpose and function of an asset register.

Asset register

An asset register is used to record all non-current assets and is an internal check on the
accuracy of the nominal ledger.

For example, an asset may have been scrapped and the asset register updated, but the
asset has not yet been written off in the accounting records.

In an asset register, the following details about each non-current asset are found:

• Purchase date

• Cost depreciation method

• Estimated useful life

• Carrying amount

• Description of asset

• Location of asset

• Internal reference number

• Manufacturer’s seriel number

89
 Syllabus D5. Depreciation

D5a) Understand and explain the purpose of depreciation.

Depreciation

Where assets held by an enterprise have a limited useful life, it is necessary to apportion
the value of an asset used in a period against the revenue it has helped to create.
Therefore, with the exception of land held on freehold or very long leasehold, every non-
current asset has to be depreciated.

A charge is made in the statement of profit or loss to reflect the use that is made of the
asset by the business. This charge is called depreciation. The need to depreciate non-
current assets arises from the accrual assumption.  If money is spent on an asset, then
the amount must be charged against profits.

Some key terms

• Depreciation: - the allocation of the depreciable amount of an asset over its

estimated useful life.

• Useful life: - the period over which a depreciable asset is expected to be used by
the enterprise; or the number of production or similar units expected to be
obtained from the asset by the enterprise.

• Depreciable amount: - cost/revalued amount – residual value

• Residual value: - the amount the asset is expected to be sold for at the end of its
useful life. It is also known as scrap value

90
D5b) Calculate the charge for depreciation using straight line and reducing balance methods.

Main methods

There are two main methods for calculating depreciation

• Straight line method

• Reducing balance method

Straight line method

The depreciation charge is the same every year.

Formula



Cost of asset – residual value

---------------------------------

Expected useful life of asset


OR



(Cost – Residual value) × %


This method is suitable for assets which are used up evenly over their useful life, e.g.
fixtures and fittings in the accounts department.

91
 Reducing balance method

This method is suitable for those assets which generate more revenue in earlier years
than in later years; for example machinery in a factory where productivity falls as the
machine gets older.

Under this method the depreciation charge will be higher in the earlier years and reduce
over time.

Formula



Depreciation rate (%) × Net Book Value (NBV)


Net book value (NBV) / Carrying value = cost – accumulated depreciation to date

This method ignores residual value, since the NBV under this method will never reach
zero.

92
D5c) Identify the circumstances where different methods of depreciation would be appropriate.

Appropriate Method

It is up to the business to decide which method of depreciation to apply to its non-

current assets.

The chosen method of depreciation should be applied consistently from year to year.

This is an instance of the fundamental accounting assumption of consistency.

The depreciation method has to be reviewed. If there are any changes in the expected
pattern of use of the asset, then the method used should be changed.

In such cases, the remaining net book value is depreciated under the new method, i.e.
only current and future periods are affected.

The change is prospective.

93
 D5d) Illustrate how depreciation expense and accumulated depreciation
are recorded in ledger accounts.

Depreciation expense and accumulated depreciation

are recorded in ledger accounts

Depreciation has a dual effect which needs to be accounted for

• It reduces the value of the asset in the statement of financial position.

• It is an expense in the statement of profit or loss.

The double-entry for depreciation is: 



Dr Depreciation expense (I/S)

Cr Accumulated Depreciation (SOFP)


with the depreciation charge for the period.

94
 D5f) Calculate the adjustments to depreciation necessary if changes are made in the
estimated useful life and/or residual value of a non- current asset.

Useful life

The useful life of an item of property, plant and equipment should be reviewed at least
every financial year-end and, if expectations are significantly different from previous
estimates, the depreciation charge for current and future periods should be revised.

This is achieved by writing the net book value off over the asset's revised remaining
useful life.



NBV – residual value

----------------------

Revised useful life

95
 Syllabus D6. Intangible non-current assets and amortisation

D6a) Recognise the difference between tangible and intangible non-current assets.

The difference between tangible and intangible

non-current assets

Tangible non-current assets are defined as those which

1. are held for use in the production or supply of goods or services for administrative
purposes; and

2. are expected to be used during more than one period.

An intangible non-current asset is an identifiable, non-monetary asset without physical

substance.

96
 D6b) Identify types of intangible assets.

Examples of intangible assets

• Development expenditure

• Goodwill

• Concessions, patents, licences, trade marks, copy rights

• Computer software

Paper F3 only requires the accounting treatment of research and development

expenditure

97
 D6c) Identify the definition and treatment of “research costs” and “development costs” in
accordance with International Financial Reporting Standards.

Research and Development Expenditure

Many businesses in the commercial world spend vast amounts of money, on an annual
basis, on the research and development of products and services. These entities,
including pharmaceutical and motor companies, do this with the intention of developing
a product or service that will, in future periods, provide significant amounts of income
for years to come.

Definitions

Research is original and planned investigation undertaken with the prospect of gaining
new scientific or technical knowledge and understanding. 

An example of research could be a company in the pharmaceuticals industry

undertaking activities or tests aimed at obtaining new knowledge to develop a new
vaccine. The company is researching the unknown, and therefore, at this early stage, no
future economic benefit can be expected to flow to the entity.

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

design for the production of new or substantially improved materials, devices, products,
processes, systems, or services, before the start of commercial production or use. 

An example of development is a car manufacturer undertaking the design, construction,

and testing of a pre-production model.

98
 Accounting Treatment of Research and Development

IAS 38, Intangible Assets, separates a research and development project into a research
phase and a development phase.

• Research phase



It is impossible to demonstrate whether or not a product or service at the research
stage will generate any probable future economic benefit. As a result, IAS 38
states that all expenditure incurred at the research stage should be written off to
the statement of profit or loss as an expense when incurred, and will never be
capitalised as an intangible asset.

• Development phase


Under IAS 38, an intangible asset must demonstrate all of the following criteria:

◦ Probable future economic benefits

◦ Intention to complete and use or sell the asset

◦ Resources (technical, financial and other resources) are adequate and

available to complete and use the asset

◦ Ability to use or sell the asset

◦ Technical feasibility of completing the intangible asset (so that it will be

available for use or sale)

◦ Expenditure can be measured reliably

If any of the recognition criteria are not met then the expenditure must be charged to
the statement of profit or loss as incurred.

Note that if all the recognition criteria have been met, capitalisation must take place:

Dr Intangible non-current assets (SOFP)

Cr Bank/Payables

99
 D6e) Explain the purpose of amortisation.

Treatment of Capitalised Development Costs

Once development costs have been capitalised, the asset should be amortised in
accordance with the accruals concept over its finite life.

What is amortization?

A tangible non-current asset, e.g. machinery, is capitalised and then depreciated over
its useful life.  Similarly, the cost of the development expenditure should be amortised
over the useful life.   Therefore, the cost of the development expenditure is matched
against the revenue it produces.

Amortisation must only begin when the asset is available for use (hence matching the
income and expenditure to the period in which it relates). It is an expense in the
statement of profit or loss: -

Dr Amortisation expense (I/S)

Cr Accumulated amortization (SOFP)

Each development project must be reviewed at the end of each accounting period to
ensure that the recognition criteria are still met. If the criteria are no longer met, then the
previously capitalised costs must be written off to the statement of profit or loss
immediately.

If the intangible asset is considered to have an indefinite useful life, it should not be
amortised but should be subjected to an annual impairment review, i.e. check wehter
there has been a fall in the value of the intangible asset.

100
 Syllabus D7. Accruals and prepayments

D7a) Understand how the matching concept applies to accruals and prepayments.

Matching concept

We have mentioned that one of the underlying assumptions in the “Framework for the
Preparation and Presentation of Financial Statements” is the accruals concept.

It is also known as the matching concept because of the way it strives to match costs
against the revenues generated by incurring those costs.

Its basic tenet is that revenues should be recognised (i.e. included in the statement of
profit or loss) in the period in which they are earned, not necessarily when they are
received in cash.

Thus, for example, a sale made to a customer on credit just before the year-end would
be included in that year's statement of profit or loss, even though the cash may not be
received until the following year.

In the same way, expenses are recognised according to the period to which they relate,
and not when they are paid.

For example, an electricity bill not paid by the year-end would still be charged in that
year's statement of profit or loss whereas rates paid in advance would be held back and
not charged until the next year.

101
D7b) Identify and calculate the adjustments needed for accruals and prepayments in preparing
financial statements.

Accrued expenses

Accrued expenses (accruals) are expenses which relate to an accounting period but
have not been paid for. They are expenses which are charged against the profit for a
particular period, even though they have not yet been paid for.

Accruals are included in payables as current liabilities as they represent liabilities which
have been incurred but for which no invoice has yet been received.

Accounting Treatment: Accruals

Dr Expense (I/S)

Cr Accruals (SOFP)

102
 Prepaid expenses

Prepaid expenses (prepayments) are expenses which have already been paid but relate
to a future accounting period. Therefore, these are payments which have been made in
one accounting period, but should not be charged against profit until a later period,
because they relate to that later period.

Prepayments are included in receivables in current assets in the statement of financial

position. They are assets as they represent money that has been paid out in advance of
the expense being incurred.

Accounting Treatment: Prepayments

Dr Prepayments (SOFP)

Cr Expense (I/S)

103
 D7c) Illustrate the process of adjusting for accruals and prepayments in preparing
financial statements.

Reversal of Accruals and Prepayments

Accruals and prepayments brought forward at the beginning of the year must be
reversed.

Five steps are involved

1. At the beginning of the year, reverse opening accrual or prepayment

2. Double-entry: -



1. Reversal of an accrual


Dr Accruals (SOFP)

Cr Expense (I/S)


2. Reversal of a prepayment


Dr Expense (I/S)

Cr Prepayment (SOFP)

3. Post the cash paid during the year

4. Post any closing accrual or prepayment

5. Balance off the expense and accruals/prepayments accounts

104
 D7d) Prepare the journal entries and ledger entries for the creation
of an accrual or prepayment.

An entity will accrue income when it has earned the income during the period but it has
not yet been invoiced or received. This will increase income in the statement of profit or
loss and be shown as a receivable in the statement of financial position at year end.

Accounting Treatment: Accrued Income

Dr Accrued income (SOFP)

Cr Income Account (I/S)

When an entity has received income in advance of it being earned, it should be deferred
to the following period. This will reduce income in the statement of profit or loss and be
shown as a payable in the statement of financial position at the year end.

Accounting Treatment: Deferred Income

Dr Income Account (I/S)

Cr Deferred Income (SOFP)

105
 D7e) Understand and identify the impact on profit and net assets
of accruals and prepayments.

106
 Syllabus D8. Receivables and payables

D8b) Identify the benefits and costs of offering credit facilities to customers.

The benefits and costs

Today, very few businesses expect to be paid immediately in cash. 

Most businesses buy and sell to one another on credit terms. 

A business will allow credit terms to customers and receive credit terms from its
suppliers.  

This provides the benefit of allowing businesses to keep trading without having to
provide cash 'up front'. 

However, providing credit facilities to customers can lead to problems. 

Customers might fail to pay, either out of dishonesty or because they have gone
bankrupt. 

Therefore, the costs of offering credit facilities to customers can include:

1. Interest costs of an overdraft, if customers do not pay promptly.

2. Costs of trying to obtain payment, e.g. chasing customers by phone

3. Court costs, e.g. the costs of legal letters

107
 If an entity fails to pay its suppliers by the normal due dates, it may
lead to:

• Reduction in credit rating

• Therefore, difficulty in obtaining credit from new suppliers

108
 D8c) Understand the purpose of an aged receivables analysis.

The Accounts Receivable Aging

A tool to control these problems of providing credit facilities is the aged receivables
analysis.

All outstanding accounts receivable are compiled into the accounts receivable aging
report

This shows how long invoices have been outstanding, current, 30 days, 60 days, 90 and
90+ days, and may also indicate that a customer is unable to pay.

Most credit controllers will have a system of chasing up payment for long outstanding
invoices.

109
 D8d) Understand the purpose of credit limits.

Credit Limit

Another tool in credit control is the credit limit. A customer will be given a credit limit,
which cannot be exceeded. This is a threshold that a company will allow its customers
to owe at any one time without having to go back and review their credit file.   Credit
limit is the maximum amount that a firm is willing to risk in an account.

110
 D8eg) Prepare the bookkeeping entries to write off an irrecoverable debt.
Identify the impact of irrecoverable debts on the statement of profit or loss and on the
statement of financial position.

Irrecoverable debts (bad debts)

Irrecoverable debts (bad debts) are specific debts owed to a business which it decides
are never going to be paid. If a debt is definitely irrecoverable, the prudence concept
dictates it should be written off to the statement of profit or loss as a bad debt.

The value of outstanding receivables must be reduced by the amount written off. This is
because the customers are no longer expected to pay, and it would be misleading to
show them in the statement of financial position as current assets of the business for
which cash payment is expected within one year.

Accounting treatment

Dr Bad debts expense (I/S)

Cr  Trade Receivables (SOFP)

111
 D8f) Record an irrecoverable debt recovered.

An irrecoverable debt paid off

An irrecoverable debt which has been written off might occasionally be unexpectedly

paid. If it is paid in the same accounting period, the write-off journal can simply be
reversed. The only accounting problem to consider is when a debt written off as
irrecoverable in one accounting period is subsequently paid in a later accounting period.
In this case, the amount paid should be recorded as additional income in the statement
of profit or loss of the period in which the payment is received

Accounting Treatment

Dr Cash

Cr Trade Receivables

Dr Trade Receivables

Cr Bad debts recovered (I/S)

112
 D8h) Prepare the bookkeeping entries to create and adjust an allowance for receivables.

Doubtful Debts

If a debt is possibly irrecoverable, an allowance for the potential irrecoverability of that

debt should be made

Accounting treatment

Dr Doubtful debt expense (I/S)

Cr Allowance for receivables (SOFP)

This allowance is offset against trade receivables in the statement of financial position.

Types of allowances

There are two types of allowance for receivables

1. Specific allowance – an allowance against a particular receivable

2. General allowance – a percentage allowance based on past experience of

irrecoverable debts (e.g. 2% of all outstanding receivables)

Therefore, an allowance for receivables provides for future irrecoverable debts, as a

prudent precaution by the business.   For both types of allowance for receivables, the
double-entry still remains: -

Dr Doubtful debt expense (I/S)

Cr Allowance for receivables (SOFP)

113
 Specific allowance

There are two situations in which a specific allowance previously done is no longer
required

• customer pays outstanding amount

• customer goes bankrupt

114
 Customer pays outstanding amount

Accounting treatment

Dr Cash (SOFP)

Cr Trade Receivables (SOFP)

Therefore, this will be credited to income in the statement of profit or loss or it will
reduce the total expense for bad and doubtful debts.

Dr Allowance for receivables (SOFP)

Cr Doubtful debts expense (I/S)

Customer goes bankrupt

Accounting treatment

Dr Allowance for receivables (SOFP)

Cr Trade Receivables (SOFP)

Therefore, no entry is posted in the bad and doubtful debts account as this would have
already been debited with the expense in the first year when we have taken the specific
allowance.

115
 D8i) 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.

How do we calculate the general allowance?

There are a number of steps which must be followed.

1. Take the balance on the trade receivables account after posting credit sales and
cash received from credit customers

2. Deduct bad debts from this balance of trade receivables

3. Deduct also any specific allowances from trade receivables

4. Calculate the general allowance by applying the percentage given to the remaining
balance

Example: - General allowance

116
 General allowance – subsequent years

In subsequent years, adjustments may be needed to the amount of the allowance. The
procedure to be followed then is

1. Calculate the new allowance required.

2. Compare it with the existing balance on the allowance account (i.e. the balance b/f
from the previous accounting period).

3. Calculate increase or decrease required.


(i) If a higher allowance is required now:


Dr Irrecoverable debts expense


Cr Allowance for receivables

                                               

 with the amount of the increase.


(ii) If a lower allowance is needed now than before:


Dr Allowance for receivables


Cr Irrecoverable debts expense


with the amount of the decrease.

117
 Syllabus D9. Provisions and contingencies

D9a-f) Understand the definition of “provision”, “contingent liability” and “contingent asset”.
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.
Calculate provisions and changes in provisions.
Account for the movement in provisions.
Report provisions in the final accounts.

A provision is a liability of uncertain timing or amount.

IAS 37 requires a provision be recognised when all of the following apply:

1. an entity has a present obligation (legal or constructive) as a result of a past event

2. it is probable that an outflow of resources embodying economic benefits will be

required to settle the obligation

3. a reliable estimate can be made of the amount of the obligation

Therefore, a provision is made for something which will probably happen. It should be
recognised when it is probable that a transfer of economic events will take place and
when its amount can be estimated reliably.

Provisions can be distinguished from other liabilities (e.g. trade payables and accruals)
due to the uncertainty concerning the timing or amount of the future expenditure
required in settlement. In contrast, trade payables are liabilities to pay for goods that
have been received and invoiced, hence the timing and amount of the expenditure is
agreed with the supplier.

118
 A provision is accounted for as follows: -



Dr Expense  (I/S)

Cr Provision (SOFP)


The required provision will be reviewed at each year end and increased or decreased as
necessary.

To increase a provision:



Dr Expense (I/S)

Cr Provision (SOFP)


To decrease a provision:



Dr Provision (SOFP)

Cr Expense (I/S)

119
 Measurement of Provision

The amount recognised as a provision should be the best estimate of the expenditure
required to settle the present obligation at the end of the reporting period.

Provisions for one-off events (restructuring, environmental clean-up, settlement of a

lawsuit) are measured at the most likely amount. 

Provisions for large populations of events (warranties, customer refunds) are measured
at a probability-weighted expected value.

Worked out example

A company sells goods with a warranty for the cost of repairs required in the first 2
months after purchase.

Past experience suggests:

• 88% of the goods sold will have no defects

• 7% will have minor defects

• 5% will have major defects

If minor defects were detected in all products sold, the cost of repairs will be $24,000; if
major defects were detected in all products sold, the cost would be $200,000.

What amount of provision should be made?

(88% x 0) + (7% x 24,000) + (5% x 200,000) = $11,680.

120
 Disclosure note

• For each class of provision, an entity should disclose

◦ the net book value at the beginning and the end of the period

◦ additional provisions made in the period, including increases to existing

provisions

◦ amounts utilised during the period

◦ unused amounts reversed during the period

• An entity should also disclose, for each class of provision

◦ a brief description of the nature of the obligation and the expected timing
of any resulting outflows of economic benefits

◦ an indication about the uncertainties  about the amount and timing of

those outflows

◦ the amount of any expected reimbursement, stating the amount of any

asset that has been recognised for that expected reimbursement

121
 D9a-f) Understand the definition of “provision”, “contingent liability” and “contingent asset”.
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.
Calculate provisions and changes in provisions.
Account for the movement in provisions.
Report provisions in the final accounts.

Contingent liabilities are

1. possible obligations that arise from past events and whose existence will be
confirmed only by the occurrence or nonoccurrence of one or more uncertain
future events not wholly within the control of the entity

2. present obligations that arise from past events but are not recognised because:


i. they are not probable that an outflow of resources embodying economic benefits
will be required to settle the obligation; or


ii. the amount of the obligation cannot be measured with sufficient reliability

Recognition

Contingent liabilities should not be recognized in financial statements but they should
be disclosed, unless the possibility of any outflow is remote.

The required disclosures are:

• A brief description of the nature of the contingent liability;

• An estimate of its financial effect;

122
 • An indication of the uncertainties that exist relating to the amount or timing of any
outflow; and

• The possibility of any reimbursement.

Disclosure Note

Unless the possibility of any outflow is remote, for each class of contingent liability, an
entity should disclose at the end of the reporting period, a brief description of the nature
of the contingent liability and where practicable

• an estimate of its financial effect

• an indication of the uncertainties relating to the amount or timing of any outflow;

and

• the possibility of any reimbursement

123
 D9a-f) Understand the definition of “provision”, “contingent liability” and “contingent asset”.
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.
Calculate provisions and changes in provisions.
Account for the movement in provisions.
Report provisions in the final accounts.

Contingent assets

Contingent assets are possible assets that arise from past events and whose existence
will be confirmed only by the occurrence or nonoccurrence of one or more uncertain
future events not wholly within the control of the entity.

A contingent asset must not be recognized. Only when the realization of the related
economic benefits is virtually certain should recognition take place. At that point, the
asset is no longer a contingent asset!

Contingent assets must only be disclosed in the notes if they are probable.   A brief
description of the contingent asset must be provided together with an estimate of its
financial effect and details of any uncertainties

Disclosure Note

Where an inflow of economic benefits is probable (contingent asset), an entity should

disclose a brief description of the nature of the contingent assets at the end of the
reporting period and, where practicable, an estimate of their financial effect.

124
 Syllabus D10. Capital structure and finance costs

D10a) Understand the capital structure of a limited liability company including:

i) Ordinary shares
ii) Preference shares (redeemable and irredeemable)
iii) Loan notes.

Capital structure of a limited liability company

The owners' capital in a limited liability company consists of share capital. When a
company is originally set up, it issues shares. 

These are paid for by investors, who then become shareholders of the company. Shares
are issued in units of 10 cents, 25 cents, 50 cents, $1 or even $2. 

The 'face value' of the shares is called their par value or nominal value, e.g. 100,000
shares of $1 each par value were issued at $1 each.

However, shares may be issued at a price higher than their par value, e.g. the company
may issue 20,000 shares of $1 each at $1.25 per share. This excess over the par value
is called share premium.

1. Authorised capital is the maximum amount of share capital that a company is

empowered to issue. 


The amount of authorised share capital can change by agreement. For example, a
company's authorised share capital might be 10,000,000 ordinary shares
of $1 each.

125
 2. Issued capital is the amount at nominal value of share capital that has been issued
to shareholders. 


This amount of issued share capital cannot exceed the amount of authorised
capital. 


Therefore, the company with authorised share capital of 10,000,000 ordinary

shares of $1 might have issued 6,000,000 shares. 


It may issue 4,000,000 more shares at some time in the future.

3. Called-up capital. When shares are issued, a company may not always be paid the
full amount for the shares at once. 


It might call up only a part of the issue price, and wait until a later time before it
calls up the remainder. 


For example, if a company issues 6,000,000 ordinary shares of $1, it might call up
only, say, 80 cents per share. 


Although the issued share capital would be $6,000,000, the called-up share
capital would only be $4,800,000.

4. Paid-up capital. When capital is called up, some shareholders might delay their
payment (or even default on payment). 


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


For example, if a company issues 6,000,000 ordinary shares of $1 each, calls up

80 cents per share, but only receives payments of $3,600,000, the capital not yet
paid up would be $1,200,000 (4,800,000 – 3,600,000)

126
 D10ai) Ordinary shares

Ordinary shares

Ordinary shares carry no right to a fixed dividend but ordinary shareholders are entitled
to all profits.

In fact, the amount of ordinary dividends fluctuates from year to year.

Ordinary shareholders are sometimes referred to as equity shareholders

Rights of Ordinary shareholders:

1. Shareholders can attend company general meetings.

2. They can vote on company matters such as:


- the appointment or re-election of directors


- the appointment of auditors

3. Ordinary shareholders are the effective owners of a company. 


They own the 'equity' of the business including any reserves of the business.

4. They are entitled to receive dividends

5. They will receive the annual report and accounts


127
 Equity finance

• is raised through the sale of ordinary shares to investors.

Liquidation

• The ordinary shareholders are the ultimate bearers of risk as they are at the
bottom of the creditor hierarchy in a liquidation.


This means that they might receive nothing after the settlement of all the
company's liabilities.


128
 D10aii) Preference shares (redeemable and irredeemable)

Preference shares

1. Carry the right to a final dividend


which is expressed as a percentage of their par value


e.g. a 5% $1 preference share carries a right to an annual dividend of 5c.

2. Have priority over ordinary dividends


The managers of a company are obliged to pay preference dividend first.


Also, preference shareholders have priority over ordinary shareholders to a return

of their capital if the company goes into liquidation.

3. If the preference shares are cumulative


it means that before a company can pay any ordinary dividend it must not only
pay the current year's preference dividend, but must also make good any arrears
of preference dividends which were not paid in previous years.

4. Do not carry a right to vote


However, Preference shares carry LIMITED voting rights where dividends are in
arrears.

5. Should be classified as liabilities

129
 Preference shares may be either redeemable

or irredeemable

Redeemable preference shares

Redeemable preference shares mean that the company will repay the nominal value of
those shares at a later date. 

For example, 'redeemable 6% $1 preference shares 20X8' means that the company will
pay these shareholders $1 for every share they hold on a certain date in 20X8. 

Redeemable preference shares are treated like loans and are included as non-current
liabilities in the statement of financial position. 

However, if the redemption is due within 12 months, the preference shares will be
classified as current liabilities. 

Dividends paid (6c per share in our example) on redeemable preference shares are
included as a finance costs (added to interest paid) in the statement of profit or loss.

Irredeemable preference shares

Irredeemable preference shares form part of equity and their dividends are treated as
appropriations of profit.

130
 D10aiii) Loan notes.

Loan Notes

Limited liability companies may issue loan stock or bonds to raise finance. These are
non-current liabilities but are different from share capital

1. Shareholders are the owners of a company, while providers of loan capital are
creditors of the company.

2. Shareholders receive dividends whereas loan holders are entitled to a fixed rate of
interest every year. This interest is an expense in the statement of profit or loss
and is calculated on the par value, regardless of its market value.

3. Loan holders have to be paid interest when due. Otherwise, they can take legal
action against the company if their interest is not paid. Therefore, loan stock is
generally less risky than shares.

131
D10c) Identify and record the other reserves which may appear in the company statement of
financial position.

Other reserves which appear in the company SFP

When describing ordinary shareholders, we have said that these own the ‘equity’ of the
business including any reserves. Shareholders' equity consists of

• Share capital (at nominal value)

• Share premium – the difference between the issue price of the share and its par
value

• Revaluation surplus – a non-distributable reserve representing unrealised profits

on the revalued assets

• Other reserves – very often, these are revenue reserves which may either have a
specific purpose (e.g. asset replacement reserve) or not (e.g. general reserve)

• Retained earnings – these are profits earned by the company and which have
been retained by the business, i.e. they have not been paid out as dividends,
taxes or transferred to another reserve.  This reserve usually increases from year to
year as companies do not normally distribute all their profits.

132
 D10d) Define a bonus (capitalisation) issue and its advantages and disadvantages.

Increase Share Capital

A company may wish to increase its share capital without needing to raise additional
finance. A bonus issue raises no funds.

A company can make a bonus issue to re-classify some of its reserves as share capital.
Any reserve may be re-classified in this way, including a share premium account or
other reserve. Therefore, these reserves will be debited and share capital credited. Such
a re-classification increases the capital base of the company and gives greater
protection to the company’s creditors.

Advantage

• Increases share capital without reducing present shareholders' holdings

• Capitalises reserves, therefore less is available for distribution as dividends

Disadvantages

• Does not increases cash

• If profits fall, the payment of dividends could be jeopardised

133
 D10e) Define a rights issue and its advantages and disadvantages.

Issue of shares for cash

A rights issue is an issue of shares for cash.

These shares are usually issued at a discount to the current market price.

The 'rights' are offered to existing shareholders, who can sell them if they wish.

Advantages

• Raises cash

• Reserves are available for future dividend distribution

Disadvantages

• If a shareholder sells his rights, he will be losing (diluting) his control in the
company

Illustration 1 - TERP

Cow Co. makes a 1 for 5 rights issue, at $2.50 (MV before issue made $3)

This market value just before the issue is known as the cum rights price.

What is the theoretical ex-rights price?

134
 Solution

5 shares @ $3.00

1 share @ $2.50

So the value per share after the rights issue (TERP) is: $17.50/6 = $2.92

135
 D10f) Record and show the effects of a bonus (capitalisation) issue in the statement of
financial position.

Accounting Treatment

Dr Share Premium

Cr Share Capital


A bonus issue is always done at nominal value.

136
 D10g) Record and show the effects of a rights issue in the statement of financial position.

Accounting Treatment



Dr Cash

Cr Share Capital

Cr Share Premium

137
 D10h) Record dividends in ledger accounts and the financial statements.

Appropriation of retained earnings to shareholders

Dividends are an appropriation of retained earnings to shareholders. They are not an

expense in the statement of profit or loss.

Accounting treatment

Dr Retained Earnings (SOFP)


Cr Dividends Payable (SOFP)


Dividends can be paid during the year (interim dividends) or at the end of the year (final
dividends).  The final dividend will only be accounted for if it has been declared before
year end. Otherwise, it will be disclosed as a note to the financial statements

138
 D10i) Calculate and record finance costs in ledger accounts and the financial statements.

Interest expense incurred

The interest expense incurred on loan stock and bonds will be shown as an expense
called ‘finance costs' in the statement of profit or loss. We have also seen that
dividends paid on redeemable preference shares are also included as finance costs.

Accounting treatment

Dr Finance Costs (I/S)


Cr Bank

139
 D10j) Identify the components of the statement of changes in equity.

The revised statement of changes in equity separates owner and non-owner changes in
equity.  It includes only details of transactions with owners, with all non-owner changes
in equity presented as a single line – total comprehensive income.

Statement of changes in equity – Proforma

140
 Syllabus E. PREPARING A TRIAL BALANCE
Syllabus E1. Trial balance

E1abc) Identify the purpose of a trial balance.

Extract ledger balances into a trial balance.
Prepare extracts of an opening trial balance.

Purpose

The entries in each ledger account are then totaled and a balance is found.

Balances are usually collected in a trial balance which is then used as a basis for
preparing a statement of profit or loss and a statement of financial position.

A trial balance is a list of ledger balances shown in debit and credit columns.

It lists the balances on ledger accounts and totals them.

Total debits should equal total credits.

Therefore, it is a method used to test the accuracy of the double-entry bookkeeping, i.e.
the accuracy of the accounting records.

141
 E1d) Identify and understand the limitations of a trial balance.

The limitations of a trial balance

We have seen that the trial balance is a method used to test the accuracy of the
accounting records. 

Therefore, if the two columns of the list are not equal, there must be an error in
recording the transactions in the accounts. 

However, the trial balance will not disclose the following types of errors.

• The complete omission of a transaction, because neither a debit nor a credit is

made.

• The posting of a debit or credit to the correct side of the ledger, but to a wrong
account.

• Compensating errors (e.g. an error of $500 is exactly cancelled by another $500

error elsewhere).

• Errors of principle, e.g. cash from receivables being debited to receivables

account and credited to cash at bank instead of the other way round.

These errors will be discussed again in the chapter “Correction of Errors”.

142
 Closing Inventories

A business will purchase goods to sell during the year. It is unlikely that all of these
goods will have been sold by the year end. 

The goods still held at the year end are known as closing inventories. 

These are an asset of the business and so should be included in the statement of
financial position. 

Also, these inventories will be included in the cost of sales calculation. 

When a business determines its profit for the year it should match the sales revenue
earned to the cost of goods it sold.

The double-entry for closing inventories is: -



Dr Inventories (SOFP)

Cr Closing Inventories (COS)


Closing inventories will be discussed in further detail in the chapter “Inventories”.

143
 Syllabus E2. Correction of errors

E2a) Identify the types of error which may occur in bookkeeping systems.

Types of error which may occur in bookkeeping

systems

The following are five frequent types of error

1. Errors of transposition


When two digits in an amount are accidentally recorded the wrong way round.

2. Errors of omission


Failing to record a transaction at all, or making a debit or credit entry, but not the
corresponding double entry.

3. Errors of principle


Making a double entry in the belief that the transaction is being entered in the
correct accounts, but subsequently finding out that the accounting entry breaks
the 'rules' of an accounting principle or concept.

4. Errors of commission


Where the bookkeeper makes a mistake in carrying out his or her task of recording
transactions in the accounts. Two examples are: - putting a debit/credit entry in
the wrong account; errors of casting (adding up)

144
 5. Compensating errors


Errors which are, coincidentally, equal and opposite to one another.

Errors corrected by journal entry

Some of these errors can be corrected by journal entry; some require the use of a
suspense account.

• If the correction involves a double entry in the ledger accounts, then it is done by
using a journal entry in the journal.

• When the error breaks the rule of double entry (single entry or error on one side
only), then it is corrected by the use of a suspense account as well as a journal
entry.

145
 E2b) Identify errors which would be highlighted by the extraction of a trial balance.

Errors highlighted by the extraction of a trial balance

Errors that can be detected by a trial balance include

• Errors of transposition

• Errors of omission (if the omission is one-sided)

• Errors of commission (for e.g. if one-sided, or two debit entries are made)

Other errors will not be detected by extracting a trial balance, but may be spotted by
other controls (such as bank or control account reconciliations).

146
 E2c) Prepare journal entries to correct errors.

Suspense Accounts

A suspense account is a temporary account. It never appears in the final accounts.

It is used for two main reasons:

1. To account for a debit or credit entry when the accountant is unsure as to where it
should go

2. To make a preliminary trial balance balance when an error has been detected.

Steps to clear a suspense account

• Determine the original accounting entry which was made.

• Decide what entry should have been made.

• Make the required adjustment.

147
E2d) Calculate and understand the impact of errors on the statement of profit or loss and other
comprehensive income and statement of financial position.

When errors are corrected they may affect the business' profit for the year figure. In
order to find the correct figure for profit, a statement of adjustments to profit has to be
prepared.

Proforma – Statement of Adjustment to Profit

148
 Syllabus E3. Control accounts and reconciliations

E3a) Understand the purpose of control accounts for accounts receivable

and accounts payable.

A control account

A control account is a total account in the nominal ledger. Its balance represents an
asset or a liability which is the grand total of many individual assets or liabilities.

The control accounts provide a convenient total which can be used immediately in
extracting a trial balance or preparing accounts.

Most businesses operate control accounts for trade receivables and payables, but such
accounts may be useful in other areas too, e.g. sales tax control account.

The accounts of individual trade receivables and payables are found in the Receivables
Ledger (RL) and Payables Ledger (PL) respectively.

These are maintained for memorandum purposes only.

Therefore, entering a sales invoice in the account of an individual customer is not part of
the double entry process.

These individual accounts are necessary for administrative convenience.

For example, a customer may wish to query the balance he owes to the business.

Reconciliation between the control account total and the receivables ledger will help to
detect errors, thus providing an important control.


149
 E3b) Understand how control accounts relate to the double-entry system.

In previous topic, we discussed the books of prime entry.  We have also looked at the
flow of information where we have seen that the totals from the books of prime entry are
posted in the nominal accounts using double-entry.

The trade receivables figure shows the total amount owed by all customers at a
particular point in time. It is also called the receivables ledger control account (RLCA).

The trade payables figure shows the total amount owed to all suppliers at a particular
point in time. It is also called the payables ledger control account (PLCA).


150
 E3c) Prepare ledger control accounts from given information.

Main entries in control accounts

The two main entries in the RLCA are credit sales and cash received from credit
customers. 

The double-entry for credit sales is: -

Dr RLCA

Cr Sales

The double-entry for cash received from customers is: -

Dr Bank/Cash

Cr RLCA

The two main entries in the PLCA are credit purchases and cash paid to credit
suppliers.

The double-entry for credit purchases is: -

Dr Purchases

Cr PLCA

The double-entry for cash paid to suppliers is: -

Dr PLCA

Cr Bank/Cash

There are other entries which will be included in the control accounts. It is important to
note that any transaction recorded in the RLCA or the PLCA is also reflected in the
memorandum ledgers.

151
 Other entries in control accounts

Contras

This is where an amount of money is owed to a supplier, who is also a customer who
owes money, i.e., a payable who is also a receivable. 

Instead of paying the full amount to the creditor, who then pays the full amount of their
debt to you, the two amounts owed and owing are offset against each other and only
the difference is settled in cash. This must be reflected in the individual accounts in the
sales and purchase ledgers and in the control accounts in the nominal ledger.

The double entry for a contra is: -

Dr PLCA

Cr SLCA

The contra value is of the maximum common amount. A contra always has the effect of
reducing both receivables and payables.

Returns, Credit Notes and Refunds

When a customer returns goods which have already been paid, he may either be given
a credit note or refunded for the value of these returned goods.

When a credit note is given, the double-entry is: -

Dr Returns In (sales returns)

Cr RLCA

When the customer is refunded: -

Dr RLCA

Cr Bank

The same applies when a customer over-pays an invoice.

152
 Interest charged on overdue accounts

An entity may decide to charge interest if a customer does not pay within the specified
credit period.  

The double-entry for interest charged on these overdue accounts is: -

Dr RLCA

Cr Interest Receivable (Income (I/S))

Discounts

There are two types of discounts

1. Trade discount is a reduction in the list price of an article, given by a wholesaler or

manufacturer to a retailer. It is often given in return for bulk purchase orders.

2. Cash/settlement discount is a reduction in the amount payable for the purchase of

goods or services in return for payment in cash, or within an agreed period.

Trade discounts received are deducted from the cost of purchases. Trade discounts
allowed are deducted from sales. Therefore, sales are recorded net of trade discounts
but inclusive of settlement discounts.

Purchases are also recorded net of trade discounts but inclusive of settlement
discounts. Therefore, trade discounts never appear in the financial statements.

153
 Sales Tax and Discounts

Sales tax is calculated on the amount after all discounts, regardless of whether the
discount is taken or not.

154


Control account balances

Very often, PLCA’s have a credit balance since payables are a liability. However, there
may be situations when there will be a debit balance on a PLCA

• Returning goods which have been paid for and receiving a ‘credit’ (to us, a debit)
on our account

• Overpayment

• Payments in advance

155
 Credit balance on a RLCA

There may be situations when there will be a credit balance on a RLCA

• Returned goods credit to account

• Overpayment

• Payments in advance

156
 E3d) Perform control account reconciliations for accounts receivable and accounts payable.

Reconcile control accounts

Both the receivables and payables control accounts should be balanced regularly and
the balance agreed to the sum of the balances on the memorandum ledgers, the
receivables ledger and the payables ledger respectively.

Therefore, if the balances in the receivables/payables ledgers are added up, they should
agree to the RLCA/PLCA balances. If not, an error must have occurred at the same
point in the system.

157
 E3f) Identify and correct errors in control accounts and ledger accounts.

Types of error

• Errors which affect the control accounts

◦ Over/undercast SDB, PDB, CB.

◦ Transposition error in posting total from SDB/PDB/CB to nominal ledger.

◦ Entry omitted from SDB/PDB/CB.

• Errors which affect the list of balances (receivables/payables ledger)

◦ Omit balance from the list

◦ List a debit balance as a credit/vice versa.

◦ Transposition error in filling ledger from books of prime entry.

• Errors which affect both the lists of balances and RLCA/PLCA

◦ Details being incorrectly recorded on the original source documentation i.e.

sales/purchase invoice.

◦ Loss of original source documentation so it is not recognised anywhere in

the system.

158


159


160
 Syllabus E4. Bank reconciliations

E4a) Understand the purpose of bank reconciliations.

Bank Reconciliation

We have already discussed the cash book as one of the main books of prime entry.
The cash book is used to record the detailed transactions of receipts and payments
affecting the bank account. These are then posted to the nominal ledger periodically. At
the end of each accounting period, the balance on the cash book should equal the
balance in the nominal ledger cash/bank account.

As an extra control over the cash figure, it should be possible to agree this figure to an
independent figure provided by the bank statement. This is not always a straightforward
agreement as there are many reasons why the two figures may not be exactly the same.
Therefore, we need to produce a reconciliation.

Aim of reconciliation

The aim of the reconciliation is to prove the

• completeness

• accuracy

• validity

of cash receipts and payments.

161
 E4b) Identify the main reasons for differences between the cash book
and the bank statement.

The main reasons for differences between the cash

book and the bank statement

The balance on the cash account (which should be the same as the balance in the cash
book) is compared to the balance on the bank statements at a given date. However,
these two balances may not agree. There are various reasons

1. Time lag between writing a cheque and the payment appearing on the bank
statement (unpresented cheques)

2. Time lag between depositing amounts into the bank account and these appearing
on the bank statement (unrecorded lodgements)

3. Direct debits and standing orders are not yet recorded in the cash account (or
cash book)

4. Bank charges not recorded in the cash account (or cash book)

5. Errors, such as transposition errors, or casting errors in the cash account (or cash
book)

6. Errors made by the bank on the bank statement

162
 Differences between the cash book and the bank statement

Therefore, differences between the cash book and the bank statement arise for 3
reasons

• Errors – usually in the cash book

• Omissions – such as bank charges, standing orders and direct debits not posted
in the cash book

• Timing differences – such as unpresented cheques and unrecorded lodgements

Always remember

In our cash book, 

A debit bank balance indicates an asset

but

In the bank statement,

A debit balance indicates a bank overdraft (we owe money to the bank – an asset for
the bank)

In our cash book,

A credit bank balance indicates a liability (overdraft)

but

In the bank statement,

A credit balance indicates a positive balance (the bank owes us money)

163
 E4c) Correct cash book errors and/or omissions.

164
 E4def) Prepare bank reconciliation statements.
Derive bank statement and cash book balances from given information.
Identify the bank balance to be reported in the final accounts.

Bank reconciliation

The bank reconciliation is produced after checking that all the items on the bank
statement have been recorded in the cash book. Any items not in the cash book will
need to be recorded. The balance per bank statement must be adjusted for any timing
differences or errors by the bank.

165
 Syllabus F. PREPARING BASIC FINANCIAL
STATEMENTS
Syllabus F1. Statements of financial position

F1abc) Recognise how the accounting equation, accounting treatments (as stipulated within
sections D, E and examinable documents) and business entity convention underlie the
statement of financial position.
Understand the nature of reserves.
Identify and report reserves in a company statement of financial position.

Statement of financial position

The accounting equation expresses the statement of financial position as an equation.

It emphasises the equality between assets and liabilities (including capital as a liability).

In accounting, capital is an investment of money (funds) with the intention of earning a

return. A business proprietor invests capital with the intention of earning profit.

As long as that money is invested, accountants will treat the capital as money owed to
the proprietor by the business.

Also, the business entity concept states that, regardless of how a business is legally set
up, in accounting a business is always treated separately from its owners(s).

Assets = Liabilities

Assets = (Capital + Profit - Drawings) + Payables

Assets - Payables = Capital + Profit - Drawings

Net Assets = Proprietor’s Interest

166
 Example

At 1.1.X3 Henry has net assets of $120,000. During the year he puts in capital of
$50,000 and draws out $90,000. His net assets at 31.12.X3 are $25,000.

Required:

What is his profit or loss for the year?

Answer

Closing Net Assets = Opening Net Assets + Capital Introduced + Profit - Drawings

25,000 = 120,000 + 50,000+ P - 90,000

Loss = 55,000

167
 F1e) Understand why the heading retained earnings appears in a company statement of
financial position.

Balances remaining

The balances on all remaining ledger accounts (including the profit or loss in the
statement of profit or loss) can be listed and rearranged to form the statement of
financial position.

A credit balance brought down denotes a liability.

An asset would be represented by a debit balance brought down.

The statement of financial position is not part of the double-entry system so the
balances are not transferred out.

168
 Syllabus F2. Statements of profit or loss and other
comprehensive income

F2a) 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.

Income and expenditure T-accounts

The first step in the process of preparing the financial statements is to open up another
ledger account, called the statement of profit or loss.

The balances on all the income and expenditure T-accounts are transferred to the
statement of profit or loss and the closing inventory adjustment is made.

The statement of profit or loss is part of the double entry system, so the basic rule of
double entry still applies: every debit must have an equal and opposite credit entry.

169
 F2b) Understand how accounting concepts apply to revenue and expenses.

Revenue Recognition - IFRS 15 - 5 steps

Ok let’s now get into a bit more detail…

Step 1: Identify the contract(s) with a customer

• The contract must be approved by all involved

• Everyone’s rights can be identified

• It must have commercial substance

• The consideration will probably be paid

Step 2: Identify the separate performance obligations in the contract

This will be goods or services promised to the customer

These goods / services need to be distinct and create a separately identifiable

obligation

• Distinct means:


The customer can benefit from the goods/service on its own AND

The promise to give the goods/services is separately identifiable (from other

promises)

170
 • Separately identifiable means:


No significant integrating of the goods/service with others promised in the

contract 

The goods/service doesn’t significantly modify another good or service promised

in the contract. 


The goods/service is not highly related/dependent on other goods or services

promised in the contract.

Step 3: Determine the transaction price

How much the entity expects, considering past customary business practices

• Variable Consideration

If the price may vary (eg. possible refunds, rebates, discounts, bonuses,
contingent consideration etc) - then estimate the amount expected

• However variable consideration is only included if it’s highly probable there won’t
need to be a significant revenue reversal in the future (when the uncertainty has
been subsequently resolved)

• However, for royalties from licensing intellectual property - recognise only when
the usage occurs

171
 Step 4: Allocate the transaction price to the separate performance
obligations

If there’s multiple performance obligations, split the transaction price by using their
 standalone selling prices. (Estimate if not readily available)

• How to estimate a selling Price


- Adjusted market assessment approach 


- Expected cost plus a margin approach 


- Residual approach (only permissible in limited circumstances).

• If paid in advance, discount down if it’s significant (>12m)

Step 5: Recognise revenue when (or as) the entity satisfies a

performance obligation

Revenue is recognised as control is passed, over time or at a point in time.

• What is Control


It’s the ability to direct the use of and get almost all of the benefits from the asset. 

This includes the ability to prevent others from directing the use of and obtaining
the benefits from the asset.

• Benefits could be:


- Direct or indirect cash flows that may be obtained directly or indirectly


- Using the asset to enhance the value of other assets; 


- Pledging the asset to secure a loan


- Holding the asset.

172
 • So remember we recognise revenue as asset control is passed (obligations
satisfied) to the customer


This could be over time or at a specific point in time.

Examples (of factors to consider) of a specific point in time:

1. The entity now has a present right to receive payment for the asset;

2. The customer has legal title to the asset;

3. The entity has transferred physical possession of the asset;

4. The customer has the significant risks and rewards related to the ownership of the
asset; and

5. The customer has accepted the asset.

Contract costs - that the entity can get back from the customer

These must be recognised as an asset (unless the subsequent amortisation would be

less 12m), but must be directly related to the contract (e.g. ‘success fees’ paid to
agents).

Examples would be direct labour, materials, and the allocation of overheads  - this asset
is then amortised

173
 F2b) Understand how accounting concepts apply to revenue and expenses.

Revenue Recognition - IFRS 15

When & how much to Recognise Revenue?

Here you need to go through the 5 step process…

1. Identify the contract(s) with a customer

2. Identify the performance obligations in the contract

3. Determine the transaction price

4. Allocate the transaction price to the performance obligations in the contract

5. Recognise revenue when (or as) the entity satisfies a performance obligation

Before we do that though, let’s get some key definitions out of the way..

174
 Key definitions

• Contract

An agreement between two or more parties that creates enforceable rights and
obligations.

• Income

Increases in economic benefits during the accounting period in the form of

increasing assets or decreasing liabilities

• Performance obligation

A promise in a contract to transfer to the customer either:

- a good or service that is distinct; or 

- a series of distinct goods or services that are substantially the same and that
have the same pattern of transfer to the customer.

• Revenue

Income arising in the course of an entity’s ordinary activities.

• Transaction price

The amount of consideration to which an entity expects to be entitled in exchange

for transferring promised goods or services to a customer.

175
 F2b) Understand how accounting concepts apply to revenue and expenses.

Presentation in financial statements

Show in the SFP as a contract liability or a receivable, depending on when paid and
performed

i.e.. Paid upfront but not yet performed would be a contract liability - Dr Cash Cr
Contract Liability

i.e.. Paid later but already performed - Dr Receivable Cr Revenue (see below)

Performed but not paid would be a contract receivable or asset

1. A contract asset if the payment is conditional (on something other than time)

2. A receivable if the payment is unconditional

Contract assets and receivables shall be accounted for in accordance with IFRS 9.

Disclosures

All qualitative and quantitative information about:

• its contracts with customers;

• the significant judgments in applying the guidance to those contracts; and

• any assets recognised from the costs to fulfil a contract with a customer.


176
 Syllabus F3. Disclosure notes

F3a) Explain the purpose of disclosure notes.

Notes to the accounts

Notes to the accounts are prepared for the following three purposes:

1. present information about the basis of preparation of the financial statements and
the specific accounting policies used;

2. disclose the information required by IFRSs that is not presented elsewhere in the
financial statements; and

3. provide information that is not presented elsewhere in the financial statements, but
is relevant to an understanding of any of them.

177
 Syllabus F4. Events after the reporting period

F4a) Define an event after the reporting period in accordance with International Financial
Reporting Standards.

IAS 10

According to IAS 10, “Events after the reporting period” are those events, both
favourable and unfavourable, that occur between the end of the reporting period and
the date when the financial statements are authorised for issue”.

These events can have important effects on the financial statements

178
 F4b) Classify events as adjusting or non-adjusting.

Types of events

Two types of events can be identified

1. those that provide evidence of conditions that existed at the end of the reporting
period (adjusting events); and

2. those that are indicative of conditions that arose after the end of the reporting
period (non-adjusting events).

Examples of adjusting events given in IAS 10 are

• the resolution of a court case, as the result of which a provision has to be

recognised instead of the disclosure by note of a contingent liability;

• evidence of impairment of assets;

• bankruptcy of a major customer;

• sale of inventories at prices suggesting the need to reduce the figure in the
Statement of Financial Position to the net value actually realized;

• discovery of fraud or errors that show the financial statements were incorrect

179
 Examples of non-adjusting events given in IAS 10 are

• decline in market value of investments;

• announcement of a plan to discontinue part of the enterprise;

• major purchases and sales of assets;

• destruction of a major asset by fire etc;

• sale of a major subsidiary;

• major dealings in the company's ordinary shares;

180
 Further provisions covered by IAS 10

1. Authorisation for issue of financial statements

An enterprise should disclose the date when the financial statements were
authorised for issue and who gave that authorisation. If the owners or others have
the power to amend the financial statements after issue, that fact should be
disclosed.

2. Going concern

If the management decides after the end of the reporting period that it is
necessary to liquidate the enterprise, the financial statements should not be
prepared on a going concern basis.

3. Dividends

If an entity declares dividends after the reporting period, the entity shall not
recognise those dividends as a liability at the end of the reporting period. That is a
non-adjusting event.

181
 F4c) Distinguish between how adjusting and non- adjusting events are reported
in the financial statements.

How adjusting and non-adjusting events are reported

Financial statements should be adjusted for adjusting events. This means that the
amounts in the financial statements should be changed.

Non-adjusting events do not, by definition, require an adjustment to the financial

statements, but if they are of such importance that non-disclosure would affect the
ability of users of the financial statements to make proper evaluations and decisions,
the enterprise should disclose by note:

• the nature of the event; and

• an estimate of its financial effect, or a statement that such an estimate cannot be

made.

182
 Syllabus F5. Statements of cash flows (excluding
partnerships)

F5a) Differentiate between profit and cash flow.

Control cash flow

A business may appear profitable on its statement of profit or loss, however if its cash
outflow exceeds its cash inflow over a prolonged period then it will not survive. 

Readers of a company's financial statements might also be misled by a reported profit

figure.

1. Shareholders might believe that if a company makes a profit after tax, then this is
the amount which it could afford to pay as a dividend.

2. Employees might believe that if a company makes profits, it can afford to pay
higher wages next year.

3. Survival of a business entity depends not so much on profits as on its ability to

pay its debts when they fall due.

Indeed, a business must generate sufficient cash from its operations to reward the
various stakeholders e.g., shareholders and lenders. An expanding company might have
negative operating cash flow as it builds up the level of its inventories and receivables in
line with the increased turnover. However, an increase in working capital without an
increase in turnover might indicate operational inefficiencies and will lead to liquidity
problems.

183
 F5c) Recognise the benefits and drawbacks to users of the financial statements of a
statement of cash flows.

Advantages and Disadvantages

One of the most useful financial statements produced by a business is the statement of
cash flow because it provides a clear and understandable picture of cash movements
over the financial year.

A statement of cash flow provides useful additional information that is not provided by
the statement of profit or loss.

For example, it identifies whether cash has increased or decreased from one year to the
next and also where the cash has come from.

Statements of cash flow are a useful addition to the financial statements of a company
because accounting profit is not the only indicator of performance.

They concentrate on the sources and uses of cash and are a useful indicator of a
company's liquidity and solvency.

Also, users of accounts can readily understand cash flows, as opposed to statements of
profit or loss and statements of financial position which are subject to manipulation by
the use of different accounting policies.

However, the main weakness of a statement of cash flow is that it is a historic

statement.

Therefore, it does not indicate whether the business will be able to meet its debts in the
future.

A more helpful statement would be a forecast statement of cash flow.


184
 F5d) Classify the effect of transactions on cash flows.

185
 IAS 7, Statements of Cash Flows

IAS 7, Statements of Cash Flows, splits cash flows into the following headings:

• Cash flows from operating activities

• Cash flows from investing activities

• Cash flows from financing activities

186
 Cash flows from operating activities

These represent cash flows derived from operating or trading activities. 

There are two methods which can be used to find the net cash from operating
activities: 

direct and indirect method.

Cash flows from investing activities

These are related to the acquisition or disposal of any non-current assets or

investments together with returns received in cash from investments

i.e. dividends and interest.

Cash flows from financing activities

Financing cash flows comprise receipts from or repayments to external providers of

finance in respect of principal amounts of finance. 

For e.g.

1. Cash proceeds from issuing shares

2. Cash proceeds from issuing debentures, loans, notes, bonds, mortgages and
other short or long term borrowings

3. Cash repayments of amounts borrowed

4. Dividends paid to shareholders

187
 In order to calculate such figures the closing statement of financial position figure for
debt or share capital and share premium is compared with the opening position for the
same items.

Statement of cash flows for the year ended 31 December 20X7

(INDIRECT METHOD)

188
 * This could also be shown as an operating cash flow.

189
 F5e) Calculate the figures needed for the statement of cash flows including:
i) Cash flows from operating activities
ii) Cash flows from investing activities
iii) Cash flows from financing activities

190
 F5f) Calculate the cash flow from operating activities using the indirect and direct method.

In the direct method, the cash records of the business are analysed for the period,
picking out all payments and receipts relating to operating activities.

These are summarised to give the net figure for the cash flow statement.

Not many businesses adopt this approach as it can be quite time consuming.

However, this is the preferred method under IAS 7.

Statement of cash flows for the year ended 31 December 20x7

(DIRECT METHOD)

191
 Syllabus F6. Incomplete records

F6a) Understand and apply techniques used in incomplete record situations:

i) Use of accounting equation
ii) Use of ledger accounts to calculate missing figures
iii) Use of cash and/or bank summaries
iv) Use of profit percentages to calculate missing figures.

Introduction

Incomplete records problems occur when a business does not have a full set of
accounting records, for one of the following reasons.

• The proprietor of the business does not keep a full set of accounts.

• Some of the business accounts are accidentally lost or destroyed.

192
 F6ai) Understand and apply techniques used in incomplete record situations:
Use of accounting equation

Calculating a profit or loss figure

It is still possible to calculate a profit or loss figure by using the fact that the profit of a
business must be represented by more assets. We list and value the opening and
closing net assets, then calculate the profit as the difference between the two             



Profit = Closing net assets - Opening net assets


Allowance must be made for proprietor's drawings and extra capital introduced, so the
formula becomes:



Profit = Closing net assets - Opening net assets + Drawings - Capital introduced

193
 F6aii) Understand and apply techniques used in incomplete record situations:
i) Use of accounting equation
ii) Use of ledger accounts to calculate missing figures

Control Accounts

A receivables ledger control account can be prepared to calculate missing credit sales.
However, the figures for the opening and closing receivables of a business and the cash
received from customers must be given.

194
 The same technique can be used to calculate credit purchases.   A payables ledger
control account can be prepared using given figures for opening and closing payables
and cash paid.

Note 



Total sales = Cash sales + Credit sales

Total purchases = Cash purchases + Credit purchases

Cash/Bank

A cash account may need to be set up to find the figure missing for proprietor’s
drawings or cash stolen. Details of cash receipts and payments plus details of opening
and closing balances must be given

Cost Structure

• Margin: gross profit is expressed as a percentage of sales


For example a margin of 25% gives:


Sales    100%

Cost of sales     75%

Gross profit      25%

• Mark-up: gross profit is expressed as a percentage of cost of sales


For example a mark-up of 35% gives:


Sales     135%

Cost of sales      100%

Gross profit       35%



Cost of sales = opening inventories + purchases – closing inventories

195
 Goods Drawn By Proprietor

The owners of the business may at times take goods or cash from the business for their
own use. This is known as drawings.

• Cash Drawings


Dr Drawings

Cr Cash

• Goods taken for own use


Dr Drawings

Cr Purchases



These are recorded at the cost to the business not at selling price. They are taken out of
purchases and not recorded against inventories

Goods destroyed, stolen or lost

When inventory is stolen, destroyed or otherwise lost, the loss must be accounted for
depending on whether or not these goods were insured against the loss.

If the lost goods were not insured, 

Debit expense (e.g. admin expenses in the I/S)

Credit cost of sales

If the lost goods were insured,

Debit insurance claim account (current asset in SFP)

Credit cost of sales


196
 Syllabus G. CONSOLIDATED FINANCIAL
STATEMENTS
Syllabus G1. Subsidiaries

G1a) Terms:
Define and describe the following terms in the context of group accounting:
i) Parent
ii) Subsidiary
iii) Control
iv) Consolidated or group financial statements
v) Non-controlling interest
vi) Trade / simple investment

Group accounting

• Parent

An entity that has one or more subsidiaries

• Subsidiary

An entity, including an unincorporated entity such as a partnership, that is
controlled by another entity (known as the parent).

• Control

The power to govern the financial and operating policies of an entity so as to
obtain benefits from its activities

• Consolidated or group financial statements


The financial statements of a group presented as those of a single economic
entity.

197
 • Non-controlling interest

Non-controlling interest (NCI) arises when the parent entity controls a subsidiary
but does not own 100% of it; e.g. if P owns only 70% of the ordinary shares of S,
there is a NCI of 30%

• Trade/simple investment

An investment in the shares of another entity, that is held for the accretion of
wealth, and is not an associate or a subsidiary. Trade investments are shown as
investments under non-current assets in the consolidated SFP of the group.

198
 G1b) Identify subsidiaries within a group structure.

199
 Subsidiary within a group structure

P is an individual legal entity, known as the parent. The parent is an entity that has one
or more subsidiaries.

S is an individual legal entity, known as the subsidiary.

P owns more than 50% of the ordinary shares of S. It has enough voting power to
appoint all the directors of S.   P has the power to govern the financial and operating
policies of an entity so as to obtain benefits from its activities.

Although P and S remain distinct, in economic substance, they can be regarded as a

single unit, the group.

Although control is usually based on ownership of more than 50% of voting power, IAS
27  lists the following situations where control exists, even when the parent owns only
50% or less of the voting power of an enterprise.

1. The parent has power over more than 50% of the voting rights by virtue of
agreement with other investors

2. The parent has power to   govern the financial and operating policies of the
enterprise by statute or under an agreement

3. The parent has the power to appoint or remove a majority of members of the
board of directors (or equivalent governing body)

4. The parent has power to cast a   majority of votes at meetings of the board of
directors

Consolidated financial statements present the results of the group; they do not replace
the financial statements of the individual group companies.


200
G1c) Describe the components of and prepare a consolidated statement of financial position
or extracts thereof including:
i) Fair value adjustments at acquisition on land and buildings (excluding depreciation
adjustments)
ii) Fair value of consideration transferred from cash and shares (excluding deferred and
contingent consideration)
iii) Elimination of intra-group trading balances (excluding cash and goods in transit)
iv) Removal of unrealised profit arising on intra-group trading
v) Acquisition of subsidiaries part way through the financial year

Consolidated SFP

1. Take the individual accounts of the parent and subsidiary and cancel out items
which appear as an asset in one company and a liability in another, e.g.
receivables in one company and payables in another.

2. Add together all the uncancelled assets and liabilities throughout the group on a
line by line basis.

3. The investment in the subsidiary (S) shown in the parent’s (P) statement of
financial position is replaced by the net assets of S.

The consolidated statement of financial position shows

• The net assets of the whole group (P + S)

• The share capital of the group which always equals the share capital of P only and

• The retained profits, comprising profits made by the group (i.e. all of P’s historical
profits + profits made by S post-acquisition).

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G1d) Calculate goodwill (excluding impairment of goodwill) using the full goodwill method only
as follows:
Fair value of consideration X
Fair value of non-controlling interest X
Less fair value of net assets at acquisition (X)
Goodwill at acquisition X

The value of a company will normally exceed the value of its net assets. The difference
is goodwill. This goodwill represents assets not shown in the statement of financial
position of the acquired company such as the reputation of the business and the loyalty
of staff.

Value of the subsidiary

Where less than 100% of the subsidiary is acquired, the value of the subsidiary
comprises two elements:

• The value of the part acquired by the parent;

• The value of the part not acquired by the parent, known as the non-controlling
interest.

Positive goodwill

1. An intangible non-current asset in the SFP

2. Tested annually for impairment (amortisation of goodwill is not permitted).

Impairment of goodwill is not examinable for F3 purposes

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 Negative goodwill

1. Arises where the cost of the investment is less that the value of net assets
purchased.

2. Negative goodwill is credited directly to the statement of profit or loss.

Although there are two methods in which goodwill may be calculated following the
update to IFRS 3, only the full goodwill method is examined in F3.

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 Syllabus G2. Associates

G2ab) Define and identify an associate and significant influence and identify the situations
where significant influence or participating interest exists.
Describe the key features of a parent-associate relationship and be able to identify an
associate within a group structure.

IAS 28 defines an associate as

An entity over which the investor has significant influence but not control or joint control
and that is neither a subsidiary nor an interest in joint venture. 

Significant influence is the power to participate in the financial and operating policy
decisions of the investee but is not in control or joint control over those policies.

There are several indicators of significant influence, but the most important are usually
considered to be a holding of between 20% and 50% of the voting shares and board
representation.

The existence of significant influence by an investor is usually evidenced in one or

more of the following ways:

• representation on the board of directors or equivalent governing body of the

investee

• participation in the policy-making process

• material transactions between the investor and the investee

• interchange of managerial personnel

• provision of essential technical information


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 Syllabus H. INTERPRETATION OF FINANCIAL
STATEMENTS
Syllabus H1. Importance and purpose of analysis of financial
statements

H1a) Describe how the interpretation and analysis of financial statements is used in a business
environment.

Financial information

The financial statements of a business provide important financial information for people
outside the business (external users) who do not have access to the internal accounts.
For example, current and potential shareholders can see how much profit a business
made, the value of its assets and the level of cash reserves.

Although these figures are useful, they do not mean a great deal by themselves.
To summarise and present financial information in a more understandable form, they
need to be properly analysed using accounting ratios and then compared with either the
previous year’s ratios or against averages for the industry.

The lack of detailed information available to the external user is a considerable

disadvantage in undertaking ratio analysis. There may simply be insufficient data to
calculate all of the required ratios.

Comparisons with previous year’s ratios can be difficult especially if there have been
changes in accounting policies or in the nature of the business.  Comparability between
companies may be impaired due to different accounting policies and different
environments in which the two companies are operating.

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 H1b) Explain the purpose of interpretation of ratios.

Associate investment in parent FS

Equity accounting brings an associate investment into the parent company’s financial
statements initially at cost.

The basic principle of equity accounting is that P Co should take account of its share of
the earnings of A Co whether or not A Co distributes the earnings as dividends.   A’s
sales revenue, cost of sales, expenses and revenue are not added with those of the
group. Instead the group share only of A’s profit after tax is included in the consolidated
statement of profit or loss as a single amount.

P Co should also include its share of A Co’s other comprehensive income in its
consolidated statement of comprehensive income.

In the consolidated statement of financial position, the associate is included as a non-

current asset investment, calculated as

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 Syllabus H2. Ratios

H2ai/b) Calculate key accounting ratios

i) Profitability /
Explain the interrelationships between ratios

Return on Capital Employed (ROCE)

A business buys assets such as trucks, computers, etc to help makes its operations
more efficient, cut down on costs and make bigger profits.

ROCE shows how well a business has generated profit from its long-term financing.

It is expressed in the form of a percentage, and the higher the percentage, the better.

ROCE is calculated:

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 How can firms increase the ROCE ratio?

Movements in return on capital employed are best interpreted by examining profit

margins and asset turnover (in more detail below) as ROCE is made up of these
component parts.

Firms can increase their ROCE ratio by:

1. Cutting costs so as to increase the profit margin ratio

2. Increasing the revenue made from their assets, i.e. more efficient use of assets

Limitations of using ROCE ratio

• Be careful when using the ROCE ratio because it does not always yield the correct
percentage.



For instance, a company may simply run down its old assets. 


This means the denominator Total Assets - Current Liabilities (value of assets is
lower) will be lower and so give a higher ROCE percentage.


In this case, there has been no improvement in operations of the company, in fact
the firm is cutting down on potentially profitable capital investments.

• Always compare a companys ROCE to the interest rate it is charged.


The ROCE needs to be higher.


Similarly if a company pays off a 5% loan, while its current ROCE is 10%, then this
is illogical. It should use the money to get 10% not pay off a loan which only costs
5%.

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 Asset Turnover

Asset turnover shows how efficiently management have utilised assets to generate
revenue.

It is calculated as:

When looking at the components of the ratio, a change will be linked to either a
movement in revenue, a movement in net assets, or both.

An increase in asset turnover can result from:

1. a significant increase in sales revenue

2. the business entering into a sale and operating lease agreement, then the asset
base would become smaller, thus improving the result.

Return on Equity (ROE)

The ROE ratio reveals how much profit has been made in comparison to shareholder
equity.

A business that has a high return on equity is more likely to be one that is capable of
generating cash internally.

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 Gross Profit Margin

The gross profit margin looks at the performance of the business at the direct trading
level.

Variations in the Gross Profit Margin are as a result of:

1. changes in the selling price/sales volume

2. changes in cost of sales

For example, cost of sales may include inventory write downs that may have occurred
during the period due to damage or obsolescence, exchange rate fluctuations or import
duties.

Net Profit Margin

The net profit margin is generally calculated by comparing the profit before interest and
tax of a business to revenue.

However, the examiner may specifically request the calculation to include profit before
tax.

Analysing the net profit margin enables you to determine how well the business has
managed to control its indirect costs during the period. In the exam, when interpreting
operating profit margin, it is advisable to link the result back to the gross profit margin.

For example, if gross profit margin deteriorated in the year then it would be expected
that the net profit margin would also fall. 

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 However, if this is not the case, or the fall is not so severe, it may be due to good
indirect cost control or perhaps there could be a one-off profit on disposal distorting the
operating profit figure.

It is important to note that the profit margin and asset turnover together explain the
ROCE.

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 H2aii/b) Calculate key accounting ratios
ii) Liquidity /
Explain the interrelationships between ratios

Current Ratio

Current Assets

--------------------

Current Liabilities


The current ratio considers how well a business can cover the current liabilities with its
current assets. It is a common belief that the ideal for this ratio is between 1.5 and 2 : 1
so that a business may comfortably cover its current liabilities should they fall due.

However this ideal should be considered in the context of the company: the nature of
the assets in question, the company’s ability to borrow further to meet liabilities and the
stability of its cash flows.

For example, a business in the service industry would have little or no inventory and
therefore could have a current ratio of less than 1. This does not necessarily mean that it
has liquidity problems so it is better to compare the result to previous years or industry
averages.

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 Quick Ratio

Current Assets – Inventories


-----------------------------

Current Liabilities

One of the problems with the current assets ratio is that the assets counted include
inventories which may or may not be quickly sellable (or which may only be sellable
quickly at a lower price).

The ideal ratio is thought to be 1:1, but as with the current ratio, this will vary depending
on the industry in which the business operates.

The quick ratio is also known as the acid test ratio. This name is used because it is the
most demanding of the commonly used tests of short term financial stability.

When assessing both the current and the quick ratios, remember that both of these
ratios can be too high. This would mean too much cash is being tied up in current
assets as opposed to new more profitable investments.

It is important to look at the information provided within the question to consider

whether or not the company has an overdraft at year-end.  The overdraft is an additional
factor indicating potential liquidity problems and this form of finance is both expensive
(higher rates of interest) and risky (repayable on demand)

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 H2aiii/b) Calculate key accounting ratios
iii) Efficiency /
Explain the interrelationships between ratios

Inventory Turnover Period

Closing (or average) Inventory x 365


---------------------------------------

COS                                     


This ratio calculates how long goods to be sold stay in stock.

Generally, the lower the number of days that inventory is held the better as holding
inventory for long periods of time constrains cash flow and increases the risk associated
with holding the inventory. The longer inventory is held the greater the risk that it could
be subject to theft, damage or obsolescence. However, a business should always
ensure that there is sufficient inventory to meet the demand of its customers.

Receivables Collection Period (in days)

Trade Receivables x 365


------------------- 

Credit Sales 


This ratio calculates how long credit customers take to pay.

A short credit period for receivables will aid a business’ cash flow. However, some
businesses base their strategy on long credit periods to achieve higher sales in highly
competitive markets.

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 If the receivables days are shorter compared to the prior period, it could indicate better
credit control or potential settlement discounts being offered to collect cash more
quickly whereas an increase in credit periods could indicate a deterioration in credit
control or potential bad debts

Payables Payment Period (in days)

Trade Payables x 365


---------------------

Credit Purchases 


This ratio calculates how long the company takes to pay its suppliers.

An increase in payables days could indicate that a business is having cash flow
difficulties and is therefore delaying payments. It is important that a business pays
within the agreed credit period to avoid conflict with suppliers. 

If the payables days are reducing, this indicates suppliers are being paid more quickly.
This could be due to credit terms being tightened or taking advantage of early
settlement discounts being offered.

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 Working Capital Cycle (cash cycle)

A company only gets cash once an item has been in stock and then the debtor pays
(Inventory days + receivables days).

This total should then be reduced by the payable days (the company doesn’t need the
cash until the end of this).

So, the working capital cycle (in days) is:



Inventory (in days) + Receivables (in days) – Payables (in days)

This needs to be kept as small as possible for liquidity purposes.

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