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Acca f3 Course Notes Financial Accounting
Acca f3 Course Notes Financial Accounting
F3 Course notes
Chapter 1
An Introduction to Financial Accounting – Its
Scope and Purpose
Transactions are recorded in books of prime entry. The totals of these books of
prime entry are posted to the ledger accounts. Finally, transactions are summarized
in the financial statements. We will be study in detail these procedures later on in
Chapters, 4, 5 and 6.
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
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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.
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.
Lecture Example 1
Which of the following are differences between sole traders and limited liability
companies?
1. A sole traders’ financial statements are private; a company’s financial
statements are sent to shareholders and may be publicly filed
2. Only companies have capital invested into the business
3. A sole trader is fully and personally liable for any losses that the
business might make; a company’s shareholders are not personally
liable for any losses that the company might make
A. 1 and 2 only
B. 2 and 3 only
C. 1 and 3 only
D. 1, 2 and 3
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Advantages Disadvantages
Profits have to be shared
Limited Liability
out amongst a potentially
More capital can be raised
larger number of people
as no limit on number of
Detailed legal procedures
shareholders
must be followed to set up
Control of company can
the business – consuming
not be lost to outsiders –
time and money
shares only sold if all
Financial statements have
shareholders agree
to comply with legal and
The business will continue
accounting requirements
even if one of the owners
Financial information can
dies, shares being
be inspected by any
transferred to another
member of the public once
owner – separate legal
filed with the Registrar,
identity
including competitors
Advantages Disadvantages
Personal satisfaction Limited sources of finance
Secrecy Restricted growth
Personal Control Full personal responsibility
Enjoyment of all profits for the decisions and due
Absence of legal to unlimited liability the
formalities when debts of the business
establishing business
Financial advantages in
terms of low taxes, longer
period to pay taxes and
lower accountancy fees.
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Advantages Disadvantages
There are no legal Partners are jointly and
formalities to complete severely liable for the acts
when setting up the and omissions of the other
business partners
Each partner can Profits have to be shared
specialize amongst more owners
Partners can share the Partners may disagree
workload The size of a partnership
Financial advantages in is limited to a maximum of
terms of low taxes, longer 20 partners, however
period to pay taxes and there are exceptions to
lower accountancy fees. 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.
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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Lecture Example 2
What are the needs of these different users and how would they use the financial
information?
b. Investors/shareholders:
c. Trade suppliers:
d. Trade customers:
e. Providers of finance:
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h. The public:
Corporate governance was defined by the Cadbury Committee 1 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.'
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.
1The Cadbury Report, titled Financial Aspects of Corporate Governance, is a report of a committee
chaired by Adrian Cadbury that sets out recommendations on the arrangement of company boards
and accounting systems to mitigate corporate governance risks and failures.
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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.
Lecture Example 3
A. Shareholders
B. Board of directors
C. Top executive officers
Lecture Example 4
A. Shareholders
B. Board of directors
C. Top executive officers
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KEY POINTS
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2. Define: -
a. Sole traders – Sole traders are people who work for themselves. They
have unlimited liability.
In law, sole traders and partnerships are not separate entities from their owners.
On the other hand, a limited liability company has a separate legal identity from
its shareholders.
4. A limited liability company has many advantages compared to a sole trader and
a partnership. It has limited liability and finds it easier to raise finance. It has a
separate legal identity from its shareholders. Hence, a company continues to
exist regardless of the identity of its owners.
There are various groups of people who need information about the activities of
a business. These include investors, suppliers and customers, providers of
finance, the employees of the company, government and the general public
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7. Corporate Governance
Board of Directors: -
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.
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QUESTION BANK
____________________
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1. Financial reporting is the name given to the actual transactions carried out by a
business.
A. True
B. False
A. Bank statements
B. Financial statements for the past five years
C. Tax records for the past five years
D. Budgets for the coming financial year
A. Bank statements
B. Financial statements for the past five years
C. Tax records for the past five years
D. Budgets for the coming financial year
5. The IASB Framework identifies user groups. Which of the following is not an
information need for the ‘Investor’ group?
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ANSWER BANK
_________________
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14
2. B
3. D
4. A
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Chapter 2
The Regulatory Framework
2.1.1 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).
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. 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.
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.
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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 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.
Lecture Example 1
A To enforce IFRSs
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B To issue IFRSs
The IFRS Advisory Council (IFRS AC) gives advice to the IASB on a range of issues
which includes, but is not limited to, the following:
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 IFRIC reviews, on a timely basis within the context of current International
Financial Reporting Standards (IFRSs) and the IASB Framework, accounting issues
that are likely to receive divergent or unacceptable treatment in the absence of
authoritative guidance, with a view to reaching consensus on the appropriate
accounting treatment.
The IFRS IC addresses issues of reasonably widespread importance, not issues that
are of concern to only a small minority of entities. The interpretations cover both:
newly identified financial reporting issues not specifically dealt with in IFRSs;
or
issues where unsatisfactory or conflicting interpretations have developed, or
seem likely to develop in the absence of authoritative guidance, with a view to
reaching a consensus on the appropriate treatment.
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Lecture Example 2
Lecture Example 3
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KEY NOTES
_________________
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2. The Structure
Its roles: -
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1. The trustees appoint the members of the IASB, IFRSIC and the IFRS AC.
2. 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.
3. These trustees also raise the funds necessary to support the IFRSF
Its roles: -
1. The IASB aims to develop a single set of high quality, understandable and
enforceable global accounting standards that require transparent and
comparable information in general purpose financial statements.
2. It co-operates with national accounting standard-setters to achieve
convergence in accounting standards around the world.
Its roles: -
Its roles: -
1. provides guidance on both how to apply existing IFRSs and how to account
for new financial reporting issues where no IFRS exists.
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__________________
QUESTION BANK
___________________
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23
A. IASB
B. IASCF
2. The IASB has the power to enforce compliance with IASs/ IFRSs. Is this
statement?
A. True
B. False
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ANSWER BANK
______________
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25
1. A
2. B
3. C
4. B
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26
Chapter 3
The Qualitative Characteristics of Financial
Information
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:
i. assist in the development of future IFRS and the review of existing standards
by setting out the underlying concepts
iii. 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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1. Relevance
Materiality
2. Faithful Representation
it is complete
it is neutral
it is free from error
.
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IAS 1 states that an entity whose financial statements comply with IFRSs should
disclose that fact.
In this case an entity should depart from the requirement of the standard provided
the relevant regulatory framework permits such departure.
1. Comparability
2. Verifiability
3. Timeliness
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4. Understandability
1. classified
2. characterised
3. 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.
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The Framework sets out two concepts which can be presumed when reading
financial statements:
• Accrual Basis
The effects of transactions and other events are recognised when they occur,
rather than when cash or its equivalent is received or paid, and they are
reported in the financial statements of the periods to which they relate.
• Going Concern
2. Fair presentation
The financial statements must "present fairly" the financial position, financial
performance and cash flows of an entity.
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Lecture Example 1
Sales revenue should be recognised when goods and services have been supplied;
costs are incurred when goods and services have been received.
The accounting concept which governs the above is the
Lecture Example 2
(1) Accruals
(2) Completeness
(3) Going concern
(4) Neutrality
A. 1 and 2
B. 2 and 4
C. 2 and 3
D. 1 and 4
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Historical cost has been defined as the amount paid or fair value of the consideration
given.
1. The cost is known and can be proved (e.g. against an invoice). It is therefore
objective
2. It enhances comparability
3. It leads to stable pricing – using current market values would lead to volatility
in asset values
2. Since non-current asset values are low, depreciation is low and does not fully
reflect the value of the asset consumed during the accounting year
3. Lower costs, e.g. depreciation expense, would lead to higher profits. There is
a possibility that this may lead to higher taxation, wage demands and dividend
expectation (based on overstated earnings per share). The combination of
these effects is that a company may overspend or over distribute its profits
and not maintain its capital base.
6. Where assets, particularly land and buildings, are being used as security to
raise finance, it is current value that lenders are interested in, not historical
values
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KEY NOTES
_________________
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34
The IASB’s Conceptual Framework for Financial Reporting describes the basic
concepts by which financial statements are prepared.
1. Relevance
Materiality
2. Faithful Representation
To be useful, financial information must not only be relevant, it must also represent
faithfully the phenomena it purports to represent.
it is complete
it is neutral
it is free from error
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1. Comparability
2. Verifiability
3. Timeliness
4. Understandability
classified
characterised
presented clearly and concisely
Underlying Assumptions
• Accrual Basis
• Going Concern
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2. Fair presentation
The financial statements must "present fairly" the financial position, financial
performance and cash flows of an entity.
4. Historical cost
In times of rising prices, historical cost accounting tends to understate asset values
and overstate profits.
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37
_________________
QUESTION BANK
_________________
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38
2. The accounting concept which requires assets to be valued at their net book
value, rather than their 'breakup' value is the
A. materiality concept
B. going concern concept
C. prudence concept
D. business entity convention
A. To comply with the law, the legal form of a transaction must always be
reflected in financial statements.
True False
True False
True False
True False
E. The substance over form convention means that the legal form of a
transaction must always be shown in financial statements even if this differs
from the commercial effect.
True False
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_________________
ANSWER BANK
_________________
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40
1 A
2 B
A. FALSE
B. FALSE
C. TRUE
D. FALSE
E. FALSE
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Chapter 4
The Main Elements of Financial Reports
The principle financial statements of a sole trader are the statement of financial
position and the statement of profit or loss.
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.
4.1.1 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.
Lecture Example 1
List some examples of assets found in a business and state whether they are
classified as non-current or current assets: -
a. _________________________________________________
b. _________________________________________________
c. _________________________________________________
d. _________________________________________________
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42
4.1.2 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.
Lecture Example 2
List some examples of liabilities found in a business and state whether they are
classified as non-current or current liabilities: -
a. _________________________________________________
b. _________________________________________________
c. _________________________________________________
d. _________________________________________________
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,
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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43
A TRADER
PROFORMA STATEMENT OF FINANCIAL POSITION AS AT 30 APRIL 20X8
$ $
Assets
Non-Current Assets
Land and buildings 100,000
office equipment 80,000
Motor vehicles 30,000
Furniture and fixtures 10,000
220,000
Current Assets
Inventories 30,000
Trade Receivables 27,000
less: Allowance for receivables (2,000)
25,000
Prepayments 15,000
Cash in hand and at bank 10,000
80,000
Total assets 300,000
Current Liabilities
Bank overdraft 20,000
Trade payables 30,000
Accruals 10,000
60,000
Total capital and liabilities 300,000
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4.2.1 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).
4.2.2 Expenses
Expenses arise in the course of the ordinary activities of the enterprise. They
include, for example, cost of sales, wages and depreciation.
A TRADER
PROFORMA STATEMENT OF PROFIT OR LOSS FOR THE YEAR ENDED 30 APRIL
20X8
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45
$ $
Sales 300,000
Less: Cost of Sales
Opening Inventories 50,000
Purchases 200,000
Carriage Inwards 30,000
280,000
Closing Inventories (70,000)
210,000
Gross Profit 90,000
Sundry Income 15,000
Discounts Receivable 5,000
110,000
Less: Expenses
Telephone expenses 2,000
Office stationery 8,000
Wages and salaries 12,000
Depreciation expense 7,000
Bad and doubtful debts 4,000
Discounts allowed 2,000
Carriage out 1,000
Electricity expense 6,000
42,000
Profit for the year 68,000
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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46
__________________________
KEY NOTES
_________________
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47
The statement of financial position (SOFP) is a list of all the assets owned and the
liabilities owed by a business as at a particular date.
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.
Non-current assets are assets that are held and used in operations for a long time.
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.
Current liabilities are due to be settled within the normal operating cycle or 12
months after the end of the reporting period.
Capital is the amount invested in a business by the owner. This is the amount the
business owes to the owner.
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Revenue Expenses
Revenue 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 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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_________________
QUESTION BANK
_________________
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50
A Inventory
B Receivables
C Plant and machinery
D Loan
A Inventory
B Receivables
C Plant and machinery
D Petty cash
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51
_________________
ANSWER BANK
_________________
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52
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53
Chapter 5
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.
4. Goods received note: - a list of goods that a business has received from a
supplier
5. Goods despatched note: - a list of goods that a business has sent out to a
customer
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54
Sales Purchase
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Returns Returns
Day Book Day Book
55
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.
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.
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56
When customers return goods for some reason, a credit note is raised. All credit
notes are recorded in the sales returns day book.
The purchase day book lists all purchases made on credit, i.e. a list of all invoices it
receives.
The purchase returns day book records credit notes received in respect of goods
which the business sends back to its suppliers.
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.
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57
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:
$
Cash still held in petty cash (250 - 55) 195
Plus voucher payments (25+5+10+15) 55
Must equal the agreed sum or float 250
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.
Receipts Payments
Date Narrative Total Date Narrative Total Postage Stationery
$ $ $ $
20x8
1 Oct Cheque 55 2 Oct Post 10 10
cashed Office
3 Oct XY 15 15
Bureau
25 10 15
Keeping cash (even in small amounts) on the premises is a security risk. Therefore a
petty cash system is usually subject to strict controls.
Lecture Example 1: -
Petty cash is controlled under an imprest system. The imprest amount is $100.
During a period, payments totaling $53 have been made. How much needs to be
reimbursed at the end of the period to restore petty cash to the imprest account?
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Debit Credit
$ $
Account to be debited
Account to be credited
Narrative to explain the transaction
Lecture Example 2
State which books of prime entry the following transactions would be entered
into:
i. Your business pays X Blackman (a supplier) $600
ii. You send Y Young (a customer) an invoice for $850.
iii. The marketing manager asks you for $100 urgently in order to buy some
postage stamps.
iv. You receive an invoice from X Blackman for $500.
v. You pay Y Young $500.
vi. F Clark (a customer) returns goods to the value of $650.
vii. You return goods to X Price to the value of $890.
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.
1. Receivables Ledger
2. Payables Ledger
This ledger shows how much is owed to the business by each individual customer
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Sunshine Co
Date Narrative Sales Cash Total
$ $ $
Oct 4 Invoice 145 452.60 452.60
Clouds Co
Date Narrative Sales Cash Total
$ $ $
Oct 4 Invoice 146 254.20 254.20
This ledger shows how much is owed by the business to each individual supplier.
Jupiter Co
Date Narrative Cash Purchases Total
$ $ $
Oct 1 Invoice J851 556.10 556.10
Oct 5 Cash book 250.00 306.10
Mars Co
Date Narrative Cash Purchases Total
$ $ $
Oct 1 Invoice M048 189.60 189.60
Venus & Co
Date Narrative Cash Purchases Total
$ $ $
Oct 1 Invoice 0124 245.50 245.50
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__________________________
KEY NOTES
_________________
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61
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.
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Sales Purchase
Returns Returns
Day Book Day Book
Receipts
and Errors and
Small cash
payments Credit Credit Adjustments
transactions
Sales Purchases
Goods Goods
returned returned to
by supplier
customer
s
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4. Memorandum Ledgers
Memorandum Ledgers
Receivables Payables
Ledger Ledger
Amounts owed to
Amounts owed by each individual
each individual supplier
customer
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_________________
QUESTION BANK
_________________
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65
A. Sales invoice
B. Purchase day book
C. Sales day book
D. Journal
A. Purchase invoice
B. Quotation
C. Sales invoice
D. Receipt and claim form
A. Supplier's invoices
B. Customer's invoices
C. Details of goods returned to suppliers
D. Details of goods returned by customers
4. All petty cash claims are automatically paid from petty cash.
Is this statement:
A. True
B. False
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_________________
ANSWER BANK
_________________
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67
2. D
3. C
4. B – only authorized and evidenced claims are paid out of petty cash
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68
Chapter 6
Double-Entry Book-Keeping Principles
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).
Example: -
Cash A/C
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.
69
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”.
The rules as to when to debit a T account and when to credit a T account can be
summarized in the following table.
Increase Decrease
Asset
Expense Debit Credit
Purchases
Drawings
Liability
Income Credit Debit
Sales
Capital
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70
Lecture Example 1: -
Apply the 3 double-entry rules to the following transactions. State the double-entry
of each of these transactions and open the necessary nominal accounts.
20X7
Jan 1 Paid $50,000 into a business bank account
Jan 3 Bought shop premises $20,000, paid by cheque
Jan 5 Bought shop fittings, paid by cheque $2,500
Jan 9 Bought goods for resale $14,000, paid by cheque
Jan 10 Withdrew $100 cash from the bank for his own personal use
Jan 11 Cash sales $5,000
Jan 12 Bought stationery, paid in cash $20
Jan 16 Bought a van, paid by cheque $2,500
Jan 19 Sold goods for $8,500, received payment by cheque
Jan 23 Paid petrol bill for van, $15 by cheque
Jan 26 Sold goods on credit to J. Parker $3,500
Jan 28 Paid for shop cleaning $20 cash
Jan 29 Bought goods for resale $3,000 on credit from A. Young
Jan 31 Received cheque from J. Parker for $2,000 in part payment of his
account
Required: -
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71
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. This is done by 'balancing off' each account.
Lecture Example 3: -
Required: -
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72
__________________________
KEY NOTES
_________________
___________________________________________________________________________
73
Repetitive transactions are initially captured in books of prime entry. The total of
each book of prime entry, or the single transaction, is recorded in the double-entry
system by being posted to the nominal accounts in the general/nominal ledger.
The principles of double entry work on the basis that for each debit entry there must
be a credit entry (total debits must equal total credits). This is also known as the dual
effect.
Assorted business
transactions
Categorized in books of
prime entry
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74
Increase Decrease
Asset
Expense Debit Credit
Purchases
Drawings
Liability
Income Credit Debit
Sales
Capital
At the end of each period the nominal ledger accounts are 'balanced off' to
determine the closing balance on each nominal account.
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75
__________________________
QUESTION BANK
_________________
___________________________________________________________________________
76
A. A Co is owed $3,000 by B Co
B. B Co has sold $3,000 of goods to A Co
C. B Co is owed $3,000 by A Co
D. A Co has sold $3,000 of goods to B Co
4. Which of the following is the best description of the function of the books of prime
entry in a standard double entry bookkeeping system?
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77
6. How is the total of the purchases daybook posted to the nominal ledger?
7. You have bought stationery with a company cheque from the stationery shop
next door. How should this transaction be recorded?
A. DR Stationery CR Payable
B. DR Cash CR Payable
C. DR Stationery CR Cash
D. DR Payable CR Cash
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78
__________________________
ANSWER BANK
_________________
___________________________________________________________________________
79
1. B
3. C
4. B
5. C is correct
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80
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81
Chapter 7
PREPARING FINANCIAL STATEMENTS
In Chapter 6, we have seen the posting of transactions into ledger accounts using
double-entry (duality concept). 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.
Lecture Example 1
$
Bank overdraft 2,000
Cash 11,700
Capital 13,000
Rent expense 1,880
Purchases 12,400
Sales 24,600
Trade payables 12,820
Trade receivables 12,000
Other expenses 12,420
Equipment 2,020
Required: -
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82
Lecture Example 2
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.
1. The complete omission of a transaction, because neither a debit nor a credit
is made.
2. The posting of a debit or credit to the correct side of the ledger, but to a wrong
account.
3. Compensating errors (e.g. an error of $500 is exactly cancelled by another
$500 error elsewhere).
4. 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.
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.
Dr Inventories (SOFP)
Cr Closing Inventories (COS)
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83
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.
Lecture Example 3
Prepare the statement of profit or loss for P Powell both as a ledger account and in
vertical form.
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.
Lecture Example 4
84
Assets $ Liabilities $
Assets = Liabilities
Lecture Example 5
Lecture Example 6
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:
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85
Lecture Example 7
Nancy's business has net assets of $13,200 at the beginning of the year. During the
following month she purchases new equipment for $1,200, makes sales on credit of
$7,500, receives payments from customers of $3,750 and receives bills from
suppliers of $2,250. These are not payable until next month.
A. $15,750
B. $18,450
C. $18,150
D. $20,700
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86
__________________________
KEY NOTES
_________________
___________________________________________________________________________
87
1. Trial Balance
A trial balance is a list of ledger balances shown in debit and credit columns.
Total debits should equal total credits. Therefore, it is a method used to test
the accuracy of the double-entry bookkeeping.
The trial balance will not disclose the following types of error:
a) The complete omission of a transaction
b) The posting of a debit or credit to the correct side of the ledger,
but to a wrong account
c) Compensating errors
d) Errors of principle
Closing inventories are items which are still held at year-end. They are
included as assets in the statement of financial position. They are also
included in the calculation of cost of sales in the trading account (Opening
inventories + Purchases – Closing inventories)
Dr Inventories (SOFP)
Cr Closing Inventories (COS)
The balances on all the income and expenditure T-accounts are transferred to
the statement of profit or loss. The statement of profit or loss is part of the
double entry system.
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88
Assets Liabilities
=
___________________________________________________________________________
89
__________________________
QUESTION BANK
_________________
___________________________________________________________________________
90
2. William Young
William Young has the following transactions to record for the month of May:
91
Required
A. assets plus profit less drawings less liabilities equals closing capital
B. assets less liabilities less drawings equals opening capital plus profit
C. assets less liabilities less opening capital plus drawings equals profit
4. Which of the following is the correct format for the accounting equation?
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92
5. Which one of the following would not cause a trial balance imbalance?
$
Sales 54,000
Purchases 21,000
Inventory 9,500
Cash 27,250
Receivables ?
Motor vehicle 7,500
Payables 5,500
Capital 18,500
If the trial balance balances, what is the missing figure for receivables?
__________________
7. Which of the following is the correct posting from the sales day book to the
nominal ledger?
8. Bill, a sole trader, set up business on 1 October 20X0 with $30,000 of his own
money. During the year to 30 September 20X1 he won $50,000 on the lottery and
paid $30,000 of this into his business. He took cash drawings of $5,000 during
the year and at 30 September 20X1 the net assets of the business totalled
$59,000.
What was the profit or loss of the business for the year ended 30 September
20X1?
A. $4,000 profit
B. $6,000 profit
C. $16,000 loss
D. $6,000 loss
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93
9. Harry has been unable to calculate his business' profit or loss for the year ended
31 December 20X8 as fire destroyed most of his accounting records. He has,
however, been able to provide the following information.
What was Harry's profit or loss for the year ended 31 December 20X8?
A. $8,750 profit
B. $1,750 loss
C. $9,800 profit
D. $2,750 loss
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94
__________________________
ANSWER BANK
_________________
___________________________________________________________________________
95
1. Bank account
$ $
Capital 25,000 a) Delivery Van 8,000
h) Sales 1,200 b) Purchases 6,000
m) Receivables Control 3,600 c) Rent 2,400
e) Stationery 100
i) Telephone 140
k) Payables control 2,500
l) Drawings 1,200
Balance c/d 9,460
29,800 29,800
Balance b/d 9,460
Capital account
$ $
Bank 25,000
Purchases account
$ $
b) Bank 6,000
f) Payables Control 4,500 Balance c/d 10,500
10,500 10,500
Balance b/d 10,500
Rent account
$ $
c) Bank 2,400
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96
Sales account
$ $
d) Receivables ledger control 2,700
g) Receivables ledger control 5,200
h) Bank 1,200
Balance c/d 12,100 j) Receivables ledger control 3,000
12,100 12,100
Balance b/d 12,100
Stationery account
$ $
e) Bank 100
Telephone account
$ $
i) Bank 140
Drawings account
$ $
i) Bank 1,200
___________________________________________________________________________
97
Trial balance
Debits Credits
$ $
Bank 9,460
Capital 25,000
Delivery van 8,000
Purchases 10,500
Rent 2,400
Receivables ledger control account 7,300
Sales 12,100
Stationery 100
Payables ledger control account 2,000
Telephone 140
Drawings 1,200
39,100 39,100
2. William Young
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98
$ $
Sales 15,250
less cost of sales 12,000
Gross Profit 3,250
Dividends Received 25
3,275
Less expenses
Rent 1,000
Motor 50
Stationery 150
Insurance 200
Bank Charges 60
Wages 400 1,860
Net Profit 1,415
Non-current Assets $ $
Investment 600
Motor Car 2,000
Computer 2,500
Van 5,000
10,100
Current Assets
Receivables (1,600+350) 1,950
Cash and cash equivalents 6,565
8,515
18,615
Financed by:
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99
Non-Current Liabilities
Loan 5,000
Current Liabilities
Payables 2,000
Accruals – rent 500
2,500
18,615
3. C
4. C
6. $12,750
Dr Cr
Sales 54,000
Purchases 21,000
Inventory 9,500
Cash 27,250
Motor vehicle 7,500
Payables 5,500
Capital 18,500
i.e. Receivables 12,750 _____
78,000 78,000
7. C
8. A
$
Net assets 1.10.X0 30,000
Capital introduced 30,000
Drawings (5,000)
Profit (missing figure) 4,000
Net assets 30.09.x1 59,000
___________________________________________________________________________
100
9. A
$
Net assets at 31.12.X8 32,500
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101
Chapter 8
Accounting for Sales Tax
8.1.1 Introduction
Sales tax is an indirect tax on the supply of goods and services which is eventually
borne by the final customer, but it is collected at each stage of the production and
distribution chain.
Lecture Example 1
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102
Sales tax charged on goods and services sold by a business is referred to as output
tax. Sales tax paid on goods and services ‘bought in’ by a business is referred to as
input tax.
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.
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: -
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 $500.00
Dr Sales tax control account $ 87.50
Cr Cash/trade payables $587.50
Lecture Example 2
All of Jimmy's sales are subject to sales tax at 17.5%. He invoices a customer for
$1,700 plus sales tax and receives a cheque in full payment the following month.
How is the cheque posted to the nominal ledger?
103
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: -
Lecture Example 3
The following information relates to Eva Co's sales tax for the month of March 20X3:
$
Sales (including sales tax) 109,250
Purchases (net of sales tax) 64,000
Sales tax is charged at a flat rate of 15%. Eva Co's sales tax account showed an
opening credit balance of $4,540 at the beginning of the month and a closing debit
balance of $2,720 at the end of the month.
What was the total sales tax paid to regulatory authorities during the month of March
20X3?
A. $6,470.00
B. $11,910.00
C. $14,047.50
D. $13,162.10
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104
__________________________
KEY NOTES
_________________
___________________________________________________________________________
105
Sales Tax
Indirect Tax
Amount
Output Tax - Input Tax = payable to
tax
authorities
Sales tax charged on goods and services sold by a business is referred to as output
tax. Sales tax paid on goods and services ‘bought in’ by a business is referred to as
input tax.
2. Accounting Treatment
Dr Purchases (NET)
Dr Sales tax control account (SALES TAX ELEMENT)
Cr Cash/trade payables (GROSS)
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106
Where sales tax cannot be recovered, it 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
___________________
QUESTION BANK
___________________
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107
1. W is registered for sales tax. The managing director has asked four staff in the
accounts department why the output tax for the last quarter does not equal 17.5%
of sales (17.5% is the rate of tax). Which one of the following four replies she
received was not correct?
A. The company had some exports that were not liable to sales tax
B. The company made some sales of zero-rated products
C. The company made some sales of exempt products
D. The company sold some products to businesses not registered for
sales tax
2. Anwar makes sales in the quarter of $34,075 including sales tax at 17.5%. His
total purchases net of sales tax are $11,010, of which $2,500 is for zero rated
goods.
A. $4,473.88
B. $3,435.21
C. $3,585.75
D. $3,807.55
A. Yes
B. No
4. A business in its first period of trading charges $4,000 of sales tax on its sales
and suffers $3,500 of sales tax on its purchases which include $250 sales tax on
business entertaining. What is the amount owed to tax authorities?
_____________
___________________________________________________________________________
108
5. A sales tax registered trader has recorded the following transactions during the
accounting period.
$
Standard rated sales 200,000
Purchases 150,000
_______________
A. Sales tax is charged on purchases and sales after trade discounts and
before settlement discounts.
B. Exempt and zero rated supplies have the same tax effect.
C. Sales tax is not reclaimable on capital expenditure.
D. Sales tax is charged on purchases and sales after trade discounts and
after settlement discounts
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109
______________________
ANSWER BANK
______________
___________________________________________________________________________
110
1. D
2. C
4. $750
5. $18,617
$
Input tax
Purchases 150,000
Less: motor car (20,000)
entertaining (5,000)
125,000
6. D
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111
Chapter 9
Inventories
All businesses must therefore ensure that their financial statements account for
inventory accurately in terms of:
1. the accounting adjustment
2. its valuation
Inventory is generally accounted for as a year end adjustment via a journal entry.
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.
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112
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. 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.
Dr Inventories (SOFP)
Cr Cost of sales (I/S)
Lecture Example 1
Which of the following entries for these opening and closing inventory figures are
made when completing the financial records of the business?
Debit Credit
$ $
A. Inventory account 180,000
Statement of profit or loss 180,000
Statement of profit or loss 220,000
Inventory account 220,000
113
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.
There are other methods which, in theory, might be used for the valuation of
inventory: -
(iii) Inventories might be valued at their historical cost (ie the cost at
which they were originally bought).
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.
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114
9.5.1 Cost
1. Purchase
2. Costs of conversion
3. Other costs incurred in bringing the inventories to their present location and
condition, e.g. carriage inwards
(i) Costs directly related to the units of production, e.g. direct materials, direct
labour
(ii) 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)
The net realisable value of an item is essentially its net selling proceeds after all
costs have been deducted.
___________________________________________________________________________
115
It is calculated as:
$
Estimated selling price X
Less: estimated costs of completion (X)
Less: estimated selling and distribution costs (X)
X
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.
Lecture Example 2
1. 400 coats, which had cost $80 each and normally sold for $150 each. Owing
to a defect in manufacture, they were all sold after the reporting date at 50%
of their normal price. Selling expenses amounted to 5% of the proceeds.
2. 800 skirts, which had cost $20 each. These too were found to be defective.
Remedial work in February 20X3 cost $5 per skirt, and selling expenses for
the batch totalled $800. They were sold for $28 each.
A. $281,200
B. $282,800
C. $329,200
D. None of these
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116
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.
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 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.
Lecture Example 3
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117
This method is only used if specifically mentioned in the exam question. Otherwise,
the cumulative weighted average method should be used.
Lecture Example 4
Using the information in lecture example 3, calculate the value of closing inventory at
the end of December using the periodic weighted average.
In valuing inventory, we also follow the prudence concept which states that a profit
cannot be anticipated before it is realised.
___________________________________________________________________________
118
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.
Inventories
Inventories are valued at the lower of cost and net realizable value. Cost is
determined using first in, first out method. Net realizable value is the
estimated selling price in the ordinary course of business, less the costs
estimated to make the sale.
2011 2010
___________________________________________________________________________
119
Lecture Example 5
Which of the following statements about the treatment of inventory and work
in progress in financial statements are correct?
1. Inventory should be valued at the lowest of cost, net realisable value and
replacement cost.
2. In valuing work in progress, materials costs, labour costs and variable and
fixed production overheads must be included.
3. Inventory items can be valued using either first in, first out (FIFO) or weighted
average cost.
4. A company’s financial statements must disclose the accounting policies used
in measuring inventories.
Lecture Example 6
Between 1 November 20X3 and 4 November 20X3 the following transactions took
place:
1. Goods costing $38,400 were received from suppliers.
2. Goods that had cost $14,800 were sold for $20,000.
3. A customer returned, in good condition, some goods which had been sold to
him in October for $600 and which had cost $400.
4. The company returned goods that had cost $1,800 in October to the supplier,
and received a credit note for them.
What figure should appear in the company’s financial statements at 31 October 20X3
for closing inventory, based on this information?
A. $458,700
B. $505,900
C. $508,700
D. $461,500
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120
__________________________
KEY NOTES
_________________
___________________________________________________________________________
121
3. Accounting treatment: -
i. Opening Inventories
Dr Inventories (SOFP)
Cr Cost of sales (I/S)
4. Inventories should be measured at the lower of cost and net realisable value
for each separate item or group of items.
5. Cost: -
1. Purchase
2. Costs of conversion
3. Other costs incurred in bringing the inventories to their present
location and condition, e.g. carriage inwards
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122
It is calculated as:
$
Estimated selling price X
Less: estimated costs of completion (X)
Less: estimated selling and distribution costs (X)
X
7. FIFO: -
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
8. AVCO: -
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.
In times of rising prices, using FIFO method will mean the financial statements show
higher inventory values and higher profit.
___________________________________________________________________________
123
__________________________
QUESTION BANK
_________________
___________________________________________________________________________
124
A. Historic cost
B. Lower of cost and net realisable value
A. 1 and 2 only
B. 2 and 4 only
C. 1 and 3 only
D. 2, 3 and 4
3. The entries required to correctly reflect inventory and cost of sales in the
financial accounts for the first year of trading are:
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125
A. FIFO
B. AVCO
6. Which of the following is not an acceptable basis for inventory valuation under
IAS 2?
7. For Morgan the direct cost of production of each unit of inventory is $46
(including carriage inwards of $11 and import duties of $1 on the raw
materials element). Production overheads amount to $15 per unit. Currently
the goods can only be sold if they are modified at a cost of $17 per unit. The
selling price of each modified unit is $80 and selling costs are estimated at
10% of selling price. At what value should each unmodified unit of inventory
be included in the statement of financial position?
8. The inventory counters of Crocodile Co inform you that there are 6,000 items
of product A, and 2,000 of product B, these cost $10 and $5 respectively.
They also tell you the following information:
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126
20X2
1 July Purchased 500 engines at $220 each
1 November Sold 400 engines for $160,000
20X3
1 February Purchased 300 engines at $230 each
15 April Sold 250 engines for $125,000
A. $188,500
B. $195,500
C. $166,000
D. None of these figures
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ANSWER BANK
_________________
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128
1. B
2. D
3. D
4. $18,760
5. B
6. A
7. $ 55
46 + 15 80 – 17 – 8
= 61 = 55 55
8. $68,800
500 x 8 = 4,000
5,500 x 10 = 55,000
6,000 59,000
100 x 3 = 300
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1,900 x 5 = 9,500
2,000 9,800
68,800
9. A
50 @ $190 9,500
500 @ $220 110,000
300 @ $230 69,000
188,500
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Chapter 10
Tangible Non-Current Assets
and Depreciation
Non-current assets - all assets other than current assets shall be classified as non-
current assets. They include both tangible and intangible assets.
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131
Transactions
Nature of Meaning
Transaction
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132
expenditure is sold
iii. it decreases the value of non-current assets
Lecture Example 1: -
Arthur sets up his demolition business from scratch on 1 January 20X1. During the
year he:
Dr Non-Current Asset
Cr Cash/Payables
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133
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
iii. Dismantling cost – cost of removing old asset from its place in order to put in
the new one
Lecture Example 2: -
______________
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134
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.
4. 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
OR
This method is suitable for assets which are used up evenly over their useful life, e.g.
fixtures and fittings in the accounts department.
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135
Lecture Example 3: -
A non-current asset costing $60,000 has an estimated life of 5 years and a residual
value of $7,000.
Required: -
(a)
(b)
Year Cost Accumulated NBV
Depn
$ $ $
1
2
3
4
5
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.
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136
This method ignores residual value, since the NBV under this method will
never reach zero.
Lecture Example 4: -
A business buys a lorry costing $17,000. After 5 years, it is expected to be sold for
scrap for $2,000. The depreciation rate is 35% on a reducing balance basis.
Required
Calculate depreciation expense, accumulated depreciation and net book value
of the machine for these five years using the reducing balance basis.
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.
Lecture Example 5: -
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137
Required: -
Show the depreciation charge for each year of the asset’s life.
Lecture Example 6: -
Required
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138
Accounting Treatment: -
(4) Balance off disposal account to find the profit or loss on disposal.
Lecture Example 7: -
A company buys a machine on 31 August 20X0 for $22,000. It has an expected life
of seven years and an estimated residual value of $1,000. On 30 June 20X4 the
machine is disposed of for $9,000. The company's year end is 31 December. Its
accounting policy is to charge depreciation using the straight line method with a
proportionate charge in the years of acquisition and disposal.
Required:
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139
(a) Calculate the profit or loss on disposal of the machine which will appear
in the statement of profit or loss for the year ended 31 December 20X4
(b) Prepare the ledger accounts to show how the disposal would be
accounted for.
Lecture Example 8: -
The plant and equipment account in the records of a company for the year ended 31
December 20X6 is shown below:
The company’s policy is to charge depreciation on the straight line basis at 20% per
year, with proportionate depreciation in the years of purchase and sale.
What should be the charge for depreciation in the company’s statement of profit or
loss for the year ended 31 December 20X6?
A $184,800
B $192,600
C $191,400
D $184,200
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.
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140
Lecture Example 9:
Required
(a) Calculate the profit or loss on disposal of the machine.
(b) Calculate the amount of cash paid for the new machine.
(c) Complete the ledger accounts to show both the disposal and the
acquisition.
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 surplus directly to retained earnings.
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141
Accounting treatment:
Required:
Show the treatment of the revaluation surplus and compute the revised annual
depreciation charge.
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.
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142
This is achieved by writing the net book value off over the asset's revised remaining
useful life.
Required: -
Show the depreciation charge for each year of the asset’s life.
On 1 January 20X0 Goblin bought a machine for $63,000. It was estimated that the
machine's useful life would be 7 years and its residual value $7,000. Two years later
the useful life was revised to four remaining years with a residual value of $7,000. At
31 December 20X4 the machine was sold for $30,000. No depreciation was
provided in 20X4.
A $3,000 loss
B $7,000 profit
C $3,000 profit
D $7,000 loss
143
o additions
o disposals
o acquisitions through business combinations
o revaluation increases or decreases
o impairment losses
o reversals of impairment losses
o depreciation
o net foreign exchange differences on translation
o other movements
Depreciation
At 1 January 2010 16,000 6,000 4,000 26,000
Charge for year 4,000 3,000 2,000 9,000
Eliminated on disposals (500) (500) - (1,000)
At 31 December 2010 19,500 8,500 6,000 34,000
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144
Carrying Amount
At 31 December 2010 45,500 6,500 4,000 56,000
At 1 January 2010 34,000 4,000 4,000 42,000
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
Lecture Example 13
Which of the following disposals, if not deducted from the asset register could
account for the difference?
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145
__________________________
KEY NOTES
_________________
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146
1. Non-current assets
All assets other than current assets shall be classified as non-current assets.
They include both tangible and intangible assets.
2. Current assets
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147
A charge is made in the statement of profit or loss to reflect the use of the
asset by the business
OR
Under this method the depreciation charge will be higher in the earlier years
and reduce over time.
148
If there are any changes in the expected pattern of use of the asset, then the
method of depreciation 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.
Accounting Treatment: -
(4) Balance off disposal account to find the profit or loss on disposal.
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149
The part exchange allowance takes the place of proceeds in the disposals
account.
Accounting treatment:
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.
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150
___________________
QUESTION BANK
___________________
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151
1. A business sells a non-current asset for $55,000. The asset originally cost
$100,000 and accumulated depreciation is $45,000. What is the profit or loss
on disposal?
A. $10,000 profit
B. No gain or loss
C. $10,000 loss
What is the net effect on the statement of profit or loss for the year ended 31
December 20X2?
A. Increase of $2,200
B. Decease of $2,200
C. Increase of $12,000
D. Decrease of $12,000
What is the net book value of the machine that will be shown in Demolition's
statement of financial position at the year end? $___________
What is the profit or loss on disposal of the machine which will appear in the
statement of profit or loss for the year ended 31 December 20X4?
$_________
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5. Vernon Vinyl purchased some new equipment on 1 April 20X1 for his mobile
disco for $6,000. The estimated scrap value of the new equipment in 5 years'
time is estimated to be $400. Vernon charges depreciation on the straight line
basis, with a proportionate charge in the period of acquisition.
What should the depreciation charge for the plant be in Vernon's accounting
period of twelve months to 30 September 20X1? $ _________
6. The NBV of B's property, plant and equipment is $51,000 at 1 January 20X5
and $100,000 at 31 December 20X5. A motor vehicle costing $20,000 was
purchased during the year and land was revalued by $43,000.
7. The plant and equipment account in the records of a company for the year
ended 31 December 20X6 is shown below:
A. $184,800
B. $192,600
C. $191,400
D. $184,200
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_________________
ANSWER BANK
_________________
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154
1. B - Net book value is $55,000 ($100,000 – $45,000). So the proceeds are the
same as NBV and so there is no gain or loss.
2. A
$
31.12.X0 - NBV 14,000
31.12.X1 - NBV 9,800
Proceeds 12,000
NBV (9,800)
Profit 2,200
3. $16,920 $
Cost (15,000 + 1,300 + 2,500) 18,800
Depreciation (10% x 18,800) (1,880)
NBV 16,920
6. $14,000
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155
PPE - NBV
Balance b/d 51,000 Depreciation expense 14,000
Bank 20,000
Revaluation Surplus - Land 43,000
Balance c/d 100,000
114,000 114,000
7. B
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Chapter 11
IAS 38:- Intangible Assets
As stated in Chapter 10, tangible non-current assets are defined as those which:
a. are held for use in the production or supply of goods or services for
administrative purposes; and
b. are expected to be used during more than one period.
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IAS 38, Intangible Assets, separates a research and development project into a
research phase and a development phase.
Research phase
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
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158
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:
Lecture Example 1
A company, Clarke Ltd, incurs research costs, during one year, amounting to
$125,000, and development costs of $490,000. The accountant informs you that the
recognition criteria (as prescribed by IAS 38) have been met. How should these
costs be accounted for in the financial statements?
Lecture Example 2
Required:
How should each of the above items be shown in the financial statements of
Medica for the year ended 31 December 20X7?
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159
Once development costs have been capitalised, the asset should be amortised in
accordance with the accruals concept over its finite life.
What is amortization?
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: -
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.
Lecture Example 3
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160
Project J9 4,000,000
This project began in 20X4 and the $4m balance
represents expenditure qualifying for capitalisation
to 31 December 20X5
Project J9 is due to be completed in 20X9
––––––––
18,000,000
––––––––
During the year ended 31 December 20X6 the following further expenditure was
incurred:
Project J9
Further expenditure qualifying for capitalisation $1,500,000
Project A20
Investigation into new materials for aircraft construction $3,000,000
Required:
Calculate the amounts for research and development to be included in the
company’s statement of profit or loss and statement of financial position for
the year ended 31 December 20X6.
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161
Development expenditure
$
Net book value at 1 April 20X0 X
Additions X
Amortisation charge (X)
Disposals (X)
Net book value at 31 March 20X1 X
At 31 March 20X0
Cost X
Accumulated amortization (X)
Net book value X
At 31 March 20X1
Cost X
Accumulated amortisation (X)
Net book value X
Lecture Example 4
Which TWO of the following items must be disclosed in the note to the
financial statements for intangible assets?
(1) The useful lives of intangible assets capitalised in the financial statements
(2) A description of the development projects that have been undertaken during the
period
(3) A list of all intangible assets purchased or developed in the period
(4) Impairment losses written off intangible assets during the period
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162
A. 1 and 4
B. 2 and 3
C. 3 and 4
D. 1 and 2
__________________________
KEY NOTES
________________
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163
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164
Research Development
Application of
the entity acquires research findings
new scientific or
technical knowledge
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165
_____________________________
QUESTION BANK
___________________
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166
A. 1, 2 and 4 only
B. 1 and 3 only
C. 2 and 4 only
D. 3 and 4 only.
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167
A. 1 and 4
B. 2 and 4
C. 2 and 3
D. 1 and 3
The following statements about the provisions of IAS 38 may or may not be
correct.
1) Capitalised development expenditure must be amortised over a period not
exceeding five years.
2) If all the conditions specified in IAS 38 are met, development expenditure
may be capitalised if the directors decide to do so.
3) Capitalised development costs are shown in the statement of financial
position under the heading of Non-Current Assets.
4) Amortisation of capitalised development expenditure will appear as an
item in a company’s statement of changes in equity.
A. 3 only
B. 2 and 3
C. 1 and 4
D. 1 and 3
5. A newly set up dot-com entity has engaged you as its financial advisor. The
entity has recently completed one of its highly publicized research and
development projects and seeks your advice on the accuracy of the following
statements made by one of its stakeholders.
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168
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169
_________________
ANSWER BANK
_________________
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170
3. C
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171
Chapter 12
Accruals and Prepayments
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172
Dr Expense (I/S)
Cr Accruals (SOFP)
Lecture Example 1
Light Stores receives electricity bills quarterly. It paid the following electricity
bills during its accounting year ended 28 Feb 20X7:
Date paid
$
4.6.X6 (covering quarter ended 31.5.20X6) 70.50
5.9.X6 (covering quarter ended 31.8.20X6) 81.80
2.12.X6 (covering quarter ended 30.11.20X6) 100.20
10.2.X7 (covering the two months to 28.1.20X7) 108.00
On 3.6.20X7 an electricity bill was received for $105 covering the quarter
ended 30.4.20X7.
Lecture Example 2
What rent expense and accrual should be included in the company’s financial
statements for the year ended 31 January 20X3?
12.2.2 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.
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173
Dr Prepayments (SOFP)
Cr Expense (I/S)
Lecture Example 3
A business opens a shop on 1 January 20X7. The rent is $20,000 per annum
and is payable quarterly in advance. Payments were made as follows: -
$
1 January 20X7 5,000
20 March 20X7 5,000
25 June 20X7 5,000
29 September 20X7 5,000
24 December 20X7 5,000
Lecture Example 4
Michelle rents premises at an annual rental of $1,000. The rates payable for
the accounting year 1 July 20X6 – 30 June 20X7, his first year of business,
were $360. Cheques for rent and rates were paid as follows: -
20X6 $
July 28 Rates for 9 months to 31 March 20X7 220
Sept 28 Rent for 3 months to 30 September 20X6 250
20X7
Jan 3 Rent for 3 months to 31 December 20X6 250
Mar 28 Rent for 3 months to 31 March 20X7 250
Apr 30 Rates for 6 months to 30 September 20X7 280
What rent and rates expense should be included in the company’s statement
of profit or loss for the year ended 30 June 20X7
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174
Accruals and prepayments brought forward at the beginning of the year must be
reversed.
1. Reversal of an accrual
Dr Accruals (SOFP)
Cr Expense (I/S)
2. Reversal of a prepayment
Dr Expense (I/S)
Cr Prepayment (SOFP)
Lecture Example 5
At 1 July 20X4 RCA Malta had prepaid insurance of $8,200. On 1 January 20X5 the
company paid $38,000 for insurance for the year to 30 September 20X5.
What figures should appear for insurance in the company’s financial statements for
the year ended 30 June 20X5?
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175
Lecture Example 6
What figures should be included in the company’s financial statements for the year
ended 30 June 20X6?
Statement of profit or loss Statement of Financial Position
$ $
A 11,100 9,000 prepayment (Dr)
B 11,700 9,000 prepayment (Dr)
C 11,100 9,000 accrual (Cr)
D 11,700 9,000 accrual (Cr)
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.
Lecture Example 7
A company sublets part of its office accommodation. In the year ended 30 June
20X5 cash received from tenants was $83,700.
Details of rent in arrears and in advance at the beginning and end of the year were:
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176
In arrears In advance
$ $
30 June 20X4 3,800 2,400
30 June 20X5 4,700 3,000
What figure for rental income should be included in the company’s statement of profit
or loss for the year ended 30 June 20X5?
A. $84,000
B. $83,400
C. $80,600
D. $85,800
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177
__________________________
KEY NOTES
_________________
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178
1. The accruals concept states 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. In the same way, expenses are
recognised according to the period to which they relate, and not when they are
paid.
Dr Expense (I/S)
Cr Accruals (SOFP)
3. Prepaid expenses (prepayments) are expenses which have already been paid
but relate to a future accounting period. Prepayments are included in
receivables as current assets in the statement of financial position.
Dr Prepayments (SOFP)
Cr Expense (I/S)
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179
4. Accruals and prepayments brought forward at the beginning of the year must
be reversed.
1. Reversal of an accrual
Dr Accruals (SOFP)
Cr Expense (I/S)
2. Reversal of a prepayment
Dr Expense (I/S)
Cr Prepayment (SOFP)
5. 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.
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180
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181
__________________________
QUESTION BANK
_________________
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182
1. B, a limited liability company, receives rent for subletting part of its office
premises to a number of tenants.
In the year ended 31 December 20X4 B received cash of $318,600 from its
tenants.
Details of rent in advance and in arrears at the beginning and end of 20X4 are as
follows:
31 December 20X4 31 December 20X3
$ $
Rent received in advance 28,400 24,600
Rent owing by tenants 18,300 16,900
What figure for rental income should be included in the statement of profit or loss
of B for 20X4?
A. $341,000
B. $336,400
C. $300,800
D. $316,200
2. During 20X4, B, a limited liability company, paid a total of $60,000 for rent,
covering the period from 1 October 20X3 to 31 March 20X5.
What figures should appear in the company’s financial statements for the year
ended 31 December 20X4?
3. Beth’s draft accounts for the year to 31 October 20X5 report a loss of $1,486.
When she prepared the accounts, Beth did not include an accrual of $1,625 and
a prepayment of $834.
What is Beth’s profit or loss for the year to 31 October 20X5 following the
inclusion of the accrual and prepayment?
A. a loss of $695
B. a loss of $2,277
C. a loss of $3,945
D. a profit of $1,807
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183
What is the charge for telephone in the statement of profit or loss for the year
ended 31 December 20X1?
5. On 1 April 20X0 a sole trader paid $3,080 in rent for the year ending 31 March
20X1. This was an increase of 10% on the charge for the previous year.
What is the correct charge for rent in her statement of profit or loss for the year
ended 31 December 20X0?
What amounts for this rent should appear in the company’s financial statements
for the year ended 31 January 20X6?
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184
__________________________
ANSWER BANK
_________________
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185
1. D
2. A
60,000
----------- --------
3. B
$
Original loss (1,486)
Accrual (1,625)
Prepayment 834
Revised loss (2,277)
4. $3,374.27
5. $3,010
$
$3,080 × 9/12 2,310
$3,080 × 100/110 × 3/12 700
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186
3,010
6.
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187
Chapter 13
Irrecoverable Debts and
Allowance for Receivables
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'.
A tool to control these problems of providing credit facilities is the aged receivables
analysis. 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.
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.
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188
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
Lecture Example 1
Required: -
a) Calculate the new balance on the trade receivables account
b) Calculate the bad debts expense which is transferred to the statement of profit
or loss
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)
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189
Lecture Example 2
Required: -
Accounting Treatment
Lecture Example 3
Following from Lecture Example 1, a further review of Dora’s customer files indicates
that there is some uncertainty whether Benny Co will pay its amount due of $2,500.
Required: -
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190
There are two situations in which a specific allowance previously done is no longer
required: -
1. customer pays outstanding amount
2. customer goes bankrupt
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.
Lecture Example 4
Following from Lecture Examples1 and 3, Benny Co has paid his amount due of
$2,500 in cash.
Required: -
Accounting treatment
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191
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.
Lecture Example 5
Following from Lecture Examples 1 and 3, Benny Co has been declared bankrupt
and his amount due of $2,500 is now considered irrecoverable.
Required: -
Show the accounting treatment in the books of Dora Co.
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
192
Lecture Example 6
Lecture Example 7
It was decided that debts totalling $13,000 were to be written off, and the allowance
for receivables adjusted to five per cent of the receivables.
What figures should appear in the statement of financial position for trade
receivables (after deducting the allowance) and in the statement of comprehensive
income for the total of irrecoverable debts and movement on receivables allowance?
Irrecoverable debts
and receivables allowance Net trade receivables
$ $
A. 8,200 807,800
B. 7,550 808,450
C. 18,450 808,450
D. 55,550 808,450
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193
Lecture Example 8
Alpha buys goods from Beta. At 30 June 20X5 Beta's account in Alpha's records
showed $5,700 owing to Beta. Beta submitted a statement to Alpha as at the same
date showing a balance due of $5,200.
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194
__________________________
KEY NOTES
_________________
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195
3. A credit limit 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.
4. Irrecoverable debts (bad debts) are specific debts owed to a business which it
decides are never going to be paid.
Accounting treatment
Accounting Treatment
Dr Cash
Cr Trade Receivables
Dr Trade Receivables
Cr Bad debts recovered (I/S)
Accounting Treatment
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196
Accounting treatment
Dr Cash (SOFP)
Cr Trade Receivables (SOFP)
Accounting treatment
a. Take the balance on the trade receivables account after posting credit
sales and cash received from credit customers
b. Deduct bad debts from this balance of trade receivables
c. Deduct also any specific allowances from trade receivables
d. Calculate the general allowance by applying the percentage given to
the remaining balance
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197
__________________________
QUESTION BANK
_________________
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198
1. A company has been notified that a receivable has been declared bankrupt.
The company had previously made a specific allowance for this debt. Which
of the following is the correct double entry?
DR CR
A. Irrecoverable debts account Account receivable
B. Account receivable Irrecoverable debts account
C. Allowance for receivables Account receivable
D. Account receivable Allow for receivables
A. $61,000
B. $22,000
C. $24,000
D. $23,850
It was decided:
a) To write off debts totalling $28,000 as irrecoverable;
b) To adjust the allowance for receivables to the equivalent of 5% of the
remaining receivables based on past experience.
A. $49,500
B. $31,500
C. $32,900
D. $50,900
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199
What are the final amounts for inclusion in the company’s statement of
financial position at 30 June 20X6?
Trade Allowance for Net
Receivables Receivables Balance
$ $ $
A. 838,000 60,000 778,000
B. 766,000 60,000 706,000
C. 766,000 108,000 658,000
D. 838,000 108,000 730,000
A. $16,000
B. $65,000
C. $30,000
D. $16,150
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200
__________________________
ANSWER BANK
_________________
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201
1. C
2. B
3. B
$
Closing receivables 458,000
Irrecoverable debts w/off (28,000)
430,000
Allowance required (5% × 430,000) 21,500
Existing allowance (18,000)
Increase required 3,500
Charge to statement of profit or loss (28,000 + 3,500) 31,500
4. B
5. A
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Chapter 14
Control Accounts
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.
In Chapter 5, 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.
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203
B = $600 B = $450
Source Cheques
Invoices Received
Documents A = $500 A = $520
Receivables account
Ledger Sales account (control a/c) Cash account
Accounts CR Total DR Total
(Nominal Sales $1100 DR Total $ Sales $970
/ General Sales 1100
Ledger) CR Total
Cash 970
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).
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204
The two main entries in the RLCA are credit sales and cash received from credit
customers.
Dr RLCA
Cr Sales
Dr Bank/Cash
Cr RLCA
The two main entries in the PLCA are credit purchases and cash paid to credit
suppliers.
Dr Purchases
Cr PLCA
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.
14.3.2.1 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.
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205
Dr PLCA
Cr RLCA
The contra value is of the maximum common amount. A contra always has the effect
of reducing both receivables and payables.
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.
Dr RLCA
Cr Bank
An entity may decide to charge interest if a customer does not pay within the
specified credit period.
Dr RLCA
Cr Interest Receivable (Income (I/S))
14.3.2.4 Discounts
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206
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.
Lecture Example 1
Joe buys goods worth $3,500 from Eddie. On $2,000 worth, he gets trade discount
of 20%, no trade discount is available on the rest. However Joe always makes sure
that he pays within 10 days in order to obtain Eddie's settlement discount of 5%.
How much will Joe pay Eddie?
A. $2,495
B. $2,945
C. $2,800
D. $3,025
Sales tax is calculated on the amount after all discounts, regardless of whether the
discount is taken or not.
Lecture Example 2
Cloud buys goods with a list price of $50,000 from Moon. Cloud receives a trade
discount of 12% from Moon on all its purchases and a further 4% discount if payment
is made within 10 days. Sales tax is charged at 15%.
What figure should Cloud show in Moon’s personal account to record its purchase?
___________________
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207
39,400 39,400
Lecture Example 3
For the year ended 30 September 20X9 the following particulars are available.
$
Sales 63,728
Purchases 39,974
Cash from trade accounts receivable 55,212
Cash to trade accounts payable 37,307
Discount received 1,475
Discount allowed 2,328
Returns inwards 1,002
Returns outwards 535
Irrecoverable debts written off 326
Cash received in respect of debit balances in payables ledger 105
Amount due from customer as shown by receivables ledger,
offset against amount due to the same firm as shown by
payables ledger (settlement by contra) 434
Allowances to customers on goods damaged in transit 212
208
You are required to write up the following accounts recording the above transactions
bringing down the balances as on 30 September 20X9:
a. Receivables control account
b. Payables control account
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
a) Returning goods which have been paid for and receiving a ‘credit’ (to us, a debit)
on our account
b) Overpayment
c) Payments in advance
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.
209
Reconciliation Statement
$ $ $
+ -
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210
Reconciliation Statement
$ $ $
+ -
Lecture Example 4
A receivables ledger control account shows a balance of $35,100, while the list of
balances totals $36,500.
The following discrepancies are discovered:
a. A credit balance of $350 has been included in the list of balances as a debit
b. A refund of $125 has not been posted to the receivables ledger control
account
c. One page of the sales day book has been undercast by $575
A. $36,500
B. $35,800
C. $35,225
D. $37,200
Lecture Example 5
In reconciling the payables control account to the payables ledger, the following
discrepancies are noticed:
a. a credit note for $105 has been posted to the wrong side of the control
account;
b. the payables ledger has not been adjusted for a receivables ledger offset of
$2,055;
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211
c. an account with a credit balance of $348 has been omitted from the list of
payables ledger balances.
The balance on the payables control account is $3,627. The balance on the
payables ledger is $5,124.
A. $3,627
B. $3,069
C. $3,417
D. $3,765
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212
__________________________
KEY NOTES
_________________
___________________________________________________________________________
213
a. Credit Sales
Dr RLCA
Cr Sales
Dr Bank/Cash
Cr RLCA
c. Credit purchases
Dr Purchases
Cr PLCA
Dr PLCA
Cr Bank/Cash
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214
a. Contras
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.
Dr RLCA
Cr Bank
Dr RLCA
Cr Interest Receivable (Income (I/S))
d. Discounts
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.
Dr Discounts allowed
Cr RLCA
Dr PLCA
___________________________________________________________________________
215
Cr Discounts received
Sales tax is calculated on the amount after all discounts, regardless of whether the
discount is taken or not.
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.
Types of error: -
___________________________________________________________________________
216
__________________________
QUESTION BANK
_________________
___________________________________________________________________________
217
1. The balance on the receivables ledger control account is $52 more than the
list of customer balances.
This could be caused by which one of the following?
2. Mabel's supplier has allowed her 5% discount for prompt payment of her
account. How should this be posted?
3. Andrew buys goods with a list price of $7,200 on which he receives 20% trade
discount. His supplier offers 5% discount for payment within 10 days. Andrew
pays half of the invoiced amount within 10 days and the balance 3 weeks
later.
What is the total amount of money that he will pay for this order?
A. $5,616
B. $5,580
C. $5,400
D. $6,300
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218
(i) A cheque sent by Ordan for $270 has not been allowed for in
Alta’s statement.
(ii) Alta has not allowed for goods returned by Ordan $180.
(iii) Ordan made a contra entry, reducing the amount due to Alta by
$3,200, for a balance due from Alta in Ordan’s receivables
ledger. No such entry has been made in Alta’s records.
What difference remains between the two companies’ records after adjusting
for these items?
A. $460
B. $640
C. $6,500
D. $100
Which one of the following possible errors could account in full for the
difference?
219
C. $12,780 cash paid to a supplier was entered on the credit side of the
supplier’s account in the payables ledger.
D. The total of discount received $6,390 has been entered on the credit
side of the payables ledger control account.
What should the closing balance at 31 January 20X5 be after correcting the
errors in the account?
A. $292,380
B. $295,420
C. $292,940
D. $377,200
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220
What should the closing balance be when all the errors are corrected?
A. $133,840
B. $135,540
C. $137,740
D. $139,840
10. The following payables ledger control account contains some errors. All
goods are purchased on credit.
1,390,400 1,390,400
What should the closing balance be when the errors have been corrected?
A. $325,200
B. $350,400
C. $358,800
D. $376,800
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221
__________________________
ANSWER BANK
_________________
___________________________________________________________________________
222
1. C
2. C
3. A
$
Purchase price (7,200 x 80%) 5,760
Discount ((5,760/2) x 5%) (144)
5,616
4. C
5. A
6. D
$
Balance per Alta 3,980
Cheque not yet received (270)
Goods returned (180)
Contra Entry (3,200)
Revised Balance per Alta 330
Balance per Ordan (230)
Remaining Difference 100
7. B is correct.
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223
8. C
480,700 480,700
9. B
10. A
1,347,800 1,347,800
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224
Chapter 15
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.
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
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225
Therefore, differences between the cash book and the bank statement arise for 3
reasons:
Always remember: -
___________________________________________________________________________
226
Bank Account
Lecture Example 1
On investigation of the difference between the two sums, it was established that:
1. The cash book had been undercast by $90.00 on the debit side.
2. Cheques paid in not yet credited by the bank amounted to $208.20, called
outstanding lodgements.
3. Cheques drawn not yet presented to the bank amounted to $425.35 called
unpresented cheques.
Required
a. Show the correction to the cash book.
b. Prepare a statement reconciling the balance per bank statement to the
balance per cash book.
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227
Lecture Example 2
Gemma is reconciling her cash book to the bank statement. Her cash balance is
$2,357 and the balance on her statement is $25 overdrawn. She finds the following
differences:
a. bank charges of $23 and direct debits totalling $100 have not been
posted to the cash book;
b. there are unpresented cheques of $324; she paid in a batch of
cheques two days ago totalling $2,503 and these have not yet been
credited to her account;
c. a cheque she paid in last week for $80 has been dishonoured.
A. $2,154
B. $2,204
C. $2,357
D. $2,277
Lecture Example 3
A. $1,900 overdrawn
B. $500 overdrawn
C. $1,900 in hand
D. $500 in hand
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228
Lecture Example 4
What was the balance as shown by the bank statement before taking the items
above into account?
_______________________
___________________________________________________________________________
229
__________________________
KEY NOTES
_________________
___________________________________________________________________________
230
1. 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.
This figure should also agree with the balance on the bank statement.
3. 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.
$
Balance per bank statement X RECONCILE
less unpresented cheques (X)
plus unrecorded lodgements X
plus/less bank errors X
Balance per adjusted cash book X
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231
__________________________
QUESTION BANK
_________________
___________________________________________________________________________
232
2. After checking a business cash book against the bank statement, which of the
following items could require an entry in the cash book?
1. Bank charges
2. Cheque from a customer which was dishonoured
3. Cheque not presented
4. Deposits not credited
5. Credit transfer entered in bank statement
6. Standing order entered in bank statement.
A. 1, 2, 5 and 6
B. 3 and 4
C. 1, 3, 4 and 6
D. 3, 4, 5 and 6
3. At 30 April 20X8 the balance on the bank account in Jim’s general ledger
showed that he had $685 cash at the bank. When he carried out his bank
reconciliation, he found that he had omitted bank charges of $722 for the year
to 30 April 20X8.
A. $685 debit
B. $685 credit
C. $37 debit
D. $37 credit
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233
Assuming the amount of the overdraft per the bank statement of $39,800 is
correct, what should be the balance in the cash book?
A. $158,100 overdrawn
B. $19,900 overdrawn
C. $68,500 overdrawn
D. $59,700 overdrawn as stated
A. $43,100 overdrawn
B. $16,900 overdrawn
C. $60,300 overdrawn
D. $34,100 overdrawn
A. Unpresented cheques
B. Unposted direct debits
C. Bank charges
D. Dishonoured cheques
___________________________________________________________________________
234
7. Elaine is preparing her bank reconciliation. She has noted the following:
(i) the bank has levied charges on her account
(ii) a cheque payable to S. Wright has not been presented at the bank
Which of the above errors require an entry in the bank account in her general
ledger?
What should the final cash book balance be when all the above items have
been properly dealt with?
A. $43,650 overdrawn
B. $33,630 overdrawn
C. $5,110 overdrawn
D. $72,170 overdrawn
A. 1 and 3
B. 2 and 3
C. 1 and 4
D. 2 and 4
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235
__________________________
ANSWER BANK
_________________
___________________________________________________________________________
236
1. C
The bank is overdrawn.
$
Overdraft (38,600)
Deposits 41,200
2,600
Unpresented cheques (3,300)
Overdraft (700)
3. D
4. B
$
Overdraft per bank statement 39,800
Less: deposits credited (64,100)
Add: outstanding cheques 44,200
Overdraft per cash book 19,900
5. A
$
Balance per bank statement (38,600)
Bank charges 200
Lodgements 14,700
Cheque payments (27,800)
Cheque payment misposted 8,400
Balance per cash book (43,100)
6. A
All of the others will require an entry in the cash book
7. B
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237
8. B
___________________________________________________________________________
238
Chapter 16
Correction of Errors
Lecture Example 1
2. Errors of omission
3. Errors of principle
4. Errors of commission
5. Compensating errors
Some of these errors can be corrected by journal entry; some require the use of a
suspense account.
1. If the correction involves a double entry in the ledger accounts, then it is done
by using a journal entry in the journal.
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239
2. 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.
16.2 ACCA SYLLABUS GUIDE OUTCOME 2
Identify errors which would be highlighted by the extraction of a trial balance
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).
Suspense Accounts: -
Lecture Example 2
The trial balance of Z failed to agree, the totals being: debit $836,200 credit
$819,700.
A suspense account was opened for the amount of the difference and the following
errors were found and corrected:
1. The totals of the cash discount columns in the cash book had not been posted
to the discount accounts. The figures were discount allowed $3,900 and
discount received $5,100.
2. A cheque for $19,000 received from a customer was correctly entered in the
cash book but was posted to the customer's account as $9,100.
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240
What will be the remaining balance on the suspense be after the correction of these
errors?
A. $25,300 credit
B. $7,700 credit
C. $27,700 debit
D. $5,400 credit
Lecture Example 3
Which of the following errors could result in a suspense account being required to
'balance' the trial balance?
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.
$ $ $
+ -
Original profit X
Adjustment:
Over depreciation expense charged X
Unrecorded expense X
Unrecorded sale X
X (X) X
Adjusted Profit X
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241
Lecture Example 4
At the year end of T Down & Co, an imbalance in the trial balance was revealed
which resulted in the creation of a suspense account with a credit balance of $1,040.
1. A sale of goods on credit for $1,000 had been omitted from the sales account.
2. Delivery and installation costs of $240 on a new item of plant had been
recorded as a revenue expense.
3. Cash discount of $150 on paying a supplier, JW, had been taken, even
though the payment was made outside the time limit.
4. Purchases of stationery at the end of the period of $240 had been ignored.
5. A purchase of raw materials of $350 had been recorded in the purchases
account as $850.
6. The purchase returns day book included a sales credit note for $230 which
had been entered correctly in the account of the customer concerned, but
included with purchase returns in the nominal ledger.
Required:
Lecture Example 5
Debit $1,796,100
Credit $1,852,817
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242
He then opened a suspense account for the difference and began to check through
the accounting records to find the difference. He found the following errors and
omissions:
1. $8,980 – the total of the sales returns book for September 20X8, had been
credited to the purchases returns account.
2. $9,600 paid for an item of plant purchased on 1 April 20X8 had been debited
to plant repairs account. The company depreciates its plant at 20% per
annum on a straight line basis, with proportional depreciation in the year of
purchase.
3. The cash discount totals for the month of September 20X8 had not been
posted to the nominal ledger accounts. The figures were:
Discount allowed $836
Discount received $919
4. $580 insurance prepaid at 30 September 20X7 had not been brought down as
an opening balance
5. The balance of $38,260 on the telephone expense account had been omitted
from the trial balance
6. A car held as a fixed asset had been sold during the year for $4,800. The
proceeds of sale were entered in the cash book but had been credited to the
sales account in the nominal ledger. The original cost of the car $12,000, and
the accumulated depreciation to date $8,000, were included in the motor
vehicles account and the accumulated depreciation account. The company
depreciates motor vehicles at 25% per annum on a straight line basis with
proportionate depreciation in the year of purchase but none in the year of
sale.
Required:
1. Open a suspense account for the difference between the trial balance
totals. Prepare the journal entries necessary to correct the errors and
eliminate the balance on the suspense account. Narratives are not
required.
2. Draw up a statement showing the revised profit after correcting the above
errors.
___________________________________________________________________________
243
___________________________
KEY NOTES
_________________
___________________________________________________________________________
244
1. Types of errors: -
2. Suspense Account
Where the trial balance does not balance a suspense account will be opened and
the errors, once identified, will be corrected via a journal entry. A suspense
account should never appear in the final accounts.
___________________________________________________________________________
245
3. Adjustments to Profit
Where the process of correcting errors requires changes to income and expense
accounts the business’ profit will be affected. In this case a statement of
adjustments to profit has to be prepared to determine the revised profit figure for
the year.
___________________________________________________________________________
246
__________________________
QUESTION BANK
_________________
___________________________________________________________________________
247
1. Sales returns of $460 have inadvertently been posted to the purchase returns,
although the correct entry has been made to the accounts receivable control.
A. $460 debit
B. $460 credit
C. $920 debit
D. $920 credit
2. The trial balance of a company did not balance, and a suspense account was
opened for the difference.
A. 1 and 2
B. 2 and 3
C. 3 and 4
D. 2 and 4
A. 1 only
B. 1 and 2 only
C. 3 and 4 only
D. All four items
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248
1. The proceeds of issue of 100,000 50c shares at 70c per share were
correctly entered in the cash book but had been credited to sales
account.
2. During the year $8,000 interest received on a holding of loan notes had
been correctly entered in the cash book but debited to interest payable
account.
3. In arriving at the net sales and purchases totals for the year, the
$48,000 balance on the returns outwards account had been transferred
to the debit of sales account and the $64,000 balance on the returns
inwards account had been transferred to the credit of purchases
account.
4. A payment of $4,000 for rent had been correctly recorded in the cash
book but debited to the rent account as $40,000.
Required:
5. A company’s trial balance failed to agree, and a suspense account was opened
for the difference.
Subsequent checking revealed that discounts allowed $13,000 had been credited
to discounts received account and an entry on the credit side of the cash book for
the purchase of some machinery $18,000 had not been posted to the plant and
machinery account.
Which two of the following journal entries would correct the errors?
Debit Credit
$ $
1. Discounts allowed 13,000
Discounts received 13,000
2. Discounts allowed 13,000
Discounts received 13,000
Suspense account 26,000
3. Suspense account 26,000
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A. 1 and 4
B. 2 and 5
C. 2 and 4
D. 3 and 5
1. The cost of an item of plant $48,000 had been entered in the cash book and in
the plant account as $4,800. Depreciation at the rate of 10% per year ($480)
had been charged.
2. Bank charges of $440 appeared in the bank statement in December 20X5 but
had not been entered in the company’s records.
3. One of the directors of the company paid $800 due to a supplier in the
company’s payables ledger by a personal cheque. The bookkeeper recorded a
debit in the supplier’s ledger account but did not complete the double entry for
the transaction. (The company does not maintain a payables ledger control
account).
4. The payments side of the cash book had been understated by $10,000.
Which of the above items would require an entry to the suspense account in
correcting them?
A. $634,760
B. $624,760
C. $624,440
D. $625,240
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ANSWER BANK
_________________
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251
1. C
The sales returns of $460 have been credited to accounts receivable and also $460
has been credited to purchase returns. Therefore the trial balance needs a debit of
2 × $460 = $920 to balance.
2. B
1. Dr Motor vehicles
Cr Motor expenses
2. Dr Wages
Cr Suspense
3. Dr Discounts received
Dr Discounts allowed
Cr Suspense
4. Dr Receivables
Cr Cash
3. A
The trial balance still agrees if there is an error of omission, commission, principle or
complete reversal of entries.
4. (a)
Dr Cr
$ $
1. Sales 70,000
Share capital 50,000
Share premium 20,000
2. Suspense 16,000
Interest payable 8,000
Interest receivable 8,000
3. Sales 16,000
Purchases 16,000
Suspense 32,000
OR
Suspense 48,000
Sales 48,000
Purchases 64,000
Suspense 64,000
Sales 64,000
Suspense 64,000
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252
Suspense 48,000
Purchases 48,000
4. Suspense 36,000
Rent 36,000
(b)
$ $ $
+ -
Original profit 830,000
Adjustment:
Sales 70,000
Interest 16,000
Sales/purchases 32,000
Rent 36,000
52,000 (102,000) (50,000)
Adjusted Profit 780,000
5. C
6. B
3. Dr Suspense 800
Cr Directors’ account 800
4. Dr Suspense 10,000
Cr Cash 10,000
7. D
+ -
$ $ $
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Chapter 17
Incomplete Records
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.
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
Allowance must be made for proprietor's drawings and extra capital introduced, so
the formula becomes:
Lecture Example 1
A business has net assets of $70,000 at the beginning of the year and $80,000 at
the end of the year. Drawings were $25,000 and a lottery win of $5,000 was paid into
the business during the year. What was the profit for the year?
A. $10,000 loss
B. $30,000 profit
C. $10,000 profit
D. $30,000 loss
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254
259,850 259,850
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: -
Lecture Example 2
Senji does not keep proper accounting records, and it is necessary to calculate her
total purchases for the year ended 31 January 20X4 from the following information:
$
Trade payables
31 January 20X3 130,400
31 January 20X4 171,250
Payments to suppliers 888,400
Cost of goods taken by Senji for her personal use 1,000
Refund received from suppliers 2,400
Discounts received 11,200
Compute the figure for purchases for inclusion in Senji's financial statements.
Lecture Example 3
The following information is available for the year ended 31 December 20X1 for Ski,
a well-run company:
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255
$
Opening cash 1,000
Closing cash 2,000
Opening balance on the trade payables control account 8,000
Closing balance on the trade payables control account 10,000
Opening balance on the trade receivables control account 12,000
Closing balance on the trade receivables control account 14,000
Cash paid to trade accounts payable in the period 9,000
Opening inventory 6,000
Closing inventory 7,000
Assuming the information above is complete, what was the sales figure for the
period?
____________
17.1.3 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.
Lecture Example 4
B Co maintains a cash float of $50. In 20X7, all receipts from credit customers were
banked, after the following payments from the till had been made:
$
General expenses 4,500
Drawings 6,250
Total banking in the year amounted to $28,454, and opening and closing trade
receivables were $1,447 and $1,928 respectively.
Required
Based on the information above what was the value of sales made during the year?
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256
Sales 100%
Cost of sales 75%
Gross profit 25%
Sales 135%
Cost of sales 100%
Gross profit 35%
Lecture Example 5
Aluki fixes prices to make a standard gross profit percentage on sales of 33 1/3%. The
following information is available for the year ended 31 January 20X4 to compute her
sales total for the year:
$
Inventory
1 February 20X3 243,000
31 January 20X4 261,700
Purchases 595,400
Purchases returns 41,200
Calculate the sales figure for the year ended 31 January 20X4.
Lecture Example 6
A business usually has a mark-up of 20% on cost of sales. During a year, its sales
were $90,000. What was the cost of sales?
__________
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257
Lecture Example 7
Brown has budgeted sales for the coming year of $175,000. He achieves a constant
gross mark-up of 40% on cost. He plans to reduce his inventory level by $13,000
over the year. What will Brown's purchases be for the year?
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
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.
Lecture Example 8
A business has opening inventories of $273 and makes purchases during the year of
$2,781. The proprietor removes goods costing $87 for his own use. The business
achieves a constant mark-up of 20% on cost and records sales for the year of
$3,360.
______________
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.
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258
Lecture Example 9
Based on this information, what is the cost of the inventory destroyed in the
fire?
A. $185,000
B. $140,000
C. $405,000
D. $360,000
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259
__________________________
KEY NOTES
_________________
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260
1. 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.
Allowance must be made for proprietor's drawings and extra capital introduced.
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.
2.3 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.
Sales 100%
Cost of sales 75%
Gross profit 25%
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261
Sales 135%
Cost of sales 100%
Gross profit 35%
Cash drawings
Dr Drawings
Cr Cash
Dr Drawings
Cr Purchases
These are recorded at the cost to the business. They are taken out of purchases
and not recorded against inventories.
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__________________________
QUESTION BANK
_________________
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263
2. The profit earned by a business in 20X7 was $72,500. The proprietor injected
new capital of $8,000 during the year and withdrew goods for his private use
which had cost $2,200.
If net assets at the beginning of 20X7 were $101,700, what were the closing net
assets?
A. $35,000
B. $39,400
C. $168,400
D. $180,000
3. A business has compiled the following information for the year ended 31 October
20X2:
$
Opening inventory 386,200
Purchases 989,000
Closing inventory 422,700
The gross profit as a percentage of sales is always 40%
Based on these figures, what is the sales revenue for the year?
A. $1,333,500
B. $1,587,500
C. $2,381,250
D. The sales revenue figure cannot be calculated from this information
4. A sole trader took some goods costing $800 from inventory for his own use. The
normal selling price of the goods is $1,600.
Which of the following journal entries would correctly record this?
A. Dr Inventories $800
Cr Purchases $800
B. Dr Drawings $800
Cr Purchases $800
C. Dr Sales $1,600
Cr Drawings $1,600
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264
D. Dr Drawings $800
Cr Sales $800
5. A sole trader fixes her prices by adding 50 per cent to the cost of all goods
purchased. On 31 October 20X3, a fire destroyed a considerable part of the
inventory and all inventory records.
Her trading account for the year ended 31 October 20X3 included the following
figures:
$ $
Sales 281,250
Cost of Sales
Opening Inventories 183,600
Purchases 249,200
432,800
Closing Inventories 204,600
Cost of Sales 228,200
Gross Profit 53,050
A. $61,050
B. $87,575
C. $40,700
D. $110,850
6. Adam, a sole trader has net assets at 31 December 20X1 of $65,250. During the
year he made a loss of $3,000, he took inventory for his own use of $850 and
removed cash of $2,250.
If he introduced capital of $5,000 during the year, what was the capital as at 1
January 20X1?
______________
7. On 30 April 20X1 part of the inventory of Neutron, a limited liability company, was
destroyed by fire.
Based on this information, what was the cost of the inventory destroyed?
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265
_________________
ANSWER BANK
_________________
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266
1.
$
Opening capital 128,000
Capital introduced 50,000
178,000
less: Drawings 48,000
130,000
Closing capital 184,000
Profit is therefore 54,000
2. D
I = P + Ci – D
= $(72,500 + 8,000 – 2,200)
= $78,300
Therefore, closing net assets = $(101,700 + 78,300) = $180,000.
3. B
Opening inventory 386,200
Purchases 989,000
Closing inventory (422,700)
Cost of sales 952,500
6. $66,350
7. $30,800
$
Theoretical gross profit 30% × $260,000 78,000
Actual gross profit:
$260,000 – $99,600 – $177,200 + $64,000 47,200
Shortfall – missing inventory 30,800
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Chapter 18
Provisions and Contingencies
IAS 37 – Provisions, Contingent Liabilities and Contingent Assets
18.1.1 Provisions
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.
Dr Expense (I/S)
Cr Provision (SOFP)
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268
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)
Measurement of Provision
A company sells goods with a warranty for the cost of repairs required in the first 2
months after purchase.
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.
Lecture Example 1
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269
A business has been told by its lawyers that it is likely to have to pay $10,000
damages for a product that failed. The business duly set up a provision at 31
December 20X7. However, the following year, the lawyers found that damages were
more likely to be $50,000. How is the provision treated in the accounts at:
(a) 31 December 20X7?
(b) 31 December 20X8?
Disclosure note
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;
An indication of the uncertainties that exist relating to the amount or timing
of any outflow; and
The possibility of any reimbursement.
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270
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: -
1. an estimate of its financial effect
2. an indication of the uncertainties relating to the amount or timing of any
outflow; and
3. the possibility of any reimbursement
Lecture Example 2
Amazon Inc. has been sued for the following two alleged infringement of law:
1. unauthorized use of a trademark; the claim is for $100 million
2. non-payment of end-of-service severance pay and gratuity to 5,000
employees who were terminated without Amazon Inc. giving any reason; the
class action lawsuit is claiming $3 million.
Legal counsel has communicated to Amazon Inc. this assessment of the two
lawsuits:
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.
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271
Disclosure Note
Lecture Example 3
How does a company account for a contingent asset that is not probable?
A. By way of note
B. As an asset in the statement of financial position
C. It does nothing
Lecture Example 4
An employee dismissed in August 20X3 began an action for damages for wrongful
dismissal in October 20X3.
She is claiming $100,000 in damages. Aluki is resisting the claim and the company’s
lawyers have advised that the employee has a 30% chance of success in her claim.
The financial statements currently include a provision for the $100,000 claim.
Required:
Explain to the directors how this matter should be treated in the financial statements
for the year ended 30 September 20X3, stating the relevant accounting standards.
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272
__________________________
KEY NOTES
_________________
___________________________________________________________________________
273
1 Provisions
2 Contingent Liabilities
Contingent liabilities should not be recognized in financial statements but they should
be disclosed, unless the possibility of any outflow is remote.
3 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.
274
of economic benefits is virtually certain then the asset is not a contingent asset and
should be recognised in the financial statements.
___________________________________________________________________________
275
___________________
QUESTION BANK
___________________
___________________________________________________________________________
276
What is the correct action to be taken in the financial statements for these
items?
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277
A. 1 and 4 only
B. 3 only
C. 2, 3 and 4
D. 1, 2 and 4
A. Provision
B. Contingent liability
C. Contingent asset
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278
______________________
ANSWER BANK
______________
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279
1. A
4. A
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280
Chapter 19
Preparing the Financial Statements of Limited
Liability Companies
There are some fundamental differences between the accounts of sole traders and
partnerships and limited liability companies. The following are perhaps the most
significant.
c) The liability for the debts of the business in a sole trader or partnership is
unlimited, which means that if the business runs up debts that it is unable to
pay, the proprietors will become personally liable for the unpaid debts, and
would be required, if necessary, to sell their private possessions in order to
repay them. On the other hand, limited liability companies offer limited liability
to their owners. Limited liability means that the maximum amount that an
owner stands to lose in the event that the company becomes insolvent and
cannot pay off its debts, is his share of the capital in the business.
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.
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281
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.
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)
282
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 form part of equity and their dividends are treated
as appropriations of profit.
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 shares normally carry voting rights. Therefore, ordinary shareholders are
the effective owners of a company. They own the 'equity' of the business including
any reserves of the business. Ordinary shareholders are sometimes referred to as
equity shareholders.
Limited liability companies may issue loan stock or bonds to raise finance. These are
non-current liabilities but are different from share capital: -
a) Shareholders are the owners of a company, while providers of loan capital are
creditors of the company.
b) 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.
c) 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.
Lecture Example 1
A company made an issue for cash of 1,000,000 50c shares at par. What is the
double-entry of this transaction?
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283
Lecture Example 2
A company made an issue for cash of 1,000,000 50c shares at a premium of 30c per
share.
Debit Credit
$ $
A. Share capital 500,000
Share premium 300,000
Bank 800,000
B. Bank 800,000
Share capital 500,000
Share premium 300,000
C. Bank 1,300,000
Share capital 1,000,000
Share premium 300,000
D. Share capital 1,000,000
Share premium 300,000
Bank 1,300,000
When describing ordinary shareholders, we have said that these own the ‘equity’ of
the business including any reserves. Shareholders' equity consists of: -
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284
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.
Advantages: -
a) Increases share capital without reducing present shareholders' holdings
b) Capitalises reserves, therefore less is available for distribution as dividends
Disadvantages: -
a) Does not increases cash
b) If profits fall, the payment of dividends could be jeopardised
Accounting Treatment
Dr Share Premium
Cr Share Capital
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285
Lecture Example 3
During 20X2 the company made a bonus issue of 1 share for every 2 held, using the
share premium account for the purpose, and later issued for cash another 60,000
shares at 80c per share.
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: -
a) Raises cash
b) Reserves are available for future dividend distribution
Disadvantages: -
a) If a shareholder sells his rights, he will be losing (diluting) his control in the
company
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286
Accounting Treatment
Dr Cash
Cr Share Capital
Cr Share Premium
Lecture Example 4
In the year ended 30 June 20X3 the company made a rights issue of 1 share for
every 2 held at $1 per share and this was taken up in full. Later in the year the
company made a bonus issue of 1 share for every 5 held, using the share premium
account for the purpose.
What was the company’s capital structure at 30 June 20X3?
Accounting Treatment
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287
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.
Lecture Example 5
Lecture Example 6
In the year ended 31 October 20X2, the company has paid the preference dividend
for the year and an interim dividend of 2c per share on the ordinary shares. A final
ordinary dividend of 3c per share is proposed.
What is the total amount of dividends relating to the year ended 31 October 20X2?
A. $580,000
B. $90,000
C. $130,000
D. $540,000
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
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288
Lecture Example 7
At 30 June 20X2 a company had $1m 8% loan notes in issue, interest being paid
half-yearly on 30 June and 31 December.
On 30 September 20X2 the company redeemed $250,000 of these loan notes at par,
paying interest due to that date.
On 1 April 20X3 the company issued $500,000 7% loan notes, interest payable half-
yearly on 31 March and 30 September.
What figure should appear in the company’s statement of profit or loss for interest
payable in the year ended 30 June 20X3?
A. $88,750
B. $82,500
C. $65,000
D. $73,750
Lecture Example 8
A company's share capital consists of 20,000 25c ordinary shares all, of which were
issued at a premium of 20%. The market value of the shares is currently 70c each.
A. $14,000
B. $6,000
C. $5,000
Lecture Example 9
A company has a tax liability brought forward of $16,000. The liability is finally
agreed at $17,500 and this is paid during the year. The company estimates that the
tax liability based on the current year’s profits will be $25,000. Calculate the tax
expense and the tax payable for the year
___________________________________________________________________________
289
Further Question: 1
$
Ordinary shares of 20 cents each 1,000,000
8% preference shares of 50 cents each 500,000
In the year ended 30 September 2010, the company paid the preference dividend for
the year and an interim dividend of 3 cents per share on the ordinary shares. A final
ordinary dividend of 5 cents per share was declared on 29 September 2010.
Calculate the total amount of dividends accounted for in the year ended 30
September 2010.
$_________
Further Question: 2
$
400,000 shares of $0.25 each 100,000
Share premium account 150,000
Calculate the balances on the share capital and share premium accounts after the
rights issue.
Further Question: 3
$
200,000 ordinary shares of $0.50 each 100,000
Share premium account 360,000
During 20X9, the company made a 1 for 2 bonus issue, using the share premium
account for the purpose, and later issued for cash another 120,000 shares at $1.60
per share.
Calculate the balances on the company’s share capital and premium accounts as at
31 December 20X9.
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290
Further Question: 4
The estimated tax liability for the year ended 31 March 2011 is $31,200
Calculate:
a) The tax expense in the statement of profit or loss.
b) The tax due at 31 March 2011 which will be included in the SFP.
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291
__________________________
KEY NOTES
_________________
___________________________________________________________________________
292
Authorised share capital: the maximum amount of share capital that a company is
empowered to issue.
Issued share capital: the amount of share capital that has been issued to
shareholders.
Called-up share capital: the amount the company has asked shareholders to pay,
for the time being, on shares issued to them.
Paid-up share capital: the amounts actually paid by shareholders on shares issued
to them.
2. Capital Structure
Ordinary shares carry no right to a fixed dividend but ordinary shareholders are
entitled to all profits. Ordinary shares normally carry voting rights.
Limited liability companies may issue loan stock or bonds to raise finance. These
are non-current liabilities and the interest is an expense in the statement of profit or
loss
3. Shareholders’ Equity
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e) Retained earnings – these are profits earned by the company and which have
been retained by the business
4. Bonus Issue
A company may wish to increase its share capital without needing to raise additional
finance. A bonus issue raises no funds. A bonus issue increases the capital base of
the company and gives greater protection to the company’s creditors
Accounting Treatment
Dr Share Premium
Cr Share Capital
5. Rights Issue
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.
Accounting Treatment
Dr Cash
Cr Share Capital
Cr Share Premium
6. Dividends
Accounting Treatment
7. Finance Costs
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.
Accounting Treatment
Dr Finance Costs (I/S)
Cr Bank
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QUESTION BANK
_________________
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2. When a company makes a rights issue of equity shares which of the following
effects will the issue have?
A. 1 only
B. 1 and 2
C. 3 only
Debit Credit
$ $
A. Share premium account 25,000
Share capital account 25,000
B. Share capital account 25,000
Share premium account 25,000
C. Share capital account 37,500
Share premium account 37,500
D. Share capital account 25,000
Cash 25,000
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Debit Credit
$ $
A. Cash 100,000
Ordinary share capital 100,000
B. Ordinary share capital 100,000
Share premium 100,000
C. Share premium 100,000
Ordinary share capital 100,000
D. Investments 100,000
Cash 100,000
A. 1 and 2
B. 1 and 3
C. 2 and 3
D. 2 and 4
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ANSWER BANK
_________________
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1. C
2. A
4. C
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Chapter 20
Financial Statements for Companies
Therefore, whereas the statement of profit or loss includes all realised gains and
losses (e.g. net profit for the year), the statement of comprehensive income would
include both the realised and unrealised gains and losses (e.g. revaluation surplus).
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Lecture Example 1
Required:
Prepare the company’s statement of changes in equity for the year ended 30
June 20X4.
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Lecture Example 2
Which of the following statements about company financial statements is/are correct,
according to International Financial Reporting standards?
1. A material profit or loss on the sale of part of the entity must appear in the
statement of comprehensive income as an extraordinary item.
2. Dividends paid and proposed should be included in the statement of
comprehensive income.
3. The statement of comprehensive income must show separately any
material profit or loss from operations discontinuing during the year.
4. The statement of changes in equity must not include unrealised gains or
losses.
A. 1, 2 and 3
B. 2 and 4
C. 3 only
Notes to the accounts are prepared for the following three purposes:
(i) present information about the basis of preparation of the financial
statements and the specific accounting policies used;
(ii) disclose the information required by IFRSs that is not presented elsewhere
in the financial statements; and
(iii) provide information that is not presented elsewhere in the financial
statements, but is relevant to an understanding of any of them.
We have already prepared the disclosure notes when dealing with the relevant
standard. However, these are the disclosure notes you would need to know for your
exams.
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o additions
o disposals
o acquisitions through business combinations
o revaluation increases or decreases
o impairment losses
o reversals of impairment losses
o depreciation
o net foreign exchange differences on translation
o other movements
Depreciation
At 1 January 2010 16,000 6,000 4,000 26,000
Charge for year 4,000 3,000 2,000 9,000
Eliminated on disposals (500) (500) - (1,000)
At 31 December 2010 19,500 8,500 6,000 34,000
Carrying Amount
At 31 December 2010 45,500 6,500 4,000 56,000
At 1 January 2010 34,000 4,000 4,000 42,000
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Development expenditure
$
Net book value at 1 April 20X0 X
Additions X
Amortisation charge (X)
Disposals (X)
Net book value at 31 March 20X1 X
At 31 March 20X0
Cost X
Accumulated amortisation (X)
Net book value X
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At 31 March 20X1
Cost X
Accumulated amortisation (X)
Net book value X
Provisions: -
At 1 April 20x0 X
Increase in period X
Released in period (X)
At 31 March 20x1 X
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;
An indication of the uncertainties that exist relating to the amount or timing
of any outflow; and
1. the date when the financial statements were authorised for issue and who
gave that authorisation.
2. if information is received after the end of the reporting period about conditions
that existed at the end of the reporting period, disclosures that relate to those
conditions should be updated in the light of the new information.
3. where non-adjusting events after the reporting period are of such significance
that non-disclosure would affect the ability of the users of financial statements
to make proper evaluations and decisions, disclosure should be made for
each such significant category of non-adjusting event regarding the nature of
the event and an estimate of its financial effect or a statement that such an
estimate cannot be made.
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IAS 18, Revenue, prescribes the requirements for the recognition of revenue arising
from an entity’s ordinary activities.
Generally, revenue is recognized when the entity has transferred to the buyer the
significant risks and rewards of ownership and when the revenue can be measured
reliably.
20.5.2 Scope
Revenue from the sale of goods should be recognized when all of the following
criteria are satisfied: -
1 The significant risks and rewards of ownership of the goods have been
transferred to the buyer
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For revenue arising from the rendering of services, revenue should be recognised by
reference to the stage of completion of the transaction at the end of the reporting
period. The following criteria must be met:
Interest, royalties and dividends are included as income because they arise from the
use of an entity’s assets by other parties. They are recognised as revenue when the
economic benefits are expected to flow to the enterprise and the amount of revenue
can be measured reliably.
Revenue does not include sales taxes, value added taxes or any other tax which is
collected for third parties.
Lecture Example 3
Xtra Ltd, a new company manufacturing and selling consumable products, has come
out with an offer to refund the cost of purchase within one month of sale if the
customer is not satisfied with the product.
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Lecture Example 4
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KEY NOTES
_________________
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2. The statement of comprehensive income includes both the realised gains and
losses from the statement of profit or loss and the unrealised gains and losses
from the statement of financial position.
Generally, revenue is recognized when the entity has transferred to the buyer
the significant risks and rewards of ownership and when the revenue can be
measured reliably.
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__________________________
QUESTION BANK
_________________
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313
A. 1, 2 and 3 only
B. 2, 3 and 4 only
C. All four items
A. 1, 3 and 4 only
B. 1, 2 and 4 only
C. 1 and 3 only
D. All five items
A. 1 and 3
B. 2 and 3
C. 1 and 2
D. 3 only
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A. 1 and 2
B. 1 and 3
C. 2 and 3
D. 3 and 4
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ANSWER BANK
_________________
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3. D - A bonus issue does not raise any funds (no cash involved) and items are
no longer classified as extraordinary.
4. D - The contents of cost of sales are not defined by any IAS; net profit is
calculated after interest; depreciation will be included under the relevant
statutory heading
5. B – Dividends are not an expense. Dividends declared but still due at year
end go into SFP and SOCIE.
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Chapter 21
IAS 10: EVENTS AFTER THE REPORTING
PERIOD
21.1 ACCA SYLLABUS GUIDE OUTCOME 1:
Define an event after the reporting period in accordance with International
Financial Reporting Standards
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”.
a. those that provide evidence of conditions that existed at the end of the
reporting period (adjusting events); and
b. those that are indicative of conditions that arose after the end of the reporting
period (non-adjusting events).
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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.
b. 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.
c. 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.
Financial statements should be adjusted for adjusting events. This means that the
amounts in the financial statements should be changed.
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Lecture Example 1
Which of the following statements are correct, according to IAS 10 Events after
the reporting period?
A 1 and 2 only
B 1, 3 and 4
C 2 and 3 only
D 2, 3 and 4
7J–INTAO1.1INT
7J–INTAr 1.1INT
Lecture Example 2
Which of the following events after the statement of financial position date would
normally qualify as adjusting events according to IAS 10 Events after the reporting
period?
A 1, 3, and 4
B 1 and 2 only
C 2 and 3 only
D 1 and 4 only
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Lecture Example 3
Which of the following events between the end of the reporting period and the date
the financial statements are authorised for issue must be adjusted in the financial
statements?
A 1 only
B 2 and 4
C 3 only
D None of them
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KEY NOTES
_________________
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Key Definitions
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.
Adjusting events:
Those events that provide evidence of conditions that existed at the end of the
reporting period.
Non-adjusting events:
Those events that are indicative of conditions that arose after the end of the
reporting period.
An enterprise should disclose the date when the financial statements were
authorised for issue and who gave that authorisation.
b. 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.
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c. 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.
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__________________________
QUESTION BANK
_________________
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325
1. Which of the following events occurring after the reporting period are
classified as adjusting, if material?
1. The sale of inventories valued at cost at the end of the reporting period for
a figure in excess of cost.
2. A valuation of land and buildings providing evidence of an impairment in
value at the year end.
3. The issue of shares and loan notes.
4. The insolvency of a customer with a balance outstanding at the year end.
A 1 and 3
B 2 and 4
C 2 and 3
D 1 and 4
4. When does an event after the reporting period require changes in the
financial statements?
A Never
B If it provides further evidence of conditions existing at the end of the
reporting period
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A Adjusting
B Non-adjusting
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327
_________________
ANSWER BANK
_________________
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328
2. B – Non–adjusting
3. B
4. B
5. A
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Chapter 22
Accounting Policies, Changes in Accounting
Estimates and Errors
Accounting policies are specific principles, bases, conventions, rules and practices
applied by an entity in preparing and presenting financial statements. Once selected,
accounting policies must be applied consistently for similar transactions, other
events and conditions. They may be changed only if the change
b) is required by a standard or an interpretation;
c) results in financial statements providing reliable and or relevant information.
Lecture Example 1
Accurate Ltd changed its accounting policy in 20X8 with respect to the valuation of
inventories. Up to 20X7, inventories were valued using a weighted-average cost
method. In 20X8, the method changed to first-in, first-out, as it was considered to
more accurately reflect the usage and flow of inventories. The impact on inventory
valuation was determined to be:
330
20X8 20X7
$ $
Revenue 250,000 200,000
Cost of sales 100,000 80,000
Gross profit 150,000 120,000
Administration costs 60,000 50,000
Selling and distribution costs 25,000 15,000
Net profit 65,000 55,000
Required: -
Present the change in accounting policy in the statement of profit or loss and the
adjusted retained earnings in accordance with the requirements of IAS 8.
Prior-period errors are omissions from, and misstatements in, financial statements
for one or more prior periods arising from a failure to use, or misuse of, reliable
information that was available at the time and could reasonably be expected to have
been obtained and taken into account in the preparation and presentation of financial
statements. Misstatements or omissions are “material” if they could, either
individually or cumulatively, influence the decisions of users of financial statements.
Lecture Example 2
The auditor of Roman Co noticed in 20X8 that, in 20X7, the entity had omitted to
record in its books of accounts an amortisation of development expenditure of
$30,000.
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331
The following are extracts from the statement of profit or loss for the years ended 31
December 20X7 and 20X8, before correction of the error: -
20X8 20X7
$ $
Gross Profit 300,000 345,000
General and administrative expenses (90,000) (90,000)
Selling and distribution costs (30,000) (30,000)
Amortisation expense (30,000) XXXXX
Net income before income taxes 150,000 225,000
Income taxes (30,000) (45,000)
Net Profit 120,000 180,000
The retained earnings of Roman Co for 20X7 and 20X8 before correction of the error
are: -
Required: -
Prepare the accounting treatment prescribed by IAS 8 for the correction of the errors.
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332
__________________________
KEY POINTS
_________________
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333
1. Accounting policies: -
2. Prior-period errors: -
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334
__________________________
QUESTION BANK
_________________
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335
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336
__________________________
ANSWER BANK
_________________
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337
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338
Chapter 23
STATEMENTS OF 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.
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.
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.
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IAS 7, Statements of Cash Flows, splits cash flows into the following headings:
1. Cash flows from operating activities
2. Cash flows from investing activities
3. Cash flows from financing activities
Cash flows
outflows inflows
Cash Cash
equivalents
340
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.
23.3.4 Statement of cash flows for the year ended 31 December 20X7
(INDIRECT METHOD)
$000 $000
Cash flows from operating activities
Profit before taxation 3,390
Adjustment for:
Depreciation 450
Investment income (500)
Interest expense 400
3,740
Increase in trade and other receivables (500)
Decrease in inventories 1,050
Decrease in trade payables (1,740)
Cash generated from operations 2,550
Interest paid (270)
Income taxes paid (900)
Net cash from operating activities 1,380
341
Lecture Example 1
Extracts from ACD Co’s statements of financial position show the following items of
property, plant and equipment at net book value:
30 June
20X7 20X6
$ $
Property, plant and equipment
Freehold property 1,230,000 750,000
Plant and equipment 465,000 380,000
Furniture and fixtures 90,000 105,000
The building element of the freehold property was depreciated by $6,000 and then
revalued on 30 June 20X7 by $95,000. Plant and equipment, which had cost
$49,000 when purchased in January 20X2 on which $35,000 of depreciation had
been charged, was disposed of in November 20X6 for $8,000. Depreciation on the
plant and equipment for the year amounted to $37,000. Depreciation of $55,000 has
been charged on furniture and fixtures.
a. What is the total figure for depreciation in ‘cash flows from operating
activities’ in respect of property, plant and equipment? ______________
d. What is the figure for proceeds from disposal of plant and equipment to
be included under ‘cash flows from investing activities’? ____________
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342
Lecture Example 2
These extracts have been taken from the accounts of Clarkes Co.
What will appear as “income tax paid” in the statement of cash flows for the
year ended 31 October 20X8? ____________
Lecture Example 3
These extracts have been taken from the accounts of Johns Co.
What will appear as “dividends paid” in the statement of cash flows for the
year ended 31 October 20X8?
A. $5,750
B. $11,500
C. $15,500
D. $21,250
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
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343
adopt this approach as it can be quite time consuming. However, this is the preferred
method under IAS 7.
$000 $000
Cash flows from operating activities
Cash receipts from customers 30,150
Cash payments to suppliers and employees (27,600)
Cash generated from operations 2,550
Interest paid (270)
Income taxes paid (900)
Net cash from operating activities 1,380
Lecture Example 4
$000
Depreciation 880
Cash paid for expenses 2,270
Increase in inventories 370
Cash paid to employees 2,820
Decrease in receivables 280
Cash paid to suppliers 4,940
Decrease in payables 390
Cash received from customers 12,800
Net profit before taxation 2,370
Required: -
Compute Mermot’s net cash flow from operating activities for the company’s
cash flow statement for the year ended 31 December 2001 using: -
a. Direct method
b. Indirect method
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344
Lecture Example 5
Notes:
1. The depreciation charge for the year was $13,000,000
2. $6,200,000 was paid during the year to settle the income tax liability at 30
June 20X5.
3. The additional loan notes were issued on 1 January 2006. All interest due was
paid on 31 December 20X5 and 30 June 20X6.
4. Dividends paid during the year totalled $4,000,000.
Required:
Prepare the statement of cash flow for the company for the year ended 30 June
20X6, using the format in IAS 7 Statements of Cash Flow.
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345
Further Questions
1. At the start of the accounting period the company has a tax liability of $50 and
at the reporting date a tax liability of $90. During the year the tax charged in
the statement of profit or loss was $100.
Required: Calculate the tax paid
2. At the start of the accounting period the company has PPE with a carrying
amount of $100. At the reporting date the carrying amount of the PPE is $300.
During the year depreciation charged was $20, a revaluation surplus of $60
was recorded and PPE with a carrying amount of $15 was sold.
Required: Calculate the cash paid to buy new PPE.
3. At the start of the accounting period the company has retained earnings of
$500 and at the reporting date retained earnings are $700. During the
reporting period a profit for the year of $450 was reported.
Required: Calculate the dividend paid.
4. Extracts from the financial statements are as follows:
Tax (32,000)
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Additional information
During the year depreciation of $50,000 and amortisation of $40,000 was charged to
profit.
Receipts from customers, combined with cash sales, were $800,000, payments to
suppliers of raw materials $400,000, other operating cash payments were $100,000
and cash paid on behalf and to employees was $126,000.
Required :
(a) Using the direct method, prepare the operating activities section of the statement
of cash flows.
(b) Using the indirect method, determine the operating activities section of the
statement of cash flows.
347
1. At the start of the accounting period the company has a tax liability of $50 and
at the reporting date a tax liability of $90. During the year the tax charged in
the statement of profit or loss was $100.
Required: Calculate the tax paid.
2. At the start of the accounting period the company has PPE with a carrying
amount of $100. At the reporting date the carrying amount of the PPE is $300.
During the year depreciation charged was $20, a revaluation surplus of $60
was recorded and PPE with a carrying amount of $15 was sold.
Required: Calculate the cash paid to buy new PPE.
PPE A/c
3. At the start of the accounting period the company has retained earnings of
$500 and at the reporting date retained earnings are $700. During the
reporting period a profit for the year of $450 was reported.
Required: Calculate the dividend paid
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348
Additional information
During the year depreciation of $50,000 and amortisation of $40,000 was charged to
profit.
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349
Receipts from customers, combined with cash sales, were $800,000, payments to
suppliers of raw materials $400,000, other operating cash payments were $100,000
and cash paid on behalf and to employees was $126,000.
Required:-
(a) Using the direct method prepare the operating activities section of the statement
of cash flows.
(b) Using the indirect method determine the operating activities section of the
statement of cash flows.
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350
__________________________
KEY NOTES
_________________
351
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.
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.
Advantages: -
Disadvantages: -
Cash comprises cash on hand and on demand deposits, less bank overdrafts.
Cash equivalents are short term, highly liquid investments such as current asset
investments (shares) which can be converted into known amounts of cash relatively
quickly without having a major impact on the entity’s activities.
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Cash flows
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353
__________________________
QUESTION BANK
_________________
1. IAS 7 requires the statement of cash flows to open with the calculation of net
cash from operating activities arrived at by adjusting net profit before taxation.
Which of the following lists consists only of items which could appear in such a
calculation?
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354
2. A draft statement of cash flows contains the following calculation of cash flows
from operating activities:
$m
Profit before tax 13
Depreciation 2
Decrease in inventories (3)
Decrease in trade and other receivables 5
Decrease in trade payables 4
Net cash inflow from operating activities 21
How will this transaction be treated in the company's statement of cash flows?
355
1. A cash flow statement prepared using the direct method produces a different
figure for operating cash flow from that produced if the indirect method is used.
2. Rights issues of shares do not feature in cash flow statements.
3. A surplus on revaluation of a non-current asset will not appear as an item in a
cash flow statement.
4. A profit on the sale of a non-current asset will appear as an item under Cash
Flows from Investing Activities in a cash flow statement.
A. 1 and 4
B. 2 and 3
C. 3 only
D. 2 and 4
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ANSWER BANK
_________________
1. B
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357
3. B - The proceeds will appear under investing activities and any profit will be
deducted under operating activities.
4. C Only cash items appear in the statement of cash flows. Therefore items 1
and 3 are incorrect as they do not involve cash movements.
5. C - A rights issue is for cash. A bonus issue is “for free”; hence it is not
included in the statement of cash flows.
Chapter 24
GROUP ACCOUNTING:
CONSOLIDATED
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358
iii. Control: - the power to govern the financial and operating policies of an entity
so as to obtain benefits from its activities
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359
P is an individual legal entity, known as the parent. The parent is an entity that has
one or more subsidiaries.
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 control is usually based on ownership of more than 50% of voting power,
IAS 273 lists the following situations where control exists, even when the parent
owns only 50% or less of the voting power of an enterprise.
(a) The parent has power over more than 50% of the voting rights by virtue of
agreement with other investors
(b) The parent has power to govern the financial and operating policies of
the enterprise by statute or under an agreement
(c) The parent has the power to appoint or remove a majority of members of
the board of directors (or equivalent governing body)
(d) 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.
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360
(ii) Fair value of consideration transferred from cash and shares (excluding
deferred and contingent consideration)
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 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).
24.3.2 Goodwill
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.
Where less than 100% of the subsidiary is acquired, the value of the subsidiary
comprises two elements:
361
The value of the part not acquired by the parent, known as the non-controlling
interest.
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: -
This results in 100% of the goodwill being shown in the group statement of financial
position – that belonging to the shareholders of the parent and that belonging to the
non-controlling interest.
Pre-acquisition profits are the reserves which exist in a subsidiary company at the
date when it is acquired.
Post-acquisition profits are profits made and included in the retained earnings of
the subsidiary company since acquisition.
Only the group share of the post-acquisition reserves of S is included in the group
statement of financial position, i.e. the reserves of S which arose after acquisition by
P.
N.B. Where the acquisition occurs during the financial year, it is important to
calculate the value of profits at the date of acquisition using time-apportionment,
___________________________________________________________________________
362
As mentioned in Section 1 above, a parent may not own all of the shares in the
subsidiary, e.g. if P owns only 70% of the ordinary shares of S, there is a non-
controlling interest of 30%.
In the consolidated statement of financial position, include all of the net assets of
S
Transfer back the net assets of S which belong to the non-controlling interest
within the capital and reserves section of the consolidated statement of financial
position. A proportion of goodwill on acquisition is also transferred back to the
NCI.
Lecture Example 1:
$ $
Investment in S 200
Other Net Assets 100 400
P acquired 80% of S on 1 January 2009 when S’s retained earnings were $80. On
the date of acquisition, the fair value of the non-controlling shareholding in S was
$36.
Lecture Example 2:
___________________________________________________________________________
363
$ $
Investment in S 200
Other Net Assets 400 500
P acquired 70% of S on 1 January 2009 when S’s retained earnings were $140. On
the date of acquisition, the fair value of the non-controlling shareholding in S was
$72.
The fair value of assets and liabilities is defined in IFRS 3 as ‘the amount for which
an asset could be exchanged or a liability settled between knowledgeable, willing
parties in an arm’s length transaction’.
IFRS 3 requires that the subsidiary’s assets and liabilities are recorded at their fair
value for the purposes of the calculation of goodwill and production of consolidated
accounts.
(1) Adjust both columns of the net assets calculation to bring the net assets to fair
value at acquisition and reporting date.
(2) At the reporting date, make the adjustment on the face of the SFP when adding
across assets and liabilities.
Lecture Example 3:
___________________________________________________________________________
364
$ $
Cost of investment S 200
Other Net Assets 800 500
Two years ago P acquired 90% of S when S’s retained earnings were $100. At
acquisition, the fair value of S’s net assets exceeded their book value by $10. Any
difference in fair value is due to land.
On the date of acquisition, the fair value of the non-controlling share of P in S was
$26.
Prepare the consolidated SFP of the group.
Lecture Example 4:
$ $
Investment in S 100
Other Net Assets 200 140
P acquired 80% of S two years ago when S’s retained earnings were $50. At that
date, S’s PPE had a fair value of $10 in excess of the carrying value.
On the date of acquisition, the fair value of the non-controlling shareholding in S was
$20.
Lecture Example 5:
___________________________________________________________________________
365
$ $
Investment in S 200
Other Net Assets 300 300
P acquired 60% of S when S’s retained earnings were $110. At that date, S’s land
had a fair value of $10 in excess of book value.
On the date of acquisition, the fair value of the non-controlling shareholding in S was
$88.
Share for share exchanges form part, or all, of the cost of investment which is used
in the goodwill calculation.
If this exchange has yet to be accounted for, the double entry is always: -
Dr Cost of Investment
Cr Share capital (with the nominal value of P shares given out)
Cr Share premium (with the premium)
Lecture Example 6:
P acquired 80% of S shares via a 2 for 1 share exchange. At the date of acquisition,
the following balances were in the books of H and S:
The share price of P was $2 at the date of acquisition. This has not been accounted
for.
Show the accounting treatment required to account for the share exchange.
Lecture Example 7:
___________________________________________________________________________
366
P acquired 80% of S shares via a 3 for 2 share exchange. The share price of P at
acquisition was $3. This has not been accounted for.
Show the accounting treatment required to account for the share exchange.
Lecture Example 8:
Able Co. bought 51,000 shares in Baker on 1.1.2011. Baker had 60,000 shares in
issue on this date.
Able Co. paid $1.25 for every share in Baker and gave Baker’s shareholders 3
shares for every 2 shares acquired. The nominal value of Able’s shares is $1 per
share and their fair value at the date of acquisition has $2.30.
What was the consideration Able has paid to control Baker?
If the companies within the same group trade with each other, then this will probably
lead to:
These are amounts owing within the group rather than outside the group and
therefore they must not appear in the consolidated statement of financial position.
They are therefore cancelled against each other on consolidation.
Lecture Example 9:
___________________________________________________________________________
367
Berino, a limited liability company, owns 70% of the shares in Muggie. Berino has
payables of $244,000. Muggie has payables of $40,000 of which $6,000 is owed to
Berino. Berino has receivables of $360,000 and Muggie has receivables of
$150,000.
Payables Receivables
$ $
A. 278,000 504,000
B. 194,600 352,800
C. 284,000 510,000
D. 290,000 516,000
(1) Determine the value of closing inventory which has been purchased from the
other company in the group.
(2) Use mark-up or margin to calculate how much of that value represents profit
earned by the selling company.
(3) Make the adjustments according to who the seller is.
If the seller is the parent company:
___________________________________________________________________________
368
H sells to S some goods at a selling price of $100. H makes 20% profit margin. S
sold ⅓ of these goods at cost.
H sells to S goods worth $600. H makes 20% profit margin. S sells $200 of these
goods at cost.
H sells to S goods worth $1000. H makes 40% profit margin. S sold $400 worth of
goods (at cost).
S sells goods to H for $600. S makes a 20% mark up. H has goods at cost left in
stock worth $200.
___________________________________________________________________________
369
Occasionally, a non-current asset is transferred within the group (say from a parent
to a subsidiary). The parent may have manufactured the asset as part of its normal
production (and therefore included the sale in revenue), or it may have transferred
an asset previously used as part of its own non-current assets. If the transfer is
done at cost, then, in the first case, the cost of the asset must be removed from both
revenue and cost of sales. In the second case, no elimination would be required.
If one company sells non-current assets to another company in the same group at a
profit, adjustments must be made for:
1. Profit on sale
2. Depreciation
The whole scenario has to be recreated as if the sales have never occurred.
Adjustment X
H sells PPE to S costing $1000 for a selling price of $1500, depreciation at 10% per
annum.
S sold a machine with a NBV of $100 000 to H at a transfer price of $120 000 at the
year start. Group policy dictates that the machine is depreciated over its remaining
life of 5 years.
___________________________________________________________________________
370
Further Questions4
Question 1
Non-equity shares
Equity shares held
held
Violet Co 80% Nil
Amber Co 25% 80%
Black Co 45% 25%
Green Co also has appointed five of the seven directors of Black Co.
A. Violet only
B. Amber only
C. Violet and Black
D. All of them
Question 2
4Ref: “Preparing Simple Consolidated Financial Statements” by J. Lucas, F3/FFA examiner, April 2012,
http://www.accaglobal.com/content/dam/acca/global/PDF-students/2012s/sa_apr12_f3ffa_finstats.pdf
___________________________________________________________________________
371
Pink Co Scarlett Co
$ $
Current assets:
Receivables 50,000 30,000
Current liabilities:
Payables 70,000 42,000
As a result of trading during the year, Pink Co’s receivables balance included an
amount due from Scarlett of $4,600.
What should be shown as the consolidated figure for receivables and payables?
Receivables Payables
$ $
A. 80,000 112,000
B. 75,400 112,000
C. 74,000 103,600
D. 75,400 107,400
Question 3
Red Co acquired 80% of Blue Co’s 40,000 $1 ordinary share capital on 1 January
2012 for a consideration of $3.50 cash per share.
The fair value of the non-controlling interest was $50,000 and the fair value of the net
assets acquired was $145,000.
A. $17,000
B. $45,000
C. $46,000
D. $112,000
___________________________________________________________________________
372
__________________________
KEY NOTES
_________________
___________________________________________________________________________
373
3. Control: - the power to govern the financial and operating policies of an entity
so as to obtain benefits from its activities.
P 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.
Arises where the cost of the investment is less that the value of net assets
purchased.
Negative goodwill is credited directly to the statement of profit or loss.
11. Pre-acquisition profits are the reserves which exist in a subsidiary company at
the date when it is acquired.
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374
12. Post-acquisition profits are profits made and included in the retained earnings
of the subsidiary company since acquisition. Only the group share of the
post-acquisition reserves of S is included in the group statement of financial
position, i.e. the reserves of S which arose after acquisition by P.
13. The value of the part not acquired by the parent is known as the non-
controlling interest.
In the consolidated statement of financial position, include all of the net assets
of S. Transfer back the net assets of S which belong to the non-controlling
interest within the capital and reserves section of the consolidated statement
of financial position. A proportion of goodwill on acquisition is also transferred
back to the NCI.
14. The fair value of assets and liabilities is defined as ‘the amount for which an
asset could be exchanged or a liability settled between knowledgeable, willing
parties in an arm’s length transaction’.
Dr Cost of Investment
Cr Share capital (with the nominal value of P shares given out)
Cr Share premium (with the premium)
16. Amounts owing within the group rather than outside the group must not
appear in the consolidated statement of financial position. They are cancelled
against each other on consolidation.
375
Adjustment X
The double-entry of this adjustment is: -
___________________________________________________________________________
376
__________________________
QUESTION BANK
_________________
1. At 1 May 2009 Tibor purchased six million of Kinnot’s ten million $1 ordinary
shares for $6,000,000. At that date Kinnot had net assets with a fair value of
___________________________________________________________________________
377
$8,450,000 and its share price was $1.10. It is group policy to value the non-
controlling interest at the fair value of the subsidiary’s identifiable net assets
using the market value of the shares at acquisition.
A. $930,000
B. $2,450,000
C. $1,550,000
D. $1,950,000
A. $4,400,000
B. $350,000
C. $750,000
D. $2,850,000
378
A. $1,150,000
B. $1,750,000
C. $750,000
D. $1,450,00
___________________________________________________________________________
379
5. Tomsett Co, a limited liability company, owns 65% of the shares in Frew Co. Frew
Co owes Tomsett Co $5,000. Tomsett Co has receivables of $300,000 and Frew
Co has receivables of $130,000.
A. $425,000
B. $381,250
C. $379,500
D. $435,00
A. (i) only
B. (i), (ii) and (iii)
C. (i) and (ii) only
D. (iii) only
What figure for non controlling interest should appear in the consolidated
statement of financial position as at 30 June 20X6?
A. $1,220,000
B. $1,300,000
C. $1,480,000
D. $1,400,000
___________________________________________________________________________
380
8. Wheddon Co purchased 60,000 ordinary shares in Raleigh Co for $85,000 five years
ago, when Raleigh Co’s retained earnings were $20,000.
A. $7,000
B. $10,000
C. $25,000
D. $43,000
___________________________________________________________________________
381
__________________________
ANSWER BANK
_________________
___________________________________________________________________________
382
1. D
$
Consideration transferred 6,000,000
Fair value of non-controlling interest (4,000,000 x $1.10) 4,400,000
10,400,000
Less fair value of net assets at acquistion (8,450,000)
Goodwill = 1,950,000
2. D
$
Consideration 8,000,000
Fair value of non-controlling interest (3 million x $1·20) 3,600,000
11,600,000
Less fair value of net assets at acquisition (8,750,000)
Goodwill 2,850,000
3. D
4. D
$
Consideration 4,000,000
Fair value of non-controlling interest (2 million x $1·10) 2,200,000
–––––––––
6,200,000
Less fair value of net assets at acquisition (4,750,000)
–––––––––
Goodwill 1,450,000
–––––––––
5. A
Tomsett Co’s receivables 300,000 + Frew Co receivables 130,000 less 5,000 due
from Tomsett Co = 425,000
6. C
___________________________________________________________________________
383
7. C
$000
At acquisition 1,300
% Post acquisition (5,600 – 4,700) x 20% 180
––––––
1,480
––––––
8. A
$
Cost 85,000
NCI 22,000
Shares (80,000)
Retained Earnings (20,000)
––––––
7,000
––––––
___________________________________________________________________________
384
Chapter 25
GROUP ACCOUNTING:
CONSOLIDATED
STATEMENT OF COMPREHENSIVE INCOME -
SUBSIDIARY
Basic principles
1. From sales revenue to profit after tax, include all of P’s income and expenses
plus all of S’s income and expenses (where a mid-year acquisition has occurred,
these must be time-apportioned).
2. Once the profit after tax is calculated, deduct share profits due to the non-
controlling interest.
Non-controlling interest
This is calculated as: NCI% x subsidiary’s profit after tax (taken from S’s column of
consolidation schedule).
Dividends
Unrealised Profits
___________________________________________________________________________
385
Interest on loan
If loans are outstanding between group companies, intra-group loan interest will be
paid and received. Both the loan and loan interest must be excluded from the
consolidated results.
If one group company sells a non-current asset to another group company, the
following adjustments are needed in the statement of profit or loss:-
1. Any profit or loss arising on the transfer must be deducted
2. The depreciation charge must be adjusted so that it is based on the cost of
the asset to the group
Mid-year acquisitions
If a subsidiary is acquired part way through the year, then it is important to time
apportion the results of S in the year of acquisition. Unless indicated otherwise,
assume that revenue and expenses accrue evenly.
Lecture Example 1:
Several years ago H acquired 80% of the ordinary share capital of S. Their results
for the year ended 31 December 2005 were as follows:
H S
(80%)
Revenue 100 100
COS (40) (40)
Expenses (40) (40)
Profit after Tax 20 20___
___________________________________________________________________________
386
Prepare the consolidated statement of profit or loss for the year ended 31
December 2005.
Lecture Example 2:
Several years ago H acquired 80% of the ordinary share capital of S. Their results
for the year ended 31 December 2005 were as follows:
H S
(80%)
Revenue 1000 800
COS (600) (200)
Expenses (100) (100)
Tax (100) (100)__
Profit after Tax 200 400___
H acquired 80% of S. At that date, 3 years ago, S’s PPE had a fair value of $100 in
excess of the carrying value and a 5 year useful economic life. Depreciation is
charged to COS.
Prepare the consolidated statement of profit or loss for the year ended 31
December 2005.
Lecture Example 3:
Exe Co acquired 70% of the ordinary share capital of Barle Co six years ago. The
following information relates to Barle Co for the year ended 30 September 20X3.
$
Sales revenue 480,000
Cost of sales 270,000
Administration expenses 90,000
Taxation 30,000
B. $63,000
C. $36,000
D. $84,000
___________________________________________________________________________
387
Example
S Co made a $30,000 revaluation gain on its property during the year. P Co has
acquired 70% of the equity of S Co five years ago.
Purple Co acquired 70% of the voting share capital of Silver Co on 1 October 2011.
The following extracts are from the individual statements of profit or loss of the two
companies for the year ended 30 September 2012:
Purple Co Silver Co
$ $
Revenue 79,300 29,900
Cost of sales (54,990) (17,940)
Gross Profit 24,310 11,960
Purple Co had made sales to Silver Co during the year of $5,000. Purple Co had
originally purchased the goods at a cost of $4,000. Half of these items remained in
inventory at the year end.
What should be the consolidated revenue for the year ended 30 September 2012?
______________
What should be the consolidated cost of sales for the year ended 30 September
2012? ___________
5Ref: “Preparing Simple Consolidated Financial Statements” by J. Lucas, F3/FFA examiner, April 2012,
http://www.accaglobal.com/content/dam/acca/global/PDF-students/2012s/sa_apr12_f3ffa_fins tats.pdf
___________________________________________________________________________
388
__________________________
KEY NOTES
_________________
___________________________________________________________________________
389
1. Non-controlling interest
This is calculated as: NCI% x subsidiary’s profit after tax (taken from S’s
column of consolidation schedule).
2. Dividends
A payment of a dividend by S to P must be cancelled. Any dividend income
shown in the consolidated statement of profit or loss must arise from
investments other than those in subsidiaries or associates.
3. Unrealised Profits
The adjustment to unrealised profit should be shown as an increase to cost of
sales. It affects the books of the SELLER.
5. Interest on loan
If loans are outstanding between group companies, intra-group loan interest
will be paid and received. Both the loan and loan interest must be excluded
from the consolidated results.
7. Mid-year acquisitions
If a subsidiary is acquired part way through the year, then it is important to
time apportion the results of S in the year of acquisition. Unless indicated
otherwise, assume that revenue and expenses accrue evenly.
___________________________________________________________________________
390
__________________________
QUESTION BANK
_________________
___________________________________________________________________________
391
1. The summarised statements of profit or loss of Big Co and Small Co, for the year
ended 31 October 2010, are provided below. Big Co acquired 3,600,000 ordinary
shares in Small Co for $5,250,000 on 1 November 2009 when the retained earnings
of Small Co were $300,000. On the same date, Big Co also acquired 40% of Small
Co’s loan notes of $400,000.
Big Co Small Co
$000 $000
Revenue 9,600 3,900
Cost of sales (5,550) (2,175)
––––––– ––––––
Gross profit 4,050 1,725
Distribution costs (1,050) (480)
Administrative expenses (1,650) (735)
Finance costs – (25)
Income from Small Co: Loan note interest 10 –
Dividends 150 –
––––––– ––––––
Profit before tax 1,510 485
Income tax expense (600) (120)
––––––– ––––––
Profit for the year 910 365
––––––– ––––––
(i) Small Co’s total share capital consists of 6,000,000 ordinary shares of $1
each.
(ii) It is group policy to value the non-controlling interest at full fair value. The fair
value of the non-controlling interest at the acquisition date was $3,200,000.
(iii) During the year ended 31 October 2010, Big Co sold goods costing $200,000
to Small Co for $300,000. At 31 October 2010, 50% of these goods remained
in Small Co’s inventory.
Required:
$000 $000
___________________________________________________________________________
392
Consideration transferred
NCI
Assets at acquisition:
Share capital
Retained earnings
Goodwill on acquisition
b) Complete the consolidated statement of profit or loss for Big Co for the
year ended 31 October 2010.
Big Co
Consolidated statement of profit or loss for the year ended 31 October 2010
$000
Revenue
Cost of sales
Gross profit
Distribution costs
Administrative expenses
Finance cost
Profit before tax
Income tax expense
Profit for the year
___________________________________________________________________________
393
2. You are presented with the following information for Bradshaw, a limited liability
company, and its subsidiary, Martin:
Bradshaw Martin
$000 $000
Revenue 125,000 77,900
Cost of sales (65,000) (38,500)
–––––––– ––––––––
Gross profit 60,000 39,400
Distribution costs (6,750) (8,050)
Administrative expenses (17,500) (9,780)
Finance costs – (20)
Income from Martin: Loan note interest 15 –
Dividends 5,200 –
–––––––– ––––––––
Profit before tax 40,965 21,550
Income tax expense (19,250) (10,850)
–––––––– ––––––––
Profit for the year 21,715 10,700
–––––––– ––––––––
Bradshaw Martin
ASSETS $000 $000 $000 $000
Non-current assets
Property, plant and equipment 75,000 31,901
Investments:
$1 ordinary shares in Martin at cost 34,000 –
Martin loan notes 150 –
––––––– ––––––
109,150 31,901
Current assets
Inventory, at cost 9,750 4,162
Receivables 17,125 11,325
Cash and cash equivalents 3,150 30,025 1,255 16,742
––––––– –––––– –––––– ––––––
Total assets 139,175 48,643
–––––– ––––––
EQUITY AND LIABILITES
Capital and Reserves
$1 Ordinary shares 77,000 23,150
Retained earnings 35,362 9,538
___________________________________________________________________________
394
––––––– ––––––
Total equity 112,362 32,688
Non-current liabilities
10% Loan note – 200
Current liabilities
Payables 16,613 9,500
Tax 10,200 6,255
Total liabilities 26,813 15,755
–––––– ––––––– ––––– ––––––
Total equity and liabilities 139,175 48,643
––––––– ––––––
(ii) It is group policy to value the non-controlling interest at full fair value. The fair
value of the non-controlling interest at the acquisition date was $7,408.
(iii) Bradshaw owns $150,000 of Martin’s loan notes. The annual interest of
$15,000 due to Bradshaw has not been paid and is included in Martin’s
payables and Bradshaw’s receivables.
(iv) During the year ended 31 October 2009 Bradshaw sold goods to Martin for
$15,000,000. Bradshaw made a profit on these goods of $2,500,000. Martin
still has all of these goods in inventory at 31 October 2009.
(v) At 31 October 2009 Martin owed Bradshaw $3,000,000 for some of the goods
that Bradshaw supplied during the year.
(vi) All Martin’s dividends of $6,500,000 were paid in the financial year ended 31
October 2009.
Required:
___________________________________________________________________________
395
$000 $000
Consideration transferred
NCI
Assets at acquisition
Share capital
Retained earnings
Bradshaw
Consolidated statement of profit or loss for the year ended 31 October 2009
$000
Revenue
Cost of sales
Gross profit
Distribution costs
Administrative expenses
Finance costs
___________________________________________________________________________
396
Bradshaw
Consolidated statement of financial position as at 31 October 2009
Current assets
Inventory, at cost
Receivables
Cash and cash equivalents
Total assets
Non-controlling interest
Total equity
Non-current liabilities
10% Loan note
Current liabilities
Payables
___________________________________________________________________________
397
Tax
Total current liabilities
Prepare your answers to the nearest $000. (CAT Paper T6 Section B Question 1)
___________________________________________________________________________
398
__________________________
ANSWER BANK
_________________
___________________________________________________________________________
399
$000 $000
Consideration transferred 5,250
NCI 3,200
Assets at acquisition:
Share capital 6,000
Retained earnings 300 (6,300)
(b) Big Co
Consolidated statement of profit or loss for the year ended 31 October 2010
$000
Revenue (9,600 + 3,900 – 300) 13,200
Cost of sales {5,550 + 2,175 – 300 + (50% x 100)} (7,475)
Gross profit 5,725
Distribution costs (1,530)
Administrative expenses (2,385)
Finance cost (25 – 10) (15)
Profit before tax 1,795
Income tax expense (720)
Profit for the year 1,075
___________________________________________________________________________
400
$000 $000
Consideration transferred 34,000
NCI (23,150 – 18,520) x $1·6 7,408
Assets at acquisition
Share capital 23,150
Retained earnings 5,338 (28,488)
––––––
12,920
––––––
$000
Revenue (125,000 + 77,900 – 15,000) 187,900
Cost of sales (65,000 + 38,500 - 15,000 + 2,500*) (91,000)
––––––
Gross profit 96,900
Distribution costs (14,800)
Administrative expenses (27,280)
Finance costs (20 – 15) (5)
––––––
Profit before tax 54,815
Income tax expense (30,100)
––––––
PROFIT FOR THE YEAR 24,715
___________________________________________________________________________
401
(ii) Bradshaw
Consolidated statement of financial position as at 31 October 2009
Notes:
___________________________________________________________________________
402
Workings
W1 - Retained earnings as at 31 October 2009
$000 $000
Bradshaw as per statement of
financial position 35,362
Less unrealised profit (2,500)
Martin :
Retained earnings 9,538
Pre-acquisition reserves (5,338)
–––––
4,200
Group share (80% x $4,200,000) 3,360
––––––
36,222
W2 - Non-controlling interest
___________________________________________________________________________
403
Chapter 26
GROUP ACCOUNTING:
ASSOCIATE
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 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.
___________________________________________________________________________
404
P Co should also include its share of A Co’s other comprehensive income in its
consolidated statement of comprehensive income.
$’000
Cost of investment X
P’s share of post acquisition profits of A X
Less: impairment losses of A (X)
X
Lecture Example 1:
A. Q and R only
B. P and R only
C. P and Q only
D. P, Q and R
Lecture Example 2:
A. The investing entity has owned its share since the incorporation of the
investee entity.
B. The investor holds greater than 20% but less than 50% of the voting power of
the investee.
C. The investing entity has some influence over other entities in the same
industry.
___________________________________________________________________________
405
A. 1 and 2
B. 2 only
C. 1 and 3 only
D. 2 and 3 only
6Ref: “Preparing Simple Consolidated Financial Statements” by J. Lucas, F3/FFA examiner, April 2012,
http://www.accaglobal.com/content/dam/acca/global/PDF-students/2012s/sa_apr12_f3ffa_finstats.pdf
___________________________________________________________________________
406
__________________________
KEY NOTES
_________________
___________________________________________________________________________
407
1. An associate is 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.
3. 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.
6. A’s sales revenue, cost of sales, expenses and revenue are not added with
those of the group.
$’000
Cost of investment X
P’s share of post acquisition profits of A X
Less: impairment losses of A (X)
X
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QUESTION BANK
_________________
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409
A. Neither statement
B. Statement 1 only
C. Both statements
D. Statement 2 only
A. All the profits after tax generated by Bingo are included in the consolidated
statement of profit or loss of Tingo as a single amount
B. All the profits after tax generated by Bingo are included by consolidating the
revenue and expenses of Bingo on a line by line basis from revenue down to
profit for the year
C. Tingo’s share of Bingo’s profit after tax is included by the payment of a
dividend from Bingo to Tingo, which is shown in the consolidated statement of
profit or loss of Tingo
D. Tingo’s share of Bingo’s profit after tax is included in the consolidated
statement of profit or loss of Tingo as a single amount
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__________________________
ANSWER BANK
_________________
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411
The following are examples that might demonstrate the existence of significant
influence:
(a) A representative of the investor on the board of directors of the
investee.
(b) The participation by the investor in the policy making process of the
investee.
(c) Material transactions between investee and investor.
(d) The interchange of management personnel between the two
companies.
(e) The provision of essential technical information by the investor to the
investee.
2. C
3. D
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Chapter 27
INTERPRETATION OF FINANCIAL
STATEMENTS
Lecture Example 1:
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414
2. Liquidity
3. Efficiency
4. Position
Calculate and interpret the relationship between the elements of the financial
statements with regard to profitability, liquidity, efficient use of resources and
financial position.
Draw valid conclusions from the information contained within the financial
statements and present these to the appropriate user of the financial
statements.
Calculate and interpret the relationship between the elements of the financial
statements with regard to profitability, liquidity, efficient use of resources and
financial position
Draw valid conclusions from the information contained within the financial
statements and present these to the appropriate user of the financial
statements
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.
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OR
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.
Note
Always compare a company’s 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 shows how efficiently management have utilised assets to generate
revenue.
It is calculated as: -
__________Revenue_________
Total assets – current liabilities
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.
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.
The gross profit margin looks at the performance of the business at the direct trading
level.
Gross profit
Revenue
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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.
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. 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.
Lecture Example 2
418
The specified ratios and the average figures for Comparator’s sector are shown
below.
Ratios of companies reporting a full year’s results for periods ending between
1 July 2003 and 30 September 2003:
Comparator’s financial statements for the year to 30 September 2003 are set out
below:
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419
Current Assets
Inventory 275
Accounts receivable 320
Bank nil 595
_____
_____
1,135
_____
Share Capital and Reserves
Ordinary shares (25 cents each) 150
Retained Earnings 185
_____
335
Non-current liabilities
8% loan notes 300
Current liabilities
Bank overdraft 65
Trade accounts payable 350
Taxation 85 500
_____ ______
1,135
______
Notes
420
2) The market price of Comparator’s shares throughout the year averaged $6.00
each.
Required:-
___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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421
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.
Lecture Example 3
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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.
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.
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.
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.
423
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).
Lecture Example 4
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27.2.4.2 Gearing
_____Debt8 ______
Debt + Equity9
OR
___Debt___
Equity
High gearing means high debt (in relation to equity). As borrowing increases so does
the risk as the business is now liable to not only repay the debt but meet any interest
commitments under it. If interest rates increase, then the company could be in
trouble unless they have high enough profits to cover this. In addition, to raise further
debt finance could potentially be more difficult and more expensive.
Leverage is the converse of gearing, i.e. the proportion of total assets financed by
equity.
OR
425
If a company has a high level of gearing it does not necessarily mean that it will face
difficulties as a result of this.
For example, if the business has a high level of security in the form of tangible non-
current assets and can comfortably cover its interest payments, a high level of
gearing should not give an investor cause for concern.
It is the equivalent of a person taking the combined interest expense from their
mortgage, credit cards etc, and calculating the number of times they can pay it with
their annual income.
PBIT has its short fallings; companies do pay taxes, therefore it is misleading to act
as if they didn’t. A wise and conservative investor would simply take the company’s
earnings before interest and divide it by the interest expense. This would provide a
more accurate picture of safety.
Lecture Example 5
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426
Lecture Example 6
Which two of the following are valid reasons why the inventory turnover of a
company increases from one year to the next?
A. 1 and 2
B. 2 and 3
C. 1 and 4
D. 3 and 4
Lecture Example 7
A company has increased the length of time allowed for customers to pay their
invoices. This has resulted in an increase in which ratio?
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427
__________________________
KEY NOTES
_________________
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428
OR
4. Asset turnover =
__________Revenue_________
Total assets – current liabilities
5. Return on equity =
Gross profit
Revenue
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429
9. Current Ratio =
___Current Assets___
Current Liabilities
430
Total debts
Total assets
16. Gearing =
_____Debt11 ______
Debt + Equity12
OR
___Debt___
Equity
.
Shareholder’s equity x 100
Shareholders’ equity + total long term debt
OR
431
__________________________
QUESTION BANK
_________________
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432
20X9 20X8
$
Profit before interest and tax 10,200
Interest (1,600)
Tax (3,300)
–––––––
Profit after tax 5,300
–––––––
Share capital 20,000
Reserves 15,600
–––––––
35,600
Loan liability 6,900
–––––––
42,500
–––––––
A. 15%
B. 29%
C. 24%
D. 12%
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433
Which of the following events is most likely to have caused the increase?
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434
__________________________
ANSWER BANK
_________________
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435
2. C – (10,200 / 42,500)
3. D – Which one would cause either Gross Profit to increase or Sales to fall?
Lower Closing Inventories in 20X1 would show as lower Opening
Inventories in X2, lower Cost of Sales, higher Gross Profit.
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436