COURSE: ADVANCED ACCOUNTING NOTE

REDSEA UNIVERSITY
CLASSES: YAER 4 &3

LECTURER: MUKTAR ABDINASIR OSMAN

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COURSE OUTLINE:
Chapter One: Company Accounting
Chapter Two: Equity Accounting and Fair value Method
Chapter Three: Consolidation Of Balance Sheet and Income Statement
Chapter Four: Revenue Recognition
Chapter Five: Statement Of Cashflow
Chapter Six: Provisions And Contingent Liability

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 CHAPTER ONE: COMPANY ACCOUNTING
An organization is a group of people that is organized and managed in a way that aims to follow
a corporate goal or need.
All types of businesses have a structure which is how the organization's people are organized.
This structure will explain who is in charge of who and who has responsibility over what!

For example, if Fred starts freelancing as a painter and decorator, he will have to do everything,
from painting to marketing through to accounting. A single-person operation is a valid, if
demanding, business set-up. But if he then takes on an assistant, he will have a group: that's now
an organization. The more people Fred takes on, the more people and things he will need to
organize and he may set up some standard processes e.g. the steps in painting a window. He may
even need to change the structure and legal status of his organization to manage and account for
its growth and activities.

Benefits of organization

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Types of organization
Organization can be profit-seeking or not for profit. Public-sector organization are generally not
run for profit, but for the administration of the state. So, we have two different goals here, profit
making and not profit making. Diagrammatically, using this as the main goal, organization are split
as follows:

Profit seeking organization

As the name suggests, the primary objective of profit seeking organization is to maximize returns
for the owners (or shareholders). These organization can further be split into two main groups:
unincorporated and incorporated.
Unincorporated organization
In unincorporated organization, the business owners and the business itself hold the same legal
identity. For example, if Fred Smith becomes self-employed as a painter and decorator, he may
decide not to incorporate and simply trade solely as Fred Smith. It certainly keeps things simple!
But there's a catch. Not incorporating means that the owners are held personally responsible for

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 the debts the business activity may incur. In other words, if Fred's business gets into debt, he will
have to pay it back out of his own money just like any other person. Therefore, unincorporated
entities are considered to have unlimited liability for the business’s debts.
The two main types of ownership in this category are:
✓ Sole trader – One sole owner of the business (wholly liable for debts), such as Fred.
✓ Partnership – A collection of owners working together (jointly liable for debts), for example if
Fred joins forces with his friend, Barney
Incorporated organization
To protect their personal finances, the business owners may decide to create a separate legal
identity for their business. This means that the owners are not held personally responsible for the
debts the company may incur. Therefore, they are considered to have limited liability for the
business’s debts. In the UK there are two main types of ownership in this category:
✓ Private limited companies (Ltd) - In a private limited company shares cannot be issued to the
public. These are often smaller companies, such as a market town retailer. However, larger
companies looking to retain a high degree of control sometimes stay private. By choosing to stay
private, they don't have to report to a large number of shareholders. However, they still have to
publish their financial accounts. For example, Walkers Snack Foods Ltd or Virgin Group Ltd.
✓ Public limited companies (PLC) - In a PLC, shares can be issued to the public. Usually, larger
companies go public when they wish to increase funding for business ventures through a public
share offering. For example, Tesco Plc and British Airways Plc. However, the owners risk losing
control by selling stakes to the public. They must also comply with additional regulations when
trading publicly.

Authorized, issued, called-up and paid-up share capital

A distinction must be made between authorized, issued, called-up and paid-up share capital.

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Authorized (or legal) capital is the maximum amount of share capital that a company is
empowered to issue. The amount of authorized share capital varies from company to company,
and can change by agreement.
For example, a company's authorized share capital might be 5,000,000 ordinary shares of $1 each.
This would then be the maximum number of shares it could issue, unless the maximum were to
be changed by agreement.
Issued capital is the par amount of share capital that has been issued to shareholders. The
amount of issued capital cannot exceed the amount of authorized capital. Continuing the example
above, the company with authorized share capital of 5,000,000 ordinary shares of $1 might have
issued 4,000,000 shares. This would leave it the option to issue 1,000,000 more shares at some
time in the future.
called-up capital. When shares are issued or allotted, a company does not always expect to be
paid the full amount for the shares at once. It might instead call up only a part of the issue price,
and wait until a later time before it calls up the remainder
Paid-up capital. Like everyone else, investors are not always prompt or reliable payers. 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 400,000 ordinary shares of $1 each, calls up 75 cents per share, and receives payments of
$290,000, we would have
Types of shares There are two main types of share an investor can buy, these are:
Ordinary shares
Ordinary shares – the most common type of share. Ordinary shares entitle the holder to voting
rights on decisions made by the company at shareholder meetings and a dividend distribution.
Ordinary shareholders are thus the effective owners of a company. They own the 'equity' of the
business, and any reserves of the business (described later) belong to them. Ordinary
shareholders are sometimes referred to as equity shareholders.
preference shares
Preference shares – a special class of share that not all companies offer. The holders of these
shares get their dividends paid first out of the profits of the business.
Preference shares carry the right to a final dividend which is expressed as a percentage of their
par value: eg a 6% $1 preference share carries a right to an annual dividend of 6c. Preference
dividends have priority over ordinary dividends. In other words, if the managers of a company
wish to pay a dividend (which they are not obliged to do) they must pay any preference dividend
first. Otherwise, no ordinary dividend may be paid.

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 Objectives of shareholders
There are a variety of objectives a company works towards. However, for a private company, the
main objective will be to maximize the wealth of its investors. In order to achieve this, a company
aims to maximize its profits which can then be paid in the form of dividends to its shareholders,
Classification of preference shares
Preference shares may be classified in one of two ways.
✓ Redeemable
✓ Irredeemable
Redeemable preference shares mean that the company will redeem (repay) the nominal value
of those shares at a later date. For example, 'redeemable 5% $1 preference shares 20X9' means
that the company will pay these shareholders $1 for every share they hold on a certain date in
20X9. The shares will then be cancelled and no further dividends paid.
Redeemable preference shares are treated like loans and are included as non-current liabilities in
the statement of financial position. Remember to reclassify them as current liabilities if the
redemption is due within 12 months. Dividends paid on redeemable preference shares are
treated like interest paid on loans and are included in financial costs in the statement of profit or
loss.
Irredeemable preference shares are treated just like other shares. They form part of equity and
their dividends are treated as appropriations of profit.
Shareholders' equity consists of the following.
➢ The par value of issued capital (minus any amounts not yet called up on issued shares) (b)
➢ Other equity
The share capital itself might consist of both ordinary shares and preference shares. All reserves,
however, are owned by the ordinary shareholders, who own the 'equity' in the company. We
looked at share capital in detail above.
'Other equity' consists of four elements. (a)
✓ Capital paid-up in excess of par value (share premium) (b)
✓ Revaluation surplus
✓ Reserves
✓ Retained earnings
Example: dividends on ordinary shares and preference shares
Garden Gloves Co has issued 50,000 ordinary shares of 50 cents each and 20,000 7% preference
shares of $1 each. Its profits after taxation for the year to 30 September 20X5 were $8,400. The

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management board has decided to pay an ordinary dividend (ie a dividend on ordinary shares)
which is 50% of profits after tax and preference dividend.
Required
Show the amount in total of dividends and of retained profits, and calculate the dividend per
share on ordinary shares.

Solution $
Profit after tax 8,400
Preference dividend (7% of $1  20,000) 1,400
Earnings (profit after tax and preference dividend) 7,000
Ordinary dividend (50% of earnings) 3,500
Retained earnings (also 50% of earnings) 3,500

The share premium account

In this context, 'premium' means the difference between the issue price of the share and its par
value. The account is sometimes called 'capital paid-up in excess of par value'. When a company
is first incorporated (set up) the issue price of its shares will probably be the same as their par
value and so there would be no share premium.
If the company does well, the market value of its shares will increase, but not the par value. The
price of any new shares issued will be approximately their market value. The difference between
cash received by the company and the par value of the new shares issued is transferred to the
share premium account. For example, if Ezy Co issues 1,000 $1 ordinary shares at $2.60 each the
book entry will be:

A share premium account only comes into being when a company issue shares at a price in excess
of their par value. The market price of the shares, once they have been issued, has no bearing at
all on the company's accounts, and so if their market price goes up or down, the share premium
account would remain unaltered.
A share premium account is an account into which sums received as payment for shares in excess
of their nominal value must be placed.

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What is Revaluation Surplus?
Revaluation Surplus is an equity account where all upwards adjustments in the value of a
company’s assets are systematically recorded. Some companies revalue their assets to determine
the recent market value of their assets. This surplus comes into existence when the fair market
value of the asset is more than the carrying value appearing in the books of account.

We need to keep in mind that Revaluation Surplus and Revaluation Reserve are two different
concepts and both are not the same.

A revaluation reserve is any upward or downward adjustment in the value of an asset. But the
Revaluation surplus is only an upwards adjustment in the value of the asset.

Revaluation Surplus Example Company A has two years old machinery costing $100,000. It uses
a straight-line method for depreciation at 20%. So, the accumulated depreciation currently is
$40,000, and thus, the carrying value is $60,000.

Now assume that Company A revalues the machinery and finds its market value to be worth
$80,000. In this case, the surplus will be $20,000 (Carrying value less market value).

The journal entry for this will be:

Retained earnings (RE) are the amount of net income left over for the business after it has paid
out dividends to its shareholders. The decision to retain the earnings or distribute them among
shareholders is usually left to company management.

A dividend is the distribution of corporate earnings to eligible shareholders.

Dividends can be distributed in the form of cash or stock. Both forms of distribution reduce
retained earnings. Cash payment of dividends leads to cash outflow. Dividends which have been
paid are shown in the statement of changes in equity (see Chapter 20). They are not shown in the
statement of profit or loss.

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Bonus and rights issues
A company can increase its share capital by means of a bonus issue or a rights issue.

Bonus (capitalization) issues

A bonus issue, also known as a scrip issue or a capitalization issue, is an offer of free
additional shares to existing shareholders. For example, a company may give one bonus share
for every five shares held.
Bonus shares are the shares allotted to existing equity shareholders without any
consideration being received from them, in cash or in kind.

A company may wish to increase its share capital without wishing to raise additional finance by
issuing new shares. For example, a profitable company might expand from modest beginnings
over a number of years. Its profitability would be reflected in large balances on its reserves, while
its original share capital might look like that of a much smaller business.

Advantages

✓ Increases capital without diluting current shareholders' holdings

✓ Capitalizes reserves, so they cannot be paid as dividends

Disadvantages

✓ Does not raise any cash

✓ Could jeopardized payment of future dividends if profits fall

A company allocates bonus issues according to each shareholder’s stake. Bonus shares do not
dilute shareholders’ equity because they are issued in a constant ratio that keeps the relative
equity of each shareholder the same as before the issue.

For example, a three-for-one bonus issue entitles each shareholder three shares for every one
that they hold before the issue. A shareholder with 1,000 shares receives 3,000 bonus shares
(1,000 × 3 ÷ 1 = 3,000).

CLARKE FRINGLAND CO STATEMENT OF FINANCIAL POSITION AS AT 31 DECEMBER 20X3

(EXTRACT)

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Clarke Ringland Co has decided on a bonus issue of shares of 1 for 4 and will use the share
premium account for this purpose. Required What is the double entry to record the bonus issue
of shares and what is the adjusted financial position extract after the bonus issue?

There are 20,000 ($10,000 ÷ 50c) shares before the bonus issue. Each shareholder will receive 1
share for every 4 held, so 5,000 (20,000 ÷ 4 × 1) new shares will be issued.

Debit Share Premium $2500

Credit Share Capital $2500

Rights issues

Rights issues A rights issue (unlike a bonus issue) is an issue of shares for cash. The 'rights' are
offered to existing shareholders, who can sell them if they wish. This is beneficial for existing
shareholders in that the shares are usually issued at a discount to the current market price.

Advantages

▪ Raises cash for the company

▪ Keeps reserves available for future dividends

Disadvantage

▪ Dilutes shareholders' holdings if they do not take up rights issue

Example: rights issue Bubbles Co (above) decides to make a rights issue, shortly after the bonus
issue. The terms are '1 for 5 @ $1.20' (ie 1 new share for every 5 already held, at a price of $1.20).
Assuming that all shareholders take up their rights (which they are not obliged to), the double
entry is:

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 Loan notes (bonds)
Limited liability companies may issue loan notes. These are long-term liabilities. In some countries
they are described as loan capital because they are a means of raising finance, in the same way
as issuing share capital raises finance. They are different from share capital in the following ways.
✓ Shareholders are members of a company, while providers of loan capital are creditors.
✓ Shareholders receive dividends (appropriations of profit) whereas the holders of loan capital are
entitled to a fixed rate of interest (an expense charged against revenue).
✓ Loan note holders can take legal action against a company if their interest is not paid when due,
whereas shareholders cannot enforce the payment of dividends.
✓ Loan notes are often secured on company assets, whereas shares are not.
Bond Issuance
A corporation records bond transactions when it issues (sells) or redeems (buys back) bonds and
when bondholders convert bonds into common stock. If bondholders sell their bond investments
to other investors, the issuing fi rm receives no further money on the transaction, nor does the
issuing corporation journalize the transaction.
Corporation can issue or sold bond on three different ways
✓ Selling bonds at face value
✓ Selling face value at premium
✓ Selling face value at discount
Issuing Bonds at Face Value
To illustrate the accounting for bonds issued at face value, assume that on January 1, 2017,
Candlestick, Inc. issues $100,000, five-year, 10% bonds at 100 (100% of face value). The entry to
record the sale is as follows.

Issuing Bonds at a Discount

To illustrate issuance of bonds at a discount, assume that on January 1, 2017, Candlestick, Inc.
sells $100,000, five-year, 10% bonds for $98,000 (98% of face value). Interest is payable annually
on January 1. The entry to record the issuance is as follows.

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Issuing Bonds at a Premium
To illustrate the issuance of bonds at a premium, we now assume the Candlestick, Inc. bonds
described above sell for $102,000 (102% of face value) rather than for $98,000. The entry to
record the sale is as follows

Understanding Question
Giant Corporation issues $200,000 of bonds for $189,000.
(A) Prepare the journal entry to record the issuance of the bonds, and
(B) show how the bonds would be reported on the balance sheet at the date of issuance.

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 QUESTION

1. Share issue AB Co issues 5,000 50c shares for $6,000. What are the entries for share capital and
share premium in the statement of financial position?

2. BC PLC declared a 3 for 2 bonus issue.

Extract of ABC PLC’s balance sheet prior to issuance of bonus shares is as follows

3. CLARKE FRINGLAND CO STATEMENT OF FINANCIAL POSITION AS AT 31 DECEMBER 20X3

(EXTRACT)

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 Clarke Fringland Co decides on a rights issue of 1 for 4 at $1.20. Required What is the double
entry to record the issue of shares and what is the adjusted financial position extract after the
issue?

4. A company has a balance on share premium account of $50,000 and on retained earnings of
$75,000. Issued share capital is 400,000 25c shares. The company decides to make a bonus issue
of 1 for 1. What are the closing balances on share premium and retained earnings?

5. Randle Inc. issues $300,000, 10-year, 8% bonds at 98. Prepare the journal entry to record the sale
of these bonds on March 1, 2017.

6. Price Company issues $400,000, 20-year, 7% bonds at 101. Prepare the journal entry to record
the sale of these bonds on June 1, 2017.

7. A company having 100,000 shares at $10 each issued right issue ratio 1:10 and issue price is 31
dollars so what is entry for this company?

8. ME plc commences business and issues one million shares with a nominal value of £3 each. The
company allows its allottees to pay £1.25 on allotment and the remainder at a later date. All the
allottees chose to do this and all the shares are sold. What is JME plc's paid-up share capital?
A. £1.25 million
B. £3 million
C. £1.75 million
D. £500,000
9. Earnings per share---------------after a bonus issue
A. Decrease
B. Increase
C. Remain constant

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 CHAPTER TWO: THE EQUITY METHOD OF ACCOUNTING FOR INVESTMENTS

At present, generally accepted accounting principles (GAAP) recognize three different approaches
to the financial reporting of investments in corporate equity securities

✓ The fair-value method.

✓ The consolidation of financial statements.
✓ The equity method

The financial statement reporting for a particular investment depends primarily on the degree of
influence that the investor (stockholder) has over the investee, a factor typically indicated by the
relative size of ownership. Because voting power typically accompanies ownership of equity
shares, influence increases with the relative size of ownership. The resulting influence can be
very little, a significant amount, or, in some cases, complete control.

Fair-Value Method

Fair value method is equity shares reporting method that is used when an investor possesses
only a small percentage of an investee company’s outstanding stock, perhaps only a few shares.
Because of the limited level of ownership, the investor cannot expect to significantly affect the
investee’s operations or decision making. according to the Financial Accounting Standards Board
(FASB) Accounting Standards Codification (ASC) Topic 320, Investments—Debt and Equity
Securities. These shares are bought in anticipation of cash dividends or in appreciation of stock
market values. Such investments are recorded at cost and periodically adjusted to fair value.

Fair value method also called A trade investment is a simple investment in the shares of another
entity that is not an associate or a subsidiary. A trade investment is a simple investment in the
shares of another entity, that is held for the accretion of wealth, and is not an associate or a
subsidiary. Trade investments are simply shown as investments under non-current assets in the
consolidated statement of financial position of the group

Consolidation of Financial Statements

Many corporate investors acquire enough shares to gain actual control over an investee’s
operation. In financial accounting, such control is recognized whenever a stockholder
accumulates more than 50 percent of an organization’s outstanding voting stock.

Equity method

Equity method is used when control is not achieved but the degree of ownership indicates the
ability for the investor to exercise significant influence over the investee. Furthermore, under the
equity method, dividends received from an investee are recorded as decreases in the investment
account, not as income.

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The equity method is the standard technique used when one company, the investor, has
a significant influence over another company, the investee. When a company holds
approximately 20% or more of a company's stock, it is considered to have significant influence

An associate is an entity over which another entity exerts significant influence. Associates are
accounted for in the consolidated statements of a group using the equity method

This type of investment is something less than a subsidiary, but more than a simple trade
investment. The key criterion here is significant influence. This is the 'power to participate', but
not to 'control' (which would make the investment a subsidiary).

Significant influence. 'The power to participate in the financial and operating policy decisions of
the investee but which is not control or joint control of those policies

If an investor holds, directly or indirectly (e.g., through subsidiaries), 20 per cent or more of the
voting power of the investee, it is presumed that the investor has significant influence,

investor holds, directly or indirectly (e.g., through subsidiaries), less than 20 per cent of the voting
power of the investee, it is presumed that the investor does not have significant influence

FASB ASC Topic 323 provides guidance to the accountant by listing several conditions that indicate
the presence of this degree of influence:

• Investor representation on the board of directors of the investee.

• Investor participation in the policymaking process of the investee.
• Material intra-entity transactions.
• Interchange of managerial personnel.
• Technological dependency.
• Extent of ownership by the investor in relation to the size and concentration of other
ownership interests in the investee.

To summarize, the following table indicates the method of accounting that is typically applicable
to various stock investments:

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In applying the equity method, the accounting objective is to report the investor’s investment
and investment income showing the close relationship between the companies.

1. The investor’s investment account increases as the investee earns and reports income.
Also, the investor recognizes investment income using the accrual method—that is, in the
same time period as the investee earns it. If an investee reports income of $100,000, a 30
percent owner should immediately increase its own income by $30,000.
2. The investor’s investment account is decreased whenever a dividend is collected.
Because distribution of cash dividends reduces the carrying value of the investee
company, the investor mirrors this change by recording the receipt as a decrease in the
carrying value of the investment rather than as revenue.

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To illustrate, assume that Big Company owns a 20 percent interest in Little Company
purchased on January 1, 2012, for $200,000. Little then reports net income of $200,000,
$300,000, and $400,000, respectively, in the next three years while paying dividends of
$50,000, $100,000, and $200,000. The fair values of Big’s investment in Little, as determined
by market prices, were $235,000, $255,000, and $320,000 at the end of 2012, 2013, and 2014,
respectively.

The sketch above compares the accounting for Big’s investment in Little across the two
methods. The fair-value method carries the investment at its market values, presumed to be
readily available in this example. Because the investment is classified as an available for-sale
security, the excess of fair value over cost is reported as a separate component of
stockholders’ equity.8 Income is recognized as dividends are received.

In contrast, under the equity method, Big recognizes income as it is earned by Little. As shown
in Exhibit 1.1, Big recognizes $180,000 in income over the three years, and the carrying value
of the investment is adjusted upward to $310,000.

Equity Method Accounting Procedures

Little Company reported a net income of $200,000 during 2012 and paid cash dividends of
$50,000. These figures indicate that Little’s net assets have increased by $150,000 during the
year. Therefore, in its financial records, Big Company records the following journal entries to
apply equity method

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Example of the Equity Method
For example, assume ABC Company purchases 25% of XYZ Corp for $200,000. At the end of year
1, XYZ Corp reports a net income of $50,000 and pays $10,000 in dividends to its shareholders.
At the time of purchase, ABC Company records a debit in the amount of $200,000 to "Investment
in XYZ Corp" (an asset account) and a credit in the same amount to cash.
At the end of the year, ABC Company records a debit in the amount of $12,500 (25% of XYZ's
$50,000 net income) to "Investment in XYZ Corp", and a credit in the same amount to Investment
Revenue. In addition, ABC Company also records a debit in the amount of $2,500 (25% of XYZ's
$10,000 dividends) to cash, and a credit in the same amount to "Investment in XYZ Corp." The
debit to the investment increases the asset value, while the credit to the investment decreases
it.
The new balance in the "Investment in XYZ Corp" account is $210,000. The $12,500 Investment
Revenue figure will appear on ABC's income statement, and the new $210,000 balance in the
investment account will appear on ABC's balance sheet. The net ($197,500) cash paid out during
the year ($200,000 purchase - $2,500 dividend received) will appear in the cash flow from / (used
in) investing activities section of the cash flow statement.

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PROBLEMS

1. The equity method is one of three methods used to account for equity investments. What
are the other two?
A. Fair Value and Consolidation
B. Lower of Cost or Market and Fair Value
C. Cost Method and Fair Value
D. Accrual Method and Consolidation
2. Under accrual accounting principles, the equity method is justified because owning at
least 20 percent of an investee's company implies the investor can exercise _____ over
the investee.
A. Significant Influence
B. Control
C. Undue Influence
D. No Influence

3. Dividends appear as an expense on the corporation's income statement.

A. True
B. False
4. The holders of majority common stock elect the corporation's board of directors
A. True
B. False

5. An ownership interest of 30% of the common stock of another corporation should be

accounted for using the:

A. fair value method.

B. cost method.

C. equity method.

D. consolidated method

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 CHAPTER THREE: CONSOLIDATION BALANCE SHEET AND INCOME STATEMENT

Acquisition Method of Accounting

The acquisition method of accounting is an approach used to record and report financial
information when one company acquires another company. Under this method, the acquiring
company combines the financial statements of the acquired company with its own financial
statements. The acquisition method follows specific accounting principles and guidelines, as
outlined by the Generally Accepted Accounting Principles (GAAP) in the United States and the
International Financial Reporting Standards (IFRS) internationally.

IAS 27 defines consolidated financial statements as ‘the financial statements of a group in which
the assets, liabilities, equity, income, expenses and cash flows of the parent and its subsidiaries
are presented as those of a single economic entity.’

The main steps involved in the acquisition method of accounting are:

➢ Identifying The Acquirer: The first step is to determine which company is the acquirer (the
company that obtains control over the acquired company).
➢ Determining the acquisition date: The acquisition date is the date when the acquirer
gains control over the acquired company. This is typically when the acquisition transaction
is closed and the acquirer starts consolidating the acquired company’s financial
statements.
➢ Measuring the fair value of the acquired company: The acquirer must determine the fair
value of the acquired company, which includes measuring the fair value of the identifiable
assets acquired, the liabilities assumed, and any non-controlling interest in the acquired
company.
➢ Recognizing and measuring goodwill or gain from a bargain purchase: Goodwill arises
when the purchase price paid by the acquirer exceeds the fair value of the net identifiable
assets acquired. If the fair value of the net identifiable assets exceeds the purchase price,
it results in a gain from a bargain purchase.
➢ Consolidating financial statements: After measuring the fair values and recognizing
goodwill or gain from a bargain purchase, the acquirer consolidates the acquired
company’s financial statements with its own, combining the assets, liabilities, revenues,
and expenses of both companies into a single set of financial statements.

Consolidation means presenting the results, assets and liabilities of a group of companies as if
they were one company.
You will probably know that many large companies actually consist of several companies
controlled by one central or administrative company. Together, these companies are called a
group.
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Group. A parent and all its subsidiaries

What is a parent company?

A parent company is one which has a controlling or majority interest in another company,
which gives it the right to control the subsidiary’s operations. Parent companies can be directly
involved in the management of their subsidiaries,

Subsidiary. An entity that is controlled by another entity (known as the parent).

Parent. An entity that controls one or more entities.
Consolidated financial statements. The financial statements of a group in which the assets,
liabilities, equity, income, expenses and cash flows of the parent and its subsidiaries are presented
as those of a single economic entity.'
Non-controlling interest. The equity in a subsidiary not attributable, directly or indirectly, to a
parent.
Accounting treatment of subsidiaries in consolidated financial statements
IFRS 10 requires a parent to present consolidated financial statements (also referred to as group
accounts) in which the accounts of the parent and subsidiary (or subsidiaries) are combined and
presented as a single entity. This presentation means that the substance, rather than the legal
form, of the relationship between parent and subsidiaries will be presented.
What does consolidation involve?
Before moving on to the formal definitions, think about what consolidation involves.
✓ Consolidation means adding together.
✓ Consolidation means cancellation of like items internal to the group.
✓ Consolidate as if you owned everything then show the extent to which you do not own
everything.
Adding together
You add together the values of the head office building and the factory to get an asset, land and
buildings, in the group accounts of $100,000 + $80,000 = $180,000. So far so good; this is what
you would expect consolidation to mean.
Intra-group debts
Suppose Pleasant has receivables of $40,000 and Sweet has receivables of $30,000. Included in
the receivables of Pleasant is $5,000 owed by Sweet. Remember again that consolidation means
presenting the results of the two companies as if they were one. Do we then simply add together

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$40,000 and $30,000 to arrive at the figure for consolidated receivables? We cannot simply do
this, because $5,000 of the receivables is owed within the group.
This amount is irrelevant when we consider what the group as a whole is owed. Further, suppose
that Pleasant has payables of $50,000 and Sweet has payables of $45,000. We already know that
$5,000 of Sweet's payables is a balance owed to Pleasant. If we just added the figures together,
we would not reflect fairly the amount the group owes to the outside world. The outside world
does not care what these companies owe to each other – that is an internal matter for the group.
Cancellation of like items
To arrive at a fair picture, we eliminate both the receivable of $5,000 in Pleasant's books and the
payable of $5,000 in Sweet's books. Only then do we consolidate by adding together.
Consolidated receivables = $40,000 + $30,000 – $5,000 = $65,000
Consolidated payables = $50,000 + $45,000 – $5,000 = $90,000
Example: cancellation
Parent Co has just bought 100% of the shares of Subsidiary Co. Below are the statements of
financial position of both companies just before consolidation.

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Example: cancellation with intra-group trading
P Co regularly sells goods to its one subsidiary company, S Co. The statements of financial position
of the two companies on 31 December 20X6 are given below.
STATEMENTS OF FINANCIAL POSITION AS AT 31 DECEMBER 20X6

Required
Prepare the consolidated statement of financial position of P Co.
Solution
The cancelling items are as follows.
✓ P Co's asset 'investment in shares of S Co' ($40,000) cancels with S Co's liability 'share
capital' ($40,000).

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 ✓ P Co's asset 'receivables: S Co' ($2,000) cancels with S Co's liability 'payables: P Co'
($2,000).
The remaining assets and liabilities are added together to produce the following consolidated
statement of financial position.
P CO CONSOLIDATED STATEMENT OF FINANCIAL POSITION AS AT 31 DECEMBER 20X6

Goodwill arising on consolidation

Goodwill arising on consolidation is recognized as an intangible asset in the consolidated
statement of financial position.
Intangible assets
Intangible assets are assets that do not have a physical existence, which means that they cannot
be touched. Although intangible assets lack physical presence, they still add value to the business
Characteristics of Intangible Assets

The following are the characteristics of intangible assets:

1. These assets do not have a physical existence.

2. These assets cannot be used as a collateral for obtaining loans for business expansion.
3. Intangible assets are amortized (except goodwill) over the useful life of an asset.

26
What is good will?
In accounting, goodwill is an intangible asset. The concept of goodwill comes into play when a
company looking to acquire another company is willing to pay a price premium over the fair
market value of the company’s net assets.
The elements or factors that a company is paying extra for or that are represented as goodwill
are things such as a company’s good reputation,
➢ A Solid (Loyal) Customer or Client Base,
➢ Brand Identity and Recognition,
➢ An Especially Talented Workforce, And
➢ Proprietary Technology.
These things are, in fact, valuable assets of a company. However, they are neither tangible
(physical) assets nor can their value be precisely quantified.
When a parent company acquires a less-than-100 percent controlling interest in another firm, the
acquisition method requires a determination of the acquisition-date fair value of the acquired
firm for consolidated financial reporting. The total acquired firm fair value in the presence of a
partial acquisition is the sum of the following two components at the acquisition date:

▪ The fair value of the controlling interest.

▪ The fair value of the noncontrolling interest.
The sum of these two components then serves as the starting point for the parent in valuing and
recording the subsidiary acquisition. If the sum exceeds the collective fair values of the net
identifiable assets acquired and liabilities assumed, then goodwill is recognized.
Example: goodwill arising on consolidation
P Co purchased all of the share capital (40,000 $1 shares) of S Co $60,000 or in cash. The
statements of financial position of P Co and S Co prior to the acquisition are as follows.
STATEMENTS OF FINANCIAL POSITION AS AT 31.12.X1

Now when the directors of P Co agree to pay $60,000 for a 100% investment in S Co, they must
believe that, in addition to its non-current assets of $40,000, S Co must also have intangible
27
assets worth $20,000. This amount of $20,000 paid over and above the value of the tangible
assets acquired is called the goodwill arising on consolidation (or sometimes premium on
acquisition).
Following the normal cancellation procedure, the $40,000 share capital in S Co's statement of
financial position could be cancelled against $40,000 of the 'investment in S Co' in the
statement of financial position of P Co. This would leave a $20,000 debit uncancelled in the
parent company's accounts. This $20,000 would appear in the consolidated statement of
financial position under the caption 'Intangible non-current assets: goodwill arising on
consolidation', as follows
CONSOLIDATED STATEMENT OF FINANCIAL POSITION OF P GROUP AS AT 31.12.X1

Workings before consolidating balance sheets of parents and subsidiary

1. Establish the group structure
Working 1 will show:
• How much of the subsidiary is owned by P
• How long P has had control over S
2. Net assets of subsidiary
Working 2 will show the following elements

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3. Goodwill
Working 3 will show

4. Non-controlling interest (NCI)

This shows the value of the subsidiary that is not owned by the parent at year-end.

5. Group retained earnings

This shows the retained earnings that are attributable to the parent's shareholders.

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 The following statements of financial position have been prepared at 31 December 20X8.

Information
Dickens acquired 16,000 ordinary $1 shares in Jones on 1 January 20X8, when Jones’ retained
earnings stood at $20,000 and its share premium was $10,000. On this date, the fair value of the
20% non-controlling shareholding in Jones was $12,500. The Dickens Group uses the fair value
method to value the noncontrolling interest.
Required
Prepare the consolidated statement of financial position of Dickens as at 31 December 20X8.
1. Establish the group structure
(percentage of shares purchased 16,000/20,000 = 80%)

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2. Net assets of Jones

3. Goodwill

31
4. Noncontrolling interest

5. Group retaining earnings

Dickens: Consolidated statement of financial position as at 31 December 20X8

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Noncontrolling interest
The ownership interests in the subsidiary that are held by owners other than the parent is a
noncontrolling interest. The noncontrolling interest in a subsidiary is part of the equity of the
consolidated group. [FASB ASC (para. 810-10-45-15)
Consolidated statement of income statement or profit or loss
The consolidated income statement presents the financial performance of group companies (i.e.
parent and subsidiaries under common control) in one, single statement.

A consolidated income statement is often referred to as an income statement, a

consolidated statement of earnings, a consolidated statement of income, a statement of
operations or a profit and loss statement. While this document has a number of different
names, it has just one main purpose: to show how a business has been perform ing
throughout a certain period of time.

33
A consolidated income statement can be created to cover an entire fiscal year or an
accounting cycle. Some businesses opt to create a consolidated income statement once
every quarter.
If the financial detail of a subsidiary is deemed to be not necessary to provide a fair and
true picture of the parent company’s financial situation, it may be excluded from the
consolidated financial statements. Subsidiaries can also be excluded if they meet the below
conditions:

• The interest the parent company holds in the subsidiary is held purely for resale purposes
• Gathering the financial information required to create consolidated financial statements
would incur highly disproportionate costs or result in long delays in returning tax reports
• There are long-term restrictions that stop the company from exerting its rights over the
subsidiary’s assets or over the management of the subsidiary

The Basic Principles

The consolidated income statement follows the same basic principles as the consolidated
statement of financial position. The volume of adjustments is, however, fewer. The steps for
consolidating the income statements are as follows:
1.Add together the revenues and expenses of the parent and the subsidiary. If the subsidiary is
acquired part way through the year all the revenues and expenses of the subsidiary must be time
apportioned during the consolidation process.
2. Eliminate intra-group sales and purchases.
3. Eliminate unrealized profit held in closing inventory relating to intercompany trading.
4. Calculate the profits attributable to the non-controlling interests.

After the net profit for the year the split of profit between amounts attributable to the equity
holders of the group and the non-controlling interests (to reflect ownership) is shown.
The objective of consolidated financial statements is to combine the individual financial
statements of all the companies in a group as though the group was one reporting entity.
Therefore, the separate financial information of each group company has to be brought together
in one set of financial statements (consolidated). In order to do this, the effects of any inter-
company transactions have to be removed. These will include sales and other transfers of income,
such as dividends, between the group companies. A typical question for this topic is shown below:

34
Company A plc acquired 80% of the issued share capital of Company B Ltd on 1 April 20X0.
Extracts from their statements of comprehensive income for the year ended 31 March 20X1 are
shown below.

Additional data

• During the year, Company A plc sold goods that had cost £2,200,000 to Company B Ltd, for
£2,980,000. A quarter of these goods still remain in inventory at the end of the year.

• Included in other income is a dividend from Company B Ltd of £1,500,000.

In order to produce the consolidated statement of comprehensive income the figures from both
companies need to be added together while making the necessary adjustments to remove any
intercompany transactions. We will now work through this process, line by line.
Revenue
The revenue from each company is added together and the value of the sales made by Company
A to Company B is deducted.
Solution

Cost of sales
The cost of sales from each company is added together and the value of the purchases made by
Company B from Company A is deducted.

35
Solution

This is fine so long as all the inventory transferred between the two companies has been sold.
However, if some remains unsold, then a further adjustment is necessary. This is because the
unsold inventory will be included in the closing inventory of Company B, valued at Company A’s
selling price, which includes an element of profit.
This is not in accordance with IAS 2 – inventory should be valued at the lower of cost and net
realizable value. Therefore, any unrealized profit has to be removed.

First, calculate the amount of profit in the inter-company transaction.

This is £2,980,000 - £2,200,000 = £780,000
Second, identify how much of the initial stock has not been sold, in this case a quarter.
Therefore, the unrealized profit is: £780,000 x 25% = £195,000
This is then added to the cost of sales as it has the effect of reducing the closing inventory.
Recalculate the cost of sales after removing the inter-company profit.
Adjusted cos of sales =34,829,000+£195,000 =£35,024,000
Gross profit
This is revenue less cost of sales: £80,243,000 - £35,024,000 = £45,219,000
This will generally relate to dividends received from investments. Since Company A owns shares
in Company B it is likely that Company A will receive dividends from Company B. These dividends
will be paid out of the profits of Company B. During the consolidation process, if we were to
include the dividends received from Company B this income would be a duplication as we are
adding the profits together anyway.
Therefore, any dividends received by Company A from Company B must be deducted when
totaling the other income.

The remaining figures in the consolidated income statement are relatively straightforward.

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Distribution costs and administration expenses
This is a simple addition: £16,296,000 + £4,180,000 = £20,476,000
Profit from operations This is the sum of gross profit plus other income less distribution costs and
administration expenses. £45,219,000 + £1,100,000 - £20,476,000 = £25,843,000
Finance costs
This is a simple addition: £2,200,000 + £640,000 = £2,840,000
Profit before tax
This is profit from operations less finance costs. £25,843,000 - £2,840,000 = £23,003,000
Taxation
This is a simple addition: £5,650,000 + £736,000 = £6,386,000
Profit for the year
This is profit before tax less taxation: £23,003,000 - £6,386,000 = £16,617,000 We can now
complete the consolidated income statement and this is shown below.
Consolidated income statement of Company A plc

At this point you have completed the consolidated income statement and have identified the
profit for the year, however, unless Company B is a wholly owned subsidiary, not all of this profit
belongs to Company A.
In this instance, Company A only owns 80% of the shares in Company B, therefore 20% of the
shares are owned by other shareholders and this will be classed as the ‘non-controlling interest’.
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It is important therefore to now show how the profit for the year is split between the equity
holders of Company B and the non-controlling interest.
The non-controlling interest is the 20% of Company B not owned by Company A and the profit
belonging to the non-controlling interest is
therefore 20% of Company B’s profit for the year: £4,600,000 x 20% = £920,000
The balance of the consolidated profit for the year belongs to the equity holders of Company A:
£16,617,000 - £920,000 = £15,697,000
The attributable shares of profits table can now be completed

Summary
To summarize, when completing consolidated income statements:

• Identify what % of the shares of company B is owned by company A to establish whether a

consolidated statement of comprehensive income is required

• Add together the revenue and remove inter-company sales at selling price

• Add together the cost of sales and remove inter-company purchases at selling price and also
add back any unrealized profit on the inventory transferred between group companies

• Add together any other income, remembering to deduct inter-company dividends

• Add together expenses

• Add together finance costs

• Add together taxation

• All other figures are calculated within the consolidated income statement

• Calculate the non-controlling interest in the total profits of the group

• Deduct this amount from the total profits to identify the profit attributable to the equity
holders of the parent company.

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Problems
1. On 1 January 20X0 Alpha Co purchased 90,000 ordinary $1 shares in Beta Co for $270,000. At
that date Beta Co's retained earnings amounted to $90,000 and the fair values of Beta Co's assets
at acquisition were equal to their book values. Three years later, on 31 December 20X2, the
statements of financial position of the two companies were:

The share capital of Beta Co has remained unchanged since 1 January 20X0. The fair value of the
non-controlling interest at acquisition was $42,000
Required:

• What amount should appear in the group's consolidated statement of financial position
at 31 December 20X2 for goodwill? Hint ans. $122,000
• What amount should appear in the group's consolidated statement of financial position
at 31 December 20X2 for non-controlling interest? Hint Ans. $49,000

2. Fanta Co acquired 100% of the ordinary share capital of Tizer Co on 1 October 20X7. On 31
December 20X7 the share capital and retained earnings of Tizer Co were as follows:

The profits of Tizer Co have accrued evenly throughout 20X7. Goodwill arising on the
acquisition of Tizer Co was $30,000.
Required:

• What was the cost of the investment in Tizer Co? Hint Ans $590,000

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3. Micro Co acquired 90% of the $100,000 ordinary share capital of Minnie Co for $300,000 on 1
January 20X9 when the retained earnings of Minnie Co were $156,000. At the date of acquisition,
the fair value of plant held by Minnie Co was $20,000 higher than its carrying amount.

The fair value of the non-controlling interest at the date of acquisition was $75,000.

Required:

• What is the goodwill arising on the acquisition of Minnie Co? Hint Ans $99,000
4. On 1 August 20X7 Patronic purchased 18 million of the 24 million $1 equity shares of Sardonic.
The acquisition was through a share exchange of two shares in Patronic for every three shares in
Sardonic. The market price of a share in Patronic at 1 August 20X7 was $5.75.

Required:

• What is the fair value of the consideration transferred for the acquisition of Sardonic? Hint
Ans $69m

40
 CHAPTER FOUR: REVENUE RECOGNITION PRINCIPLE
Revenue recognition is an accounting principle that outlines the specific conditions under
which revenue is recognized. In theory, there is a wide range of potential points at which revenue
can be recognized.
Revenue is a key indicator of the growth trajectory of a business. For investors, bankers, and
internal leaders, revenue is indispensable intel that illustrates a company’s current standing
and future outlook. If you recognize and record your revenue according to best practices, your
business will be more likely to compete and succeed in the market.
These revenue recognition practices are often required for businesses that intend to fundraise
or have set their sights on getting a loan from foreign.
Accrual accounting differs from cash accounting because it counts revenue and expenses when
they are earned or billed, rather than when the money hits a bank account. For example, you’ll
record a sale when your performance obligation to a customer is complete, instead of when
the customer pays.
Small businesses often opt for cash accounting because it’s intuitive and simple. Cash
accounting records revenue the moment it hits the company’s bank account and records
expenses the moment that they’re paid out. In other words, exchanging payment marks the
transaction in a company’s books.

Common revenue recognition terms

Accounting practices:

Small business: According to the US Internal Revenue Service (IRS), a small business is any
company that has average annual gross receipts of below $25 million for the three-year period
before the current tax year.

Cash accounting: An accounting approach that records revenue and expenses when cash is
exchanged. It’s often used by small businesses with no inventory.

Accrual accounting: An accounting approach that counts revenue and expenses when they are
earned or billed, rather than when payment is received.

Matching principle: The practice of recording expenses during the same period when the
related revenues are earned. This accounting concept yields a more accurate picture of a
company’s performance and is a defining characteristic of accrual accounting (see above).

Revenue recognition principle: A generally accepted accounting principle (GAAP) that dictates
when and how businesses “recognize” or record revenue in their books.

41
International compliance:

International Accounting Standards Board (IASB): A board of independent experts who set
the accounting standards for publicly listed companies in 144 countries. It recommends
procedures used in nearly every major market, though some countries such as the US, India,
and China don’t necessarily follow them.

International Financial Reporting Standards (IFRS): A set of standards and principles

developed by the IASB to create consistency across markets, economies, industries, and
businesses. They are less specific than the US equivalent (GAAP).
IFRS 15: The shared international guidelines developed by the IASB to create a cohesive
revenue recognition process to strengthen comparability across markets, industries, and
business models.

US compliance:

Financial Accounting Standards Board (FASB): The nonprofit organization that sets and
maintains shared accounting rules (GAAP) in the US for both for-profit companies and
nonprofit organizations.

Generally accepted accounting principles (GAAP): A group of standard accounting rules

required by the Financial Accounting Standards Board (FASB) for businesses that do not meet
the IRS definition of a small business within the US.

ASC 606: The US guidelines developed by the FASB to create a cohesive revenue recognition
process to strengthen comparability across markets, industries, and business models.

Revenue recognition concept:

Five-Step Revenue Recognition Model: The formal, five-step process for recognizing revenue
as outlined in ASC 606 and IFRS 15.

Performance obligation: A “distinct” product or service that the seller has agreed to deliver
as part of its commercial contract.

Transaction price: The amount of a performance obligation, including discounts and the rights
of the consumer, particularly for returns and refunds.

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Conditions for Revenue Recognition

According to the IFRS criteria, for revenue to be recognized, the following conditions must be
satisfied:

1. Risks and rewards of ownership have been transferred from the seller to the buyer.
2. The seller loses control over the goods sold.
3. The collection of payment from goods or services is reasonably assured.
4. The amount of revenue can be reasonably measured.
5. Costs of revenue can be reasonably measured.

Conditions (1) and (2) are referred to as Performance. Regarding performance, it occurs when
the seller has done what is to be expected to be entitled to payment.

Condition (3) is referred to as Collectability. The seller must have a reasonable expectation that
he or she will be paid for the performance.

Conditions (4) and (5) are referred to as Measurability. Due to the accounting guideline of the
matching principle, the seller must be able to match the revenues to the expenses. Hence, both
revenues and expenses should be able to be reasonably measured.

Steps in Revenue Recognition from Contracts

The five steps for revenue recognition in contracts are as follows:

1. Identifying the Contract

All conditions must be satisfied for a contract to form:

• Both parties must have approved the contract (whether it be written, verbal, or implied).
• The point of transfer of goods and services can be identified.
• Payment terms are identified.
• The contract has commercial substance
• Collection of payment is probable.

2. Identifying the Performance Obligations

Some contracts may involve more than one performance obligation. For example, the sale of a
car with a complementary driving lesson would be considered as two performance obligations –
the first being the car itself and the second being the driving lesson.

Performance obligations must be distinct from each other. The following conditions must be
satisfied for a good or service to be distinct:

43
 • The buyer (customer) can benefit from the goods or services on its own.
• The good or service is separately identified in the contract.

3. Determining the Transaction Price

The transaction price is usually readily determined; most contracts involve a fixed amount. For
example, a price of $20,000 for the sale of a car with a complementary driving lesson. The
transaction price, in this case, would be $20,000.

3. Allocating the Transaction Price to Performance Obligations

The allocation of the transaction price to more than one performance obligation should be based
on the standalone selling prices of the performance obligations.

For example,

a contract involves the sale of a car with a complementary driving lesson. The total transaction
price is $20,000. The standalone selling price of the car is $19,000 while the standalone selling
price of the driving lesson is $1,000. The transaction price allocation would be as follows:

Note: The percentage of the total is simply the standalone price divided by the total standalone
price. For example, the percentage of total for the car would be calculated as
$19,000 / $20,000 = 95%.
Recognizing Revenue in Accordance with Performance

Recall the conditions for revenue recognition. Conditions (1) and (2) state that revenue would be
recognized when the seller has done what is expected to be entitled to payment. Therefore,
revenue is recognized either:

• At a point in time; or
• Over time

44
In the example above, the revenue associated with the car would be recognized at the point in
time when the buyer takes possession of the car. On the other hand, the complementary driving
lesson would be recognized when the service is provided.

The revenue recognition journal entries for the two performance obligations (car and driving
lesson) would be as follows:
For the sale of the car and complimentary driving lesson:

Note: Revenue is recognized for the sale of the car ($18,050) but not for the complementary
driving lesson because it has not yet been provided.
When the complementary driving lesson has been provided:

For example
On 1 January 20X1, Baker entered into a contract with a customer to construct a specialized
building for consideration of $2m plus a bonus of $0.4m if the building is completed within 18
months. Estimated costs to construct the building were $1.5m. If the contract is terminated by
the customer, Baker can demand payment for the costs incurred to date plus a mark-up of 30%.
On 1 January 20X1, as a result of factors outside of its control, Baker was not sure whether the
bonus would be achieved.
45
At 31 December 20X1 Baker had incurred costs of $1m. They were still unsure as to whether the
bonus target would be met. Baker measures progress towards completion based on costs
incurred.
At 31 December 20X1 Baker had received $1 million from the customer.
Required: How should this transaction be accounted for in the year ended 31 December 20X1?
The objective of this Standard is to establish the principles that an entity shall apply to report
useful information to users of financial statements about the nature, amount, timing and
uncertainty of revenue and cash flows arising from a contract with a customer.
Solution
Constructing the building is a single performance obligation. The bonus is variable consideration.
It is excluded from the transaction price because it is not highly probable that a significant reversal
in the amount of cumulative revenue recognized will not occur. The construction of the building
should be accounted for as an obligation settled over time. Baker should recognize revenue based
on progress towards satisfaction of the construction of the building

1. Overall contract

2. Progress
An input method is used to calculate the progress, being costs to date compared to total
costs
6,000/12,000 = 50%

3. Statement of profit and loss

46
4. Statement of financial position

47
 QUESTIONS
Problem 1
Keema Co enters into a contract with a customer to supply furniture on 30 September 20X3.
Control of the furniture transfers to the customer on that date. The price stated in the contract is
$750,000 and is due for payment on 30 September 20X5.
Market rates of interest available to this particular customer are 7%.

• Required:
Explain how this transaction should be accounted for in the financial statements of Keema Co for
the year ended 30 September 20X3 and 20X4.
Problem 2
Shinji Co sells a machine and one year’s free technical support for $50,000. It usually sells the
machine for $60,000 but does not sell technical support for this machine as a stand-alone
product. Other support services offered by Shinji Co attract a mark-up of 50%. It is expected that
the technical support will cost Shinji Co $10,000.

• Required:
How should the transaction price be allocated between the machine and the technical support?

48
 CHAPTER FIVE: STATEMENT OF CASH FLOW
Introduction
Financial statements are written records that convey the business activities and the financial
performance of a company. Financial statements are often audited by government agencies,
accountants, firms, etc. to ensure accuracy and for tax, financing, or investing purposes. For-
profit primary financial statements include the balance sheet, income statement, statement of
cash flow, and statement of changes in equity. Nonprofit entities use a similar but different set
of financial statements. There are mainly four financials’ statements

✓ Balance sheet
✓ Income statement
✓ Statement of owners’ equity
✓ Statement of cashflow
Cash flow statements are one of the three fundamental financial statements financial leaders
use. Along with income statements and balance sheets, cash flow statements provide crucial
financial data that informs organizational decision-making. While all three are important to the
assessment of a company’s finances, some business leaders might argue cash flow statements
are the most important.
Business owners, managers, and company stakeholders use cash flow statements to better
understand their companies’ value and overall health and guide financial decision-making.
A cash flow statement is a financial report that details how cash entered and left a business
during a reporting period.
Usefulness of the Statement of Cash Flows
The statement of cash flows reports the cash receipts, cash payments, and net change in cash
resulting from operating, investing, and financing activities during a period. The information in a
statement of cash flows helps investors, creditors, and others assess the following.
1. The entity’s ability to generate future cash flows. By examining relationships between items
in the statement of cash flows, investors can better predict the amounts, timing, and uncertainty
of future cash flows than they can from accrual-basis data.
2. The entity’s ability to pay dividends and meet obligations. If a company does not have
adequate cash, it cannot pay employees, settle debts, or pay dividends. Employees, creditors, and
stockholders should be particularly interested in this statement because it alone shows the flows
of cash in a business.
3. The reasons for the difference between net income and net cash provided (used) by
operating activities. Net income provides information on the success or failure of a business.

49
4. The cash investing and financing transactions during the period. By examining a company’s
investing and financing transactions, a financial statement reader can better understand why
assets and liabilities changed during the period.
Classification of Cash Flows
The statement of cash flows classifies cash receipts and cash payments as
✓ Operating,
✓ Investing, and
✓ Financing activities.
Transactions and other events characteristic of each kind of activity are as follows.

1. Operating activities include the cash effects of transactions that create revenues and expenses.
They thus enter into the determination of net income.
2. Investing activities include (a) acquiring and disposing of investments and property, plant, and
equipment, and (b) lending money and collecting the loans.
3. Financing activities include (a) obtaining cash from issuing debt and repaying the amounts
borrowed, and (b) obtaining cash from stockholders, repurchasing shares, and paying dividends.
The operating activities category is the most important. It shows the cash provided by company
operations. This source of cash is generally considered to be the best measure of a company’s ability to
generate sufficient cash to continue as a going concern.

Note the following general guidelines:

1. Operating activities involve income statement items.
2. Investing involve cash flows resulting from changes in investments and long-term asset items.
3. Financing activities involve cash flows resulting from changes in long-term liability and
stockholders’ equity items.

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Significant Noncash Activities
Not all of a company’s significant activities involve cash. Examples of significant noncash activities
are as follows.
1. Direct issuance of common stock to purchase assets.
2. Conversion of bonds into common stock.
3. Direct issuance of debt to purchase assets.
4. Exchanges of plant assets
Format of the Statement of Cash Flows
The general format of the statement of cash flows presents the results of the three activities
discussed previously—operating, investing, and financing. The cash flows from operating
activities section always appears first, followed by the investing activities section and then the
financing activities section. The sum of the operating, investing, and financing sections equals the
net increase or decrease in cash for the period.
Question: Classification of Cash Flows
During its first week, Duffy & Stevenson Company had these transactions.
1. Issued 100,000 shares of $5 par value common stock for $800,000 cash.
2. Borrowed $200,000 from Castle Bank, signing a 5-year note bearing 8% interest.
3. Purchased two semi-trailer trucks for $170,000 cash.
51
4. Paid employees $12,000 for salaries and wages.
5. Collected $20,000 cash for services performed.
Required: Classify each of these transactions by type of cash flow activity.
Companies prepare the statement of cash flows differently from the three other basic financial
statements.
➢ First, it is not prepared from an adjusted trial balance. It requires detailed information
concerning the changes in account balances that occurred between two points in time.
An adjusted trial balance will not provide the necessary data.
➢ Second, the statement of cash flows deals with cash receipts and payments. As a result,
the company adjusts the effects of the use of accrual accounting to determine cash flows
The information to prepare this statement usually comes from three sources:

❖ Comparative balance sheets. Information in the comparative balance sheets indicates the
amount of the changes in assets, liabilities, and stockholders’ equities from the beginning
to the end of the period.
❖ Current income statement. Information in this statement helps determine the amount of
net cash provided or used by operating activities during the period.
❖ Additional information. Such information includes transaction data that are needed to
determine how cash was provided or used during the period.
Indirect and Direct Methods
In order to perform Step 1, a company must convert net income from an accrual basis to a cash
basis. This conversion may be done by either of two methods:

✓ The indirect method or

✓ The direct method.
Both methods arrive at the same amount for “Net cash provided by operating activities.” They
differ in how they arrive at the amount.
The indirect method is a method of preparing cash flow statement that adjusts net income for
items that do not affect cash. A great majority of companies use this method. Companies favor
the indirect method for two reasons:
(1) it is easier and less costly to prepare, and
(2) it focuses on the differences between net income and net cash flow from operating activities.
The direct method is another method of preparing cashflow which shows operating cash receipts
and payments. It is prepared by adjusting each item in the income statement from the accrual

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basis to the cash basis. The FASB has expressed a preference for the direct method but allows the
use of either method.
Indirect Method—Computer Services Company

To explain how to prepare a statement of cash flows using the indirect method, we use financial
information from Computer Services Company. Illustration 17-4 presents Computer Services’ current- and
previous-year balance sheets, its current year income statement, and related financial information for
the current year.

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Operating Activities
Determine net cash provided/used by operating activities by converting net income from an
accrual basis to a cash basis
under the indirect method, companies must adjust net income to convert certain items to the
cash basis. The indirect method (or reconciliation method) starts with net income and converts
it to net cash provided by operating activities.

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We explain the three types of adjustments in the next three sections.
Depreciation expense
Computer Services’ income statement reports depreciation expense of $9,000. Although
depreciation expense reduces net income, it does not reduce cash. In other words, depreciation
expense is a noncash charge. The company must add it back to net income to arrive at net cash
provided by operating activity.

Loss On Disposal of Equipment

The cash received from the sale (disposal) of plant assets is reported in the investing activities
section. Because of this, companies eliminate from net income all gains and losses related to the
disposal of plant assets, to arrive at net cash provided by operating activities
In our example, Computer Services’ income statement reports a $3,000 loss on the disposal of
equipment (book value $7,000, less $4,000 cash received from disposal of equipment). The
company’s loss of $3,000 should not be included in the operating activities section of the
statement of cash flows.

Changes To Noncash Current Asset and Current Liability Accounts

A final adjustment in reconciling net income to net cash provided by operating activities involves
examining all changes in current asset and current liability accounts. The accrual-accounting
process records revenues in the period in which the performance obligation is satisfied and
expenses are incurred. For example, Accounts Receivable reflects amounts owed to the company
for sales that have been made but for which cash collections have not yet been received. Prepaid
Insurance reflects insurance that has been paid for but which has not yet expired (therefore has
not been expensed). Similarly, Salaries and Wages Payable reflects salaries and wages expense
that has been incurred but has not been paid.

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Changes in noncash current assets.
The adjustments required for changes in noncash current asset accounts are as follows. Deduct
from net income increases in current asset accounts, and add to net income decreases in current
asset accounts, to arrive at net cash provided by operating activities.
Decrease in accounts receivable Computer Services’ accounts receivable decreased by $10,000
(from $30,000 to $20,000) during the period. For Computer Services, this means that cash
receipts were $10,000 higher than sales revenue. The Accounts Receivable account in Illustration
17-8 shows that Computer Services had $507,000 in sales revenue (as reported on the income
statement), but it collected $517,000 in cash
Increase in inventory Computer Services’ inventory increased $5,000 (from $10,000 to $15,000)
during the period. The change in the Inventory account reflects the difference between the
amount of inventory purchased and the amount sold. For Computer Services, this means that the
cost of merchandise purchased exceeded the cost of goods sold by $5,000. As a result, cost of
goods sold does not reflect $5,000 of cash payments made for merchandise.
Increase in prepaid expenses Computer Services’ prepaid expenses increased during the period
by $4,000. This means that cash paid for expenses is higher than expenses reported on an accrual
basis. In other words, the company has made cash payments in the current period but will not
charge expenses to income until future periods (as charges to the income statement). To adjust
net income to net cash provided by operating activities, the company deducts from net income
the $4,000 increase in prepaid expenses.

Changes In Current Liabilities.

The adjustments required for changes in current liability accounts are as follows. Add to net
income increases in current liability accounts and deduct from net income decreases in current
liability accounts, to arrive at net cash provided by operating activities.
Increase In Accounts Payable for Computer Services, Accounts Payable increased by $16,000
(from $12,000 to $28,000) during the period. That means the company received $16,000 more in
goods than it actually paid for. As shown in Illustration 17-10, to adjust net income to determine

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net cash provided by operating activities, the company adds to net income the $16,000 increase
in Accounts Payable.
Decrease In Income Taxes Payable When a company incurs income tax expense but has not yet
paid its taxes, it records income taxes payable. A change in the Income Taxes Payable account
reflects the difference between income tax expense incurred and income tax actually paid.
Computer Services’ Income Taxes Payable account decreased by $2,000. That means the $47,000
of income tax expense reported on the income statement was $2,000 less than the amount of taxes paid
during the period of $49,000.

Summary of Conversion to Net Cash Provided by Operating Activities—Indirect

Method
1. Noncash charges such as depreciation and amortization.
2. Gains and losses on the disposal of plant assets.
3. Changes in noncash current asset and current liability accounts.

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Investing and Financing Activities
Increase In Land As indicated from the change in the Land account and the additional
information, Computer Services purchased land of $110,000 by directly exchanging bonds for
land. The issuance of bonds payable for land has no effect on cash. But, it is a significant noncash
investing and financing activity that merits disclosure in a separate schedule
Increase In Buildings As the additional data indicate, Computer Services acquired an office
building for $120,000 cash. This is a cash outflow reported in the investing activities section
INCREASE IN EQUIPMENT The Equipment account increased $17,000. The additional information
explains that this net increase resulted from two transactions:
❖ A purchase of equipment of $25,000, and
❖ The sale for $4,000 of equipment costing $8,000.
These transactions are investing activities. The company should report each transaction
separately. Thus, it reports the purchase of equipment as an outflow of cash for $25,000. It
reports the sale as an inflow of cash for $4,000. The T-account below shows the reasons for the
change in this account during the year.

The following entry shows the details of the equipment sale transaction.

Increase In Bonds Payable the Bonds Payable account increased $110,000. As indicated in the
additional information, the company acquired land from the issuance of these bonds. It reports
this noncash transaction in a separate schedule at the bottom of the statement.
Increase In Common Stock The balance sheet reports an increase in Common Stock of $20,000.
The additional information section notes that this increase resulted from the issuance of new
shares of stock. This is a cash inflow reported in the financing activities section.
Increase In Retained Earnings Retained earnings increased $116,000 during the year. This
increase can be explained by two factors:

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 ➢ Net income of $145,000 increased retained earnings, and
➢ Dividends of $29,000 decreased retained earnings. The company adjusts net income to
net cash provided by operating activities in the operating activities section. Payment of
the dividends (not the declaration) is a cash outflow that the company reports as a
financing activity.

Free Cash Flow

Free cash flow describes the net cash provided by operating activities after adjustment for capital
expenditures and dividends. In the statement of cash flows, net cash provided by operating
activities is intended to indicate the cash-generating capability of a company.

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Consider the following example. Suppose that MPC produced and sold 10,000 personal
computers this year. It reported $100,000 net cash provided by operating activities. In order to
maintain production at 10,000 computers, MPC invested $15,000 in equipment. It chose to pay
$5,000 in dividends. Its free cash flow was $80,000 ($100,000 -$15,000-$5,000).
The company could use this $80,000 either
✓ To purchase new assets to expand the business or
✓ To pay an $80,000 dividend and continue to produce 10,000 computers

Direct method of cash flow statement

The direct cash flow method uses real cash inflows and outflows taken directly from company
operations. This means it measures cash as its received or paid, rather than using the accrual
accounting method.
Direct method is a method of preparing a statement of cash flows that shows operating cash
receipts and payments, making it more consistent with the objective of the statement of cash
flow
The direct method of presenting the statement of cash flows presents the specific cash flows
associated with items that affect cash flow. Items that typically do so include:

• Cash collected from customers

• Interest and dividends received

• Cash paid to employees

• Cash paid to suppliers

• Interest paid

• Income taxes paid

The advantage of the direct method over the indirect method is that it reveals operating cash
receipts and payments.

The standard-setting bodies encourage the use of the direct method, but it is rarely used,
for the excellent reason that the information in it is difficult to assemble; companies simply
do not collect and store information in the manner required for this format. Using the direct
method may require that the chart of accounts be restructured in order to collect different

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types of information. Instead, they use the indirect method, which can be more easily
derived from existing accounting reports.

Lowry Locomotion Statement of Cash Flows

for the year ended 12/31/x1

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Problems
1. Josh’s PhotoPlus reported net income of $73,000 for 2017. Included in the income
statement were depreciation expense of $7,000 and a gain on disposal of equipment of
$2,500. Josh’s comparative balance sheets show the following balances.

Required:
Calculate net cash provided by operating activities for Josh’s PhotoPlus Hint: is correct $69,700

2. Chicago Corporation issued the following statement of cash flows for 2017.
Required:
Calculate Free Cash Flow

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 3. Ragsdell Corporation had the following transactions.
1. Issued $200,000 of bonds payable.
2. Paid utilities expense.
3. Issued 500 shares of preferred stock for $45,000.
4. Sold land and a building for $250,000.
5. Lent $30,000 to Tegtmeier Corporation, receiving Tegtmeier’s 1-year, 12% note.
Required:
Classify each of these transactions by type of cash flow activity
✓ Operating,
✓ Investing, or
✓ Financing.
4. An analysis of comparative balance sheets, the current year’s income statement, and the
general ledger accounts of Wellman Corp. uncovered the following items. Assume all items
involve cash unless there is information to the contrary.
(a) Payment of interest on notes payable.
(b) Exchange of land for patent.
(c) Sale of building at book value.
(d) Payment of dividends.
(e) Depreciation.
(f) Receipt of dividends on investment
(g) Receipt of interest on notes receivable.
(h) Issuance of common stock.
(i) Amortization of patent.
(j) Issuance of bonds for land.
(k) Purchase of land.
(l) Conversion of bonds into common stock.
(m) Sale of land at a loss. in stock.
(n) Retirement of bonds.

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Instructions
Indicate how each item should be classified in the statement of cash flows using these four major
classifications:

• Operating activity (indirect method),

• Investing activity,
• Financing activity, and
• Significant noncash investing and financing activity
5. The current sections of Scoggin Inc.’s balance sheets at December 31, 2016 and 2017, are
presented here. Scoggin’s net income for 2017 was $153,000. Depreciation expense was $24,000.

Instructions:
Prepare the net cash provided by operating activities section of the company’s statement of
cash flows for the year ended December 31, 2017, using the indirect method.

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 CHAPTER SIX: PROVISIONS AND CONTINGENT LIABILITY
What are Provisions?
Provisions represent funds put aside by a company to cover anticipated losses in the future. In
other words, provision is a liability of uncertain timing and amount. Provisions are listed on a
company’s balance sheet under the liabilities section.
According to IAS 37 A provision is a liability of uncertain timing or amount.' 'A liability is a
present obligation of the entity arising from past events, the settlement of which is expected to
result in an outflow from the entity of resources embodying economic benefits.'
IAS 37 distinguishes provisions from other liabilities, such as trade payables and accruals. This is
on the basis that for a provision there is uncertainty about the timing or amount of the future
expenditure. While uncertainty is clearly present in the case of certain accruals, the uncertainty
is generally much less than for provisions.
IAS 37 states that a provision should be recognized (which simply means 'included') as a liability
in the financial statements when all three of the following conditions are met.
❖ An entity has a present obligation (legal or constructive) as a result of a past event.
❖ It is probable (more than 50% likely) that a transfer of economic benefits will be required
to settle the obligation.
❖ A reliable estimate can be made of the obligation.

What do we mean by a legal or constructive obligation?

An obligation means in simple terms that the business owes something to someone else.

A legal obligation usually arises from a contract and might, for example, include warranties sold
with products to make good any repairs required within a certain time frame.

A constructive obligation arises through past behavior and actions where the entity has raised a
valid expectation that it will carry out a particular action. For example, a constructive obligation
would arise if a business which doesn't offer warranties on its products has a history of usually
carrying out free small repairs on its products, so that customers have come to expect this benefit
when they make a purchase.

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Provisions: ledger accounting entries

When a business first sets up a provision, the full amount of the provision should be debited to
the statement of profit or loss and credited to the statement of financial position as follows.

✓ Debit Expenses (statement of profit or loss)

✓ Credit Provisions (statement of financial position)

In subsequent years, adjustments may be needed to the amount of the provision. The procedure
to be followed then is as follows.
(A) Calculate the new provision required.
(B) Compare it with the existing balance on the provision account (ie the balance b/f from the
previous accounting period).
(C) Calculate increase or decrease required.
(i) If a higher provision is required now:
DEBIT Expenses (statement of profit or loss)
CREDIT Provisions (statement of financial position) With the amount of the increase.
(ii) If a lower provision is needed now than before:
DEBIT Provisions (statement of financial position)
CREDIT Expenses (statement of profit or loss) With the amount of the decrease.
Example: provisions
A business has been told by its lawyers that it is likely to have to pay $10,000 damages for a
product that failed. The business duly set up a provision at 31 December 20X7. However, the
following year, the lawyers found that damages were more likely to be $50,000.
Required How is the provision treated in the accounts at:
(A) 31 December 20X7?
(B) 31 December 20X8?

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Solution
(A) The business needs to set up a provision as follows.
Debit Damages (SPL) $10,000
Credit Provision (SOFP) $10,000
(B) The business needs to increase the provision.
Debit Damages (SPL) $40,000
Credit Provision (SOFP) $40,000

Contingent Liability and Contingent Assets

A contingent liability must not be recognized as a liability in the financial statements. Instead, it
should be disclosed in the notes to the accounts, unless the possibility of an outflow of economic
benefits is remote.
Contingent liability as:
A possible obligation that arises from past events and whose existence will be confirmed only by
the occurrence or non-occurrence of one or more uncertain future events not wholly within the
control of the entity; or
A present obligation that arises from past events but is not recognized because:
✓ It is not probable that a transfer of economic benefits will be required to settle the
obligation; or
✓ The amount of the obligation cannot be measured with sufficient reliability.
As a general rule, probable means more than 50% likely. If an obligation is probable, it is not a
contingent liability – instead, a provision is needed. If the obligation is remote, it does not need
to be disclosed in the accounts.
A contingent asset must not be recognized as an asset in the financial statements. Instead, it
should be disclosed in the notes to the accounts if it is probable that the economic benefits
associated with the asset will flow to the entity.
A contingent asset must not be recognized in the accounts, but should be disclosed if it is
probable that the economic benefits associated with the asset will flow to the entity
If the flow of economic benefits associated with the contingent asset becomes virtually certain,
it should then be recognized as an asset in the statement of financial position, as it is no longer a
contingent asset

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For example,
a company expects to receive damages of $100,000 and this is virtually certain. An asset is
recognized. If, however, the company expects to probably receive damages of $100,000, a
contingent asset is disclosed.
Disclosures for contingent liabilities
Unless remote, disclose for each contingent liability:
✓ A brief description of its nature, and where practicable
✓ An estimate of the financial effect
✓ An indication of the uncertainties relating to the amount or timing of any outflow
✓ The possibility of any reimbursement
Disclosures for contingent assets
Where an inflow of economic benefits is probable, an entity should disclose: x

• A brief description of its nature, and where practicable

• An estimate of the financial effect

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Problems
1 A company is being sued for $10,000 by a customer. The company's lawyers reckon that it is
likely that the claim will be upheld. Legal fees are currently $5,000. How should the company
account for this?
2 Given the facts in 1 above, how much of a provision should be made if further legal fees of
$2,000 are likely to be incurred?
3. A contingent liability is always disclosed on the face of the statement of financial position. True
or false?
4. 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
D Offset against any associated liability
5. An entity shall not recognize a contingent liability __________.
A. Unless an entity has a present liability as a result of a past event
B. Unless it is probable that an outflow of resources embodying economic benefits will be
required to settle this liability
C. Unless a reliable estimate can be made of the amount of this liability
D. None of the above

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 REVERENCE
Joe B. Hoyle., Thomas F. Schaefer & Timothy S. Doupnik (2013). Advanced accounting. McGraw-
Hill/Irwin. New York, United states of America.
Jerry J. Weygandt., Paul D. Kimmel & Donald E. Kieso (2015) principles of accounting. john Wiley
& Sons, Inc. New jersey. United States of America.
F3 financial accounting paper material.accaglobalbox.com F7 financial accounting paper material.
Corporatefinanceinstitute.com
https://www.investopedia.com/terms/e/equityaccounting.asp#:~:text=Key%20Takeaways,the%
20stock%20in%20the%20investee.

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