CHAPTER 1: Visual Overview

CHAPTER 1: Visual Overview

Objective: To explain the purpose of financial reporting.
1.1.1 Types of Business Entities

1.1 Types of Business Entities

Businesses exist to make a profit by producing and selling goods and services. Profit is the difference
between the income and expense of a business.
While businesses share a similar purpose, they can still differ significantly. Businesses vary in terms of size,
financing, and legal position. These different factors influence what is reported in their financial statements.
A business can operate as a sole trader, a partnership, or a limited liability company.

Exam advice

Questions on these business arrangements are popular in the exam. Students may be tested on the ability to recognise th
features of each type of business.

1.1.2 Sole Traders

1.2 Sole Traders
A sole trader is an individual who owns, controls, and manages a business alone.

1.2.1 Legal Differences of Sole Traders

• Change in Business Ownership
To change the owner of a sole trader business, the existing sole trader would sell their business
to the new owner. The sole trader is the only person in charge, so this decision is made without
involving others.
• Business Continuation
If a sole trader exits the business, it cannot continue unless sold to another individual.
• Taxation
Sole traders are taxed on the profit the business makes. The tax authorities do not tax the
individual owner separately.
• Ownership of Business Property
There is no separation of ownership between a sole trader business and its owner.
• Legal Action
The sole trader is legally liable for any penalties and fines incurred if a legal dispute occurs and
a court judgement is made against the business

1.2.2 Advantages of Sole Traders

• Control – A sole trader has complete control over their business. The owner owns the business assets
and is fully entitled to all the profits generated by the business.
• Business Formalities – It is easy for a sole trader to set up and operate a business. There is no need
to comply with companies’ legislation and no requirement to publish financial statements.
However, the sole trader may still need to produce financial statements to provide information
for the tax authorities.
• Flexibility – A sole trader can choose how to operate and is not bound by any workload requirements.

1.2.3 Disadvantages of Sole Traders

• Liability – A sole trader is fully liable for all the business’s debts. Any personal possessions may have
to be sold to pay off the business's debts.
 • Raising Finance – A sole trader may not be able to raise the money needed to develop the business in
the longer term. The only available finance sources may be the owner’s capital or short-term finance from
the bank (overdraft).
• Business Continuity – The business will cease if the sole trader dies or retires unless arrangements
have been made for it to be sold or transferred to someone else.
Activity 1
1. Which one of the following is MOST likely to be interested in a sole trader's financial statements?
1. Shareholders
2. The financial press
3. Loan note holders
4. The tax authorities
2. Which of the following statements about sole traders are true?
i.A sole trader may be able to obtain a bank overdraft.
ii. If a sole trader owes money, the person who is owed the money will only be able to claim against the
assets of the sole trader's business.
iii. A sole trader's business may suffer if the owner becomes ill.
1. i) and ii)
2. i) and iii)
3. ii) and iii)
4. i) only
5. All of them

1.1.3 Partnerships

1.3 Partnerships
A partnership is where two or more people own and run a business together to make profits.

1.3.1 Legal Differences of Partnerships

• Change in Business Ownership
All the partners must agree to a new partner being admitted to the partnership. A partner will
typically buy into the partnership by investing.
• Business Continuation
If a partner leaves a partnership, the partnership automatically ends unless the partnership
agreement allows the remaining partners to continue the partnership.
• Taxation
Like a sole trader business, the partnership is taxed on its profits. The tax authorities do not
tax the individual partners separately.
• Ownership of Business Property
There is no separation of ownership between a partnership business and its owner (partners).
• Legal Action
The partners are legally liable for any penalties and fines incurred if a legal dispute occurs and
a court judgement is made against the partnership.

1.3.2 Advantages of Partnerships

• Defined Roles – A partnership will have a partnership agreement that sets out how the
business will be managed concerning each partner’s work scope and the profit-sharing
arrangements.
• Raising Finance – If the existing partners bring another partner into the business, the new
partner will be required to contribute financially.
• Paperwork – A partnership does not have to publish its financial statements. However,
financial information may be kept for proper accounting records and to avoid disputes
concerning tax expenses.
• Skills and Knowledge – Different partners have different business skills and knowledge.
This can enhance the business because they can concentrate on what they do best.
 • Risks – Having more partners in a partnership will spread the business risk to more people.
The impact of poor performance and losses will be reduced for each partner.

1.3.3. Disadvantages of Partnerships

• Costs - Drawing up a legally binding partnership agreement will cost money.
• Decision Making – The time taken to make decisions may be slow in a partnership if the
partners disagree. This can slow down the progression and development of business.
• Profit Sharing – Since profits and losses are shared among the partners, there may be no
incentive for the partners to work harder than the other partner.
• Business Continuity – A partnership may need to be dissolved if one of the partners cannot
continue working. For the partnership to continue, the remaining partners may need to admit a
new partner and establish a new partnership.
• Liability – Each partner’s personal assets are at risk if the business fails. Personal
bankruptcy can occur.
• Disagreements and Disputes – Severe disagreements or disputes not resolved promptly
between partners can result in hung decisions or, in the worst-case scenario, the partnership
breaking up.

1.1.4 Limited Liability Companies

1.4 Limited Liability Companies

A limited liability company is where investors invest in the company by buying shares and becoming
shareholders. Shareholders require profits on their investments in the form of dividend payments or share
value appreciation. Directors are hired to run the company on behalf of the shareholders. Shareholders are
only liable for their investment.
A limited liability company may be a private or public limited company. Public limited companies tend to be
larger, and their shares are listed on stock exchanges, which means the public can buy the business’s
shares.
A private limited company will have a smaller number of shareholders and may require the approval of
existing shareholders before issuing new shares.

1.4.1 Legal Differences of Limited Liability Companies

• Change in Business Ownership
Shareholders can buy and sell shares in a limited company without needing other shareholders
to agree. However, smaller companies can restrict the sale to make the shares available to
existing shareholders before being placed on the open market.
• Business Continuation
If a company's shareholders change, this does not affect the company’s existence.
• Taxation
The limited liability company is taxed based on the profits it generates. The individual owners
(shareholders) are taxed separately.
• Ownership of Business Property
A limited liability company can own a property itself. The ownership does not need to be in
anyone else's name. Individual shareholders do not have control over the property.
• Legal Action
The legal repercussions of a limited liability company are limited to the business only. The
owner’s (shareholders) legal liability is limited to the value of the shares they own. It is the
company that is legally liable, not its shareholders.

1.4.2 Advantages of Limited Liability Companies

 • Liability – Limited liability can protect directors and shareholders (owners) from legal actions brought
against them. The shareholders’ liability is limited to the value of their invested shares. Personal
possessions of the shareholders cannot be used to repay any of the business’s debts.
• Raising Finance – Limited liability companies may have easier access to finance and may attract a
wider pool of industry experts. It can issue shares to existing shareholders or the public to raise money
for the business.
• Business Continuation – A limited liability company can be transferred from one owner to another. If
the current shareholders decide to sell their shares, another shareholder can purchase them, and the
business will continue to operate as usual.

1.4.3 Disadvantages of Limited Liability Companies

• Costs – Setting up a limited liability company requires a substantive initial investment. There is also
considerably more administration involved in running a limited liability company than a partnership or sole
trader.
• Taxation – The profits of a limited liability company are taxed. The owners (shareholders) and directors
(employees of the company) are also individually taxed.
• Public Eye – A company cannot keep its business affairs private as it relies on the public to invest
money into the business (by purchasing shares). A limited liability company must hold general meetings
and file annual reports with the company registrar.
Activity 2
In the following activity, match each statement to the appropriate business arrangement:
• sole traders
• partnerships
• limited liability companies.
Some statements will be scenarios where the owner considers what business arrangement to operate.

Statement Business arrangement

Isabella wishes to open a small shop three days a week and wants to spend as
little time as possible on business paperwork and formalities.

The business will continue even though one of its shareholders dies.

There is a distinction between the business and its owners.

Oliver wishes to own his own business in a country where limited liability
companies must have a minimum of two shareholders.

Riley wishes to operate by himself as a builder but is concerned that he will be

personally liable for legal claims by his customers.

Lee has been running an accountancy practice by herself but is concerned that
she does not have the expertise to meet all her client’s needs.
 The business is taxed as a distinct entity from those who own it. The business
may be subject to different tax rates from its owners.

The owner’s savings are likely to be an essential business finance source.

1.2.1 Definition
2.1 Definition

The finance department in a business exists to produce reliable information, which becomes the basis for
preparing financial statements. Users of these statements want to know that the information it contains
can be understood and is reliable. Therefore, a business needs to prepare financial statements logically
and consistently.
Financial reporting is the recording, analysing, and summarising of financial data to present the
financial performance of a business.
The financial statements produced from this data are analysed by users interested in the business’s
financial standing.
• Recording
A bookkeeper records all business transactions promptly so that the information is updated.
The records should show enough information about its transactions to help managers
prepare financial statements and meet legal requirements.
For example, a business records information such as customer sales and purchase of goods.
• Analysing
A bookkeeper analyses individual transaction records and sorts the information into different
categories so the business can analyse information concisely.
For example, transactions are categorised according to their accounting type so that
managers can identify the business’s main expenses or how much cash it has received from
each customer.
• Summarising
Complete accounting records usually contain too many details for the needs of most
interested parties in the business's financials. Therefore, businesses summarise their
financial transactions and position in annual financial statements. This enables users to
obtain an overview of the business without looking through detailed accounting records.
Financial data is summarised in the financial statements at the end of each accounting
period.
• Analysis of Financial Statements
Readers compare different items in the statements to see how things have changed over
time and compare how the business has performed against others. Analysing the reports
helps readers make informed financial decisions. Therefore, financial statements need to be
accurate.
For example, readers compare the value of assets in the statement of financial position
against previous years to identify if new investments have been made. The financial
statement is also analysed using financial ratios to be compared with historical or competitor
financials.
1.2.2 Nature, Principles and Scope of Financial Statements
2.2 Nature, Principles and Scope of Financial Statements

Financial statements are a set of documents a business prepares that contain information about its
financial results and what it owns and owes.
Interested parties of the business can read and analyse the financial statements to determine its financial
viability. The readers can better assess the figures contained in the financial statements by comparing
them with those issued in other years or by similar businesses in the industry.
The main financial statements of a business are:
• Statement of Financial Position
The statement of financial position shows the business’s financial standing at the end of the
accounting period. This includes assets and liabilities such as:
o land and buildings the business owns
o equipment and motor vehicles needed for operation
o goods not yet sold to customers
o cash-in-hand and in the bank
o money owed by customers
o money owed to its suppliers
o income taxes owed to authorities
The statement also shows the sources of finance that support the business. Finance
borrowed by banks or other lenders is a form of liability. Finance supplied by investors who
have purchased shares and owner’s investments make up part of the business’s capital
(equity) portion.
The statement of financial position shows the financial strength of the business. It helps the
reader of the statements assess whether it will be able to keep operating, expand in the
future, or possibly face financial difficulties.
• Statement of Profit or Loss and Other Comprehensive Income
The statement of profit or loss and other comprehensive income shows whether the business
has made a profit for the year. It informs the reader whether the business’ sales have
exceeded its costs.
The statement gives details about different types of costs:
o Costs of trading (producing and selling goods or services)
o Other costs of running the business
o Cost of finance (interest paid to banks for borrowings)
o Income taxes on business profits
The Statement of Profit or Loss and Other Comprehensive Income shows how successfully
the business has traded over the year.
• Statement of Cash Flows
The statement of cash flows gives details about the movement of cash in the business. Cash
movements are caused by:
o receipts from customers
o payments to suppliers
o payment for the purchase of non-current assets such as land, buildings,
equipment, and motor vehicles
o payment to tax authorities
o cash borrowings and investments
The statement of cash flows indicates how well the business is at generating cash and the
primary sources of money on which it depends. It may also show if it is running out of cash.
• Statement of Changes of Equity
The statement of changes in equity provides details of the change in the equity of a business
 during the financial year.
Transactions that affect the equity balance include:
o Net profit or loss
o Proceeds from the sale of shares
o Dividend payments
o Equity gains and losses
The statement provides a breakdown of the reason for the difference between the opening
and closing equity of a business which is not provided by the Statement of Financial Position.
• Non-Financial Reports
Non-financial statements may be included in a company's annual report alongside the
financial statements:
o Financial Review (by management)
o Chairman's Statement
o Directors' Report
o Employee Reports
o Five-year Financial Record
o Analysis of Commercial Properties
o Environmental Reports
o Value-added Statements
The term "annual report" generally means the glossy, colourful brochure companies publish to meet their
statutory obligations to report to shareholders. This usually includes far more information (both financial
and non-financial) than the financial statements on which an independent auditor will report.
Financial statements also contain a written report by the business's directors. Larger companies produce
an annual report containing information other than financial such as the details of risks that the business
faces, the impact the business has on the environment and any significant issues the business faces.
All three business arrangement types – sole traders, partnerships, and limited liability companies – will
prepare these statements. It is an accountant's responsibility to make sure these statements are prepared
correctly and according to applicable accounting standards.

1.2.3 Statement of Financial Position

2.3 Statement of Financial Position

Definition

The Statement of Financial Position (SFP) is a primary statement that shows the financial position of a business at a po
time. This includes the assets owned, liabilities owed and the capital/equity balance.
The "financial position" can be defined as a company’s net worth (assets minus liabilities). The statement
of financial position shows the book value or carrying amount of the entity at a particular date for:
• Assets (resources controlled)
• Liabilities (obligations owed)
• owners' Capital or Equity (how the business is financed)

Example 1

Abu is a sole trader who operates Glara, a business that manufactures goods and sells them to tourists.
Glara has a workshop and a small shop.
Glara’s statement of financial position is shown below:
• Title – The statement of financial position shows the closing position of Glara’s assets,
capital and liabilities balance at their financial year-end of 31 December 2014.
• Non-Current Assets – Assets come first on Glara's statement of financial position. Non-
current assets are assets that glara intends to use to generate profits over more than 12
months. They include the workshop and shop that Glara occupies, equipment items, and
motor vehicles.
• Current Assets – These assets can be converted into cash or consumed by the business
within the next 12 months.
o Inventory is goods that Glara will sell in the future.
 o Trade receivables are customer debts expected to be received after the period end.
o Prepayments are expenses paid in advance.
o Lastly, it includes cash Glara holds on its premises or in its bank account.
Note: Current Assets are usually presented in the order in which they can be turned into cash
most easily (increasing liquidity order). For conversion into cash:
1. inventory takes the longest time
2. receivables and prepayments are relatively liquid and take less time
3. cash is the most liquid form.
• Capital – Capital is the owner's interest in the business. It comprises the cash invested into
the business by the owner, any profits (or losses) generated minus any owner’s withdrawals.
For Glara, capital brought forward is the earnings it has made in previous years that have
been kept in the business; this is also called retained earnings. In a limited company's
financial statements, capital is called equity.
• Non-Current Liabilities – These are liabilities of Glara that will be settled (paid) in more than
12 months. It includes long-term loans from the business's bank.
• Current Liabilities – These liabilities will be settled (paid) within 12 months.
o Trade payables are money owed by Glara to its suppliers, which it will
pay after the period end.
o Accruals are other expenses incurred that have not yet been paid.
o A bank overdraft is a negative balance on a bank account. Glara may
hold an overdraft for some time, but it is treated as a current liability because the
bank could demand it be cleared at any time.
• The Total Asset amount should equal the Total Capital and Liabilities amount.

The statement of financial position in the above example is for a sole trader business.
The statement of a limited liability company would include different information relating to capital:
shareholders own the company, and its capital is expressed as shares.

Activity 3
State whether the following statements are true or false.
1. Prepayments are a current liability.
2. The company’s bank account balance is always a current asset.
3. A current liability is due to be settled within six months of the reporting date.
4. Drawings are added to capital in a sole trader’s statement of financial position.

1.2.4 Statement of Profit or Loss and Other Comprehensive Income

2.4 Statement of Profit or Loss and Other Comprehensive Income

The statement of profit or loss and other comprehensive income (SPL&OCI) can be prepared either as a
single statement or as two separate statements:
• Single statement of comprehensive income
• Two statements
o A Statement of Profit or Loss
o A Statement of Other Comprehensive Income (which begins with profit or
loss for the period)

2.4.1 Statement of Profit or Loss

 Definition

The Statement of Profit or Loss is a primary financial statement summarising an entity's financial
performance in terms of profit or loss in a year.
This statement comprises:
• trading account summarising trading transactions (Sales – Cost of sales = Gross Profit)
• profit and loss account (also called income and expenditure account) for all other items of
income and expenditure legitimately earned because of business activities.
It shows the profit or loss for the period after taking account of all items of expenditure (including interest
and taxation), excluding components of other comprehensive income.

2.4.2 Other Comprehensive Income

Other comprehensive income consists of items of income and expense which are not recognised in profit
or loss. For example, a surplus arising on revaluation of a property which is not recognised in profit or
loss (because it is not realised as cash).

Example 2

Glara’s Statement of Profit or Loss and Other Comprehensive Income details the business’s financial
performance in terms of Income and Expenses.
 • Title – The Statement of Profit or Loss and Other Comprehensive Income reports the income
and expenses for Glara‘s accounting period of 1 January 20X2 to 31 December 20X2.
• Sales – Sales are the income generated by Glara‘s normal trading activities.
• Cost of Goods Sold – This is the cost of the goods Glara sells during the year. It includes
purchases made during the period and opening and closing inventory adjustments.
• Gross Profit – the surplus that Glara has made from its trading activities. It would be a gross
loss if the cost of goods sold exceeded sales revenue.
• Other Income – This is income generated by a business from anything other than its normal
trading activities. This can include any interest earned from Glara’s bank deposits.
• Expenses – These are costs incurred in the day-to-day running of the business.
• Net Profit – is the excess of income after all business expenses have been paid. The Net
Profit amount is transferred to the 'Profit for the Year' section of the Statement of Financial
Position, thus increasing capital.
(If a net loss is made, a negative amount is transferred to the SFP, thus reducing the
business’s capital).
• Other Comprehensive Income – highlights any profit or losses not reflected in the
Statement of Profit or Loss.
An example is a revaluation of a non-current asset, which may give rise to a revaluation gain.
For instance, a building valued at $750,000 is now worth $850,000. This is a revaluation gain
of $100,000, which is classified as other comprehensive income.
Activity 4

In the following activity, arrange the items in the order they must appear in the statement of profit or loss,
reading from top to bottom.
 Line Item Order Number
Loan Interest
Cost of Goods Sold
Property revaluation loss
Other Income
Net Profit
Gross Profit
Sales Revenue

1.2.5 Statement of Cash Flows

2.5 Statement of Cash Flows

Definition

The Statement of Cash Flows is a primary statement that shows an overall view of the inflows and
outflows of cash over the period.
The statement of cash flows is a historical statement. It shows cash inflows and outflows that have
already taken place. Users can see where cash in the business has come from and how it has been
spent.
A business's cash position is one of the most important measures of its financial situation. If a business
runs out of cash, it cannot survive even though it is making profits.
The statement of cash flows classifies the movement of cash into three categories:
• Operating Activities
• Investing Activities
• Financing Activities

Example 3

Kenravi Co is a large limited company that manufactures clothing. The Statement of Cash Flows is shown
below:
• Title – Kenravi Co's Statement of Cash Flows shows the cash receipts and payments of the
business during the period. Some of the amounts in the statement of cash flows and its
statement of profit or loss will be the same. However, the statement of profit or loss includes
 figures that are not cash movements, such as depreciation and is not included in the
Statement of Cash Flows.
• Cash Flows from Operating Activities – Cash flows from operating activities relate to
Kenravi Co's operations. They also include the interest and income taxes paid by Kenravi Co.
• Cash Flows from Investing Activities – Cash flows from investing activities show Kenravi
Co’s asset investments. The cash flows from investment can be positive or negative.
Negative is the purchase of assets, while positive is the selling of existing assets.
Kenravi Co may also invest in financial investments or other businesses. The income and
dividends received from these investments are usually included under this heading.
• Cash Flows from Financing Activities – Cash flows from financing activities are monies
Kenravi Co has received from finance providers. These would be from shareholders or
lenders. The heading also includes money that it has repaid to providers of finance.
Dividends paid to Kenravi Co's shareholders are included here, but the interest paid on loans
is usually reported within cash flows from operating activities rather than in this category. If
Kenravi Co has issued shares for cash, those receipts will be included in cash flows from
financing activities.
• Net increase in cash and cash equivalents – The totals for each category are added
together to arrive at a net figure, which is Kenravi Co's movement in cash over the year. If
cash receipts have exceeded payments, there will be an increase; if payments have
exceeded receipts, there will be a decrease.
Cash and cash equivalents include the bank overdraft. Cash equivalents are short-term
investments that can easily be converted into cash.
• Cash and cash equivalents at end of the period – This figure links the bank and cash
figure or figures in Kenravi Co's Statement of Financial Position with the movement in cash
flows. It shows the difference in cash flows between the period’s start and end.
Activity 5
For each statement of cash flow example, state whether they belong to the operating, investing or
financing activities.
1. Purchase of buildings
2. Income taxes paid
3. Profit on sale of motor vehicle
4. Dividends paid

5. 1.2.6 Statement of Changes in Equity

6. 2.6 Statement of Changes in Equity
7.
8. The purpose of the statement of changes in equity is to state the changes in equity that have
occurred in the financial year. The statement reconciles the equity account balances at the start
and end of the year.
9. Equity of a business includes share capital, share premium, revaluation surplus and retained
earnings. Each element will have its column in the Statement of Changes in Equity.
10. In this pro forma layout, the columns represent capital components, and the rows represent the
changes in the period. A whole year's comparative information also would be shown.
1.3.1 Stakeholders
3.1 Stakeholders
A stakeholder is anyone who can affect the business or is affected by the business. They are
users of the prepared financial statements.
Since the financial statements are an important record of the performance of the business in the
year, stakeholders are naturally interested in them. As there are different types of stakeholders,
they will be interested in various areas in the financial statements. This means that the financial
statements need to include enough detail to satisfy the information requirements of different
stakeholders.
3.1.1 Internal Stakeholders
• Business Owners
Owners may manage the business or appoint managers to do it for them. They need detailed
financial data to run the business effectively and efficiently and make business decisions.
Much of the information that interests a business owner is the management accounts used
daily and not available to the public.
• Employees of the company
Employees such as accountants and salespeople may be interested in the company’s
information as part of their work scope within the business. Employees may also be
interested in the company’s financial standing to assess their job stability.

3.1.2 External Stakeholders

• Customers
 Some customers will rely on the company to provide them with regular supplies. They will be
interested in whether the company is financially strong enough to continue to trade. They will
also be interested in the profits that the company is making, considering them from the
viewpoint of the prices they have to pay the company.
• Suppliers
Suppliers sell goods and services to the company. Their main concern will be that the
company will be financially secure enough to pay the suppliers and continue to use their
goods and services.
• Government and Local Authorities
The government will be interested to know if the company is complying with the law and how
it uses its resources. This will help the government understand what is happening in the
economy and influence government policy.
The taxation authorities report to the government. They will be interested in the company’s
profits to calculate the tax to pay.
• Shareholders
Shareholders are interested in the company’s results to determine how much money can be
paid to shareholders each year in the form of dividends. Shareholders will also be interested
in how much money they could make if they sell their shares in the company.
• External Lenders
Loan finance providers lend the company money for repayment in the future. Naturally, they
want to be sure that the company will pay the principal and the interest on the loan every
year. Loan finance providers will therefore be interested in how much money and resources
the company has and whether it looks like the company may find it difficult to repay what it
owes.
• Auditors
Many companies are required to have an audit each year. Auditors examine whether the
financial statements present the results and financial position accurately. Auditors will review
whether the annual financial statements agree with the detailed accounting records the
company keeps. They will also work to check how reliable the company's accounting records
are.
• The Public
The public will be interested in various aspects of the company, such as its contribution to the
economy by providing jobs. Some companies – for example, water and electricity suppliers –
deliver essential public services. The public will also be interested in anything the financial
statements say about the company’s impact on the natural environment.
The below table is a summary of the information needs of internal users of financial information:
The below table is a summary of the information needs of external users of financial information:

Activity 6
State whether the following statements are True or False.
1. Shareholders will be the most interested stakeholders in a partnership's financial statements.
2. Auditors are particularly interested in the reliability of the figures shown in the financial statements.
3. Employees will likely want to use the financial statements to assess how well the business will do in the
future.
4. Loan finance providers are likely to be interested in how much the business pays out to its owners each
year.
5. Management's primary source of daily financial information is the annual financial statements.
6. Tax authorities are interested in the financial statements of partnerships, sole traders and companies.

1 Syllabus Coverage

Syllabus Coverage

This chapter covers the following Learning Outcomes.

A. The context and purpose of financial reporting
1. The context and purpose of financial statements for external reporting
1. Define financial reporting – recording, analysing and summarising financial data.
2. Identify and define types of business entity – sole trader, partnership, limited liability
company.
3. Explain the legal differences between a sole trader, partnership and a limited liability
company.
4. Identify the advantages and disadvantages of operating as a sole trader, partnership or
limited liability company.
5. Define the nature, principles and scope of financial reporting.
2. Stakeholders’ needs
1. Identify the users of financial statements and state and differentiate between their information
needs.
3. The main elements of financial statements
1. Describe the purpose of each of the financial statements:
i. Statement of financial position
ii. Statement of profit or loss and other comprehensive income
iii. Statement of changes in equity
iv. Statement of cash flows

1 Summary and Quiz

Summary and Quiz

• A sole trader is self-employed.
• A partnership is a business owned and managed for the mutual benefit of two or more
partners.
• A limited liability company is a separate legal entity that one or more directors manage for the
benefit of the shareholders.
• Financial reporting includes:
o recording transactions ("bookkeeping")
o preparation of financial statements ("accounting")
o presentation of financial statements ("reporting")
• The main components of financial statements are the statements of:
o financial position (includes assets and liabilities)
o profit or loss (includes income and expenses)
o changes in equity (if relevant, for transactions with investors)
o cash flows (cash flows in and out of the business).
• Users of financial statements are internal (e.g. owners, managers and employees) and
external (e.g. potential investors, banks and customers).
• Financial statement users have widely differentiated information needs.
CHAPTER 2: Visual Overview
CHAPTER 2: Visual Overview
Objective: To present and explain the Statement of Financial Position and Statement of Profit or Loss and
other comprehensive income and their interrelationship.

2.1.1 Elements of the Statement of Financial Position

1.1 Elements of the Statement of Financial Position
The Statement of financial position provides a snapshot of an organisation’s assets, liabilities and capital
balances at a specified date.

1.1.1 Assets
IAS 1 defines an asset as a present economic resource controlled by the entity due to past events and has
the potential to produce economic benefits.
Assets can be split into two categories: current assets and non-current assets.
• Current assets – cash or assets that can be converted into cash or used within the next 12 months.
For example, cash in bank, amounts due from customers, and goods held for resale.
• Non-current assets – assets that a business uses for more than 12 months to generate
profits or cash flow. For example, offices, shops, warehouses, delivery vehicles and production
equipment.
 Non-Current Assets can be further split into two: tangible and intangible.
o Tangible non-current assets are non-current assets that have a physical form and can be
touched. For example, machinery, fixtures and fittings, and computer equipment.
o Intangible non-current assets are non-current assets that do not have a physical form. For
example, software licences purchased for use by the business for more than 12 months.
It is essential to understand the different categories of assets as current and non-current assets are
presented separately in the statement of financial position.

Activity 1
For each statement below, state whether they are True or False.
1. A telephone that is used daily is a current asset.
2. A machine used to create products is a tangible non-current asset.
3. A software licence that allows a business to use specific software for a period of three years is a tangible
non-current asset.
4. A truck a business uses to deliver goods to its customers is a tangible non-current asset.
5. Goods purchased by a business for resale to its customers are tangible non-current assets.
1.1.2 Liabilities
IAS 1 defines a liability as a present obligation of the entity to transfer an economic resource as a result of
past events.
Generally, a liability is an amount that is owed by the business. Liabilities imply legal responsibilities or
duties to other parties.
Liabilities can be split into two categories: current and non-current.
• Current liabilities – amounts owed by the business falling due for payment within one year of the
reporting date. For example, amounts due to suppliers for goods purchased on credit are trade payables.
• Non-current liabilities – amounts owed by the business falling due for payment beyond one year
from the reporting date (total liabilities − current liabilities).
Entities are frequently financed by credit from sources other than the owners, which gives rise to liabilities.
For example, a loan received in 20X5, which is to be repaid in five years, will be a non-current liability in
the 20X5 to 20X8 statements of financial position, with a year’s portion in current liability. In the 20X9
financial statement, the total balance owing will be classified as a current liability.

1.1.3 Capital/ Equity

A business's capital or equity balance is the residual interest owners hold in its assets after deducting all
its liabilities.
It is the difference between total assets and total liabilities:

Total Assets – Total Liabilities

It amounts to the total investment in a business entity (a proprietor's or shareholders' funds or capital) and
is sometimes called the net worth.

2.1.2 Elements of the Statement of Profit or Loss

1.2 Elements of the Statement of Profit or Loss
There are two absolute profit measures, only one of which is shown in the trading account.
1. Gross Profit - this is calculated in the trading account and is the excess of sales over the cost of goods
sold during the period.
2. Net Profit - this is calculated in the profit and loss account and is the remaining profit after all other
costs incurred in the period have been deducted from the gross profit.
The statement of profit or loss is a formal presentation of the trading and profit and loss accounts. It
summarises the organisation’s financial performance in income and expenses during the financial year.
1.2.1 Income
Income is increases in assets, or decreases in liabilities, that result in increases in equity - other than those
relating to contributions from holders of equity claims (i.e. shareholders)
Income reflects all sales made to customers in the year, regardless of whether they have been paid for.
Cash inflows from shareholders are not income.
• A sale is usually recognised as taking place when goods are despatched (or services provided) to a
customer.
• Sales made to customers on credit which have not been settled for cash at the reporting date are
shown in the Statement of Financial Position as trade receivables.

1.2.2 Expenses
Expenses are decreases in assets, or increases in liabilities, that result in decreases in equity - other than
those relating to distributions to holders of equity claims.
An expense of a business is the day-to-day running cost incurred. Payments to shareholders (such as
dividends) are not expenses.
• Cost of sales is the cost of goods that have been sold. It includes all the costs connected with the
purchase and manufacture of goods. Costs incurred are matched with revenues earned.
• Other expenses can include various costs such as electricity, rent, salaries, and interest paid.
Activity 2
In the following activity, classify the list of items into the elements of financial statements.
1. Shareholder's investment
2. Computers
3. Bookkeeper's annual salary
4. Warehouse
5. Unsold goods
6. Overdraft with the bank
7. Cash held at the bank
8. Sales of goods for cash in the factory shop
Activity 3
The following activity presents different items that need to be classified under the correct heading in the
financial statements.
• Cost of selling furniture and other costs of running Coltom Co.
• Buildings owned by Coltom Co.
• The amount paid to purchase shares in Coltom Co.
• Amounts Coltom Co. owes for goods and services purchased
• The income that Coltom Co. earns from selling furniture to its customers
Match each example to the correct financial statement heading below:
1. Assets in the Statement of Financial Position
2. Liabilities in the Statement of Financial Position
3. Equity in the Statement of Financial Position
4. Income in the Statement of Profit or Loss
5. Expense in the Statement of Profit or Loss

2.1.3 Asset Expenditure vs Expenses

1.3 Asset Expenditure vs Expenses
When items of expenditure are incurred, a decision must be made whether they affect:
• Statement of financial position as an asset expenditure
• Statement of profit or loss as expenses
 Ethics

The distinction between expenses and asset expenditure is essential in the real world.
If a business incorrectly classified expenses as asset expenditures, it would lead to expenses being
understated and profits being overstated. This would mean that the profit would not fairly represent the
business’s performance.

1.3.1 Asset Expenditure

Asset expenditure relates to the purchase of non-current assets. Asset expenditure is incurred in:
• Acquiring property and equipment for long-term use (benefits future accounting periods).
• Increasing the revenue-earning capacity of an existing non-current asset (by increasing efficiency or
useful life).
Items of asset expenditure (except for the cost of land) will ultimately be expensed to profit or loss (through
a charge called depreciation) as the asset is consumed through its use in the business.

1.3.2 Expenses
Expenses, commonly called operating expenses, are incurred in the business’s daily running (operation).
Examples include:
• buying or manufacturing goods which are sold and providing services
• selling and distributing goods
• administration costs
• repairing long-term assets
These costs are immediately charged to profit or loss and matched with the accounting period's revenues.

Activity 4
Classify the following items of expenditure as asset expenditures or expenses:
1. $27,000 on a new car.
2. $1,800 road tax incorporated in the car’s purchase price in (1) above.
3. $10,000 on a second-hand delivery van.
 4. $12,000 on refurbishing van in (3) above.
5. $1,000 monthly rental of a vehicle.
Activity 5
Rubin owns a business that sells office and computer equipment to corporate customers. His business
operates from a warehouse and has a small fleet of delivery vehicles.
Determine whether the expenditures made by Rubin's business should be classified as expenses
or asset expenditures.
1. Rubin’s business has bought some laptops and speakers from its suppliers, which will be sold to its
customer.
2. Rubin’s accountant prepares its financial statements. She ordered a photocopier to make copies of her
paperwork.
3. Rubin’s business is expanding, and he has rented a new warehouse.
4. Rubin ensures that all the vehicles have valid insurance. Each time he orders a new vehicle, he insures
it immediately.
5. Goods are delivered to customers using one of the business’s delivery vehicles. On the way back to the
warehouse, the driver crashes the side of the vehicle into the fence. The vehicle will need to be fixed to
be used again.
6. Rubin’s business orders a few new vehicles to keep up with customer orders.

2.2.1 The Duality Concept

2.1 The Duality Concept
The Duality concept is one of the accounting principles used in recording financial information. It states that
every transaction has a double (or dual) effect on the business's position as recorded in its accounts.
The second effect is equal to and "opposite" of the first effect.

Activity 6
Match the transactions to the corresponding duality statements.
Transaction Duality Statement

Sells goods on cash Sales income increases, and receivables asset increases.

Sells goods on credit Payables liability decreases, and bank asset decreases.

Goods for resale expense increase, and bank asset

Purchases goods for resale for cash decreases.

Purchases goods for resale on credit Capital introduced increases and bank asset increases.

Pays a supplier for some equipment bought on

credit Sales income increases, and bank asset increases.

Purchases some equipment for cash Equipment asset increases, and bank asset decreases.

Goods for resale expense increases, and payables liability

Starts the business by introducing cash increases.
2.2.2 The Accounting Equation
2.2 The Accounting Equation

The elements of financial statements are assets, liabilities, capital, income and expenses. These elements
relate to one another, and their relationship is expressed in the accounting equation:

Capital or Net Assets = Assets – Liabilities

At any point in time when transactions have been recorded correctly, the accounting equation will always
balance. The accounting equation can be manipulated to encompass every type of element of financial
statements.
The simple accounting equation: Assets – Liabilities = Capital/Net Assets
Capital is also known as net assets and belongs to the owner. It is the amount the owner invested minus
any amounts that owners have taken out of the business (drawings) plus the profit made by the business.
Closing Capital = Total Capital Introduced – Drawings + Profits
• Closing capital is the capital at the end of the accounting year
• Total capital introduced is the capital at the start of the accounting year plus any additional capital
invested during the year
• Drawings and profits/losses are during the year
The formula below shows the expanded accounting equation once the above elements are included:

Key Point

Assets – Liabilities = Total Capital Introduced – Drawings + Income – Expense

Activity 7
Match the equation to the corresponding rearranged accounting equation.
Transaction Duality Statement

Assets Opening capital + Profit for the period − Drawings

Closing Net Assets Closing net assets − Opening net assets + Drawings

Opening Net Assets Capital + Liabilities

Closing Capital Assets − Capital

Liabilities Closing net assets − Profit for the period + Drawings

Profit for the period Closing capital

2.2.1 The Accounting Equation and Double Entries
A transaction recorded using double entries will always cause the Accounting Equation to balance. This is
due to the dual impact of Double Entry, where each transaction creates a Debit and Credit entry that equals.
The expanded accounting equation can be rearranged to show only positive signs:
Assets + Drawings + Expenses = Capital + Liabilities + Income
The positive elements on the right side of the formula increase with a debit entry, while the negative
elements on the left increase with a credit entry.

Category A debit entry will… A credit entry will…

Asset Increase an asset Decrease an asset
Liability Decrease a liability Increase a liability
Income Decrease income Increase income
Expense Increase an expense Decrease an expense
Capital Decrease capital Increase capital
Drawings Increase drawing Decrease drawing
Example 1
Yuma owns a business that makes and delivers handmade furniture to customers.
What is the effect of the transaction on the business and the double entry to record the
transaction?
1. She buys a vehicle for the business and pays $5,000 using funds from the bank.
The vehicle (Asset) increases by $5,000, and the bank (Asset) decreases by $5,000.
The double entry to record this is DR Vehicles $5,000 and CR Bank $5,000.
2. She obtains a loan of $2,000 from a friend.
The bank (Asset) increases by $2,000, and the loan (Liability) increases by $2,000.
The double entry to record this is DR Bank $2,000 and CR Loan $2,000.
3. She buys office furniture paying $500 cash.
The office furniture (Asset) increases by $500, and the bank (Asset) decreases by
$500. The double entry to record this is DR Office Furniture $500, and CR Bank $500.
4. She pays a supplier for chairs and a table bought on credit for $1,200 credit.
The payable (Liability) decreases by $1,200, and the bank (Asset) reduces by $1,200.
The double entry to record this is DR Payables $1,200 and CR Bank $1,200.
5. She purchases a batch of raw materials paying $800 cash.
The purchases (Expense) increase by $800, and the bank (Asset) decrease by $800.
The double entry to record this is DR Purchases $800 and CR Bank $800.
6. Yuma pays rent in cash of $2,000 for the year.
The rent (Expense) increases by $2,000, and the bank (Asset) decreases by $2,000.
The double entry to record this is DR Rent $2,000, and CR Bank $2,000.
Activity 8
What is the double entry to record the following transactions?
1. Starts the business by introducing cash.
2. Purchases some equipment for cash.
3. Pays a supplier for some equipment bought on credit.
4. Purchases goods for resale on credit.
5. Purchases goods for resale for cash.
6. Sells goods on credit.
7. Sells goods for cash.
CHAPTER 3: Visual Overview
CHAPTER 3: Visual Overview
Objective: To describe the objectives of the International Financial Reporting Standards Foundation and
its relationship with the development, scope and use of International Financial Reporting Standards (IFRS
Standards).
3.1.1 Introduction to the Regulatory Framework
1.1 Introduction to the Regulatory Framework
The financial statements display relevant information to internal and external users. The information
displayed will influence decisions that stakeholders may make about the future of a particular business.
Regulations are set in place for businesses to prepare their financial statements according to
standardised principles and rules so that users of financial statements can rely on the financial
information as fairly represented.
The issuance of International Financial Reporting Standards (IFRS) and guidance comes from the
International Accounting Standards Board (IASB), which the IFRS Foundation governs.
The governance structure of setting standards can be summarised in the diagram from the IFRS website
below.

The formation of accounting standards can be represented in a three-tier structure:

• Independent Standard-Setting and Related Activity
There are two independent standard-setting boards of experts:
o International Accounting Standards Board (IASB), whose role is to
develop and publish accounting standards. The Interpretations Committee works
closely with IASB to support the application of the standards.
o International Sustainability Standards Board (ISSB), whose role is to
develop a baseline of sustainability-related disclosure standards.
• Governance, Strategy and Oversight
The development of standards by IASB and ISSB is governed and overseen by Trustees
(IFRS Foundation Trustees). The IFRS Advisory Council provides advice and counsel to the
Trustees and the boards
• Public Accountability
The Trustees are accountable to a monitoring board of public authorities (IFRS Foundation
Monitoring Board).
These regulatory bodies do not have the power to force companies to comply with their
requirements. It is up to national accounting standard-setting bodies or regulators to adopt the standards,
and only then will they become enforceable in a country.
National bodies can do this in different ways, including:
• adopting IFRSs as standards for their own country
 • using IFRSs as a basis for developing their guidance
• developing their requirements but comparing them to IFRSs to determine if their standards
are sufficient.

3.1.2 IFRS Foundation – Trustees

1.2 IFRS Foundation – Trustees
The Trustee foundation is an independent body that oversees the International Accounting Standards
Board (IASB) and the International Sustainability Standards Board (ISSB).
The Trustees are accountable to the Monitoring Board, a body of publicly accountable market authorities.
The Trustees are not involved in any technical matters relating to IFRS Standards. This responsibility
rests solely with the boards.
The IFRS Foundation Trustees focus on the needs of emerging economies and small and medium-sized
entities. This includes profit and non-profit-making organisations such as charities.
Each Trustee member is expected to understand and is sensitive to international issues relevant to the
success of an international organisation responsible for developing high-quality global accounting and
sustainability disclosure standards for use in the world's capital markets and by other users.

3.1.3 International Accounting Standards Board (IASB)

1.3 International Accounting Standards Board (IASB)
Key Point

The Board is an independent group of experts with an appropriate mix of recent practical experience in setting
accounting standards, preparing, auditing, or using financial reports, and accounting education. Board members
are responsible for the development and publication of IFRS Standards.

The IASB is committed to developing, in the public interest, a single set of high-quality, understandable,
and enforceable global accounting standards (IFRS Standards) that require transparent and comparable
information in general-purpose financial reports.
The objective of general-purpose financial reports is to provide financial information about the reporting
entity that is useful to primary users (investors and creditors).
The Board is also responsible for approving interpretations of IFRSs that the IFRS Interpretations
Committee develops.

1.3.1 Constitution
According to the IFRS Foundation Constitution:
• The IASB Board will typically comprise 14 members whom the trustees appoint. The primary
qualifications are professional competence and recent relevant experience.
• The Board has:
o complete responsibility for all board technical matters, including the issue of IFRS
Standards (other than IFRIC Interpretations) and Exposure Drafts
o complete discretion in developing the technical agenda for standard setting
Publishing standards, exposure drafts and final interpretations require a “supermajority”.
3.1.4 International Sustainability Standards Board (ISSB)
1.4 International Sustainability Standards Board (ISSB)
International investors with global investment portfolios are increasingly calling for high-quality,
transparent, reliable and comparable reporting by companies on sustainability issues such as climate and
other environmental, social and governance (ESG) matters.
In September 2020, the IFRS Foundation Trustees published a consultation paper to determine whether
there is a need for international sustainability standards and whether the IFRS Foundation should play a
role in developing such standards.
As a result, the Trustees announced the creation of a new board (ISSB) in November 2021 to meet the
demand for sustainability standards.
ISSB’s role is to deliver comprehensive global sustainability-related disclosure standards that provide
investors and other capital market participants with information about companies’ sustainability-related
risks and opportunities.

3.1.5 IFRS Advisory Council (IFRSAC)

1.5 IFRS Advisory Council (IFRSAC)
The IFRS Advisory Council advises the IFRS Foundation Trustees and the standards-setting boards
(IASB and ISSB). Its members include investors, academics, auditors and members of local standard-
setting bodies.
The board consults the IFRSAC on their agenda, priorities, and issues related to the application and
implementation of IFRSs.
The Advisory Council comprises 30 or more members appointed by the trustees (for a renewable term of
three years).
• The council provides a forum for participation by other interested parties (e.g. the
Organisation for Economic Change and Development (OECD), the United States Financial
Accounting Standards Board (FASB) and the European Commission).
• Its primary responsibility is to advise the standards-setting board on agenda issues, work
priorities and the views of IFRS Advisory Council members on the development of standards
projects.

3.1.6 IFRS Interpretations Committee (IFRS IC)

1.6 IFRS Interpretations Committee (IFRS IC)
The IFRS IC reviews and provides guidance on issues arising when IFRSs have been implemented.
These include the different ways of accounting for different types of transactions, doubt about correct
accounting treatments or unclear disclosure requirements. The IFRS IC also provides guidance on issues
not addressed in IFRSs.
The IFRS Interpretations Committee (IFRS IC) is the interpretative body of the IASB. The trustees appoint
14 voting members and a non-voting chairperson.
The committee’s responsibilities include:
• interpreting the application of IFRS Standards
• Provide timely guidance on financial reporting issues not explicitly addressed in IFRS Standards.
It publishes draft interpretations for public comment and considers comments before finalising them. It
reports to the Board and obtains the Board’s approval for final interpretations.
 Key Point

The exam may question students on the roles of each body.

Activity 1

Match the accounting body to the correct example of work carried out.
Accounting body Activity

Providing a forum for a wide range of users to discuss

IFRS Foundation (IFRSF) IFRSs

International Accounting Standards Board Advising national authorities on the process for adopting
(IASB) IFRSs

IFRS Interpretations Committee (IFRS IC) Issuing a draft of a new IFRS

IFRS Advisory Council (IFRS AC) Advising on how a current IFRS should be applied

3.2.1 Global Accounting Standards

2.1 Global Accounting Standards

The International Accounting Standards Board (IASB) develops and publishes International Financial
Reporting Standards (IFRS). Each standard is created to cover a specific aspect of accounting.
• The term IFRS includes all standards and interpretations issued under the previous
constitution (IASC) that the Board has approved.
• International Accounting Standards (IASs) and Interpretations issued by the Standards
Interpretations Committee (SIC) that have been so approved continue to be applicable until
they are withdrawn.

3.2.2 Objectives
2.2 Objectives
IASB’s Mission Statement sets out its objectives: “To develop IFRS Standards that bring transparency,
accountability and efficiency to financial markets around the world. Our work serves the public interest by
fostering trust, growth and long-term financial stability”.
The goals of the IFRS Standards are to:
• bring transparency by enhancing the international comparability and quality of financial
information so investors can make informed economic decisions.
• strengthen accountability by reducing the information gap between the providers of capital
(investors) and those to whom they have entrusted their money (management).
If the investors are not involved in the day-to-day business, they will not have access to the
same information that managers have. Managers may exploit the differences in information
for their benefit. IFRS Standards provide information that is needed to hold management to
account.
 • contribute to economic efficiency by helping investors identify opportunities and risks
worldwide, improving capital allocation. (A single, trusted accounting language lowers the
cost of capital and reduces international reporting costs for businesses.)

3.2.3 Developing IFRS Standards

2.3 Developing IFRS Standards
2.3.1 Due Process
IFRS Standards are developed through a due process which ensures that standard setting is transparent
and considers a wide range of views from interested parties such as:
• accountants, financial analysts and other users of financial statements
• the business community
• stock exchanges
• regulatory and legal authorities
• academics
• other interested individuals and organisations throughout the world.
The Board consults the Advisory Council on significant projects, agenda decisions and work priorities and
discusses technical matters in meetings open to public observation.

2.3.2 Project Development

Due process for projects typically, but not necessarily, involves the following steps:
• Setting the Agenda
When deciding what standards to develop, the IASB focuses on the relevance of the
information to investors. It also looks at the availability of existing guidance and whether
publishing an IFRS will lead to adopting a common approach.
• Planning the Project
The IASB draws up a project plan. The board may develop the standard itself or with another
standard setter, for example, the US standard-setting body, Financial Accounting Standards
Board.
National accounting requirements and practices are studied, and the board exchanges views
about the issues with national standard setters. The board consults with the Advisory Council
about adding the topic to the Board's agenda, and an advisory group (working group) is
formed to advise the Board on the project.
• Developing and Publishing a Discussion Paper
A discussion paper is developed and published for public comment (also called a discussion
document). The discussion paper gives an overview of the issues, such as a summary of
possible approaches and the initial views of the authors.
A discussion paper must be approved by a majority of the Board’s members.
• Developing and Publishing an Exposure Draft
• After considering comments and dissenting opinions (alternative views) received, an exposure draft is
developed. The draft is then published again for public comment. The IASB may publish a second
exposure draft if comments identify significant issues.
An exposure draft must be approved by a supermajority of the Board:M
o Nine of the 14 members or
o Eight if there are 13 or fewer members
• Developing and Publishing an IFRS
After the IASB has considered all the comments received and is satisfied that it has
addressed all the points raised during the consultation process, it drafts the final version of
the IFRS. IASB then has the final draft externally reviewed and obtains approval from its
members that it should be published.
 • Procedures after an IFRS is issued
After publication, the IASB may discuss with interested parties any unforeseen issues that
have happened because of the IFRS being applied. In time, the IASB may formally review the
standard if, for example, the financial reporting and legal environment have changed.
Useful Information

IFRSs used to be called International Accounting Standards (IASs), and several IASs are still in force
because there has not been a need to update them.
In many countries, there is a collection of commonly followed accounting rules, legal requirements and
standards for financial reporting referred to as the local GAAP (generally accepted accounting
practice).

3.2.4 Scope and Application

2.4 Scope and Application

IFRS Standards apply to published financial statements of any commercial, industrial or business
reporting entity (whether public or private sector).
• They apply to separate and consolidated financial statements (where applicable).
• Any limitation on the applicability of specific standards is made clear in an IFRS.
• A standard applies from a date specified in the standard and is not retroactive (unless stated
otherwise).
• Exclusions where IFRS Standards are not required to be applied:
o Non-business aspects of public sector entities.
o Private sector not-for-profit (NFP) entities.

3.2.5 Advantages and Disadvantages of IFRS Standards

2.5 Advantages and Disadvantages of IFRS Standards
The advantages of using IFRS in preparing financial statements of a business include:
• Comparisons between businesses in different countries also using IFRSs will be easier.
• Foreign investors may trust financial statements prepared in compliance with IFRSs, meaning
that companies find it easier to raise money from abroad.
• Companies operating in several countries can use IFRSs as a shared basis for preparing
their financial statements.
• National authorities can adopt IFRSs as ready-made requirements without developing their
guidance.
• Other organisations that operate internationally, for example, accountancy firms, will find it
easier to deal with a common set of standards.
The disadvantages of using IFRS in preparing financial statements of a business include:
• There will be costs involved in adopting IFRSs for the first time.
• IFRSs may not be as rigorous as national guidance in some areas.
• Adopting IFRSs may be challenging in some countries because some of its requirements
may conflict with local law.
3.3.1 Introduction to Corporate Governance
3.1 Introduction to Corporate Governance
3.1.1 Global Definitions
The Organisation for Economic Cooperation and Development (OECD) defines corporate governance as:
"The system by which business corporations are directed and controlled. The corporate
governance structure specifies the distribution of rights and responsibilities among different participants in
the corporation and spells out the rules and procedures for making decisions on corporate affairs. It also
provides the structure through which the company objectives are set, and the means of attaining those
objectives and monitoring performance."
The Australian Securities Exchange defines corporate governance as:
"The system by which companies are directed and managed. It influences how the objectives of the
company are set and achieved, how risk is monitored and assessed, and how performance is optimised.
Good corporate governance structures encourage companies to create value (through entrepreneurism,
innovation, development and exploration) and provide accountability and control systems commensurate
with the risks involved."

3.2.1 Concept of Corporate Governance

Corporate governance is a set of rules intended to create transparency and protect the interests of
shareholders and stakeholders. It sets to prescribe the roles and responsibilities of directors as the
stewards of the company, which helps align the directors' interests with that of the shareholders.
The way corporate governance operates will vary significantly between companies. In some companies,
the owner will own all the shares or a great majority of them, and corporate governance procedures will
be simple. In other companies, no single party holds a majority of shares, but some financial institutions
may have significant shareholdings.
Corporate governance mechanisms are needed to ensure that companies not only take account of the
views of powerful shareholders with more considerable shareholdings but also act in the interests of
shareholders owning a smaller proportion of shares.
The concept of corporate governance revolves around these three aspects:
• Risk Management
A company’s management must manage the level of risk the business faces and refrain from
making decisions that will create uncontrollable risk. The management should also disclose
to its stakeholders the existence and standing of faced risk in the financial statements.
Companies should maintain sound internal control systems to manage their risk levels.
For example, a company having repeatedly breached lending covenants would be on the
verge of having its borrowing facilities withdrawn. This constitutes poor risk management as
such actions would affect its ability to trade.
• Quality of Information
The company’s management should ensure that proper accounting and information systems
are in place to produce reliable financial statements. Information provided should be relevant,
timely, accurate and represent a true and fair view of the company's position.
For example, a company investing in accounting software to streamline its trading activities
ensures that information is accurate and produced on time. The company employs proper
corporate governance as the quality of information is secured.
• Stewardship
A company’s management should be open and transparent and present critical decisions on
the business's performance. They should also explain the overall strategy and their intentions
for the future so that investors can decide whether these align with their expectations.
 For example, a company portrays stewardship by providing financial information on how it
has performed over the year and the strength of its asset base.

3.3.2 Corporate Governance and Financial Statements

3.2 Corporate Governance and Financial Statements
The UK Corporate Governance Code (which applies to all listed companies but is also considered best
practice for unlisted companies and non-corporate entities) states that:
• The board of directors must:
o present a balanced and understandable assessment of the company's position
by issuing a set of financial statements
o maintain a sound system of internal control concerning risk management
• An audit committee (consisting of at least three independent non-executive directors) must:
o monitor the integrity of the financial statements
o review the internal controls and risk management systems
o monitor the internal and external auditors.

3.2.1 Duties and Responsibilities of Directors

The directors of a company have a fiduciary duty to act in good faith on behalf of the company. A
business’s directors are responsible for preparing the financial statements, ensuring appropriate
accounting systems are in place and keeping proper records.
Concerning financial statements, a company's board of directors is collectively responsible for their:
• preparation every financial year to show a “true and fair view.”
• presentation to and approval by the shareholders.
To satisfy this responsibility, the directors should:
• Only approve the financial statements if they are satisfied that the financial statements give a true and
fair view of the assets, liabilities, financial position and profit or loss
• State in the financial statements that the responsibility of preparing them lies with the directors
• Consider the appropriateness of their use of going concern principles and convey the message in the
financial documents
• Explain the company’s business model and its strategy for delivering the objectives of the company in
the financial statements
• Ensure that the financial statements are prepared per the form and content as prescribed by law and
GAAP (e.g. IFRS)
• Ensure that adequate accounting records are kept from which the financial statements are prepared.
The accounting records must be adequate to:
o show and explain the company's transactions
o disclose the company's financial position with reasonable accuracy
o prepare accounts which comply with the appropriate legal requirements
o show day-to-day entries of all sums of money received and paid (and the matters
in respect of which the receipts and payments take place)
o record the company's assets and liabilities
• Ensure that the financial statements are filed according to law. (For example, in the UK, public
companies must file the financial statements with Companies House within six months after the
reporting date.)
Other responsibilities of the directors of an organisation include:
• Prevention of Fraud – They have a duty to prevent and detect fraud. This goes beyond the financial
statements, although misstatements may be made for fraudulent reasons.
• Cooperate with Auditors - Directors should cooperate with the company's auditors and not collude,
mislead or deceive them. They must provide the auditors with the information and explanations they
need to conduct their audit.
In reviewing the financial statements, the external auditor should clearly state its independent
position and ensure no conflict of interest is evident.
 Key Point

The fiduciary duties of directors concerning the financial statements are explicitly stated in the company law of most
jurisdictions.

3.3.3 Audit Committee Responsibilities

3.3 Audit Committee Responsibilities
An audit committee is a branch of a business’s board of directors that takes charge of a company’s
financial reporting responsibilities and ensures internal controls are kept in place.
The responsibilities of the audit committee in a business include:
• Ensuring that the interests of shareholders are adequately protected concerning financial reporting and
internal control.
• Monitoring the integrity of the financial statements and announcements relating to the company’s
financial performance, including review of the significant financial reporting judgments made.
• Reviewing the company’s internal control, internal financial controls and risk management systems.
• Monitoring and reviewing the effectiveness of the internal audit function.
• Reviewing and monitoring the external auditor’s independence and objectivity and the effectiveness of
the audit process.
Activity 2
State whether the following statements about governance guidance are true or false.
1. The auditors act as the directors’ agents when they audit the financial statements.
2. Under corporate governance best practice, both directors and auditors should state their responsibilities
in the financial statements.
3. The auditors should state that the financial statements have been prepared on a going-concern basis.
4. To comply with the requirements of IFRSs, the directors should explain their strategy for delivering the
company’s objectives.

3.3.4 Ethics and Governance

3.4 Ethics and Governance
As well as being based on legal requirements, corporate governance is founded on a series of ethical
concepts.

3.4.1 ACCA’s Code of Ethics and Conduct

The ACCA Code of Ethics and Conduct is binding on all ACCA members, students, and partners in an
ACCA practice. The ethical concepts that apply to the preparation of accounting information are:
• Integrity
The Cadbury report on governance stressed that the integrity of reports depends on the
integrity of those who prepare the reports. Integrity is about being straightforward. It means
reporting financial information honestly, not misleading the users of financial statements, and
producing a balanced picture of the company’s affairs.
• Objectivity
In preparing financial statements, accountants should be unbiased when they make
judgements about what should be included in them. They should not be influenced by their
self-interest or pressures from others towards distorting the financial statements.
• Professional Competence and Due Care
Accountants preparing or reviewing financial statements must have sufficient knowledge to
do so properly. They also need to carry out their work carefully, avoiding errors.
• Professional Behaviour
 Professional behaviour includes compliance with the laws and standards related to financial
statements. It also has a broader meaning: avoiding behaving in a way that could generally
damage the accounting profession’s reputation.
• Confidentiality
Confidentiality means respecting the confidential nature of information acquired through
professional relationships. Confidential information should not be disclosed unless there is
specific permission or a legal or professional duty.
Scenario Walkthrough 1
Let’s discuss a famous business scandal where the accounting practices that the company used were
a significant issue.
Background
Enron was a massive energy sector company based in America and operating globally. It bought and
sold energy and controlled operating facilities. It stated that it aimed to transform the energy sector.
Instead, Enron collapsed in 2001 and is now best remembered as one of the biggest company
scandals in history. It also destroyed the major accountancy firm, Arthur Andersen, which was Enron’s
external auditor.
Enron’s collapse resulted in the development of the Sarbanes–Oxley Act, an essential set of laws on
corporate governance applicable to companies which report in the United States.
What happened
A significant element in the Enron scandal was its accounting policies. Enron also had other accounting
problems that internal accounting documents revealed. These included:
• Enron used connected businesses to hold assets and liabilities (particularly debt). Under the
accounting rules operating in the US, Enron did not need to show these businesses in its main
financial statements.
• Enron used its shares and not cash to fund businesses, which caused problems when the share
price of Enron began to fall.
• Enron immediately included income in the financial statements on contracts due to last for many
years. It also timed transactions so that they were accounted for at the end of a period to boost
earnings.
• Enron also hid what was happening through various trading activities, including using financial
instruments known as derivatives. Derivatives are a type of financial instrument that derives its value
from the underlying asset.
Issues of Corporate Governance and Ethics
There was a lack of transparency between the company’s management and shareholders. Enron’s
financial statements showed an incomplete picture of the company’s affairs.
There was a lack of integrity as business arrangements were made to deceive investors and others
about the actual happenings at Enron. Directors were more concerned with protecting their position
than what was best for the company, showing a lack of objectivity in decision-making.
Rules-based framework not sufficient?
What happened at Enron showed the weakness of relying on accounting standards based on specific
rules rather than guiding principles. What Enron did may not have breached the rules, but it seriously
misled investors and the stock market. Good ethical practices need to be adopted by the people
running the company, who are the directors.
Enron encouraged employees to buy its shares. As a result, many employees suffered substantial
financial losses. However, several senior managers sold their shares when the company was about to
collapse.
All staff have a responsibility to act ethically, whatever their role. Enron set stringent performance
targets, and employees who failed to meet them were sacked. This encouraged staff to focus on
reporting that they met targets even if they had not met them.
 Independence in Financial Reporting
Independence is emphasised because a company’s affairs and management must be effectively
scrutinised. Some directors, known as non-executive directors, are not involved with the company full-
time but monitor the behaviour of the executive directors who run the company daily.
The non-executive directors at Enron were condemned for being ineffective and not challenging how
the executive directors ran the company. Some non-executive directors had personal interests, which
conflicted with their role of holding the executive directors to account.
Enron’s auditor, Arthur Andersen, was responsible for reporting problems with the financial statements.
Instead, they went along with the accounting treatments that Enron used as they did not want to risk
losing a large amount of fee income from Enron.

Exam advice

Whilst ethics and specific events, such as the Enron scandal, are not examinable, students must follow ACCA’s
Code of Ethics and Conduct throughout their professional work.

3.4.1 Introduction to the Conceptual Framework

4.1 Introduction to the Conceptual Framework
If the financial statements are to be useful to interested readers, the information contained in the financial
statements should be reliable and of high quality.
This means the information must have specific characteristics and be prepared using certain
assumptions. The conceptual framework guides these characteristics and assumptions.

4.1.1 Conceptual Framework Definition and Purpose

The conceptual framework is a statement of generally accepted assumptions and principles that provides
a frame of reference for developing new practices and evaluating existing ones.
The purpose of the Conceptual Framework for Financial Reporting (Conceptual Framework) is to assist:
• the IASB (Board) in developing IFRS standards
• the preparers of financial statements in developing consistent accounting policies
• all parties to understand and interpret the standards.
The Conceptual Framework is not a standard. Therefore, nothing in the Conceptual Framework can
override a specific IFRS.

3.4.2 Qualitative Characteristics of Financial Information

4.2 Qualitative Characteristics of Financial Information
The Conceptual Framework for Financial Reporting identifies two fundamental qualitative characteristics
and four enhancing qualitative characteristics relating to useful financial information.
The fundamental qualitative characteristics of useful financial information are:
• Relevance
• Faithful Representation
The Conceptual Framework also provides four enhancing qualitative characteristics of useful financial
information are:
• Comparability
• Verifiability
 • Timeliness
• Understandability

4.2.1 Relevance
Relevant information is information that is capable of influencing the decisions of users. For financial
information to be relevant, one or both things must apply:
• The information needs to help the user form a view about what will happen to the business in the future
• the information confirms what has happened in the past.
Relevant information can be affected by its:
• Nature
Some items may be relevant to users simply because of their nature. For example, if a
director has borrowed money from the company, the transaction must always be disclosed,
even if the amount is small.
• Materiality
Information is material if its omission or misstatement could influence primary users’
decisions based on the financial information about the specific reporting entity.

4.2.2 Faithful Representation

Faithful representation means the financial statements describe financial events and conditions fairly in
words and numbers. The information given should be:
• Complete (within bounds of materiality and cost) – Information reported should be complete as an
omission can cause financial statements to be false or misleading and, therefore, unreliable.
• Neutral (free from bias)
• Free from error (no errors or omissions)
Faithful representation also means presenting the substance (the commercial effect) of an economic
phenomenon rather than its legal form.
Useful Advice

Suppose the validity and amount of a claim for damages under a legal action were disputed. In that
case, it may be inappropriate to recognise the total amount of the claim in the statement of financial
position as a liability.
To faithfully represent the situation, it may be appropriate to disclose the amount and circumstances of
the claim.

4.2.3 Comparability
Comparability means users should be able to make comparisons between information:
• about the same business in different periods
• between different businesses in the same period
Comparability requires consistent measurement and classification, and presentation of the financial
effects of similar transactions and events.
Comparability does not always mean using the same methods to prepare information. Comparability
implies that users must be informed (in the notes to the financial statements) of the principal accounting
policies used, any changes to them and the effects of such changes.
Accounting policies – the specific principles, bases, conventions, rules and practices adopted by an entity
in preparing and presenting financial statements.
Another implication of comparability is that financial statements must show corresponding information
for preceding periods. In the financial statements of a business, another column of figures is present to
show the financial information of the preceding year.

4.2.4 Verifiability
Verifiability means giving financial statements users confirmation that their financial information is
faithfully represented.
Verifiability means that knowledgeable, independent observers can reach a consensus that a particular
representation has the fundamental quality of faithfulness.

4.2.5 Timeliness
Timeliness links to relevance. For information to influence users’ decisions, it must be available when
users make their decisions. However, other aspects may be affected if the information is reported quickly.
For example, the information may not be complete and may have been prepared so fast that it is more
likely to contain errors.
Information needs to be available in time for users to make decisions. Older information is generally less
useful (but may still be useful in identifying and assessing trends).

4.2.6 Understandability
Understandability means showing information clearly and concisely. Some items in the financial
statements are complicated. However, if they are omitted, the statements will be incomplete.
Understandability also assumes that the users of the financial statements have some accounting
knowledge.
Financial information should be made understandable through clear and concise classification and
presentation.
• Users are assumed to have a reasonable knowledge of business and economic activities and
accounting and a willingness to study information with reasonable diligence.
• Information about complex matters should not be excluded because it may be too difficult for certain
users to understand.
Activity 3
Match the characteristics of good accounting information to the list of actions that preparers or
users of financial information would take to ensure it displays those characteristics.
Action Characteristic

Shareholders have been asked if there is anything in the annual financial statements
that confuses them, and they have said everything is clear. Relevance

The auditors have completed their audit work and have found that the accounting Faithful
records support the financial statements. Representation

Management checks information before publication to ensure it is all correct and does
not miss anything. Comparable

Financial advisers use financial information to see how the company is doing compared
to other companies and to advise their clients. Verifiable
 Investors use financial information to judge a company’s prospects and decide whether
to continue to invest in the company. Timeliness

The accounts department prepares financial information covering an accounting period

within two weeks of the end of the period. Understandable

3.5.1 Accounting Principles

5.1 Accounting Principles
Accounting principles are the fundamental concepts accountants use to prepare financial statements.
Standard-setting boards consider these principles when developing new frameworks and financial
standards.

5.1.1 Materiality
The item’s nature and size are evaluated when determining whether the information is material. If the
item’s non-disclosure could influence the economic decisions of users based on the financial statements,
it is material.
Each material item should be presented separately in the financial statements. At the same time,
immaterial amounts of a similar nature or function should be aggregated and need not be presented
separately.

5.1.2 Offsetting
An entity shall not offset assets and liabilities or income and expenses unless required or permitted by an
IFRS.
An organisation should report assets, liabilities, income and expenses separately. Offsetting between
these elements in the financial statements is not allowed unless the offsetting reflects the substance of
the transaction.

5.1.3 Consistency
Consistency is needed to achieve comparability. It means treating and consistently presenting similar
items in the financial statements over different periods unless there are appropriate reasons to make a
change.
Reasons for change in the treatment of similar items could be due to the following:
• a significant change in its operations or
• if another classification provides a more suitable presentation of its transaction.
• Required by a new IFRS standard
Changes in accounting policies need to be disclosed in the notes of financial statements.

5.1.4 Prudence
Prudence is the exercise of caution when making judgements under conditions of uncertainty. In
preparing a business’s financial statements, assets and income should not be overstated, while liabilities
and expenses should not be understated.
The main problem with exercising prudence is that it may result in the understatement of assets (and
income) and the overstatement of liabilities (and expenses).
However, this is not allowed as this would conflict with the qualitative characteristic of faithful
representation. Such misstatements would also lead to misstatements in future periods.
5.1.5 Duality (dual aspect)
Also known as the dual effect or dual aspect, the double entry concept explains that every transaction has
at least two impacts on a business, a debit and credit entry.

5.1.6 Historical Cost and Current Value

The historical cost concept states that all transactions are initially recorded at historical cost, which is
the cost at the time of the transaction. The historical cost system of accounting is particularly relevant to
Assets.
Current value measures provide monetary information about assets, liabilities and related income and
expenses, using information updated to reflect conditions at the measurement date.
Some bases of current value include:
• Fair value (price on an active market, or present value of future cashflows)
• Value-in-use (value derived from use of the asset)
• Current cost (value of an equivalent asset on measurement date)

5.1.7 Substance over Form

Substance over form is part of faithful representation. It means that the treatment of items in a company’s
financial statements should be determined by their commercial reality and not by how they could be
treated for legal purposes.
The concept is particularly relevant to assess:
• whether the definition of an element is met
• management’s assertions that elements of financial statements are complete, valid and accurate.
In most circumstances, substance and legal form are the same. If they are not, information about the
legal form alone would not faithfully represent the economic substance. For example:
• A legal sale of an item of equipment may, in substance, be a lease.
• Sales to a customer may be paid for using the proceeds of a loan to the customer. When the
transactions are considered together, the sale may be without substance.
• A sale of goods or services to a customer is made in exchange for purchasing a similar value of goods
or services from the customer.
Whether the substance of a transaction should prevail over its legal form is a complex deliberation and
depends on each transaction's circumstances.

3.5.2 Basis of Financial Statements Preparation

5.2 Basis of Financial Statements Preparation
The financial statements are prepared by the management (directors) of a company with these three
basic assumptions:
• The business is a going concern.
Going concern assumes that an entity will continue operating for the foreseeable future (the
next 12 months). During that time, the company directors do not intend or will not be forced to
liquidate the business or cease trading.
Going concern underlies the basis of the preparation of all published financial statements. It
is so fundamental that users are entitled to assume that this basis has been applied unless
an alternative basis is stated (in the notes to the financial statements).
• Accruals basis – The financial statements cover all transactions and events in the stated accounting
period.
Transactions and events are recognised in a company’s accounting records when they
happen and are not based on cash settlement.
 The transactions or events will be included in the financial statements for the period they
apply to. This may result in year-end accruals that are included within current liabilities in the
financial statements.
The accruals basis links to the matching concept that expenses are recognised in the same
accounting period as the revenues they relate to.
• Business Entity – The contents of the financial statement relate to the business.
The business is a separate entity from its owners/shareholders. The financial statements
should only include transactions that relate to the business and not transactions that relate to
the shareholders' personal interests.
The business entity concept is an accounting concept, not a legal concept. Therefore, it
applies to sole traders and partnerships even though the business and the owners are not
legally distinct.
Activity 4
For each statement below, comment if it is true or false.
1. The materiality concept states that omitting or misstating information may influence the decisions of
users of financial statements.
2. The accruals basis states that transactions should be accounted for when they are settled by cash.
3. Sarah is a sole trader. She has recently bought a car, which she does not use when on business. She
has paid for the car through her business's bank account and included the car as an asset in the
business's financial statements. This is a violation of the business entity concept.
4. The going concern concept implies that the business will continue operation for the longer term, at least
the next five years.
5. Substance over form means that an accountant will account for a transaction according to its legal
substance.
6. Consistency means that the same items must always be treated in the same way in the financial
statements over different periods.
7. The application of prudence means expenses should consistently be recognised if there is any
likelihood of them occurring, but accountants should be more cautious about recognising income.
CHAPTER 4: Visual Overview
Objective: To illustrate data sources and the maintenance of accounting records in a typical
accounting system.

4.1.1 Flow of Accounting Information

1.1 Flow of Accounting Information
The eventual goal of accounting is to present fairly and accurately all financial transactions in the
financial statements.
The process starts with recording all business transactions with information available in the financial
documents and classifying them into the relevant ledger accounts through computerised systems or
journals. At year-end, balances of each ledger account form the trial balance, which is used as a
basis to prepare the financial statements.
Information from business transactions travels through the accounting system, which eventually
forms the financial statements.

Exam Information

The FA/FFA exam will assume the use of computerised accounting systems, as follows:
• Sales and purchases systems (modules) will be integrated into the accounting system. This
means that any sales invoices produced within the sales module will automatically be
recognised in the Trade receivables ledger and the individual customer account, and purchase
invoices entered into the purchases system will be automatically posted to the Trade payable
ledger and the individual supplier accounts.
• It will be assumed that manual journal entries would be required to the general ledger in
respect of acquisitions and disposals of non-current assets.
• Recording of bank and cash transactions will also be manual processes for both cash
purchases and sales, payments to suppliers and receipts from customers.
• Payroll is a manual process, meaning that journal will need to be manually entered into the
general ledger weekly or monthly in respect of wages and salaries.
 Exam Information

• Inventory systems may be manual or integrated. If they are integrated, then it is assumed that
inventory levels are automatically checked before sales or purchase orders are made, and
inventory movements inwards will be updated automatically to the general ledger purchases
accounts. However, manual journals would be required in both manual and integrated inventory
systems to transfer purchases to cost of sales and to record opening and closing inventory in
the cost of sales.
• Filing and archiving will be held electronically.

• Business Transactions
Business transactions are the business’s day-to-day activities that have a monetary value. For a
business to operate, it needs to generate income by making sales and incur expenses such as
purchases and overheads.
• Financial or Source Documents
A financial document is produced for each business transaction to record information about
individual transactions.
Sales, purchases, cash payments and receipts are business transactions. Their corresponding
documents are the sales invoice, purchase invoices, cheque stubs and remittance advice,
respectively.
Financial documents in a computerised system may be automatically generated as transactions are
processed; controls will be implemented that make the source document's creation, distribution, and
authorisation mandatory before any transaction is recorded.
•General Ledgers
The general ledger contains all the individual ledger accounts used by a business.
Information from the source documents is classified into their respective ledger accounts using
double entries via computerised systems and the Journal. The general ledger contains individual
accounts for the business’s assets, liabilities, capital, income and expenses.
For example, information on a sales invoice is posted into the Sales ledger and Cash or Trade
Receivables account using double entries.
• Trial Balance
Each ledger account balance is closed off, and the account balance flows to the trial balance. The
trial balance is a list of each ledger account’s closing balances. An accountant prepares the trial
balance periodically, usually once during year-end.
If the information entered into the ledgers conforms to the fundamentals of double entry, the trial
balance should have equal debit and credit balances. The trial balance is investigated to ensure no
errors have occurred in recording the transactions.
• Financial Statements
Each ledger account balance in the trial balance is totalled and summarised into financial statement
categories: assets, liabilities, capital, income or expenses.
The statement of financial position provides an overview of a business’s assets, liabilities, and
capital at the financial year-end.
The statement of profit or loss summarises a business’s income and expenses during the financial
year. The profit or loss is the net of the business’s income and expenses.
• Detailed customer and supplier balances
Detailed customer and supplier accounts can be produced from the sales and purchases modules.
These typically show all outstanding invoices, and may also show earlier invoices matched to
payment transactions.
The total of all the customer balances should be the same as the total in the Trade receivables
balance in the general ledger. Similarly, the totals of all the supplier balances should be the same
as the Trade payables account in the general ledger. Sometimes the totals in the detailed reports
may not equal the balances in the general ledger, and if this is the case, it will be necessary to find
the reasons for the differences. If there is an assumption that the sales and purchase modules are
integrated with the general ledger, then all invoices and credit note should automatically be posted
to the individual customer accounts, so the only reason for any difference would relate to payments,
as these are updated manually to both the general ledger accounts, and the individual customer/
supplier accounts. It is therefore possible that payments could be omitted (e.g. posted in the general
ledger but not the individual accounts, or vice versa.

4.2.1 Types of Business Transactions

2.1 Types of Business Transactions
Business transactions are the business’s day-to-day activities that have monetary value and will
need to be recorded in the accounting records.
The main types of business transactions are:
• Sales
Sales are the exchange of goods or services for money. These may be for cash or credit.
Cash sales are made in exchange for immediate cash payment, while credit sales are
made with a promise of payment to the business in the future.
• Sale Returns
Sales returns are faulty or incorrect goods returned from a customer due to faulty or
damaged goods being supplied.
• Purchases
Purchases are the exchange of money for goods or services. Cash purchases are made
in exchange for an immediate cash payment, while credit purchases are made with a
promise to pay the supplier in the future.
• Purchase Returns
Purchase returns are faulty or incorrect goods sent back to the supplier due to faulty or
damaged goods being supplied.
• Payments
Payments are the settlement or transfer of money to a third party
• Receipts
Receipts are due to the business receiving money from a third party
All financial transactions must have a valid financial document with details of the transaction. For
example, a sales transaction is recorded using an invoice.
Activity 1
Determine whether the statement is True or False.
1. An example of a credit purchase would be when the business pays the supplier on the delivery of
the goods.
2. An example of a cash sale would be when the business delivers goods to the customer and is
paid immediately.
3. Sums of money paid to a supplier in exchange for the receipt of goods are called 'payments'.
4. Goods delivered to a customer but then returned to the supplier would be sales returns for the
supplier.

4.2.2 Types of Financial Documents

2.2 Types of Financial Documents
Bookkeepers record business transactions based on supporting financial documentation. Financial
documents (or source documents) provide evidence of the existence of financial transactions.
• Quotation is a document sent by the seller with details of the price for each item. The quotation
highlights the quantity, description and price of the purchase required.
• Purchase Order is a document completed by the customer and sent to the supplier, highlighting
the items they want to order.
The purchase order contains the supplier’s name and address, a unique reference
number, the quantity and the description of the purchase. The business may also include
its terms and conditions regarding payment and the person responsible for placing the
order.
• Sales Order is an internal document generated to process a customer order after receiving it. It
essentially translates the format of the purchase order received to the format used by the
business (seller).
The sales order contains the customer’s name and address, the quantity and descriptions
of the required products. There may also be notes specific to the order, including terms
specified by the customer.
• Delivery Note or Goods Despatched Note is a document that accompanies the delivered
goods. The customer signs the delivery note to confirm proof of delivery when the goods are
delivered. The supplier also checks that the correct goods are being sent.
The goods despatched note contains the business's name, address, quantity and
description of goods being delivered.
• Goods Received Note (GRN) is an internal document completed by the customer to ensure
everything ordered has been received. The GRN lists the quantity and description of the goods
received.
• Sales invoice is a document sent to customers with details of the items purchased on credit.
Details include the date, quantity, price, and parties involved.
A sales invoice contains the seller’s and buyer’s name and address, as well as the
quantity, price, total value and sales tax on the sale. The seller’s payment terms will also
be stated.
• Purchase invoice is a document received from suppliers with details of the items purchased on
credit. Details include the date, quantity, price, and parties involved.
• A purchase invoice contains the seller’s and buyer’s name and address, as well as the quantity,
price, total value and sales tax on the sale. The seller’s payment terms will also be stated.
 • Credit Note is a document issued by the supplier to reduce the value of the previously issued
invoice due to faulty or damaged goods being supplied.
A credit note contains the supplier’s and customer's name and address, as well as the
quantity, price, total value and sales tax on the returned sale.
• Debit Note is a document issued by the customer to the supplier to request a credit note.
The debit note contains the customer’s and supplier’s name and address, the details of
the goods returned (quantity, price, total value and sales tax) and the reason for the
return.
• Statement of Account is a document sent by a supplier to a customer with details of all
transactions between the parties. The statement also highlights the balance owed to the supplier
at the end of the month.
A statement of account contains the seller's and customer's name and address, invoice
numbers, outstanding amounts, and payments received. Credit note numbers and values
would also be included.
The statement of accounts’ primary purpose is to support reconcilliation of the payables
ledger.
• Remittance Advice is a document sent to the supplier to show that payment has been made.
The remittance advice contains the method of payment, such as an enclosed cheque or a
direct bank transfer, and details of the invoices covered.
• Receipt is a document issued by the business to the customer to confirm that a payment has
been received that pays any outstanding invoices.
A receipt contains the business's and customer's name and address, the amount paid by
the customer and a list of the invoice numbers that have been paid.
Key Point

Source documents can be created and issued electronically through automated processes, with
the necessary fields populated from the accounting system’s databases.
The only process requiring human intervention would be the necessary authorisations to approve
the transaction. The authorisation may be applied digitally.

Activity 2
Katrod Co is a business that sells shoes directly to customers. It has some shoes which customers
can personalise, so there is no standard list price. Sales documentation is essential as it allows
Katrod Co to have accurate financial records about the volume and value of its sales.
Name the financial document associated with the activity.
Documents:
• Purchase order
• Goods despatched note
• Receipt
• Customer statement
• Quotation
• Credit note
• Sales invoice
Activity:
Katrod Co sends this to a customer who has unpaid invoices.
Katrod Co's customer sends this as confirmation of the intended purchase.
Katrod Co sends this to a customer. It provides a fixed price for the sale of some personalised
shoes.
Katrod Co issued this to the customer when she returned a pair of shoes.
Katrod Co issues this to the customer to confirm that their payment has been received.
Katrod Co issues this to the customer after delivery confirmation; It requests payment.
Katrod Co sends this to its customer with a delivery; It states there are three pairs of trainers.
Activity 3
Kathod Co needs to buy components and materials from its suppliers. It is essential that its data
and documentation are updated, or it will not be able to make its shoes on time.
Match the purchase activity to the correct financial document.
Financial
Purchase Activity Document

Katrod Co sent this document to its supplier when paying the outstanding invoices
at the end of the month. Purchase Invoice

Katrod Co sent this document to its supplier to request a purchase of a batch of

shoelaces. Purchase Order

Katrod Co's supplier issues this document requesting payment as soon as the Goods Received
delivery of the shoelaces has been confirmed. Note

Katrod Co’s supplier issues this document if the shoelaces are returned to the Remittance
supplier. Advice

Katrod Co's warehouse produces this document upon receipt of the shoelaces to
check against the original order. Credit Note

4.3.1 Purpose of General Ledgers

3.1 Purpose of General Ledgers
Most users of financial statements do not require the detail of every transaction that large
businesses will encounter daily. Therefore, the financial information of each transaction should be
summarised before completing the final accounts.
Information from the source document is classified into their respective ledger accounts using
double entries via computerised systems or the Journal.
The general ledger contains individual accounts for the business’s assets, liabilities, capital, income
and expenses. For example, information on a sales invoice is posted into the Sales ledger and
Cash or Trade Receivables account.
The general ledger contains all the individual ledger accounts used by a business.

3.1.1 T-Accounts
The individual ledger accounts within the general ledger are called T-accounts, as it is a graphical
representation of a ledger account.

4.3.2 Main General Ledger Accounts

3.2 Main General Ledger Accounts
3.2.1 Statement of Financial Position Accounts
Statement of financial position accounts are those used for recording assets, liabilities and capital
transactions. These accounts are included in the Statement of Financial Position:
Examples of statement of financial position ledger accounts are:
• Trade Receivables – This asset ledger account records sales made where the settlement has
not been received. A debit entry into the Trade Receivables ledger increases its balance.
 Credit sales increase the trade receivables balance, while payment received from credit
customers reduces its balance.
• Cash/Bank – This asset ledger account records the business’s cash movements. A debit entry
into the Cash/Bank ledger increases its balance.
Receipts from customers increase the Cash/Bank balance, while payments to suppliers or
expenses reduce its balance.
• Trade Payables – This liability account records purchases that have been incurred but not yet
paid. A credit entry into the Trade Payables ledger increases its balance.
Credit purchases increase the trade payables balance, while payment to credit suppliers reduces its
balance.

Asset and liability a/c

A DEBIT entry represents A CREDIT entry represents

1 an INCREASE in a ASSET; or 1 an INCREASE in a LIABILITY; or

2 a DECREASE in a LIABILITY. 2 a DECREASE in an ASSET.

2.2.2 Income and Expenditure Accounts

Income and expenditure (expense) accounts record the transactions determining profit (or loss) for
a period.
Examples of income and expenditure ledger accounts are:
• Sales – This income ledger account records the business’s cash or credit sales. A credit entry
into the Sales ledger increases its balance.
Sales generated by the business increase the Sales balance. A sales return transaction
reduces the Sales account balance if no separate Sales Return ledger is maintained.
• Expenses – This expense ledger account records the business’s purchases and expenditures. A
debit entry into the Expenses ledger increases its balance.
Purchases or expenditure incurred by the business increases the Expense account. A
purchase return transaction reduces the Expenses ledger balance if no separate
Purchase Returns ledger is maintained.

Income and expenditure a/c

A DEBIT entry represents A CREDIT entry represents

1 an INCREASE in EXPENSE; or 1 an INCREASE in a INCOME; or

2 a DECREASE in a INCOME. 2 a DECREASE in an EXPENSE.

4.3.3 Closing Off Ledger Balances
3.3 Closing Off Ledger Balances
Balancing the accounts is the first step in ensuring that the double entries have been recorded
correctly.
• To balance an account means to put in a balancing figure (balance c/d)
• Accounts can be balanced at any time, generally at every month’s end.
Key Point

Books will always be balanced before they are closed at the end of a reporting period when the
financial statements will be drawn up.
“Books”, in this case, also refers to ledgers maintained in an electronic system.

3.3.1 Steps to Close off Ledger Account

Closing of ledger accounts is applied systematically to every account.
1. Sum the debit side and note the total. Sum the credit side and note the total.
2. Whichever is the larger will be the total on both sides.
3. Insert the balancing figure so that both sides are equal (balance c/d)
4. If the sum of the debits exceeds the sum of the credits, the balancing figure is a debit balance.
This is brought down (b/d) on the account’s debit side.
If the sum of the credits exceeds the sum of the debits, the balancing figure is a credit
balance. This is brought down (b/d) on the credit side of the account.
 Example 1
The below T-Account is Manisha's Bank account in the general ledger for the year ended
31st December 20X6: her first year of trading.
Manisha has posted cash receipts and payment entries into the Bank ledger account as shown
and is now closing her accounts.
DR Bank (Asset) CR
31-Mar-X6 Cash Receipts $300 31-Mar-X6 Cash Payments $220
30-June-X6 Cash Receipts $800 30-June-X6 Cash Payments $160
30-Sept-X6 Cash Receipts $400 30-Sept-X6 Cash Payments $720
31-Dec-X6 Cash Receipts $500 31-Dec-X6 Cash Payments $80
31-Dec-X6 Balance c/d (S3) $820
(S2) $2,000 (S2) $2,000
01-Jan-X7 Balance b/d (S4) $820
To close the Bank ledger account, the following steps are made:
1. Sum the debit and credit sides:
Total Debits = $300 + $800 + $400 + $500 = $2,000
Total Credits = $220 + $160 + $720 + $80 = $1,180
2. Since the debit side is higher than the credit, the total to be included in the ledger is $2,000.
3. Insert the balancing figure so that the sum balances.
4. Since the sum of the debit side is larger than the credit, the balance c/d will be brought down
as the opening amount on the debit side for the following period.
In this case, Manisha has a closing bank balance of DR $820 which will show on the debit side of
the Bank ledger in the following financial period.

3.3.2 Application of Ledger Close-off

Ledger accounts that contain balances used in the preparation of the statement of financial position
are treated differently from those ledger accounts used for the statement of profit or loss.
• Statement of financial position ledger accounts
These are asset, liability and capital accounts. The closing balances for this year are the
opening balances for next year. The ledger accounts show balances carried down and
brought down, as seen for the Bank ledger in the earlier example.
• Statement of profit or loss ledger accounts
These are income and expense accounts. Profit is calculated as income minus expenses
and becomes part of capital at the year’s end.
The ledger accounts will reference the statement of profit or loss instead of the balance
carried down. There is no brought-down balance because the balances will all be
transferred to the profit or loss ledger account at the year’s end. The profit or loss ledger
account is created at year-end and is transferred to the capital section of the statement of
financial position.
Activity 4
Match the example of the overall balance of a specific ledger account to the possible explanation of
the general ledger’s name and its debit and credit balance.

Overall Balance Explanation

Balance b/d $9,810 (an Wages expense account. Total debits $25,800 and total credits
overdraft) $1,000
Balance b/d debit $34,900 Bank account. Total debits $47,570 and total credits $57,380
Profit or loss debit $24,800 Receivables account. Total credits $47,570 and total debits $57,380
Profit or loss credit $34,900 Payables account. Total credits $25,800 and total debits $1,000
Balance b/d credit $24,800 Vehicle account. Total debits $36,900 and total credits $2,000
Balance b/d debit $9,810 Sales account. Total credits $36,900 and total debits $2,000

4.4.1 Computerised Accounting Systems

4.1 Computerised Accounting Systems
Technological advancements make it unlikely that financial transactions are recorded on paper.
Instead, business transactions are now recorded using a computerised accounting software system.
Using a computerised system, a business may input details of the source document, and an
automated double entry is generated to the relevant ledger accounts.
In a computerised system, activities are categorised into three processes:
• Inputs – Inputs are data entered into the accounting system from the source documents.
• Processing – Data entered is posted into the relevant ledger accounts
• Output – Financial statements and other reports are produced for management use

4.1.1 Features of a Computerised System

• A typical accounting computerised system comprises several modules to operate different
business functions such as sales, purchases, inventory, receivables and payables.
• Computerised information can be integrated with other management modules to
update transaction trails. For example,
o Sales invoices generated through the sales system are automatically posted
into the receivables or cash ledger accounts. It can also update the inventory system
to record its movement and reduce the quantity.
o Details of purchase invoices are entered into the purchases system, and the
relevant ledger accounts, such as the payables, inventory, and any other relevant
general ledgers, are updated.
• Back-ups of the data in a computerised system are available in the event of lost files.
• Authorisation of transactions by senior personnel is done through PINs, passwords, security
tokens or apps. For cloud-based systems, authorisation may be done remotely.
• A computerised system allows you to amend transaction details and keep a log of the changes.
• There is a reduced likelihood of errors and omissions as computer systems do not allow error
data to be processed.
• Real-time comprehensive and accurate management reports can be generated cost-
effectively.
Examples of output reports from a receivables ledger system include:
 o Sales invoice
o Customer statement
o Receivables ageing list
o Sales analysis report
Examples of output reports from a payables ledger system include:
o List of outstanding supplier balance
o Purchases analysis report

4.1.2 Desktop vs Cloud Accounting Systems

A desktop accounting (on-premise) software system is hosted on a computer’s hard drive. The
software is initially installed on the business premise’s desktop and is maintained regularly.
A cloud accounting software system is hosted, updated, and maintained online. The organisation
pays a fee to a service provider that hosts the software on remote servers.

Desktop Software Cloud Software

Accessible on the desktop where

software is installed Accessibility Accessible only with an internet connection

Single access. Only one person can use Multiple users can use the software, even
the software at a time Users remotely.

Updates and Backup need to be Updates and Automatically updates and backups data to
performed manually Backup an online server

One-time fee until renewal Pricing Monthly subscription fee

Needs installation Installation No installation required

Security tied to the desktop. Data can Security depends on the cloud software
be lost if the computer crashes or system, usually with multiple layers of
breaks down. Security encryption.
4.4.2 Sources of Information for Accounting Systems
4.2 Sources of Information for Accounting Systems
The accounting system will draw information from several sources to facilitate processing:

Source Description Example

A human keys transactional • A cashier inputs customer purchases

information into the system, with a bar code scanner, then captures
usually through a terminal. payment information with a point-of-sale
payment device that reads the
Hardware input devices
customer’s credit card.
such as scanners or
• A clerk keys in the details of an invoice
barcode readers may
Manual data into the accounting system at a terminal
support this.
entry for processing.

An automated system
reads an input source and • The accounting system automatically
updates the necessary reads emails and attached documents
fields in the accounting received from customers from its
system data entry. purchasing email address and
automatically populates the fields for a
This process may be
sales order to be authorised.
assisted by robotic process
• A robot automatically scans, detects,
automation and AI that can
Computer- and records RFID tags attached to
identify and read
assisted inventory to update inventory records
documents and other input.
data entry automatically.

• The system will automatically query

approved supplier data to populate the
Files that store large necessary fields for a requested
amounts of data. purchase order.
• The system will collate and aggregate a
It may contain customer
customer’s transaction history to
and supplier master data
process a request for the customer’s
and transaction history.
Databases statement for outstanding receivables.

• When a customer’s supply of material

Accounting systems may runs low, an automatic purchase order
be integrated with the is sent to the business’s accounting
systems of suppliers and system, verifying the order and creating
Integrated customers to facilitate the a sales order and despatch note
systems fast processing of orders. automatically.
4.4.3 The Journal
4.3 The Journal
Definition

A journal is a record of accounting entries posted to the general ledger.

A Journal is a double-entry record to be posted into the general ledger for unconventional
transactions that are not posted via the sales and purchases computerised systems.

4.3.1 The Use of Journals

A Journal is used to record financial activities such as:
• Unusual or One-off Transactions
Journal entries are used to post unusual or one-off transactions into the relevant ledgers.
Examples of unusual or one-off transactions include:
o Purchase of a non-current asset
o Recording goodwill
o Record one-off lawsuit charges
o Write off losses due to theft or fraud
• Period-End Adjustments During year-end, the amount of each ledger account is reviewed, and
adjustments may be made to reflect their balance accurately. Examples of period-end
adjustments include:
o Write off irrecoverable debt
o Record of accruals and prepayments
o Record depreciation and amortisation of assets
o Closing inventory adjustment
The journal entries of each transaction will be discussed in their respective chapters.
• Correct Errors in the Trial Balance
Errors of commission, principle, omission, and reversal may occur. Errors can also be
identified after performing bank or trade payables reconciliations. The correction of such
mistakes is made to the general ledger accounts using journal entries.
For unusual transactions, error corrections and period-end adjustments, the transactions are
manually recorded and classified into the general ledger accounts using journals.
The journal will have the following format:

General Ledger Account $

Debit XXX X

Credit XXX X

Explanation of the Journal Entry posting.

Activity 5

State whether the transactions listed below will be reflected in the Journal.
1. Goods delivered and the invoice is received
2. Rent expense debited in error to repair expense ledger account
3. Car repair expense was debited in error to the car asset ledger account
4. Payment received from a customer
Activity 6
For each of the transactions listed below, record the journal entries to correct the error.
1. Rent expense debited in error to repair expense ledger account. The amount concerned is $50.
2.General Ledger Account $

Debit

Credit

2. Car repair expense was debited in error of $60 to the car asset ledger account.

General Ledger Account $

Debit

Credit

Exam advice

The exam will often require students to identify the appropriate journal entries for a given
narrative.
This is explored in subsequent parts of this text.
4.4.4 Accounting Systems
4.4 Accounting Systems
Definition

Accounting system – The records and procedures, both formal and informal, which relate to the
assembling, recording, retrieval and reporting of information related to the financial operations and which
also provide necessary internal controls.

A sound accounting system:

• is necessary to ensure resources are allocated efficiently and effectively.
• incorporates policies and procedures, including necessary internal controls, to assist management
in achieving organisational objectives.

4.4.1 Useful Accounting Information

Accounting is concerned with the collection, analysis and communication of financial information
which users need for decision-making purposes.
For information to be useful, it must possess certain qualities. It must be:
• relevant to the needs of the user
• reliable (complete, accurate and objective)
• complete for the purpose(s) for which it is intended
• accurate so that users have confidence in it
• objective (without bias)
• comparable to make meaningful comparisons
• cost-effective (the cost of preparation does not exceed its value)
• user-friendly so that it is understandable and clear
• concise (distinguishing important matters and ignoring trivia)
• timely so that information arrives on time to inform decisions.

4.4.2 Organisational Objectives

Management must ensure, as far as possible:
• Orderly and efficient business conduct, including adherence to management policies
• That assets are safeguarded
• The prevention and detection of fraud and error
• The accuracy and completeness of the accounting records
• Timely preparation of reliable financial information.
Internal controls relating to the accounting system seek to ensure that:
• transactions are authorised and valid
• all transactions and other events are recorded promptly at the correct amount, in the appropriate
accounts and the proper period (accurate and complete)
• access to assets and records is restricted
• recorded assets (e.g. in an asset register or perpetual inventory records) are compared with
physical assets periodically (and appropriate action is taken regarding any differences).
4.4.5 Policies, Procedures, and Performance
4.5 Policies, Procedures, and Performance
Accounting is concerned with providing useful economic information which will be helpful to those
directly (and to some extent indirectly) connected with an organisation.
Although only part of the broader business system, all elements of the business system rely directly
(to some degree) on accounting information.
The information provided by the accounting function should:
• Assist management in planning, controlling and decision-making;
• Assist business functions in achieving their objectives;
• Assess the performance of the various areas in an organisation;
• Assess the performance of the managers of the organisation; and
• Enable compliance with various statutory requirements (e.g. Annual financial statements).

4.5.1 Policies
Policies are the principles, rules or guidelines for achieving an organisation’s long-term goals. There
are many policies covering areas such as pricing, pay, asset replacement, etc.

4.5.2 Procedures
Procedures are step-by-step activities for completing a task. For example, accounting has
procedures for recording sales and purchases.

4.5.3 Performance
Performance concerns outcomes and results – how well or badly actions have been carried out and
what the outcomes are.
For example, whether the company’s profits are higher or lower than expected.

4.4.6 Accounting System Activities

4.6 Accounting System Activities
There are several financial systems in a business organisation.
Each system has objectives for what it is intended to do and policies and procedures for how it
should do it.
Each system would have policies and procedures to ensure these objectives are achieved.

4.6.1 Accounting System Activities

• Initiation (e.g. Manually or by programmed procedures);
• Recording (e.g. Identify, capture and record valid transactions and relevant information on a
timely basis, including information for disclosure);
• Processing (e.g. Edit, validate, calculate, measure, summarise, reconcile and classify);
 • Reporting (e.g. Preparation of financial and other statements so that the transactions, disclosures
and other information are correctly presented); and
• Maintaining accountability (for the related assets, liabilities and equity).

4.6.2 Transaction Processing System (TPS)

A transaction processing system (TPS) is the foundation of all financial systems. It records all the
financial transactions of the company.
Aspects of a TPS include:
• Part of an accounting package
A TPS will record and collate information as part of an accounting package that will
analyse the data into useful information for users.
• Coding
A TPS would involve using codes to identify accounts, transactions, and other items.
• Accuracy, speed, volume
A TPS should be capable of handling the company’s transaction volume quickly and
accurately and may have automation to minimise errors.
• Management information
A TPS can quickly report summary information for management to use.
CHAPTER 5: Visual Overview
CHAPTER 5: Visual Overview
Objective: To describe how credit transactions are recorded in ledger accounts.

5.1.1 Types of Business Transactions

1.1 Types of Business Transactions
The monetary value of business transactions is shown in financial documents, and its
data is entered into the ledger accounts using double entries.
This chapter will discuss the recording of these business transactions:
• Cash and Credit Sales
• Sales Returns
• Cash and Credit Purchases
• Purchase Returns
 • Petty Cash transactions
There is an assumption in the FA/FFA exam that businesses will be using computerised
accounting systems where the sales and purchase modules are integrated with the
general ledger module. This means that the general ledger will automatically be
updated with relevant journals when sales invoices and credit notes are produced by
the sales module, or when purchase invoices or credit notes from suppliers are entered
into the purchases module. However, the bank will not be integrated with the general
ledger, so bank transactions will need to be entered using manual journals.

5.1.2 Cash and Credit Sales

1.2 Cash and Credit Sales
1.2.1 Cash and Credit Sales
A cash sale arises from a sale to a customer for immediate payment. The double entry
to record a cash sale is:
Individual Account Category Explanation
DR Cash/Bank Asset Cash (Asset) increased
CR Sales Income Sales (Income) increased
A credit sale arises from a sale to a customer for future payment. At the point of sale,
the customer owes the business the sale amount. The amount is classified as trade
receivables. The double entry to record a credit sale is:
Individual Account Category Explanation
DR Trade Receivables Asset Receivables (Asset) increased
CR Sales Income Sales (Income) increased

1.2.2 Sales Return

The journal entry to record a sale return transaction is:

General Ledger Account Category Explanation

DR Sales Income Sales (Income) decreased

CR Trade Receivables Asset Receivables (Asset) decreased

Some businesses may use an additional account called “Sales returns”. If that is the
case, the journal entry to record a credit note becomes:

General Ledger Account Category Explanation

DR Sales returns Income Sales (Income) decreased

CR Trade Receivables Asset Receivables (Asset) decreased

At the end of each financial period, the balance on the sales return account would be
deducted from the balance in the Sales account, giving the same sales value as if the
credit note had been directly debited to Sales. In the exam questions, if no Sales returns
are mentioned in the question, use the first of the journals above (i.e. debit credit notes
against Sales, rather than Sales returns.
Journals relating to sales returns would be posted automatically to the general ledger
from the sales module in an integrated accounting system.

1.2.3 Receipts from Customer

At the end of the credit term, the customers should pay the business for the outstanding
balance for purchases. The double entry to record receipts from credit customers is:

Individual Account Category Explanation

DR Bank/Cash Asset Bank/Cash (Asset) increased
CR Trade Receivables Asset Receivables (Asset) decreased

5.1.3 Cash and Credit Purchases

1.3 Cash and Credit Purchases
1.3.1 Cash and Credit Purchases
A cash purchase arises from a purchase from a supplier for immediate payment. The
double entry to record a cash purchase is:
Individual Account Category Explanation
DR Purchases Expense Purchases (Expense) increased
CR Cash/Bank Asset Cash (Asset) decreased
A credit purchase arises from a purchase from a credit supplier for future payment. At
the point of purchase, the business owes the business to the seller. The purchase
amount is classified as Trade Payables. The double entry to record a credit purchase is:
Individual Account Category Explanation
DR Purchases Expense Purchases (Expense) increased
CR Trade Payables Liability Payables (Liability) increased
In an integrated system, the journal in respect of purchases would be posted to the general
ledger automatically when the purchase invoice is booked into the system.

1.3.2 Purchase Returns

Purchase returns are goods returned to the seller by the business due to an error, such
as delivering damaged or incorrect items. The seller issues credit notes to reduce the
value of the previously issued purchase invoice.
The double entry to record a purchase return is:
Individual Account Category Explanation
DR Trade Payables Liability Payables (Liability) decreased
CR Purchase Return Expense Purchase (Expense) decreased
As with sales returns, some businesses may use a Purchase returns account which is credited
when a credit note is received from a supplier, rather that crediting directly to the purchases/ or
expense account. If that is the case, the balance on the purchase returns would be deducted
from the balance on the purchases account at the end of the year.

1.3.3 Payments to Suppliers

At the end of the credit term, the business should pay the supplier for the purchased
items. There is an assumption in FA/FFA that the bank is not integrated with the general
ledger, so bank transactions must be entered manually. The manual journal to record
payments made to suppliers is:
Individual Account Category Explanation
DR Trade Payables Liability Payables (Liability) decreased
CR Bank/Cash Asset Cash (Asset) decreased

5.1.4 Petty Cash Transactions

1.4 Petty Cash Transactions
Petty cash refers to small amounts of money kept on business premises for small-value
purchases. The petty cash ledger records when cash is used to make sundry small
payments such as postage stamps, coffee and taxi fares.
The petty cash will be kept securely in a locked cash box. The amount of money
typically held in the petty cash box is known as a float.
The two sources of petty cash are:
• Small Receipts
A business may make petty cash sales on small-value items on the business
premise. For example, a business client comes to the office for a meeting and
uses the office photocopier to print some documents. They may pay a small
fee due in cash. This would be placed in the cash float.
• Imprest System
The business decides how much float it would like to keep in the cash box by
employing an imprest or non-imprest system. Periodically, cash is withdrawn
from the bank account to maintain the amount of the float.

1.4.1 Methods of Replenishing

An imprest system of replenishing is where a fixed sum of money is maintained in the
petty cash tin to pay for items of petty expenditure. This sum is replenished at regular
intervals or when needed.

Key Point

Imprest Amount = Balance in the Petty Cash tin + Petty Cash Vouchers
Example 1
In a week, the petty cash tin had the following transactions:
$ $
Imprest balance at the beginning of the week 100
Less: Paid during the week
 Stationery 9
Tea and coffee 14
Telephone 2
Taxi 4
Auditor’s lunch 39
68
Petty cash-in-hand at the end of the week 32
At the end of the week, $68 of cash will be drawn from the bank to reimburse the petty
cash tin to top it up to the imprest balance of $100.
A non-imprest system is any other method of replenishing than an imprest system. An
amount added into the petty cash tin, regardless of the petty cash taken out during the
week, is a non-imprest system.
• For example, a business starts with $125 in the petty cash tin at the beginning of the
period. During the week, the business uses up $38 of petty cash. $40 is added back
into the petty cash tin, bringing to total petty cash amount to $127.
• Another example of a non-imprest method is when a business replenishes a fixed
amount of $30 regardless of the balance in the Petty Cash tin.
The petty cash tin is reimbursed by transferring money from the business bank account.
The double entry to record petty cash replenishment is:
Individual Account Category Explanation
DR Petty Cash Asset Petty Cash (Asset) increased
CR Bank Asset Cash in Bank (Asset) decreased

5.2 Need for a Record

The Petty Cash ledger is maintained, and relevant transactions are recorded to
establish internal controls.
The record of petty cash transactions helps minimise the risk of theft and fraud
(expenses must have documentary support).
• Every payment out of the petty cash tin is supported with a voucher. The cashier will
authorise the voucher.
• At the end of each month, the petty cash book is totalled, and the expense totals are
posted to the general ledger accounts.
The record of petty cash transactions in the ledger also collects information valuable to
the manager’s operations. If the petty cash expenses are high in a period, the petty
cash ledger can provide the transaction documentation to support any issues.

5.2.1 General Principles

2.1 General Principles
Key Point

A sales tax is an indirect tax imposed by tax authorities or governments. A percentage is

charged on goods sold.
An indirect tax is a tax charged on goods and services rather than on the profits made
by a business. Indirect taxes are not taken directly from a person through their tax
affairs but via the business where they bought the item.
Sales tax is an example of an indirect tax.
Businesses must register with the tax authorities in their country to become sales tax
collecting agents for the government. Businesses charge tax on sales (output tax) and
reclaim tax on purchases (input tax).
A business must be registered to collect or reclaim sales tax.
• Output Tax is the sales tax charged on sales to customers.
• Input Tax is the sales tax paid on purchases of goods and services.
If Output tax exceeds Input Tax = Tax Payable to authorities (Current Liability)
If Input tax exceeds Output Tax = Tax Reclaimable from authorities (Current Asset)
The settlement of collected sales tax to the authorities is made regularly (either monthly
or quarterly). The business submits a sales tax return, which shows the calculation of
the amount of sales tax due, along with the payment.
When a business is registered for sales tax, the tax authorities may demand that the
business's sales tax-related documentation and records are maintained and that
administrative rules are followed. The legislation will vary between countries, but the
basic principles will be the same.
Example 2
Hassan is the owner of a stationery stop and is registered as a Sales Tax collecting
agent of the tax authorities.
1. Hassan purchases several boxes of pencils from a supplier. The sales tax paid for
the purchases is the input tax. Hassan will record the sales tax portion in the Sales
Tax ledger on the debit side (Asset) as the input tax can be reclaimed from tax
authorities.
2. Hassan sells some pencils to a local shop and charges sales tax. The sales tax
collected from the local shop is the output tax. Hassan will record the sales tax
collected in the Sales Tax ledger on the credit side (Liability), as the output tax is
payable to the tax authorities.
3. At each period-end, the total output tax and the total input tax for the period are
calculated in the Sales Tax ledger. The output and input tax figures are included on
the sales tax return. The sales tax collection period can be monthly or every three
months.
If the business is in a net credit position, payment must be made to the tax authorities. If
the business is in a net debit position, it can reclaim the amount from them.
Activity 1
State whether the following statements regarding sales tax are True or False.
1. The difference is paid to the tax authority if the output tax for a period is greater than
the input tax.
2. Input tax is sales tax charged on sales to customers.
3. All businesses charge output tax on sales to customers.
4. The business must keep copies of sales tax invoices for sales and purchases for a
statutory minimum period.
5.2.2 Sales Tax Calculation
2.2 Sales Tax Calculation
The rates of sales tax that apply to sales and purchases will vary from country to
country. The sales tax calculation can be identified by the gross or net amount provided.

Key Point

The Net Amount is the sale or purchase price before sales tax and is always 100%.
Gross Figure is the sale or purchase price, including sales tax. The gross figure is
always 100% + sales tax %.
Gross Figure: the sale or purchase price, including sales tax.
Net Figure: the sale or purchase price, excluding sales tax.
Example 3
Hanna is a sole trader selling furniture from her shop. The sales tax rate in Hanna's
country is 20%. This example illustrates her sale of a table.
1. If the Net price of the table is $250, the sales tax is:
Net Amount Sales Tax Gross Amount
$250 $50 $300
($250 × 20/100) ($250 + $50)
Always 100% 20% 120%
2. If the Gross price of the table is $300, the sales tax is:
Net Amount Sales Tax Gross Amount
$250 $50 $300
($300 - $50) ($300 × 20/120)
Always 100%
3. 20% 120%
Activity 2
1. Binta works at a luxury car dealership. She makes a sale to a customer for $23,500,
excluding sales tax. The sales tax rate is 25%.
How much sales tax is charged on this transaction, and what is the total
amount due from the customer?
Sales Tax ($) Amount due from customer ($)
a) 5,875 23,500
b) 4,700 23,500
c) 5,875 29,375
d) 4,700 28,200
2. Lisha also works at a car dealership in a different country. She makes a sale to a
customer for $33,000, including sales tax. The sales tax rate for this car is 10%.
How much sales tax is charged on this transaction, and what is the total
amount due from the customer?
Sales Tax ($) Amount due from customer ($)
a) 3,000 33,000
b) 3,300 36,300
 c) 3,000 36,000
d) 3,300 33,000
3. Desmond makes two sales of goods to customers—one for $800 (net price) and the
other for $1,200 (gross price). The sales tax rate is 20%.
How much sales tax does Desmond charge on these sales?
1. $333
2. $360
3. $373
4. $400

5.2.3 Accounting for Sales Tax

2.3 Accounting for Sales Tax
Sales Tax may be relevant to several transactions, such as:
• Cash and credit sales
• Cash and credit purchases
• Payment/ receipt of sales tax to authorities

2.3.1 Cash and Credit Sales

The journal entries for cash and credit sales were described above in section 2. Where
there is sales tax, the journal entry changes slightly:

General Ledger Category Explanation

Account

DR Cash/Trade Asset Trade receivable/Cash (asset) increased with

Receivable the gross value of the invoice

CR Sales Income Sales (income) net of sales tax increases

CR Sales tax Liability A liability to the tax authorities for the

collection of sales tax has increased.
In a computerised accounting system where the sales module is integrated with the
accounting system, this journal would be posted automatically when the invoice is
issued by the sales system.

2.3.2 Sales Returns

As explained in section 1 above, sale returns occur when goods are returned to the
business by the customers due to an error on the business’s part, such as delivering
damaged or incorrect items. If the original sales invoice included sales tax, the sales
return should also include a refund of the sales tax element.
The journal entry for recording a sales return with sales tax is:
 General Ledger Category Explanation
Account

DR Sales (or sales Income Reducing the portion of the net sales to which
returns) the return relates

DR Sales tax Liability A refund of the sales tax on the sale represents
a reduction of the business’s liability to the tax
authorities

CR Trade Liability Trade receivables.

receivables
Activity 3
On 1 March, Darek sold goods to Jan. The goods had a list price of $1,000, excluding
sales tax, which is levied at 15% in the country where Darek and Jan live. The goods
were dispatched on 1 March and Darek issued the invoice on that date.
On 2 March Jan checked the goods and discovered that some of the items were
broken. The broken items had a value of $150 excluding sales tax. Jan called Darek,
who was extremely apologetic and agreed to issue a credit note for the faulty goods.
Show the journal entries that would be posted in Darek’s general ledger account:
• On the original sale
• On the issue of the credit note.

2.3.3 Cash and Credit Purchase

A credit purchase arises from a purchase from suppliers for future payment. For credit
purchases incorporating sales tax, the amount attributable to sales tax is recorded as
input tax in the Sales Tax account.
The double entry to record cash or credit purchases with sales tax is:
• DR Purchases (Expense)
• DR Sales Tax (Asset)
• CR Cash/ Trade Payables (reduce Asset/ increase Liability)
The amount to be entered into the Purchases or Expense accounts is the net amount
(price after trade discount)
2.3.4 Credit Notes in respect of purchases
Purchase returns are goods returned to the seller by the business due to an error, such
as delivering damaged or incorrect items. The double entry to record purchase returns
with sales tax is:
• DR Trade Payables (reduce liability)
• CR Sales Tax (reduce Asset)
• CR Purchase Returns (reduce Expense)
Activity 4
Maya bought some goods from Arushi for $750 plus sales tax at 25%. After receiving
the invoice, Maya discovered that half the products by value were faulty and sent them
back, requesting a credit note. Arushi agreed and issued a credit note for $375 plus
sales tax.
Show the journal entries that would be posted to Maya’s general ledger:
• On the original sale
• On the receipt of the credit note?

2.3.5 Payment to/Receipt from Tax Authorities

At the end of every quarter, the sales tax returns are filled with the output and input
sales tax amount.
• If the output tax exceeds the input tax (more sales), the business will make payment
to the tax authorities.
• If the input tax exceeds the output tax (more purchases), the business will collect
refunds from the tax authorities.
When a business makes a payment for the balance owed to the tax authorities, the
double entry is:
• DR Sales Tax (reduce Liability)
• CR Cash (reduce Asset)
When a business receives a refund from the tax authorities, the double entry is:
• DR Cash (increase Asset)
• CR Sales Tax (reduce Asset)
The Sales Tax ledger is summarised in the below T-Account after all the relevant
entries have been posted:
DR Sales Tax (Liability) CR
Balance b/d (if reclaimable position) X Balance b/d (if payable position) X
Cash/Credit Purchases (Input) X Cash/Credit Sale (Output) X
Sale Returns X Purchase Returns X
Cash paid to tax authorities X Cash received from tax authorities X
Balance c/d XX Balance c/d
X X
Balance b/d (if reclaimable) Balance b/d (if payable) XX
 Linzarp Co is a store that sells electrical goods. The sales tax applicable in the country her
business operates is 10%. On 1st March, Linzarp owes the sales tax authorities $140 for sales
and purchase transactions in January and February.
1. On the 21st of March 20X5, Rohan buys a television from Linzarp Co on credit for
$330, including sales tax.
$330 is the gross amount (including sales tax). The sales tax amount is (330
× 10/110) × 10% = $30. The double entry for this credit sale is:
o DR Trade Receivables $330, CR Sales $300, CR Sales Tax $30
2. On the 22nd of March 20X5, Linzarp Co buys a DVD player from their
supplier, Naima, on credit for $150, excluding sales tax.
$150 is the net amount (excluding sales tax). The sales tax amount is ($150
× 10/100) × 10% = $15. The double entry for this credit purchase is:
• DR Purchases $150, DR Sales Tax $15, CR Trade Payables $165
3. On 31st March, Linzarp pays the tax authorities the amount owed of $140.
The double entry to record the tax payment is:
• DR Sales Tax $140, CR Cash $140.
4. On 10th April, Linzarp made a cash sale to a customer for $440, including
sales tax.
The sales tax amount is ($440 × 10/110) × 10% = $40. The double entry to
record this cash sale is:
• DR Cash $440, CR Sales $400, CR Sales Tax $40
5. On 20th April, Rohan pays Linzarp the amount owed of $330.
Sales Tax is recorded at the point of sale or purchase, not at the payment.
The receipt of $330 will not affect the sales tax account. The double entry to
record this receipt is:
• DR Cash $330, CR Trade Receivables $330.
The Sales Tax ledger will show the following after the above entries are made:
DR Sales Tax CR

22-Mar-X5 Credit Purchase (2) $15 01-Mar-X5 Balance b/d $140

31-Mar-X5 Paid to authorities (3) $140 21-Mar-X5 Credit Sales (1) $30

30-Apr-X5 Balance c/d $55 10-Apr-X5 Cash Sales (4) $40

$210 $210

01-May-X5 Balance b/d $55

Activity 5
Complete the sales tax ledger account from the list of transactions during a
period.
Narrative $
Sales tax on cash sales 1200
Sales tax on credit sales 300
Sales tax on credit purchases 750
Sales tax on cash purchases 120
 Cash paid to tax authority 560
Amount due to tax authority at start of period 560
The Sales Tax ledger will show the following after the above entries are made:
DR Sales Tax CR

5.3.1 Trade Discounts

3.1 Trade Discounts
A discount is a reduction in the price of goods, or services, below the price at which they
would typically be sold to customers. The two types of discounts that a business may
encounter are trade and settlement discounts.
Definition

A trade discount reduces the cost of goods or services bought or sold. It is given
unconditionally on either cash or credit transactions.
Trade discounts offered to customers are guaranteed discounts, and customers are
expected to take advantage of the discount. Therefore, trade discounts offered are
always considered when recognising sales.

3.1.1 Trade Discounts Allowed and Received

Trade discounts on sales are discounts allowed, while trade discounts on purchases are
discounts received.
In both scenarios, the sale or purchase transaction is recorded net of the trade discount.
Example 5
Maple Leaf is a wholesaler and retailer of medicines, cosmetics and perfumes. It has
an extensive catalogue of products.
1. The listed price of a new fragrance is $40 a bottle. Maple Leaf offers Kirby, a retail
shop owner, a 25% discount on ten bottles. Kirby takes advantage of the discount
price offered. What are the accounting entries in Maple Leaf's ledgers if Kirby:
1. pays immediately in cash:
Maple Leaf has made a cash sale of $300 ($40 × 10 bottles −
trade discount 25%). The double entry to record this is DR Cash
$300 and CR Sale $300.
2. is given 30 days in which to pay:
Maple Leaf has made a credit sale of $300. The double entry to
record this is DR Trade Receivables $300 and CR Sale $300.
2. Maple Leaf purchases five boxes of eye cream primer at a list price of $150 per box
from ForEyever. Purchases of 3 boxes and above entitle the customer to a discount of 10% on
the entire purchase. What are the accounting entries in Maple Leaf’s ledgers if they:
1. Pays immediately in cash:
 Maple Leaf has made a cash purchase of $675 (5 boxes × $150 −
trade discount 10%). The double entry to record this is DR
Purchases $675 and CR Cash $675.
2. Is given one month in which to pay:
Maple Leaf has made a credit purchase of $675. The double entry
to record this is DR Purchases $675 and CR Trade Payables
$675.
The transaction is recorded net of trade discounts for both trade discounts allowed (on
sale) and received (on purchase).

5.3.2 Settlement Discounts

3.2 Settlement Discounts
Definition

A settlement discount (or prompt payment discount) is a discount offered to customers or

given by suppliers for payment made within a specific timeframe. It is offered only in credit
transactions.
A settlement discount encourages the customers to pay outstanding balances to the
business earlier than the standard credit agreement term (credit period).

3.2.1 IFRS 15 Revenue from Contracts with Customers

Offering settlement discounts to credit customers to encourage prompt payment can
help a business's cash flow. However, whether the customer will take advantage of the
discount at the point of sale is unknown.
Per IFRS 15, settlement discounts are recognised only when a business expects that
customers will accept the discount by making the payment within the settlement
window.
When recording the initial credit sale, the business must consider the probability of the
discount being taken using judgement and considering its experience with each
customer. The business must determine the amount of consideration (money) it expects
from the sale per the criteria of IFRS 15.
If the business expects the customer to take advantage of the discount, the revenue
recognised should be the amount after the settlement discount has been deducted.

3.2.2 Settlement Discounts Allowed

Settlement discounts allowed are offered to customers who pay the amount owed to the
business within an agreed time.
If the supplier expects the customer to take advantage of the settlement discount, sales
are recorded at the net amount after deducting settlement discounts. This is the same
treatment as trade discounts.
 Example 6 (expects to take up settlement discount)
Simon sells Arthur $500 of goods on credit and offers him a 5% discount for payment
within seven days. Simon expects Arthur to take advantage of the discount offered.
What are the accounting entries in Simon's ledgers if Arthur:
1. Takes the discount
2. Does not take the discount
Solution:
Simon expects Arthur to take up the settlement discount at the initial sale entry.
Therefore, the amount to be recognised as sales is net of the settlement discount: $500
− Settlement Discount $25 ($500 x 5%) = $475
The double entry to record the sale is DR Trade Receivables $475 and CR Sale $475.
1. When Arthur takes up the discount by paying within seven days, Simon will record
the cash receipt: DR Cash $475 and CR Trade Receivables $475.
2. Arthur does not take up the settlement discount means that he pays $500 after
seven days. Since Simon expected Arthur to take it up, he deducts the settlement
discount amount when recognising his sales.
Therefore, Simon has to recognise the settlement discount portion as sales.
The double entry to record this cash receipt is:
DR Cash $500 (record cash receipt)
CR Trade Receivables $475 (remove receivables balance)
CR Sales $25 (balancing figure)
Example 7 (not expected to take up settlement discount)
Hannah sells Joycelyn $650 of goods on credit and offers her a 15% discount for
payment within two weeks. Hannah does not expect Joycelyn to take advantage of the
discount offered as she has not taken it up in the past. What are the accounting entries
in Hannah's ledgers if Joycelyn:
1. Pays in 30 days (the credit term)
2. Pays in 10 days
Solution:
Hannah does not expect Joycelyn to take up the settlement discount at the initial sale
entry. Therefore, the amount recognised as sales does not consider the settlement
discount.
The double entry to record the sale is DR Trade Receivables $650 and CR Sale $650.
1. If Joycelyn pays in 30 days, she pays for the full amount. Hannah records the cash
receipt: DR Cash $650 and CR Trade Receivables $650.
2. If Joycelyn pays in 10 days, she is eligible for the settlement discount and pays
only: $650 − Settlement Discount $97.50 ($650 × 15%) = $552.50
Since Hannah did not record the settlement discount at the point of sale, she
will reduce (debit) the sales portion by the settlement discount amount. The
double entry to record this entry is:

DR Cash $552.50 (record cash receipt)

DR Sale $97.50 (balancing figure)
CR Trade Receivables $650 (remove receivables balance)
3.2.3 Settlement Discount Received
Settlement discounts received are given by a supplier on purchases where the business
pays within an agreed time.
Settlement discounts on purchases are recorded differently than other forms of discount
as it is only recorded on payment. At the point of purchase, the full invoice amount is
recognised as purchases (expense). There should be no deduction of the settlement
discount even if the business expects to take it up.
The settlement discount is only recorded when the discount is taken up during payment
• Suppose the business pays within the stipulated period and takes advantage of the
settlement discount. The business will record the cash payment and include the
discount portion as Discount Received (Income/reduction in expense). The double
entry to record the payment is:
o DR Trade Payables (to clear the balance owed to the supplier)
o CR Cash (by the actual amount paid)
o CR Discount Received (by the settlement discount amount)
• If the business pays after the stipulated timeframe, it will record the cash payment
normally. The double entry to record this is:
o DR Trade Payables
o CR Cash
Example 8
Clara buys goods from Jaime for $100 on credit. Jaime offers Clara a 5% discount for
early settlement within seven days. What are the accounting entries in Clara's ledgers
if:
1. Clara pays within seven days
2. Clara pays after seven days
Solution:
1. Record the purchase at full price
At the point of the credit purchase, Clara recognises $100 as purchases in
her ledgers. The double entry to record this is:
DR Purchases $100 and CR Trade Payables $100
2. Record the cash payment
1. If Clara pays within seven days, she takes advantage of the settlement
discount.
In a settlement discount received scenario, the settlement discount
is only recorded at the point of payment. The discount is
recognised as a reduction of expenses under a new ledger,
“Discounts Received”.
The actual payment will be net of the settlement discount: $100 −
Settlement Discount $5 ($100 − 5%) = $95. The double entry to
record is:
DR Trade Payables $100 (remove payables balance)
CR Cash $95 (record cash payment)
CR Discounts Received $5 (balancing figure)
2. If Clara pays after seven days, she is not entitled to the settlement
discount and pays the full price of $100. The double entry to record the
cash payment is:
DR Trade Payables $100
CR Cash $100
 Exam advice

You will not be required to judge the expectation of a discount being taken up. Where relevant,
this will be stated.

3.2.4 Trade and settlement discounts together

Where trade and settlement discounts occur in the same invoice, the settlement
discount would be based on the invoiced amount after any trade discounts. This is
because the settlement discount is based on the amount that is owing to the supplier.

Activity 6
Sunrise offers Moonlight a trade discount of 5% on all goods, in recognition of the fact
that Moonlight is a valued customer. Sunrise also offers a 3% settlement discount to all
customers that pay within 30 days of the invoice date.
On 1 March Moonlight ordered some goods from Sunrise with a list price of $1,000. The
goods were dispatched and invoiced the same day. Moonlight paid the invoice on 28
March.
Show what journals would be posted in Sunrise’s general ledger for the initial
invoice, and for the receipt of the payment if:
(i) Sunrise expected Moonlight to take the settlement discount
(ii) Sunrise did not expect Moonlight to take the settlement discount.

Activity 7
Match the statement describing discounted transactions to the correct
accounting treatment.
Transaction Accounting Treatment
For settlement discount taken by a customer where it DR Purchases $4,500
was not initially expected to be taken up is presented CR Bank $4,275
in the financial statements as CR Discount Received
$225
Settlement discounts received are presented in the DR Bank $4,275 and
financial statements as CR Trade Receivables
$4,275
The payment receipt of a $4,500 invoice with a 5% Deduction from Sales in
settlement discount from a credit customer where he the Statement of Profit or
was expected to take the discount Loss
An invoice of $4,500 was paid to a supplier with a Income in the Statement
settlement discount of 5% of Profit or Loss
The summary of the accounting treatment of discounts received and allowed is
illustrated in the table below:
 Trade Discounts Settlement Discounts

Settlement discounts or prompt

payment discounts are offered if an
invoice is paid within a specified
Trade discounts are price period.
reductions given to The discount is conditional as it
businesses for bulk purchases depends on the timing of the
Definition or repeat orders. invoice payment.

If the customer is expected to pay

Accounting Credit sales are recognised within the stipulated time, the credit
Treatment: net of the trade discount. sale is recognised net of the
Discounts DR Receivables/Cash settlement discount.
Allowed CR Sale DR Receivables, CR Sale

The business only records the

settlement discount on payment.
The purchase is recorded in full
initially. DR Purchase, CR Payable.
During payment, the settlement
Credit purchases are discount is recorded as discounts
Accounting recognised net of the trade received.
Treatment: discount. DR Payables
Discounts DR Purchase, CR Cash
Received CR Payables/Cash CR Discount Received

5.4.1 Purpose of Bank Reconciliations

4.1 Purpose of Bank Reconciliations

Definition

A bank reconciliation is a reconciliation between the bank statement balance and the
balance on the Bank ledger account.
The statement of financial position shows all the assets, liabilities and capital of a
business. Users of this statement assess the business’s health by analysing the
business cash balance.
Therefore, controls are set in place to ensure the cash balances recorded in the
financial statements are accurate. This means that the reported bank balance should
reflect the amount of cash in the bank. A control measure to ensure the accuracy of the
Bank ledger balance is regularly performing a bank reconciliation.
The bank keeps records of transactions in and out of the business's bank account.
Information on these transactions is sent to the business through a bank statement.
In the modern era of digital banking, bank statements and other banking records are
easily extracted from the bank’s internet website.
The balance on the bank statement or internet banking records received may be
different from the balance in the Bank ledger account. In such cases, a bank
reconciliation is prepared to highlight the differences and calculate the correct Bank
account balance.
Activity 8
For each of the statements regarding bank reconciliations below, answer whether
they are True or False.
1. A bank reconciliation can identify errors and omissions in the bank ledger.
2. A bank reconciliation can identify errors and omissions made by the bank.
3. It is a statutory requirement to prepare the bank reconciliation monthly.
4. Bank reconciliations are good control procedures.

5.4.2 Reasons for Differences

4.2 Reasons for Differences
The bank statement balance may not necessarily agree with the Bank ledger account
balance due to errors, omissions, or timing differences.
• Errors can be found in both the Bank ledger accounts and the bank
statement. Errors may occur due to transactions posted twice or an incorrect
amount reflected in either of these balance statements.
• Omission of transactions could cause a difference between the two sources’
balances. Transactions such as standing orders, direct debits, bank charges,
or interest received could be reflected in the bank statement but not in the
Bank ledger account or vice versa.
o A standing order is an instruction given by a payer to its
bank telling the bank to pay a fixed amount on a predetermined
date to a third party. The third party cannot request payment from
the bank or change the amount.
o A direct debit is an authority given by a payer to a third party
(the payee) to debit the payer's account on a specific date (or
nearest banking day). This authority can be a fixed amount (loan
repayment) or a variable amount (phone bill payments).
• Dishonored cheques (bounced cheques) are cheques received from a
customer that has not been honoured by the customer’s bank due to
insufficient funds or incorrect cheque filing. Since there is no actual payment,
the bank statement will not include this receipt.
• Timing Differences are due to the following:
1. Unpresented Cheque is a cheque payment made to a supplier that
the supplier has not yet taken to their bank. Since there is no
payment out of the bank account, the bank statement will not reflect
this transaction.
2. Outstanding Lodgement is a cheque payment received and taken
to the bank but has yet to be recorded in the bank statement. This
could be due to cheques cashed on the same day the bank
statement is prepared.
 3. Direct credit receipts or payments which take a few days to clear in
the bank account may also cause timing differences between the
time the transactions were made and when they appear on the
bank statement.
Timing differences arise due to a delay between the business posting in the
Bank ledger and the bank recognising the payments and receipts. Neither the
Bank ledger nor the bank statement is incorrect. These differences will
appear in the bank reconciliation at the end of the process.

5.4.3 Preparing Bank Reconciliation

4.3 Preparing Bank Reconciliation
4.3.1 Bank Reconciliation Procedure
The bank reconciliation will align the balances in the bank statement to the balances in
the Bank ledger. The bank reconciliation steps are:
1. Check that the opening balances agree (bank balance at the start of the month).
2. Compare the transactions of both balances. Record and correct any missing or
erroneous transactions in the Bank ledger. A new Bank ledger balance is calculated.
3. The new Bank ledger balance and Bank Statement balance are compared again. A
Bank Reconciliation template is drawn up if they still do not agree.
o Record the Bank Statement balance at the top.
o Make adjustments by deducting any uncleared payments (unpresented
cheques) and adding any uncleared receipts (outstanding lodgements).
o Correct any errors found in the bank statement.
The Bank Reconciliation template is shown as follows:
Bank Reconciliation Statement
Bank Statement Balance X
Less: Unpresented Cheques (X)
Add: Outstanding Lodgements X
Add/(Less): Bank Error X/(X)
Bank Ledger Balance X
The amended bank statement balance should then agree with the new Bank ledger
balance.
Key Point

The statement of financial position will report the agreed balance (corrected cash book balance) as
at the reporting date.

Activity 9
For each of the differences below, state whether the difference should be
adjusted in the Bank ledger or included in the bank reconciliation.
1. A business makes payments of $500 on 30 December that has yet to appear on the
bank statement.
2. The bank statements show a direct debit payment of $600 that the business has not
recorded.
3. The bank statements show a dishonoured cheque of $200 that had been received
from a customer and banked by the business.
 4. A business deposits $800 of receipts on 29 December that has yet to appear on the
bank statement.
5. The bank statement shows $100 of interest charges. Upon investigation, these
charges have been included on the bank statement in error.
*Please use the notes feature in the toolbar to help formulate your answer.
4.3.2 Bank Reconciliation
Example 9
Tabby Wear Co is a company that sells children’s clothing to clothing retailers with a
financial year-end of 31 December.
On 30 June 20X5, Tabby received her bank statement with a CR balance of $23,325.
Tabby Wear Co’s Bank ledger balance is only DR $17,970. A bank reconciliation is
prepared for the difference of $5,355. (From the bank’s perspective, CR in the bank
statement is a positive balance).
Upon investigation, Tabby identifies the following:
1. Tabby Wear Co made payments of $20,110 on 29th June 20X5. These payments
have not appeared on the bank statement.
o This is an unpresented cheque and is a timing difference. This amount
will be adjusted in the bank reconciliation.
2. Tabby Wear Co banked receipts of $10,935 on 30th June 20X5. Similarly, these
receipts have not appeared on the bank statement.
o This is an outstanding lodgement and is a timing difference.
This amount will be adjusted in the bank reconciliation.
3. The bank has deducted bank charges of $625 on the bank statement in error.
o This bank error will be adjusted in the bank reconciliation.
4. A standing order for a phone bill payment of $2,300 is shown in the bank
statement but omitted from the Bank ledger.
o This standing order of $2,300 will be adjusted in the Bank
ledger via the journal. The journal entry to record this is DR Phone
Expense, CR Bank.
5. A dishonoured cheque from a credit customer for $895. Tabby Wear Co had
banked this cheque, but the bank informed them that the customer had insufficient
funds to pay this receipt.
o This dishonoured cheque of $895 is adjusted in the Bank ledger
as the receipt was not transferred. The journal entry is DR Trade
Receivables, CR Bank.

The Bank ledger should be as follows once the correction entries (4 and 5) are made:
DR Bank (Asset)
30-June Balance b/d $17,970 30-June Standing Order $2,3
30-June Dishonoured Cheque $8
30-June Balance c/d (Revised) $14,7
$17,970 $17,9
01-July Balance b/d $14,775
The revised balance in the Bank ledger ($14,775) is compared again to the balance in
the bank statement ($23,325). Since there is still a difference of $8,550 ($23,325 −
$14,775), a Bank Reconciliation is prepared.
 The Bank Statement balance is entered at the top, and all the timing differences and
bank errors are recorded. The totalled balance should agree with the Bank ledger
balance:
Bank Reconciliation Statement
Bank Statement Balance $23,325
Less: Unpresented Cheques ($20,110)
Add: Outstanding Lodgements $10,935
Add: Bank Charges in Error $625
Bank Ledger Balance $14,775
The DR $14,775 balance is the correct Bank ledger closing balance to be reported in
the trial balance and the financial statements.
Activity 10
The accountant at Tabby Wear Co received a bank statement on 30 September 20X5
showing that the balance at the bank is $16,896.
The accountant noticed a deduction for bank charges of $256, which had not been
recorded in the cash book.
Also, a cheque for $345 banked in from a customer has been dishonoured, and a
standing order payment for $2,100 has not been recorded in the Bank ledger.
The Bank ledger on 30 September 20X5 shows a balance of DR $22,458. The
accountant notices that there are cheques that have not been presented for payment
amounting to $12,980 and receipts of $15,841 banked that have not been identified on
the bank statement.
State the correct amount to be recorded in the Statement of Financial Position as
Bank and show the bank reconciliation computation.
CHAPTER 6: Visual Overview
CHAPTER 6: Visual Overview
Objective: To explain how receivables and payables are accounted for and the period-end
adjustments for irrecoverable debts.

6.1.1 Introduction to Receivables

1.1 Introduction to Receivables
1.1.1 Receivables Definition
Definition

Receivables are the amounts due to the business from individuals, organisations, or other
entities to satisfy a debt or a claim.

1.1.2 Examples of Receivables

Examples of receivables include:
• Trade Receivables – These are amounts due from customers for credit sales of goods or
services.
• Prepayments or Prepaid Expenses – These are the amounts that have already been paid
by the business but relate to a future accounting period. For example, insurance that was paid in
advance by the business.
• Other Receivables – This would include receivables that cannot be classified under a specific
receivable heading in the financial statements. Examples of other receivables include:
 o Rents due to be received from tenants
o Tax refunds due (due to overpayment or net reclaimable position)
o Loan receivables to another party
o Interest receivable (from bank deposits)
o Advance payments to suppliers. (the advance is refundable until the supplier delivers the
goods or services.)
o Dividend payments not yet received from the purchase of shares.

6.1.2 Credit Facilities

1.2 Credit Facilities
Credit facilities offered to customers allow the customer to purchase goods or services from the
business for payment in the future. A business provides this option to customers to have an
advantage over its competitors.
In practice, most businesses operate by offering credit to customers, even though it may seem to be
a risky strategy.
When customers purchase goods from a business, they will arrange with the business to settle the
account at an agreed time in the future. The credit terms define the agreed time and the penalties
resulting from payment exceeding that period.
Customers will also be given a credit limit. This is the maximum amount the customer can owe the
business for sales already made before it expects payment from them.
It is the job of the business's credit controller to ensure that customers pay the amounts owed within
the credit terms.

1.2.1 Advantages and Disadvantages of Credit Facilities

Advantages Disadvantages
• Seller increases revenues. • May increase the cost of items purchased (For
• Buyer obtains and can use example, if a customer does not pay on time, the
purchased item immediately. business may have to borrow money from its bank
• Minimises the need to carry cash or and be charged interest fees).
write cheques. • Legal fees may be incurred for credit customers who
• Makes expensive items affordable refuse to pay.
by allowing them to be paid for over • Late payment fees and penalties may be costly to the
a period. buyer.
• Buyer convenience, as the buyer • Administrative costs to the seller and the risk of
does not have to be present at the irrecoverable ("bad") debts.
point of purchase (e.g. online • It may require security or other guarantees.
shopping).

1.2.2 Credit Control

Credit control concerns not only “chasing” overdue accounts but establishing the foundations for
granting credit to customers:
• Who gets credit? The initial screening of potential credit customers is essential (For example,
businesses only allow credit facilities for references)
• Agree on terms of credit and the credit limit in advance.
• Accurate invoicing to avoid disputes which delay their settlement.

1.2.3 Credit Limits

Definition

The credit limit is the threshold a business will allow a customer to owe at any time
without having to go back and review their credit file.
It is the maximum amount the business is willing to risk on an account.
The primary purpose of credit limits is to limit risk exposure. There are numerous benefits of
having credit limits.
• Established credit limits free up valuable time for other credit management tasks.
 • Speed up the sales process as the amount of credit allowed is established.
• Improve collection activity and efforts.
• Serve as an account monitoring tool (For example, if a limit is regularly reached, it is time to
consider increasing the limit or prompt the customer to pay overdue amounts).

6.1.3 Aged Receivables (Debt) Analysis

1.3 Aged Receivables (Debt) Analysis
The Aged Receivables Analysis is a report of all the receivables balances analysed by customer
name with information on each customer's credit limit and cumulative turnover for the accounting
period as well as the age of the outstanding amount, that is:
• amounts that have been outstanding for 30 days or less
• amounts that have been outstanding for more than 30 days but less than 60 days
• amounts that have been outstanding for more than 60 days but less than 90 days
• amounts that have been outstanding for 90 days or more
The receivable ageing will be used in conjunction with credit control procedures. For example, first
and second reminders and final notices are prompted as a balance (debt) owed becomes
increasingly overdue. The percentage of total balances falling into each period can be monitored,
and prompt corrective action can be taken if the profile deteriorates.

6.1.4 Irrecoverable Debts

1.4 Irrecoverable Debts
Definition

Irrecoverable or bad debt is an account receivable which will likely remain uncollectable and should be written off.
Unfortunately, some customers will be unable or unwilling to pay for any business. When this is the
case, the debt is termed to be irrecoverable.
Indicators that debt may become irrecoverable include:
• Taking longer to pay than is usual
• Paying in instalments outside normal credit terms
• Regular disputing of invoices (as a delaying tactic)
• Going into receivership (administration)/liquidation

1.4.1 Irrecoverable Debt Write-off

When a business is owed money by a customer unable to pay, there is little point in keeping the
customer's account in the business' receivables ledgers.
If the debt is not an asset, it should not be carried in the statement of financial position. To give a
fair presentation in the accounts, irrecoverable debts are written out of the books and expensed to
profit or loss, thereby reducing profit (or increasing a loss) using a journal.
The journal entry to write off the irrecoverable debt is:
Individual Account Category Explanation

DR Irrecoverable Debt Expense Bad Debt (Expense) increased

CR Receivables Asset Receivables (Asset) decreased

Example 1
A business sells $500 of goods to Mr Maxwell on credit. The double entry to record the
initial sale is: DR Trade Receivable $500, CR Sales/ Revenue $500
During the year, the debt is found to be irrecoverable. The double entry to record the
irrecoverable debt is: DR Irrecoverable Debt $500, CR Trade Receivable $500
 Exam advice

If a trial balance includes an amount for bad debts, the receivable amount has already been
reduced.

Activity 1
KYY Co. owns a factory that makes plastic containers and offers customers credit terms of three
months. KYY Co. sells its containers to different businesses.
1. What is the journal entry to record the sale of $10,000 to Deji's Diamonds on credit?
2. What is the journal entry to record an irrecoverable debt of $5,000 for Alan's Motors?
3. The balance on the irrecoverable debts expense account is presented in the Statement of
Financial Position as an expense. True or False?

1.4.2 Subsequent Bad Debt Recovery

A bad debt written off may subsequently become recoverable. The double entry to record an
irrecoverable debt recovery is:
Step 1: Reverse the irrecoverable debt write-off
Individual Account Category Explanation
DR Receivables Asset Receivables (Asset) increased
CR Irrecoverable Debt Expense Bad Debt (Expense) decreased
Since the balance owed has been paid, the amount is not irrecoverable. Therefore, an adjustment
to reverse the earlier write-off is made.
Step 2: Record the receipt
Individual Account Category Explanation
DR Bank Asset Bank (Asset) increased
CR Receivables Asset Receivables (Asset) decreased
Therefore, the net effect of the above two entries is DR Bank, CR Irrecoverable Debt.
Individual Account Category Explanation
DR Receivables Asset Receivables (Asset) increased
DR Bank Asset Bank (Asset) increased
CR Irrecoverable Debt Expense Bad Debt (Expense) decreased
CR Receivables Asset Receivables (Asset) decreased
Example 2
Continuation from Example 1 previously.
$217 is received from Mr Maxwell for a debt written off as irrecoverable in the following
year. The journal entry to record the irrecoverable debt recovery is:
DR. Cash/Bank $217 and CR Irrecoverable Debt $217

Note: It is irrelevant if the amount recovered bears no relation to the amount written off.
Activity 2
KYY Co. runs a factory making plastic containers and sells them to customers, offering them credit
terms of three months.
Haruka's Homes bought some containers for $50,000. Unfortunately, Haruka was declared
bankrupt, and the full amount was irrecoverable. Two months later, a cash settlement of $10,000
was received.
State whether the below statements are True or False.
1. When the debt becomes irrecoverable, the irrecoverable debt expense account is debited
$50,000.
2. The cash settlement of $10,000 is credited to receivables.
3. The irrecoverable debt of $50,000 would be removed from sales.

6.1.5 Allowance for Receivables

1.5 Allowance for Receivables
In general, businesses estimate expected credit losses on trade receivables. The expected loss
estimate is recognised as an expense under Allowance for Receivables. These may be specific or
general.
• Specific allowances are made against one particular receivable.
For example, a customer has disputed the amount that has been invoiced and is taking a
long time to pay.
• General allowances are made against non-specific balances and may represent a
percentage of the amount due after more than 90 days on the aged receivables analysis.
For example, based on experience, a business may expect to write off 5% of all balances
in the aged receivables account that have been outstanding for more than 90 days.

1.5.1 Presentation of Allowance for Receivables

The amount of the loss allowance is offset against Trade Receivables for presentation in the
statement of financial position.
$ $
Current assets
Inventory x
Trade receivables x
Less: Allowance for Receivables (x) x
Cash x
x

1.5.2 Accounting for Allowance for Receivables

The amount of the loss allowance is forward-looking and based on the expectation that some
customers will not settle their outstanding balances in full. When it is uncertain that a debt will be
recovered, the expected loss is recognised.
At the end of each accounting period, the business reviews its customer accounts and identifies
customers with evidence to suggest they might not pay. The business will also make a general
estimate of the percentage of receivables expected to be irrecoverable.
The steps needed to account for the allowance for receivables are:
1. Calculate the closing allowance for the receivables balance at the year-end
2. Calculate the difference between the closing allowance for receivables and the opening
allowance for receivables.
3. The increase or decrease is adjusted in the Allowance for Receivables ledger account to
reflect the closing allowance for receivables.
An initial allowance is made and then adjusted year-on-year (incrementally) to reflect overall
outstanding trade accounts receivable. The adjustment for Allowance for Receivables is made
through the Journal as a year-end adjustment.
If the current closing allowance calculated is more than the opening allowance balance, the double
entry to record the adjustment is:
Individual Account Category Explanation
DR Irrecoverable Debt Expense Bad Debt (Expense) increased
CR Allowance for Receivables Asset Receivables (Asset) decreased
Since it has been identified that the closing allowance is more than the opening allowance, the
difference is posted as an expense under Irrecoverable Debt in the statement of profit or loss.
If the current closing allowance calculated is less than the opening allowance balance, the double
entry to record the adjustment is:
Individual Account Category Explanation
DR Allowance for Receivables Asset Receivables (Asset) increased
CR Irrecoverable Debt Expense Bad Debt (Expense) decreased
Since the closing allowance is less than the opening allowance, the difference is posted to decrease
the irrecoverable debt expense. The reduced expense will be shown in the statement of profit or
loss.
Exam advice

The term 'receivables expense' may also be used for 'irrecoverable debts expense'.
If a specific doubtful debt is deemed irrecoverable, the Receivables and Allowance for Receivables
accounts are reduced by the irrecoverable amount. There is no need to recognise a further bad debt
(as it has already been written off in maintaining the allowance for receivables). There will be no
further SOCI effect.
The double entries are:
Individual Account Category Explanation
DR Allowance for Receivables Asset Receivables (Asset) increased
Cr Receivables Asset Receivables (Asset) decreased
Since the closing allowance is less than the opening allowance, the difference is posted to decrease the
irrecoverable debt expense. The reduced expense will be shown in the statement of profit or loss.

(Note – while the Allowance for irrecoverable debts is described as an asset account, it is a negative asset,
as it reduces the value of trade receivables in the statement of financial position.)
Example 3

On 31 December 20X5, Aztec made an allowance for irrecoverable debts of $100. During the
year ended 31 December 20X6, $50 of trade receivables was written off as irrecoverable debts.
Required:
Write up the journal entries, the irrecoverable debts expense a/c and the allowance for
irrecoverable debts a/c assuming that the allowance for irrecoverable debts needed at 31
December 20X6 is:
(i) $180
(ii) $80
Solution:
(i) Allowance for irrecoverable debts is $180
DR Irrecoverable debts expense account $50

CR Trade receivables $50

Being the write off of trade receivables during the year.
The allowance for irrecoverable debts has increased from $100 at 31 December 20X5 to $180
at 31 December 20X6, an increase of $80. The journal entries used to record this are:
 DR Irrecoverable debts expense account $80

CR Allowance for irrecoverable debts $80

DR Irrecoverable debts expense account CR

Debt written off $50

Increase in allowance $80 Transfer to Statement of Profit or loss $130

$130 $130

DR Allowance for Irrecoverable Debts (Asset) CR

31-Dec-X5 Balance b/d $100

31-Dec-X6 Balance c/d 180 31-Dec-X5 Irrecoverable debts expense account $80

$180 $180

01-Jan-X7 Balance b/d 180

(ii) Allowance for irrecoverable debts is $80
DR Irrecoverable debts expense account $50

CR Trade receivables $50

Being the write off of trade receivables during the year.
The allowance for irrecoverable debts has fallen from $100 at 31 December 20X5 to $80 at 31
December 20X6, a decrease of $20. The journal entries used to record this are:

DR Allowance for irrecoverable debts $20

CR Irrecoverable debts expense account $20

DR Irrecoverable debts expense account CR

Debt written off $50 Decrease in allowance $20

Transfer to Statement of Profit or loss $30

$50 $50

DR Allowance for Irrecoverable Debts (Asset) CR

31 Dec X6 Irrecoverable debts expense account $20 31-Dec-X5 Balance b/d $100

31 Dec X6 Balance c/d $80

$100 $100
 $

01-Jan-X7 Balance b/d $ 80

1.6 Calculating the Allowance

Under IFRS 9, Financial Instruments, an allowance for credit losses must be calculated for every
receivable from the moment of its origination (i.e. the date that the sale is made). Calculating the
allowance involves the use of expected values. This is beyond the scope of the FA/FFA exam, so
you would be told what the allowance should be at the start and end of each year, if needed.

Example 4
Zan runs a business selling engine parts to the motor industry. In Zan’s ledgers,
Chandni owns a motor manufacturing business and owes Zan $56,000. Chandni has
been disputing the amount owed for two months. Zan believes Chandni will not pay,
so she wants to make a specific allowance against this receivable.
Zan has also looked at her aged receivables balance and has noted that the amount
relating to other customers who have not paid in the last four months totals $45,000.
She would like to make a general allowance of 3% against these receivables.
This is Zan’s first year in operation. Her financial year-end is 31st December X2.
Specific Allowance:
Zan will create a specific allowance for Chandi’s receivables balance of $56,000 as
there is evidence that the amount may not be settled. The double entry to record the
special allowance is:
DR Irrecoverable Debt $56,000
CR Allowance for Receivables $56,000
General Allowance:
Zan also makes a general allowance for receivables of 3% of the outstanding amount
from other customers whom Zan believes will not pay. The amount is $45,000 × 3% =
$1,350. The double entry to record the general allowance is:
DR Irrecoverable Debt $1,350
CR Allowance for Receivables $1,350
Since this is Zan’s first year in operation, she has no opening Allowance for
Receivables. Her Allowance for Receivables ledger should be as follows:

DR Allowance for Receivables (Asset) CR

31-Dec-X2 Balance c/d $57,350 31-Dec-X2 Specific Allowance $56,000

31-Dec-X2 General Allowance $1,350

$57,350 $57,350

01-Jan-X3 Balance b/d $57,350

Next Year:
In the following year ending 31st December 20X3, Zan calculated her total closing
Allowance for Receivables as $45,660. What is the year-end adjustment to record the
allowance?
The closing allowance ($45,660) is compared to the opening allowance ($57,350).
Since the current closing allowance is less than the opening balance by $11,690
($57,350 – $45,660), the double entry to record the entry is:
DR Allowance for Receivables $11,690
 CR Irrecoverable Debt $11,690
Zan’s Allowance for Receivables will be as follows on 31st December 20X3:
DR Allowance for Receivables (Asset) CR

31-Dec-X3 Decrease in Allowance $11,690 01-Jan-X3 Balance b/d $57,350

31-Dec-X3 Balance c/d $45,660

$57,350 $57,350

01-Jan-X4 Balance b/d $45,660

The closing balance of the Allowance for Receivables (balance c/d) is $45,660. The
amount will be carried forward as the opening allowance in the following year.
Activity 3
Kimi runs a small factory making tins of paint. Kimi has a financial year end of 31 December 20X6.
The balance of receivables in her general ledger is made up of the following balances at year-end:
30 days Husna $1,350
30 days Manisha $23,540
60 days Ken $12,800
60 days Jing $42,800
90+ days Han $12,960
Total $93,450
Kimi was notified that Husna had been made bankrupt and that she would not receive the amount
owed by that business.
In addition, she believes that there is a possibility that Han would not pay the amount outstanding,
and a specific allowance against the amount should be made. She would also like to make a
general allowance against the remaining balances of 2%. The general allowance brought forward
from last year was $267.
What is the balance of the Trade Receivables, Irrecoverable Debt and Allowance for
Receivables account at the financial year-end?

1.6.1 Writing off debts where an allowance has already been made
When a debt, against which an allowance has already been made is eventually written off, the
accounting entry is the same as for writing off any irrecoverable expense:

Individual Account Category Explanation

DR Irrecoverable debt Expense Bad debt (expense) increased

CR Receivables Asset Receivables (asset) decreased

You may be concerned that this would lead to the cost of the bad debt being double counted: first
when the allowance is made, and secondly when the debt is written off. However, that is not the
case. When the debt is finally written off, it will also be taken out of the allowance for irrecoverable
debts. A reduction in the allowance leads to a credit to the irrecoverable debts expense account,
which cancels out the expense recognised when the debt is written off.
 Exam advice

Any debt against which a specific allowance is made must be ignored when calculating the general
allowance (to avoid double-counting).

6.2.1 Introduction to Payables

2.1 Introduction to Payables
2.1 1 Payables Definition
Definition

Payables are the amounts owed for the cost of purchases or other obligations entered but not yet paid.

2.2 2 Examples of Payables

Examples of payables include:
• Trade Payables – These are the amounts owed to trade suppliers regarding credit purchases
of goods or services.
• Bank Overdraft – An overdraft exists where the balance of cash held at the bank is negative.
This sum is repayable to the bank on demand.
• Sales Tax Liability – The amounts owed to the tax authority for sales tax collected on sales to
customers.
• Income Tax Liability – This is the income tax due from profits the business makes.
• Accruals – These are expenses of the business that has been incurred during the accounting
period and has not yet been paid, such as electricity and rent.
• Other Payables – Examples of other payables are:
o Prepaid Income
o Loans and interest thereon (may include penalty payments).
o Advance payments received from customers.
o Amounts due to group companies.
o Salaries and wages earned by but not yet paid to employees.
o Dividends declared by a company but not yet paid to shareholders.

2.2.3 The Trade Payables Ledger

In a computerised system, the payables ledger (sometimes referred to as the Payments module)
contains all the credit purchase transactions and their details, which are recorded and journal
entries are posted to the general ledger accounts to record purchases and trade payables. Each
individual supplier also has an account which is not part of the general ledger, where details of all
transactions with that supplier are recorded so that individual supplier balances can be monitored.
The individual account balances will be reconciled with statements received from suppliers to
ensure accuracy and reliability. Supplier statement reconciliations are discussed later in this
chapter.

6.2.2 Receivables and Payables Contra

2.2 Receivables and Payables Contra
Trade payables are most commonly settled in cash via bank transfers. In some cases, amounts due
to suppliers also may be settled through contra-entry, where the supplier is also a customer.
In this case, the parties agree that amounts may be offset. Therefore, only the net amounts are
settled in cash. The double entry to book the contra adjustment via the journal is as follows:
Individual Account Category Explanation
DR Trade Payables Liability Payables (Liability) decreased
CR Trade Receivables Assets Receivables (Asset) decreased
Once the contra entry takes place, only the difference is reflected in the Trade Receivables or Trade
Payables account.
Exam advice

The amount of offset must be the lower amount.

Example 4
Company A owes $1,000 to company B, and company B owes $1,200 to company A. The two
parties agree to offset their accounts.
Company A’s ledger
The double entry in Company A’s ledgers is:
DR Trade Payables $1,000

CR Trade Receivables $1,000

Company A’s receivable balance is $1,200, and its payable balance is $1,000.
After the contra entry, Company A’s receivable balance is $200, and its payable balance is
zero. Company B only owes Company A $200.
Company B’s ledger
The double entry in Company B’s ledger is:
DR Trade Payables $1,000

CR Trade Receivables $1,000

Company B’s receivable balance is $1,000, and its payable balance is $1,200.
After the contra entry, Company B’s receivable balance is zero, and its payables balance is
$200. Company A no longer owes Company B any amount.

6.2.3 Supplier Statements

2.3 Supplier Statements
A supplier of goods or services will send customers a monthly statement (similar to a credit card
statement) showing what is owed.
The supplier issues the statement of accounts (supplier statement) at each month’s end. The
statement of account shows the outstanding balance at the month’s end. It includes the opening
balance plus the invoices raised by the supplier during the month, less any credit notes and
payments received by the supplier.
Example 5
Sweety Sweets runs a confectionery shop and purchases chocolate bars from Puja Chocolate
Supplies. At the end of each month, Puja Chocolate Supplies sends Sweety Sweets a
statement outlining the invoices still needing to be settled.
The statement sent by the supplier would look as follows:
The supplier statement of account highlights several items:
• Supplier’s details– The supplier’s name, address, phone, fax and sales tax
registration number are shown in the statement.
• Customer’s details– The customer‘s name and address are displayed.
• Received Stamp – The business will stamp the statement to show the date the
statement was received.
• Transaction list – The statement will highlight all the invoices, credit notes and
payments between the business and the supplier.
• Debits and Credits – Since the statement is from the supplier’s perspective,
debits are the amount the business owes to the supplier (opening balance and
invoices). In contrast, credits are the amounts that reduce the outstanding balance
(credit notes and payments).
• Total Amount Due – The statement highlights the total amount owed from the
business at the end of the month.
• Credit Terms – The credit limit and payment terms are highlighted in the
statement.
6.2.4 Supplier Statement Reconciliation
2.4 Supplier Statement Reconciliation
Definition

A supplier statement reconciliation is a reconciliation between the balances in the Trade Payables ledger and the
supplier statement.
The Trade Payables ledger represents the balance outstanding to suppliers. It is the value of
purchase invoices received, less credit notes and payments to suppliers.
The supplier account and the supplier statement balance should match as both show the amount
owed from a business to the supplier. However, these balances may differ due to timing
differences or entry errors.
Differences may arise due to timing differences, such as:
• Supplier has recorded invoices or credit notes that a business has not received
• Payments were made to the supplier after the Supplier Statement was generated
• Payments made but not yet received by the supplier
Differences may also occur due to the business or supplier making erroneous entries, such as:
• omitted recording invoices, credit notes, or payments made
• making transposition errors when entering information from the purchase invoice (For
example, $56 is entered into the system as $65)
• allocating the supplier invoice against the wrong supplier
• not updating the accounting records for settlement discounts taken
• recording document information twice (duplicate entry)
Reconciliation between these two balances is needed to verify between internal information
(supplier account) and an external source (supplier statement).
Although supplier statements, as external documents, are a reliable source of information, errors
may still appear. These errors should be communicated to the supplier quickly and professionally to
ensure the business sustains no monetary losses and maintains a good relationship between the
parties.

2.4.1 Reconciliation
A business will want to ensure that its liabilities are wholly and accurately recorded and that it does
not overpay. Therefore, it will reconcile the supplier's statement periodically and adjust (accounting
entries) for any errors.
Example 6
Sweety Sweets (SS) receives a statement of account from Puja Chocolate Supplies (PCS), which
shows an outstanding balance of $588.42 at the end of the month.
However, Sweety Sweets’ ledger shows an outstanding balance owed to Puja Chocolate Supplies
of $873.55.
The transactions that agree are highlighted, and any missing transactions are noted.
Upon investigating, Sweety Sweets noticed the reasons for the difference:
1. Credit Note 258, worth $258.13, was not recorded in their payable ledger but reflected in the
supplier statement.
2. The supplier statement incorrectly recorded Invoice 19892 as $458.13 instead of $485.13, with a
difference of $27.
The missing credit note is recorded in the ledger account with the double entry: DR Payables
$258.13, CR Purchases $258.13.
The revised ledger account is now $615.42 ($873.55 – $258.13) and is the correct payable balance
to be reported in the Statement of Financial Position.
A Supplier Statement Reconciliation is prepared:
Reconciliation of Puja Chocolate Supplies Payables
$
Balances per Payables Ledger 615.42
Adjustments – to Payables Ledger
Add: Invoice -
Less: Credit Note -
Less: Payment made -
Adjustments – to Supplier Statement
Less: Invoice -
Add: Credit Note -
Add: Payment made -
Less: Invoice 19892 error (27)
Balances per Supplier Statement 588.42
Several reasons the supplier statement balance did not agree with the payable ledger account are
summarised in the table below.
Type of Difference Reason for occurrence Action Plan
 Payments made by SS SS made payment to PCS, This timing difference between SS’s and
but not received by which has not been received or PCS’s records will resolve itself when PCS
PCS (payments in recorded yet. receives the cash in the following month.
transit)

Omitted invoices Invoices have been sent by SS records are incorrect, and the ledger
PCS but not recorded/ received should be adjusted.
by SS.

Omitted credit notes Credit notes have been issued SS records are incorrect, and the ledger
by PSC but have not been should be adjusted.
recorded by SS yet.

Other input errors SS or PCS may input the If SS made the error, the error is
invoice, credit note or payment corrected in the ledger.
If PCS made the error, include the error
amount incorrectly in the
in the reconciliation under adjustments
accounting system.
to the supplier statement and inform the
supplier promptly.

Activity 4
Bill’s Cocoa Co is one of Sweetie Sweet Co’s suppliers. The balance on Bill’s Cocoa Co account in
Sweetie Sweet Co’s purchases system showed a balance of $275 at 30 June 20X2.
Extracts from Bill’s Cocoa Co account are as follows:
Supplier name - Bill's Cocoa
Sales

Date Reference Type Net tax Total

$ $ $

1 Jun 20X2 Inv 510 Purchase invoice 150 30 180

5 Jun 20X2 Inv 562 Purchase invoice 230 46 276

27 Jun 20X2 Inv 574 Purchase invoice 170 34 204

28 Jun 20X2 Pending credit note -170 -34 -204

30 Jun 20X2 Pmt 4820 Payment -150 -30 -180

Total balance 276

A few days later, Sweetie Sweets Co received a statement of account from Bill’s Cocoa Co,
showing a balance of $768.00:
Supplier statement
Bill’s Cocoa Co
Statement of Account at 30 June 20X2
Customer: Sweetie Sweets Co
 Date Description Amount Paid Balance

1 Jun X2 Inv 510 180.00 0.00 180.00

4 Jun X2 Invoice 562 384.00 0.00 384.00

27 Jun X2 Invoice 574 204.00 0.00 204.00

Balance at 30 June 20X2 768.00

On investigation, the following differences were discovered:

1. Invoice 562, for $320 plus sales tax of 20%, had been entered into Bill’s Cocoa Co’s individual
account as $230 plus sales tax of 20%.
2. Some good received on 27 June from Bill’s Cocoa Co had been damaged in transit. Bill had
agreed to issue a credit note for the full amount of $170 plus sales tax of 20%. The credit note
was not issued until 1 July, but the bookkeeper had included it in Bill’s Cocoa Co’s individual
account on 28 June as pending.
3. A payment of $180 made on 30 June did not reach Bill’s Cocoa Co’s bank account until 1 July, so
was not reflected in the statement of account.

Required:
(i) After identifying any errors, calculate the correct balance in Bill’s Cocoa Co’s individual account.
(ii) Reconcile the corrected balance to the supplier statement received from Bill’s Cocoa Co.

Key Point

No adjustments related to supplier statements are made for timing differences. These will be corrected in
the next accounting period.
CHAPTER 7: Visual Overview
CHAPTER 7: Visual Overview
Objective: To explain the accounting treatment for provisions and contingencies.

7.1.1 Provision Definition

1.1 Meaning
Definition

A provision is a liability of uncertain timing or amount. (IAS 37)

A liability is a present obligation arising from past events, the settlement of which is expected to result
in an outflow of economic resources. (IAS 37)
Note: The definition of liability used in IAS 37 is slightly different from that used in the IFRS conceptual
Framework discussed in Chapter 2.
Some common examples of liabilities are:
• Warranty provisions: where businesses give warranties on their products. If the product is
faulty, the customer can return it.
• Provisions for clean-up costs: companies may have an obligation to clean up land at the end of
the life of their production facilities. The liability would consist of the future costs of cleaning up.

7.1.2 Recognition Criteria

1.2 Recognition Criteria
For any liability, including provisions, to be recognised, all three of the following criteria must be satisfied:
 1. A present obligation (legal or constructive) exists due to a past event (obligating event).
2. An outflow of resources to settle the obligation is probable.
3. A reliable estimate of the obligation can be made.
(It may be impossible to make a reliable estimate only in rare cases.)
Key Point

An outflow of resources is probable if the event is “more likely than not” to occur (greater than 50%
likelihood).

7.1.3 Measurement
1.3 Measurement
Key Point

The amount provided should be the best estimate, at the reporting date, of the expenditure required to settle the
obligation.
The best estimate might be:
• evidenced by events after the reporting date
• the mid-point of a range of possible values (Example 1)
• the most likely outcome for single/one-off obligations
• an expected value after weighting all possible outcomes by their probabilities which can be used to
estimate obligations such as warranties for products sold or other similar obligations (Example 2)
Example 1
In 20X6, Benedict was sued for damages by a significant customer for breach of contract. In March 20X7,
the court ruled in favour of the customer but deferred its ruling on the amount of damages until June. For
legal advice in defence of this claim, Benedict paid $15,000 in 20X6; a further $20,000 to date (to be paid
once the matter is settled in June), and Benedict expects to pay an additional $10,000 before the case is
wholly settled.
Benedict’s legal adviser thinks that Benedict will be directed to reimburse the customer's legal costs,
which he estimates will be as much as Benedict’s. Based on the level of damages claimed, he also
believes these are likely to be in the region of $250,000 to $300,000.
Analysis of best estimate
Benedict should provide for the following:
• its legal costs incurred after the end of the reporting period ($15,000 incurred in 20X6 is already
expensed, so not considered in calculating the provision.)
• the best estimate of the customer's legal costs
• the best estimate of the damages. This is the most subjective. As the estimated range of the outcome is
relatively narrow, any amount in this range may be considered as good an estimate as any other.
However, a midpoint may be selected as the lower end of the range may be considered imprudent, and
the upper end over prudent.
For Benedict’s legal costs ($20,000 + $10,000) $30,000
For the customer's legal costs ($15,000 + $20,000 + $10,000) $45,000
For the award of damages (mid-point of range) $275,000
$350,000
Therefore, the best estimate might be $350,000 to be recognised as a provision in the statement of
financial position.
Example 2
The facts are the same as in Example 1, except that the legal adviser is of a different opinion regarding
the damages to be awarded.
The legal adviser suggests that the most likely award of damages will be $120,000. However, there is an
outside chance that the court may rule for punitive damages amounting to $500,000.
He thinks there also is an outside chance that the ruling may consider some contributory negligence on
the part of the customer and award only nominal damages (of a minimal monetary amount).
 Analysis of best estimate
Even if specific probabilities could be assigned to the extremes (say 10% each), the calculation of an
expected value is not appropriate.
For example, taking $0 as an approximation of nominal: (10% × $0) + (80% × $120,000) + (10% ×
$500,000) = $146,000
This amount does not correspond to any of the outcomes envisaged. (Also, as a relatively specific
amount, it suggests an inappropriate degree of precision.)
The best estimate is the most likely item, $120,000.
This example shows that an expected value approach is inappropriate for a single obligation.
Example 3
Cassie sells skateboards with a six-month warranty. During the second half of the year to 30 June 20X5,
she sold 504 boards. (The warranty on boards sold in the year’s first half will have expired.) If a board
comes back for minor repairs, it will cost her $10; If it needs major repairs, it will cost her $30.
From experience, Cassie estimates that 20% of boards will come back for minor repairs, and 5% will
come back for major repairs.
How should Cassie estimate the amount of provision needed?
Provisions for warranties, such as in Cassie’s case, involve many individual items. Cassie will know her
repair costs, but she must estimate how many items will be affected.
This can be done using the expected value method.
Minor repairs: (504 × 20%) × $10= $1,008
Major repairs: (504 × 5%) × $30 = $756
This gives her an amount of $1,764 ($1,008 + $756) for potential repairs under warranty as at 30 June
20X5.

7.1.4 Accounting Treatment

1.4 Accounting Treatment
Key Point

Provisions must be recognised in the financial statements when all the recognition criteria have been
met.
The steps needed to account for the Provisions are:
1. Calculate the closing provision balance at the year-end.
2. Calculate the difference between the closing and opening provision balance.
3. The increase or decrease is adjusted in the Provisions ledger account to reflect the closing
Provision amount.
If the current provision calculated is more than the opening provision balance,
Individual Account Category Explanation
DR Individual Expense Expense Individual Expense increased
CR Provision Account Liability Provisions (Liability) increased
If the current provision calculated is less than the opening provision balance,
Individual Account Category Explanation
DR Provision Account Liability Provisions (Liability) decreased
CR Individual Expense Expense Individual Expense decreased
Example 4
Tamara operates a factory. The local government has told all businesses in the area that they must
install smoke detectors on their premises by 30 March 20X6. It is 30 April 20X6 – Tamara's reporting
period end. She has not yet installed the smoke detectors and intends to do so the following day. She
has been quoted a cost of $12,000.
1. Is the requirement to install smoke detectors an obligation due to a past event?
Yes. The obligation is legal as it is a local government requirement, and the deadline for
installing the smoke detectors has passed; it was 30 March.
 2. Will there be a transfer of economic benefits?
Yes. The business is expected to pay to install smoke detectors, so money will leave the
business.
3. Can we make a reliable estimate of the cost?
Yes. Tamara has been quoted $12,000 to install the smoke detectors.
4. Should we record the addition of the smoke detectors as an expense in the statement of
profit or loss?
No, they will last for more than one year if maintained, which would be a non-current asset and
not an expense. Once the smoke detectors have been purchased, we should record the smoke
detectors as non-current assets.
5. Should the provision be presented in the financial statements as a liability?
Yes, this provision should be recognised as a liability in the statement of financial position. It is
a current liability as it must be settled in less than one year.
Example 5
Harry's business sells cookers through his retail shop. Harry hopes the cookers will not develop faults
once delivered to the customer. However, he knows there will always be faulty goods that will be
returned.
At each year’s end, he estimates the amount of repair work he will have to pay for and therefore accounts
for a provision. He will record the movement in this provision.
In the past, the provision has been based on 2% of annual sales. However, this year there have been
more repairs than usual required, so the agreed provision level has increased to 3.5%. Sales for the year
were $157,143.
Last year, Harry’s business made a provision for repairs of $4,000 and $3,000 was utilised. Therefore,
last year’s closing provision balance (opening this year) is $1,000 ($4,000 − $3,000).
At the end of the current reporting period, 31 December 20X5, the new provision should be 3.5% ×
157,143 = $5,500
Since the current provision calculated is more than the opening provision balance by $4,500, the double
entry to record the movement is:
DR Repairs Expense (SPL) $4,500
CR Provision (Liability) $4,500
DR Provision (Liability) CR
01-Jan-X5 Balance b/d (Opening) $1,000
31-Dec-X5 Balance c/d $5,500 31-Dec-X5 Repairs Expense $4,500
$5,500 $5,500
01-Jan-X6 Balance b/d $5,500
The closing balance on the provision account is $5,500. This is recorded as a liability in the statement of
financial position for the year ended 31 December 20X5.

7.2.1 Introduction to Contingencies

2.1 Introduction to Contingencies
An asset or liability may be contingent because:
• uncertain future events may or may not occur or
• recognition criteria have not been met (if a reliable estimate of the amount cannot be made).
The mere fact that an accounting estimate is involved does not create the type of uncertainty that
characterises a contingency.
A range of outcomes can express the uncertainty of a contingency. The approaches range from specific
to general.
• Quantified probabilities (40% chance of A and 60% chance of B) are specific. This suggests a
level of precision which is unlikely to be supported by available information.
• General descriptions, better supported by the available information, use terms ranging from
probable to remote.
7.2.2 Contingent Liabilities
2.2 Contingent Liabilities
2.2.1 Contingent Liability Definition
Contingent liability is either:
• A possible obligation arising from past events 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 arising from past events is not recognised (i.e. as a liability) because:
o an outflow of resources is not probable or
o it cannot be measured with sufficient reliability
For example:
• Sharif is the guarantor of the overdraft of another business. The likelihood of a liability arising under
guarantee is assessed as possible. This is a contingent liability as Sharif may have to pay on behalf of
the other business.
• Sharif has been taken to court by a customer who claims they slipped and fell on his premises and
suffered a personal injury. The court case is ongoing, and the lawyers believe that Sharif may lose the
case, but it is impossible to estimate the potential damages. Sharif has to disclose a contingent liability
in respect of the court case.

2.2.2 Accounting Treatment

Key Point

Contingent liabilities should not be recognised as liabilities.

Contingent liabilities should be disclosed (unless the possibility of expenditure is remote) in the notes to
the financial statements.
If the likelihood of expenditure becomes probable, a provision will then be recognised (assuming a reliable
estimate can be made). This is another example of the application of the prudence concept.

7.2.3 Contingent Assets

2.3 Contingent Assets
2.3.1 Contingent Asset Definition
A contingent Asset is a possible asset arising from past events whose existence will be confirmed only
by the occurrence or non-occurrence of one or more uncertain future events not wholly within the entity’s
control.
For example:
• Sharif had to write off computers held as inventory due to a fire in the warehouse. He has claimed on the
insurance but has not heard if he is covered for such losses. This is a contingent asset because he may
receive some insurance monies.
• Sharif has decided to take a builder to court as they have failed to complete work due on his premises,
and this delay has led to a loss of earnings for the business. The lawyers think that it is likely that Sharif
will win the case. He can therefore disclose a contingent asset.

2.3.2 Accounting Treatment

For contingent assets, the following apply:
• Existence should be disclosed if it is probable that a gain (economic benefits) will be realised. The
disclosure must avoid giving misleading implications about the likelihood of realisation.
• When the realisation is virtually inevitable, there is no contingency, and recognition is appropriate.
Key Point

Contingent assets should not be recognised as assets (because this may result in the recognition of revenue
which may never be realised).
Activity 1

Determine which of the following uncertainties meets the criteria of a contingency.

1. Pending litigation
2. Estimating useful lives of asset
3. Guarantee (a bank loan)
4. Recoverability of a liquidated debt
5. Estimates of amounts owed for services received
6. Net realisable value of slow-moving inventories

7.3.1 Scope of IAS 37

3.1 Scope of IAS 37
IAS 37 Provisions, Contingent Liabilities and Contingent Assets apply to all entities and details the
accounting treatment for provisions, contingent liabilities and contingent assets, excluding those covered
by other Standards.
Provisions, contingent liabilities and contingent assets all lack certainty about when the events will occur
and the value placed on them. This affects the way these items are reported in the financial statements.

7.3.2 Disclosure Requirements

3.2 Disclosure Requirements
3.2.1 Provisions
For each class of provision, the following must be disclosed:
• A brief description of the obligation (nature and timing)
• An indication of uncertainties and assumptions about the amount or timing of outflows
• Any expected reimbursement due relating to the provision
• A detailed breakdown of the movement in the provision – opening and closing balances, additions,
amounts used and any reversals

3.2.2 Contingencies
The following disclosures are required for contingencies:
• Nature of the contingent liability/asset.
• Estimate of financial effect (where practicable).
• The uncertainties affecting the amount or timing.
The below table summarises the disclosure requirements for each of the conditions:
Conditions Assets Liabilities
Expected/ Virtually Certain (>95%) Recognised as an Asset Recognised as a Liability
Probable (51% - 95%) Disclosed as Recognised as a Provision
Contingent Asset
Possible (5% - 50%) No disclosure Disclosed as
Contingent Liability
Remote (<5%) No disclosure No disclosure
Activity 2
Match the scenario on the left to the corresponding disclosure on the right.
The business has been taken to court by a customer who You would disclose only the nature and
slipped on the floor in the shop. The court has yet to decide possible amount.
who is at fault, and the case could go either way.

The business has been taken to court by an employee injured You would disclose that you are waiting for
at work. The court ruled in the employee's favour, and the the decision and that it would lead to
business is waiting to hear how much they will need to pay. possible liability in the future.
The business has decided to take a builder to court to claim You would need to disclose the nature and
damages for poor-quality work. The case has yet to be heard. possible amount of the contingency.

An insurance company has accepted a claim for damaged You would not disclose any information at
inventory following a fire but has yet to finalise the amount it will this point.
pay the business.
CHAPTER 8: Visual Overview
CHAPTER 8: Visual Overview
Objective: To explain the period-end accounting entries for inventory.

8.1.1 Inventory Overview

1.1 Inventory Overview
1.1.1 Inventory Classification
Inventory is the term used to describe the goods, materials and supplies held at the accounting period end that have been
purchased by a business and are either ready for sale or used in the production of completed products for sale. Common
classifications of inventories include:
• Goods purchased for resale (For example, by a wholesaler or retailer)
• Raw materials and components purchased for manufacturing into goods for sale
• Products and services in intermediate stages of completion (Work-in-progress)
• Finished goods
Activity 1
Inventory is an asset in the statement of financial position.
What is the future economic benefit that the business will derive from selling the goods held as inventory?
1.1.2 The Accruals Concept
The accruals concept requires that business expenses be matched to the related business income. This means that the
statement of profit or loss needs to ensure that the sales income generated in the year matches the trading costs associated
with those sales.
Inventory purchases not sold during the year make up part of the closing inventory at the financial year-end. Furthermore,
sales generated during the year may be for items purchased in the previous year that are held as opening inventory.
The statement of profit or loss needs to be adjusted to apply the accruals concept. To correctly account for inventory according
to the accruals concept, the statement of profit or loss records the cost of goods sold instead of items purchased.
8.1.2 Accounting for Inventories
1.2 Accounting for Inventories
Businesses will purchase raw materials and goods for resale throughout an accounting period. These purchases are recorded
in the purchases account (Expense) at the point of the purchase.
At year-end, the total purchases appear in the statement of profit or loss under the heading Cost of Sales. To determine the
final Cost of Sales figure, the business must adjust for opening and closing inventory.
The Cost of Sales is the cost of the inventory sold during the accounting period.
Key Point

Cost of Goods Sold = Opening Inventory + Cost of Goods − Closing Inventory

Opening Inventory = value of inventory held at the start of the accounting period.
Closing Inventory = value of inventory held at the accounting period’s end.
Cost of goods = Purchase cost of the goods for resale or all the direct costs such as materials, supplies and wages needed to
make the goods.
Example 1
Amit runs a shop that sells computer ink cartridges to local offices. He is preparing financial statements for his year-end of 30
November 20X9. Amit has recorded the following:
• During this period, he sold 4,100 cartridges.
• On 1 December 20X8, his inventory consisted of 1,600 cartridges valued at $67,500.
• During the year, he purchased 3,500 cartridges for $129,600.
• On 30 November 20X9, he held 1,000 cartridges in inventory, valued at $34,800.
Cost of Sales for the year = Opening Inventory + Cost of Goods − Closing Inventory
Units $
Opening Inventory 1,600 67,500
Add: Cost of Goods (Purchases) 3,500 129,600
Less: Closing Inventory (1,000) 34,800
Cost of Sales 4,100 162,300
The above table shows that 4,100 units of cartridges were sold during the year. The cost of sales of the 4,100 units is
recorded in Amit’s Statement of Profit or Loss for the year ended 30 November 20X9 as $162,300.
1.2.1 Inventory Double Entry
The record of inventory and cost of goods sold are made at the end of the year using Journals. The objective of the double
entries is to:
• Ensure the Inventory account reflects the closing inventory valuation
• Cost of Goods Sold account is created and reflects the correct amount
To achieve these objectives, there are three double-entry steps to make:
1. Remove the Opening Inventory
Opening inventories are removed and transferred to the Cost of Goods Sold account. This entry is necessary because the
opening inventories are now used to generate sales in the current accounting period.
Individual Account Category Explanation
DR Cost of Goods Sold Expense Opening Inventory cost now included as Expenses
CR Inventory Asset Inventory (Asset) decreased
The cost of opening inventories is reflected as a current-year expense in the statement of profit or loss.
2. Close off the Purchases account
A business makes purchases for inventory for resale. The cost is debited to the Purchases account and credited to
cash/payables at the point of purchase. At year-end, the amount in the Purchases account is closed off and transferred to the
Cost of Goods Sold.
Individual Account Category Explanation
DR Cost of Goods Sold Expense Purchases (Expense) is transferred to COGS
CR Purchases Expense Purchases (Expense) is closed off
3. Post the Closing Inventory
The balance in the inventory account at year-end should reflect the value of closing inventory. The closing balance is
presented in the statement of financial position as a current asset.
Since closing inventories are items purchased that are not sold in the accounting period, their cost should not be reflected as
an expense in the Cost of Goods Sold account (SPL). Therefore, the value of closing inventory is transferred out of expenses
and reflected as Closing Inventory in the statement of financial position.
 Individual Account Category Explanation
DR Inventory Asset Inventory (Asset) increased
CR Cost of Goods Sold Expense Costs (Expense) decreased
The value of closing inventory will be next year’s opening inventory value.
Activity 2
For each statement below, state if they are True or False.
1. The opening inventory of $45,000 will be in the inventory account as a debit balance.
2. To record the closing inventory balance of $54,000, the double entry is:
DR Cost of sales $54,000
CR Inventory account $54,000
3. The opening inventory increases the cost of sales in the statement of profit or loss, and the closing inventory reduces it.
4. The closing inventory of $54,000 is recognised in the statement of financial position as a non-current asset.

8.1.3 Inventory Quantity

1.3 Inventory Quantity
Businesses need to know the inventory volume/quantity to attribute a value to the opening and closing inventory. This allows
the business to calculate the cost of sales, which will be included in their statement of profit or loss.
Inventory management is also crucial for businesses to track their inventory levels at different time stages. This allows a
smooth process of purchasing further inventory to meet sales.
1.3.1 The Continuous Approach
In this approach, each product sold by a business has its inventory record, either on a manual card or a computer record.
The card records quantities of purchases and sales of that product. It is set up to keep a running total of the amount of
inventory as each new transaction (either sales or purchases) takes place. The record identifies how much inventory the
business holds at any time.
This system uses the following principle: Opening Inventory + Purchases − Sales = Closing Inventory
1.3.2 The Periodic Approach
In this approach, there are no record cards. Inventory is physically counted at the end of the year (inventory count), and their
quantities are recorded in a list.
The inventory count is usually performed on the last day of the accounting period when the business is closed with no
inventory movements occurring.
Keeping continuous records can be time-consuming for businesses with multiple lines of products to sell, even if they are
computerised. A business typically performs an inventory count at year-end, even when continuous records are kept. It may
also carry out inventory counts on specific items during the year to keep a check on the card records.
Where year-end inventory is based on the valuation of balances extracted from continuous inventory records, the recorded
quantities must be shown to be accurate and up to date. Businesses may require an inventory-management system, which
includes:
• A test-counting program designed to cover all product/line items at least once a year.
• The investigation and correction of differences between the ledger and physical quantities.
Key Point

If the stock-checking system is ineffective, a complete physical count may be required for financial reporting.

8.2.1 IAS 2 Inventories

2.1 IAS 2 Inventories
Under IAS 2 Inventories, inventories are valued at the lower of cost or net realisable value (NRV).
2.1.1 Cost
The cost of inventory includes the cost of bringing the inventories to their current location and condition. The below flowchart
illustrates the components that make up the cost of inventories.
If the business manufactures the goods, the inventory cost includes raw materials purchases plus the cost of converting the
material into the finished product (for example, wages and overheads).
IAS 2 stipulates several costs that are excluded in calculating the cost of inventory, as illustrated in the diagram below:
The cost is determined using applicable pricing valuation methods (FIFO, continuous weighted average or periodic weighted
average).
Activity 3
For each of the costs below, state whether they should be included in the inventory cost.
1. Purchase of fruit
2. Delivery to customers (Carriage outwards)
3. Cost of rotten fruit that was thrown away
4. Labour cost for those working on the production line
5. Cost of labels for the tin
6. Delivery of fruit to the factory (Carriage inwards)
2.1.2 Net Realisable Value (NRV)
The net realisable value (NRV) of an item of inventory is its selling price after all further costs to complete and sell the item
have been considered.
Selling expenses include expenses in getting the inventories from the business premises to the customer, including delivery
costs that the business will incur.
NRV = Estimated selling price − Estimated future costs of completion − Estimated future selling expenses (if inventory is still in
production)
Activity 4
1. Hiroto has carried out an inventory count and has 10,000 toy cars in his warehouse. He has established the following
information on the potential inventory value of each toy car.
Cost $5.00
Selling price $6.00
Selling expenses $0.75
Trade discount received 0%
2. What is the correct valuation of the inventory per IAS 2?
a) $50,000
b) $52,500
c) $60,000
3. Hiroto has carried out an inventory count and has 20,000 toy cars in his warehouse. He has established the following
information on the potential inventory value of each toy car.
Cost before trade discount $7.00
Selling price $7.00
Selling expenses $0.25
Trade discount received 5%
4. What is the correct valuation of the inventory per IAS 2?
a) $133,000
b) $135,000
c) $140,000
5. Hiroto has carried out an inventory count and has 5,000 toy cars in his warehouse. He has established the following information
on the potential inventory value of each toy car.
Cost $7.00
Selling price $7.00
Selling expenses $0.25
Settlement discount received 5%
a) $33,250
b) $33,750
c) $35,000

8.2.2 Pricing Valuation Methods

2.2 Pricing Valuation Methods
The cost price of each item is called the unit cost. If this stays the same throughout the accounting period, then it is simple to
determine the price per item in the inventory. However, inventory prices may rise or fall over the accounting period. Therefore,
the order of sold inventory needs to be established to determine the value of closing inventory.
There are two methods of calculating the cost of inventory:
• First In-First Out (FIFO)
This method assumes that inventories that are purchased first are sold first.
• Average Cost (AVCO)
The average cost (AVCO) is calculated by determining the average cost for items held in the opening inventory
and purchased during the period. There are two main methods of calculating average cost.
o The first is where the calculation is done on a periodic (such as monthly) basis, known as the periodic
weighted average.
o The other method is where an average value for inventory is calculated before every issue from inventory
and is known as the cumulative weighted average.
FIFO and AVCO calculate the cost of inventory, which is then compared to the net realisable value to determine which is lower
and should be presented as the inventory value in the statement of profit or loss.
After obtaining the opening and closing value, the cost of sales is calculated and recorded in the statement of profit or loss.
Cost of sales = Opening inventory + Cost of goods − Closing inventory
2.2.1 First In-First Out (FIFO)
FIFO assumes that inventory leaves the warehouse in the same order as its receipt. Therefore, the inventories remaining in the
warehouse at the end of the accounting period are the most recently purchased and should be valued at the most recent
purchase price.
Example 2
Tariq's Lighting Supplies Co. had the following inventory transactions during the first week of April 20X5:
Date Quantity in units Unit cost $ Total cost $
1 April Opening inventory 500 5.00 2,500
2 April Purchase 250 5.10 1,275
3 April Purchase 300 5.20 1,560
4 April Issue 400
5 April Purchase 200 5.30 1,060
6 April Issue 500
7 April Closing inventory 350
These logs show that inventory has left the warehouse because of customer sales. Inventory leaving the warehouse is called
an issue.
Using the FIFO method of valuation, the missing figures are calculated as follows:
1. 4 April Issue
Using the FIFO principle, it is assumed that the 400 items sold are the first to have been purchased. These are
400 of the 500 items in inventory on 1 April. Each item is valued at $5.00, so the total value of the 4 April issue is
(400 units × $5) = $2,000
2. 6 April Issue
Applying the FIFO principle, it is assumed that the 500 items are the remaining 100 from 1 April, 250 from the 2
April purchase, and 150 from the 3 April purchase. The value is calculated as (100 units × $5) + (250 units ×
$5.10) + (150 units × $5.20) = $2,555
3. 7 April Closing Inventory
The 350 items of closing inventory will be valued as the last items that have been purchased and are unsold.
These would be 200 units from the 5 April purchase plus the remaining 150 units from the 3 April purchase. The
value of the inventory is (200 × $5.30) + (150 × $5.20) = $1,840
4. The Cost of Sales
Cost of sales = Opening $2,500 + Cost of goods ($1,275 + $1,560 + $1,060) − Closing $1,840 = $4,555
Activity 5
Aarav is a sole trader who sells office supplies to businesses. The inventory schedule of issues and purchases of pens for the
month of June 20X3 is available. Aarav is confident that the pens will be sold for more than he paid. This means that the
inventory will be measured at cost.
1. Calculate and enter the missing figures in the inventory schedule and the missing unit costs in the space below,
labelled (a), (b), and (c).
Date Quantity in units Unit cost $ Total cost $
1 June Opening inventory 1,000 0.75
12 June Purchase 500 0.80
13 June Purchase 1,200 0.85
20 June Issue 1,300 (a)
25 June Purchase 200 0.99
29 June Issue 900 (b)
30 June Closing inventory 700 (c)
2. Calculate the cost of sales.
3. Record the double entry of the closing inventory in the general ledger.
2.2.2 Periodic Weighted Average
With this inventory valuation method, the business totals the value of purchases of raw materials at the end of the reporting
period. Then it divides the value by the number of units acquired.
This provides an average cost used to value the cost of goods sold and the inventory at the period end.
Example 3
Tariq's Lighting Supplies Co. had the following inventory transactions during the first week of April 20X5:
Date Quantity in units Unit cost $ Total cost $
1 April Opening inventory 500 5.00 2,500
2 April Purchase 250 5.10 1,275
3 April Purchase 300 5.20 1,560
4 April Issue 400
5 April Purchase 200 5.30 1,060
6 April Issue 500
7 April Closing inventory 350
Using the periodic weighted average method of valuation, the missing figures are calculated as follows:
1. Closing Inventory
First, sum up the total cost: $2,500 + $1,275 + $1,560 + $1,060 = $6,395
Then, add up all the purchases in units: (500 + 250 + 300 + 200) = 1,250 units
The average cost per unit is: $6,395 ÷ 1,250 units = $5.12 per unit
The closing inventory: 350 units at $5.12 each = $1,792
Date Quantity in units Unit cost $ Total cost $
1 April Opening inventory 500 5.00 2,500
2 April Purchase 250 5.10 1,275
3 April Purchase 300 5.20 1,560
4 April Issue (400)
5 April Purchase 200 5.30 1,060
6 April Issue (500)
Total for the period $6,395
7 April Closing inventory 350
2. Cost of Sales
The cost of the issues is calculated as the number of units sold x the unit cost
Cost of Sales = (400 units + 500 units) × $5.12 = $4,608
2.2.3 Cumulative Weighted Average
With this inventory valuation method, calculate the average unit price of the inventory after each purchase. The average is
therefore adjusted throughout the period.
Example 6
Tariq's Lighting Supplies Co. had the following inventory transactions during the first week of April 20X5:
Date Quantity in units Unit cost $ Total cost $
1 April Opening inventory 500 5.00 2,500
2 April Purchase 250 5.10 1,275
3 April Purchase 300 5.20 1,560
4 April Issue 400
5 April Purchase 200 5.30 1,060
6 April Issue 500
7 April Closing inventory 350
Using the Cumulative Weighted Average method of valuation, the missing figures are calculated as follows:
1. 4 April Issues
 Determine the average cost per unit after 3 April ($2,500 + $1,275 + $1,560) ÷ (500 + 250 + 300 units) =
$5,335/1,050 units = $5.08/unit)
The unit cost for the 4 April issues = 400 units × $5.08 = $2,032
Finally, subtract the 4 April issue from the totals already calculated to arrive at the new quantity in units and the
new total cost.
Note that the average cost is used to value the remaining inventory.
Average cost per
Date Quantity in units Unit cost $ Total cost $ unit $

1 April Opening inventory 500 5.00 2,500

2 April Purchase 250 5.10 1,275

3 April Purchase 300 5.20 1,560

Total 1,050 5,335 $5,335 ÷ 1,050 = $5.08

4 April Issue (400) 5.08 (2,032)

650 5.08 3,303

2. 6 April Issues
The revised totals for the quantity in units and the total cost for the 6 April issues should be calculated according
to the previous step.
Date Quantity in units Unit cost $ Total cost $ Average cost per unit $

Total 650 5.08 3,303

5 April Purchase 200 5.30 1,060

Total 850 4,363 $4,363 ÷ 850 = $5.13

6 April Issue (500) 5.13 (2,565)

3. Closing Inventory
The closing inventory is $5.13 × 350 = $1,796
4. Cost of Sales
The cost of sales Opening $2,500 + Purchases ($1,275 + $1,560 + $1,060) − Closing $1,796 = $4,599
Activity 6

Match the statement to the corresponding pricing valuation method below.

First In-First Out Net realisable value

The valuation of closing inventory when it is sold for Values closing inventory at the average purchase price paid for the
below cost. inventory items.

Average Cumulative Weighted Average Method Values closing inventory at the most recent purchase prices paid for the
inventory items.

2.2.4 Impact of Pricing Methods on Profit and Assets

The different methods of valuing inventory affect the profit and asset amount reported in the financial statements.
The closing inventory is reported as the inventory asset amount in the statement of financial position. At the same time, the
cost of goods sold is an expense which reduces the profit figure in the statement of profit or loss.
Example 4
Under different pricing valuation methods, the closing inventory and cost of sales of Tariq's Lighting Supplies Co are:
Inventory valuation Cost of sales
($) ($)

FIFO 1,840 4,555

AVCO - periodic method 1,792 4,608

 AVCO – cumulative weighted average method 1,798 4,597

• FIFO has the lower cost of sales figure. Therefore, it will show a higher profit. This will always be the case if the purchase
costs rise throughout the period. However, if the purchase costs were falling through the accounting period, using the AVCO
periodic method would give a higher profit figure.
Ethical issues must be considered when determining which valuation method a business should use.
Businesses should consistently apply the FIFO or AVCO methods from one year to the next. This prevents businesses from
using valuation methods to report a better profit figure that may not represent their financial standing fairly.
If a change is made, the previous year's financial statements must be restated so that results are comparable year-on-year.
However, if the method is used consistently and reflects how the inventory is used, it should be fine, as there is no intention to
mislead.
Activity 7

Kavita oversees buying jewellery in small batches for Emeralds and Diamonds Co. She buys the jewellery from different
suppliers to take advantage of the lowest prices available. Kavita puts the inventory on display in the order of when it was
purchased. All the inventory is sold at a profit; therefore, the NRV is greater than the cost.
1. Should Kavita use the FIFO or AVCO system to calculate the inventory value?
2. Complete the inventory schedule below:

3. What is the cost of sales?

8.2.3 Inventory Disclosures

2.3 Inventory Disclosures
2.3.1 Disclosure Requirements
For businesses that manufacture goods, the disclosure should include the accounting policy for inventory and a breakdown of
inventory into appropriate classifications such as materials, work-in-progress and finished goods.
The business is also required to disclose the following in the financial statements:
• The valuation method it has used in valuing its inventories
• How the business has applied those methods to calculate the inventory value
CHAPTER 9: Visual Overview
CHAPTER 9: Visual Overview
Objective: To explain the accounting treatment for non-current tangible assets per International Financial Reporting
Standards.

9.1.1 IAS 16 Property, Plant and Equipment (PPE)

1.1 IAS 16 Property, Plant and Equipment (PPE)
IAS 16 Property, Plant and Equipment prescribe the accounting treatment for tangible non-current assets. This standard
outlines the initial measurement of assets, the determinations of their carrying value, the depreciation expense, and any
impairment losses to be recognised.
The principal issues prescribed in the standard are:
• The initial recognition of assets at acquisition
• The determination of an asset’s carrying amount
• The depreciation charges of assets
• Any impairment losses to be recognised
9.1.2 Initial Measurement of PPE
1.2 Initial Measurement of PPE
1.2.1 Cost of Tangible Non-Current Assets
IAS 16 states that a tangible non-current asset should be initially recorded at its cost, which includes:
• Purchase Cost
• Any Cost directly attributable to bringing the asset to the condition and location necessary to enable it to be used for its
intended purpose
• Estimated cost of dismantling and site restoration
The total cost to be recognised as non-current assets is the following:
Purchase Price (after deducting trade discounts)
+ Directly Attributable Cost (see below)
+ Cost of Dismantling and Site Restoration
Cost to be Capitalized
1.2.2 Directly Attributable Costs
Directly attributable costs are costs of bringing the asset to the location and condition necessary for operation. These costs
must be classified as capital expenditure (assets) in the statement of financial position.
Examples of directly attributable costs are:
• Cost of employee benefits that arise directly from the construction or acquisition of the non-current asset (For example, wages
and salaries)
• Cost of site preparation (For example, laying of new concrete floor in the factory of new machinery)
• Initial delivery and handling cost
• Installation and assembly cost
• Testing cost on whether the asset is functioning properly
• Professional fees (For example, consultancy, legal, architect fees and stamp duties)
• Cost of extension to buildings
• Interest on the loan used to finance the acquisition of the asset
A business may construct tangible non-current assets. For example, a carpentry business makes furniture for its use, or a
construction business builds its own offices.
In such cases, all the expenditure incurred to get that asset ready for use can be included in its cost. This includes:
• raw material costs (such as timber, paint)
• labour costs (used in the construction of the asset)
• other directly incurred costs (such as energy used in the construction, any rent paid for the space used for construction).
Note that only costs that arise as a result of construction can be included. Any general business expenses, such as insurance
or administration, cannot be included. (Such costs are often called general overheads.)
Activity 1
Rhocat Co is in the business of manufacturing carpets. The management of Rhocat Co has decided to purchase and install a
new carpet-weaving machine. As a result, Rhocat Co incurred several expenditures that need to be accounted for as part of
the cost of the tangible non-current asset.
Match the item of expenditure on the left column to their corresponding description on the right.
1.2.3 Categories of Non-Current Assets
A business's tangible non-current assets can include various types of assets. Each asset type will have its ledger account in
the general ledger.
Categories of tangible non-current assets (Property, Plant and Equipment) are:
• Land and Buildings such as building premises
• Plant and Machinery such as factory machinery that may be fixed or mobile
• Fixtures and Fittings such as shelving in a shop and shop display unit
• Office Equipment such as computers, printers and cash registers
• Motor Vehicles such as delivery vans and company cars
There are several categories into which tangible non-current assets are classified, and each class and its accumulated
depreciation have its ledger account.
The final total of these ledger accounts will be included in the Statement of Financial Position and is classified under Property,
Plant and Equipment. The final figure for tangible non-current assets will be presented in the statement of financial position:
Non-Current Assets Cost Accumulated Depreciation Carrying Amount
Property, Plant and Equipment:
Land and Buildings X (X) XX
Plant and Machinery X (X) XX
Fixtures and Fittings X (X) XX
Office Equipment X (X) XX
Motor Vehicles X (X) XX
XX
The carrying amount is the cost of the non-current asset less the accumulated depreciation. The statement of financial
position will reflect each asset category’s carrying amount.

9.1.3 Double Entry for PPE Acquisition

1.3 Double Entry for PPE Acquisition
Once the cost to be capitalised has been calculated, the amount is posted to the general ledger using Journals.
The double entry to record the acquisition of non-current assets using cash is:
Individual Account Category Explanation
DR Individual Non-Current Asset Asset NCA (Asset) increased
CR Cash/Bank Asset Cash (Asset) decreased
The amount to be entered into these accounts is the Capitalization Cost.
The double entry to record the acquisition of non-current assets on credit or using a bank loan is as follows:

Individual Account Category Explanation

DR Individual Non-Current Asset Asset NCA (Asset) increased

CR Trade Payables Liability Payables (Liability) increased

Bank Loan Liability Loan payable (Liability) increased
When the business pays the credit supplier the amount owed, the double-entry is:

Individual Account Category Explanation

DR Trade Payables Liability Payables (Liability) decreased

CR Cash/Bank Asset Cash (Asset) decreased

As the business pays back the outstanding bank loan sum, the double-entry is:

Individual Account Category Explanation

DR Bank Loan Liability Loan payable (Liability) decreased

CR Bank Asset Cash (Asset) decreased

 Example 1
On 1 January 20X5, BBB Co purchased the following tangible non-current assets:
1. A computer for $1,000 with cash
The double entry: DR Office Equipment $1,000, CR Bank $1,000.
2. A new piece of plant for $5,000 with cash
The double entry: DR Plant and Machinery $5,000, CR Bank $5,000.
3. A new delivery van for $24,000 on credit
The double entry: DR Motor Vehicle $24,000, CR Payables $24,000
The impact of these double entries to the individual ledger accounts is shown in the below t-accounts (ignore opening
balances):
DR Office Equipment – Cost (Asset) CR

01-Jan-X5 Bank $1,000

DR Plant and Machinery – Cost (Asset) CR

01-Jan-X5 Bank $5,000

DR Motor Vehicle – Cost (Asset) CR

01-Jan-X5 Payables $24,000

DR Bank (Asset) CR

01-Jan-X5 Office Equipment - Cost $1,000

01-Jan-X5 Plant and Machinery - Cost $5,000

DR Payables (Liability) CR

01-Jan-X5 Motor Vehicle - Cost $24,000

9.2.1 What is Depreciation?

2.1 What is Depreciation?
An asset is a resource used by a business to generate profits.
For example, a production machine is an asset that allows a business to manufacture goods to be sold to customers, which
helps the business generate profit. Usage or consumption of the asset leads to depreciation.
As non-current assets are used (consumed), they wear out and devalue over time, and this consumption needs to be reflected
as a cost to the business on an annual basis. This cost is depreciation.
Depreciation is the expense charged to the statement of profit or loss in each accounting period to reflect how much of the
economic benefit associated with a tangible non-current asset has been used up in the accounting period.
Key Point

Depreciation is the spreading of the depreciable amount of the non-current asset over its useful economic life: (Cost − Residual Value) /
Useful Economic Life

• Useful Economic Life

The useful economic life of a non-current asset is the estimated period over which the asset will be consumed until
it is worn out or until the business no longer wishes to use it. It is the period over which an asset will be useful and
generate economic benefit for the business.
• Residual Value
Non-current assets may be sold before they are completely worn out. This can be due to a newer asset model
being required or because the asset is no longer needed. The estimated proceed from selling the non-current
asset is the residual value.
 • Depreciable Amount
The depreciable amount is the cost of the non-current asset less any expected residual value. The depreciable
amount of an asset is used to calculate the depreciation charge each year.
The purpose of depreciation is to match the revenue and expense in the same accounting period in line with the accruals
principle of accounting.
Non-current assets generate profits for a business. Depreciation is the cost of the business using the non-current asset.
Therefore, the depreciation cost is included as an expense in the statement of profit or loss so that the cost of using the asset
matches the profits generated from it. This is an application of the accruals principle.
Activity 2
For the below statements, answer if they are True or False:
1. Depreciation is a measure of the cost to the business of consuming the economic benefits associated with a tangible non-
current asset for an accounting period.
2. Depreciation measures how much the market value of a tangible non-current asset falls during an accounting period.
3. All tangible non-current assets need to be depreciated.
Exam advice

Most land cannot be consumed by a business, so it has an indefinite life. This means there is no depreciation charged on land.

9.2.2 Calculating Non-Current Asset Depreciation

2.2 Calculating Non-Current Asset Depreciation
Depreciation spreads the depreciable amount of the non-current asset over its useful economic life. The depreciation cost is
recorded in the statement of profit or loss as an expense.
There are two methods of calculating the depreciation cost in an accounting period:
• Straight-Line method
• Reducing Balance method
2.2.1 Straight-Line Method
The straight-line method of charging depreciation is where the total depreciable amount is charged in equal instalments over
the asset’s expected useful life.
In a straight-line method, the depreciation charge is calculated as follows:

Depreciation charge per year =

Depreciation charge per year = Depreciation Rate (%) × Cost of Asset

At the end of the year, the asset value will decrease by the depreciation charge. The value after the depreciation charge is
known as the carrying amount.
Example 2
Tareq purchases ten laptops for $1,000 each on 1 January X1. Tareq estimates the useful life of the laptops is three years,
after which they can be sold for $3,430. Tareq has a financial year-end of 31 December.
Using the straight-line method, what is the ten laptops’ carrying value/ carrying amount for each year?
Answer:

Depreciation charge = = $2,190

Depreciation Charge Table
End of Y1 ($) End of Y2 ($) End of Y3 ($)
Cost of Computer 10,000 10,000 10,000
Depreciation − Y1 (2,190) (2,190) (2,190)
Depreciation − Y2 (2,190) (2,190)
Depreciation − Y3 (2,190)
Accumulated Depreciation (2,190) (4,380) (6,570)
Carrying Value: 7,810 5,620 3,430
Activity 3
What are the annual depreciation charges for each of the scenarios below?
1. Tareq purchases a second-hand delivery vehicle for $15,000, which has an estimated useful life of three years and zero
residual value.
2. Tareq purchases a new mixing machine for $22,000. This has an estimated useful life of eight years and a residual value of
$2,000.
3. Tareq purchases new office furniture for $3,400. This has an estimated useful life of six years and a residual value of $340.
4. Tareq purchases a new printer for $2,500. The depreciation rate for all office equipment is 20%.
2.2.2 Reducing Balance Method
In the straight-line method, depreciation charged is expressed as a fixed percentage of the asset’s cost. In contrast, the
reducing balance method expresses depreciation as a fixed percentage of the asset’s carrying amount.
Key Point

An asset’s Carrying amount (NBV) is its value after deducting the accumulated depreciation from the asset's initial cost.
Carrying amount (NBV) = Cost − Accumulated Depreciation
The reducing balance method uses a percentage applied to the carrying amount of an asset rather than its cost.
Depreciation charge per year = Depreciation Rate (%) × Asset’s Carrying amount
In the reducing balance method, the depreciation percentage is applied to a reduced figure each year, resulting in a lower
depreciation charge each year.
Example 3
Tareq purchases ten laptops for $1,000 each on 1 January X1. Tareq depreciates his office equipment at a rate of 30% using
the reducing balance method.
What is the ten laptops‘ carrying value/ carrying amount for each year?
Answer:
$
Cost 10,000
Depreciation (Y1) 30% of $10,000 (3,000)
Carrying amount (end of Y1) 7,000

Depreciation (Y2) 30% of $7,000 (2,100)

Carrying amount (end of Y2) 4,900

Depreciation (Y3) 30% of $4,900 (1,470)

Carrying amount (end of Y3) 3,430
Activity 4
1. Tareq purchases a new delivery truck for $40,000. The reducing balance rate of depreciation is 25%.
What is the depreciation charge in year two?

2. Tareq purchases a new industrial freezer unit for $14,000. The reducing-balance rate of depreciation is 35%.
What is the carrying amount of the industrial freezer unit after three years?
 Example 4
In examples 2 and 3, Tareq depreciates the same ten laptops using straight-line and reducing balance methods. The table
below demonstrates the depreciation expense and the carrying amount using the two methods:
Straight Line Method ($) Reducing Balance Method ($)
Cost 10,000 10,000
Depreciation (Y1) (2,190) (3,000)
Carrying amount (end of Y1) 7,810 7,000

Depreciation (Y2) (2,190) (2,100)

Carrying amount (end of Y2) 5,620 4,900

Depreciation (Y3) (2,190) (1,470)

Carrying amount (end of Y3) 3,430 3,430
• Year 1 Depreciation − In the first year, the depreciation charge is higher with the reducing-balance method. This means the
carrying amount is smaller at the end of the year than with the straight-line method.
The reducing-balance method assumes that more computer equipment is 'consumed' in the first year (more of the benefits
associated with the computer equipment are used up).
• Year 3 Depreciation − In the final year, the reducing-balance method results in a lower depreciation charge than the straight-
line method.
This is because the reducing-balance method assumes that fewer of the benefits of the computer equipment is consumed in
the later years.
• Carrying amount at the end of Year 3 - At the end of the computer equipment's useful life, its carrying amount is the same
under both methods. Regardless of the method used, the business starts and ends at the same position with the same
depreciable amount being charged over the three years.
2.2.3 Which Depreciation Method to Use?
A business selects the depreciation method based on how they expect to use the asset’s economic benefits.
• If the business expects equal benefits each year, the straight-line method is used.
For example, a business owns a furniture piece. Since the furniture is not expected to vary its benefit contributions
to the business throughout its useful life, the straight-line depreciation method should be applied.
• If the business expects greater benefits in earlier years, they use the reducing balance method. This is when an asset
becomes increasingly less productive for each year of use.
For example, a business owns a manufacturing machine. It is expected that the machine will produce more output in the early
years of its useful life, which decreases over the years. Since greater benefits are expected in its earlier years, the machine
should apply the reducing balance depreciation method.
Activity 5
Determine the most appropriate method of depreciation for each situation: the straight-line method or the reducing
balance method
1. Kayla has purchased a radio for her staff. In the earlier years, she expects it will motivate them to work faster, but its effect to
diminish over time.
2. Kayla buys a brand-new delivery van. The van is expected to be used most in the early years when it has low mileage and will
be used less as its mileage increases.
3. Burton has bought a lawnmower for his gardening company. He expects to get equal benefits from it each year it is used.
4. Burton buys a used delivery van which he expects to travel the same distance yearly.
2.2.4 Pro Rata Depreciation
A business may purchase an asset at any point during a financial year. In such cases, is it appropriate to calculate a full year's
depreciation charge? The answer to this question varies from business to business.
A business will have a policy stating whether it uses the full-year or pro−rata option.
• Full-Year Depreciation Policy − A full year's depreciation charge is calculated in the year an asset is purchased. A zero-
depreciation charge is applied in the year the asset is disposed of.
• Pro-Rata Depreciation Policy − The depreciation charge is calculated pro rata in the year an asset is purchased and when it is
disposed of.
Example 5
Tareq's business prepares financial statements to 30 June each year and the current financial year end is 30 June 20X5. The
following tangible non-current assets were purchased partway through the year:
Date of purchase Asset Purchase cost ($) Residual value ($) Depreciation method

1 March 20X5 Delivery vehicle 15,000 0 3 year straight line

1 October 20X4 Office furniture 3,400 340 6 year straight line

1 August 20X4 Industrial freezer unit 14,000 0 35% reducing balance

 Tareq has a policy of depreciating its non-current assets on a pro-rata basis. The financial period is from 1 July 20X4 to 30
June 20X5. The depreciation charge for the financial period ending 30 June 20X5 is:
1. Delivery Vehicle
The delivery vehicle was purchased on 1 March 20X5. Tareq has owned the non-current asset for 4 months (1
March X5 to 30 June X5).
Therefore, the delivery vehicle’s depreciation charge for the year is ($15,000 ÷ 3 years) = $5,000 × 4/12 months
= $1,667
2. Office Furniture
The office furniture was purchased on 1 October 20X4. Tareq has owned the non-current asset for 9 months (1
October X4 to 30 June X5).
Therefore, the office furniture’s depreciation charge for the year is [($3,400 − $340) ÷ 6 years] = $510 × 9/12
months = $383
3. Industrial Freezer Unit
The freezer unit was purchased on 1 August 20X4. Tareq has owned the non-current asset for 11 months (1
August X4 to 30 June X5).
Therefore, the freezer’s depreciation charge for the year is $14,000 × 35% = $4,900 × 11/12 months = $4,492
2.2.5 Changes in Depreciation Method, Useful Life or Residual Value
It is a requirement of IAS 16 that the depreciation method used for an asset is reviewed regularly. If the way that the asset
generates economic benefit alters, then the method to calculate depreciation should be changed accordingly.
At the date of the change in depreciation method, the asset is depreciated using the carrying amount of the asset and its
remaining useful life.
Example 6
Tareq purchased a delivery truck on 1 July 20X4 for $40,000, which had an estimated useful life of eight years, a residual
value of $4,000 and was initially depreciated at a rate of 25% a year using the reducing-balance method.
Tareq decided that from 1 July 20X5 onwards, the delivery truck would generate equal economic benefits each year.
The impact of the change in depreciation method includes:
1. Change in depreciation method
Future depreciation charges associated with the delivery truck are based on the asset’s carrying amount at the
date of the change, and the truck will be depreciated under the new method.
In this example, the change date is 1 July 20X5, and the new method is straight-line depreciation.
2. Carrying Value at the date of the change
The carrying amount of the delivery truck on 1 July 20X5 (after one year of reducing-line balance depreciation at
the rate of 25%) is:
$
Cost 40,000
Depreciation year 1($40,000 × 25%) (10,000)
Carrying amount at the end of year 30,000
3. Establish the Remaining Useful Life and Residual Value
At the date of purchase (1 July 20X4), Tareq had estimated that the truck’s useful life was eight years.
Therefore, the remaining useful life is seven years on 1 July 20X5 (one year later). The residual value is
unchanged at $4,000.
4. Calculate the depreciation charge based on the new method
The depreciation charge is ($30,000 − $4,000) ÷ 7 years = $3,714
The useful life (UL) or residual value (RV) of a non-current asset may change during the lifetime of an asset. Such a scenario
may occur as the asset’s useful life and residual value are estimated at the acquisition point. Therefore, these may change
over time.
Dealing with useful life or residual value changes is similar to depreciation method changes. The asset’s carrying amount at the
change date is depreciated over the revised useful life and residual value.
Example 7
Tareq purchased a mixing machine on 1 July 20X4 for $22,000. At that date, he estimated that the residual value was $2,000
and the useful life was eight years. The machine is depreciated using the straight-line method.
As a result of new technologies being introduced for mixing machines, on 1 July 20X7, Tareq re-assessed the useful life of the
mixing machine down to six years and the residual value down to $1,000.
At the date of change (1 July 20X7), Tareq needs to establish the following:
1. Carrying Value
Cost = $22,000
Accumulated depreciation = [($22,000 − $2,000) ÷ 8 yrs] × 3 years = $7,500
Carrying Value = $22,000 − $7,500 = $14,500
2. Revised Useful Life
The revised useful life on 1 July 20X7 is 6 − 3 years = 3 years
3. Revised residual value
The revised residual value is $2,000 − $1,000 = $1,000
On 30 June 20X8, the depreciation charge for the mixing machine is: ($14,500 − $1,000) ÷ 3 years = $4,500
9.2.3 Double Entry for NCA Depreciation
2.3 Double Entry for NCA Depreciation
Once the depreciation charge for the year is calculated, it is posted to the general ledgers using Journals. The depreciation
charge is reported as an expense in the Statement of Profit or Loss and reduces the asset carrying value in the Statement of
Financial Position.
Individual Account Category Explanation
DR Depreciation Expense Depreciation (Expense) increased
CR NCA − Acc. Depreciation Asset Acc. depreciation reduces the value of NCA
Example 8
In the year ended 31 June X5, Tareq purchased two new motor vehicles in the year:
• a second-hand delivery vehicle for $15,000
• and a new delivery truck for $40,000
These acquisitions have been posted to the Motor Vehicle - Cost account. The Motor Vehicle Cost account’s opening figure is
$264,000. The Motor Vehicle Accumulated Depreciation account’s opening figure is $132,640.
Tareq has calculated the total depreciation charge for the motor vehicles for the year as $34,890. The double entry for the
depreciation charge is
DR Depreciation $34,890
CR Motor Vehicle − Acc. Depreciation $34,890
The impact of the acquisition and depreciation on the individual ledger accounts is shown in the below t-accounts:
DR Motor Vehicle − Cost CR

01-July-X4 Balance b/d $264,000

30-June-X5 2nd hand Delivery truck $15,000

30-June-X5 New delivery truck $40,000 30-June-X5 Balance c/d $319,000

$319,000 $319,000

01-July-X5 Balance b/d $319,000

DR Motor Vehicle − Accumulated Depreciation CR

01-July-X4 Balance b/d $132,640

30-June-X5 Balance c/d $167,530 30-June-X5 Depreciation expense $34,890

$167,530 $167,530

01-July-X5 Balance b/d $167,530

DR Depreciation (Expense) CR

30-June-X5 Motor Vehicle − Acc. Depreciation $34,890

At the end of the year, there is a balance of $319,000 on the Motor Vehicles Cost account and $167,530 on the Motor
Vehicles Accumulated Depreciation account.
This gives a carrying amount (or carrying amount) of $151,470 at the end of the year, which will be the balance for motor
vehicles that will appear in the statement of financial position.
Activity 6
Hanna owns a business that manufactures clothing for children. She employs 15 people and operates from a rented workshop.
She designs all the apparel and sews garments when she needs to. She has a financial year-end of 30 September.
During the year ended 30 September 20X6, she purchased the following tangible non-current assets:
• New sewing machines for $16,900 on 1 May 20X6
• Delivery van for $24,000 on 1 October 20X5
• Computer equipment for $3,800 on 1 December 20X5
On 1 October 20X5, the balances on her tangible non-current asset ledger accounts were:
• Plant and equipment − Cost $129,780
• Plant and equipment − Accumulated Depreciation $47,900
• Motor vehicles − Cost $24,900
• Motor vehicles − Accumulated Depreciation $14,396
All plant and equipment (which includes computer and office equipment) are depreciated at a rate of 20% a year on a straight-
line basis, and the residual value is assumed to be zero.
The motor vehicles are depreciated on a reducing-balance basis at 25% yearly. Hanna's policy is to depreciate assets on a
pro-rata basis in the year of purchase.
1. What is the depreciation charge for the year ended 30 September 20X6 in respect of each of the assets purchased by
Hanna in the year?
1. New sewing machine
2. Delivery van
3. Computer equipment
2. What is the depreciation charge for the year ended 30 September 20X6 for the assets owned by Hanna's business at the
start of the year?
1. Plant and Equipment
2. Motor Vehicle
3. What is the total depreciation charge for the year?
3. What is the double entry to post the depreciation charge to the ledger accounts?
4. What amounts will be included in the financial statements of Hanna's business for the year ended 30 September 20x6
in respect of the non-current assets?
9.3.1 Disposal of Non-Current Asset
3.1 Disposal of Non-Current Asset
A business purchases tangible non-current assets to generate profits over several years. These assets will remain with the
business until they can no longer be used and have been fully depreciated.
A business may also decide to sell or dispose of an asset before it has reached the end of its useful economic life. Examples of
such situations include:
• A newer and more efficient model of an asset (such as a computer) is available
• An asset has become redundant. the asset no longer undertakes the activity that it was used for
• The asset is broken but can be sold for its scrap value.
The four elements to consider when disposing of a non-current asset are:
4. Cost of the Asset
When an asset is sold, the business no longer has the asset to use in the business. This means the asset’s
original cost must be removed from the relevant Non-Current Asset − Cost account.
5. Accumulated Depreciation of the Asset
When disposing of a non-current asset, all aspects of the asset’s balances are removed from the general ledgers.
The asset’s accumulated depreciation must be removed from the relevant Non-Current Asset − Accumulated
Depreciation account.
The asset is removed from the statement of financial position altogether.
6. Sale Proceeds
For non-current assets with residual values, the sales proceeds received from the business by disposing of such
assets will affect the Cash/Bank ledger account.
7. Profit or Loss on Disposal
The difference between the sales proceeds and the carrying amount of an asset (Cost − Accumulated
Depreciation) determines whether the sale generates a profit or a loss on disposal.
9.3.2 Accounting for NCA Disposal
3.2 Accounting for NCA Disposal
3.2.1 Calculating the Gain or Loss on Disposal
The profit or loss on disposal of a tangible non-current asset is calculated as:
Sales Proceeds Carrying Value Profit/ (Loss)
− =
(less any costs of sale) (Cost less accumulated depreciation) on Disposal

• If the sales proceeds exceed the carrying value = profit on disposal

• if the sales proceeds are less than the carrying value = loss on disposal
Example 9
Salma is a building contractor who runs her own business. The business owns tangible non-current assets such as diggers,
power tools, vans, and computers. Salma prepares financial statements to 31 December each year.
In the year ended 31 December 20X5, Salma disposed of a power saw.
• It originally cost $2,500 a few years ago
• The accumulated depreciation is $1,750
• It is sold for $400
Did Salma make a profit or loss on selling the power saw?
Sales Proceeds = $400
Carrying Value = $2,500 − $1,750 = $750
 Since the sales proceeds are less than the carrying value ($400 − $750) of $350, Salma made a loss of disposal of $350.
Activity 7
What is the profit or loss on disposal of the items sold by Salma below?
1. Salma sold some office equipment for $250, which had originally cost $1,000 eight years ago. The estimated useful life of the
office equipment was ten years. The office equipment is depreciated using the straight-line method.
2. Salma sold a digger for $10,000 on 30 June 20X5. It had initially cost $45,000 on 1 January 20X0 and was being depreciated
using the reducing-balance method at a rate of 25% a year. Salma's policy is to charge a full year's depreciation in the year of
purchase and none in the year of disposal.

3.2.2 Double Entry for NCA Disposal

There are four steps to follow in recording the disposal of non-current assets. The double-entry steps revolve around the
Disposal Account.
The steps to record the non-current asset disposal are:
1. Remove asset from the Cost account
2. Remove asset from the Accumulated Depreciation account
3. Record sale proceeds
4. Record profit or loss on disposal
1. Remove Asset from the Cost Account
First, the business removes the asset’s cost from the Non-Current Asset − Cost account by transferring it to the disposal
account.
Individual Account Category Explanation
DR Disposal Control Offset to Disposal Account
CR Non-Current Asset - Cost Asset The asset is being removed
2. Remove Asset from the Accumulated Depreciation Account
Next, the accumulated depreciation is removed from the Asset − Accumulated Depreciation account by transferring the amount
to the Disposal account.
Individual Account Category Explanation
DR Non-Current Asset − Accumulated Depreciation Asset The accumulated depreciation of the asset is removed
CR Disposal Control Offset to Disposal Account
3. Record Sales Proceeds
The sales proceeds received are recorded in the Disposal and Cash/Bank accounts. If the disposal of the asset generates no
sales proceeds, this entry is omitted.
Individual Account Category Explanation
DR Bank Asset Bank (Asset) has increased
CR Disposal Control Offset to Disposal Account
4. Record Profit or Loss on Disposal
Finally, the Disposal account is closed off. The balance c/d is the profit or loss on disposal and is recorded as an income or
expense in the Statement of Profit or Loss.
If the sales proceeds exceed the carrying amount (profit on disposal,) the double entry is:
Individual Account Category Explanation
DR Disposal Control Offset to Disposal Account
CR Profit on Disposal Income (SPL) Profit (Income) has increased
If the sales proceeds are less than the carrying amount (loss on disposal), the double entry is:
Individual Account Category Explanation
DR Loss on Disposal Expense (SPL) Loss (Expense) has increased
CR Disposal Control Offset to Disposal Account
The Disposal account is created for each non-current asset disposal. The entries that are included in the Disposal account are
summarised as follows:

DR Disposal Account CR

Non-Current Asset – Cost X Non-Current Asset − Acc. Depreciation X

Profit on Disposal (if Profit) X Bank (Sales Proceeds) X

Loss on Disposal (if Loss) X

X X
 Example 10
Salma is selling a power saw. The information about the non-current asset is as below:
• It originally cost $2,500 a few years ago
• The accumulated depreciation is $1,750
• It is sold for $400
• A loss of $350 was made on the disposal
To record the disposal of a non-current asset, the below steps are followed:
1. Remove asset from the Cost account
DR Disposal $2,500
CR Plant and Equipment - Cost $2,500
2. Remove asset from the Accumulated Depreciation account
DR Plant & Equipment − Acc. Depreciation $1,750
CR Disposal $1,750
3. Record sales proceeds
DR Bank $400
CR Disposal $400
A. Record profit or loss on disposal
DR Loss on Disposal $350
CR Disposal $350
The impact of the disposal on the Individual Ledger Accounts is shown in the below T-Accounts:
DR Disposal CR

Plant & Equipment - Cost $2,500 Plant & Equipment - Acc. Depr $1,750

Sale Proceeds (Bank) $400

Loss on Disposal (balancing figure) $350

$2,500 $2,500

Example 11 (Scrapping Asset)

On 31 December 20X2, Salma scrapped an old broken laptop. She bought the item for the business three years ago at the
cost of $800, and he expected the business would be able to sell it for $100 after five years. This asset was depreciated using
the straight-line method.
Calculate the profit or loss on the disposal of the cash register. Compute the effect of disposal on the individual
ledger accounts.
Answer:
Sales Proceeds = $0 since scrapped
Annual depreciation charge = ($800 − $100)/ 5 years = $140
Accumulated depreciation = $140 × 3 years = $420
Carrying amount at end of Y3 = $800 − $420 = $380
Since the sales proceeds ($0) are less than the carrying amount ($380), Salma made a loss on disposal of $380.
To record the disposal of a non-current asset, the below steps are followed:
1. Remove asset from the Cost account
DR Disposal $800
CR Office Equipment - Cost $800
2. Remove asset from the Accumulated Depreciation account

DR Office Equipment − Acc. Depreciation $420

CR Disposal $420
3. Record sales proceeds
o Since the cash register is scrapped, no entry is needed.
4. Record Profit or Loss on Disposal

DR Loss on Disposal $380

CR Disposal $380

The impact of the disposal on the individual ledger accounts is shown in the below T-Accounts:
 DR Disposal Account CR

Office Equipment - Cost $800 Office Equipment - Acc. Depr $420

Sale Proceeds (Bank) -

Loss on Disposal (balancing figure) $380

$800 $800

Example 12 (Part-Exchange)
At the start of 20X3, Salma decides to upgrade her old delivery van. The old van had initially cost $10,420 and had
accumulated depreciation of $5,285 at the end of 20X2, bringing its carrying amount to $5,135.
The cost of the new van is $18,000, and the supplier has agreed to accept the old van in part exchange on top of an additional
$14,000 cash payment.
The old van is being sold for ($18,000 − $14,000) $4,000.
Record the disposal of the old van and the acquisition of the new van.
Answer:
Record disposal of the old delivery van:
Since the sales proceeds ($4,000) are less than the carrying amount ($5,135) of the delivery van, Salma has made a loss on
disposal of $1,135
To record the disposal of a non-current asset, the below steps are followed:
1. Remove asset from the Cost account:
DR Disposal $10,420
CR Motor Vehicle - Cost $10,420
2. Remove asset from the Accumulated Depreciation account:
DR Motor Vehicle − Acc. Depreciation $5,285
CR Disposal $5,285
3. Record sales proceeds:
The old van is sold not for cash but exchanged for a new van (NCA)
DR Motor Vehicle − Cost (new van) $4,000
CR Disposal $4,000
4. Record profit or loss on disposal:
DR Loss on Disposal $1,135
CR Disposal $1,135
Record acquisition of the new delivery van:
At this stage, only the cash payment of $14,000 to acquire the non-current asset is recorded. The impact of the $4,000 part
exchange is already considered in Step 3 of the recording disposal of the old van.
Dr. Motor Vehicle - Cost $14,000
Cr. Bank Account $14,000
Together with the earlier part exchange entry (DR Motor Vehicle − Cost $4,000), the Motor Vehicle − Cost account will reflect
the actual cost of the new delivery van: ($4,000 + $14,000) = $18,000
The impact of the disposal on the individual ledger accounts is shown in the below T-Accounts:
DR Disposal Account CR

Motor Vehicles - Cost $10,420 Motor Vehicles - Acc. Depr $5,285

Motor Vehicle − Cost (part exchange) $4,000

Loss on Disposal (if Loss) $1,135

$10,420 $10,420

DR Motor Vehicles - Cost CR

Disposal (part exchange) $4,000 Motor Vehicles - Disposal $10,420

Bank $14,000
 DR Motor Vehicles − Acc. Depreciation CR.

Motor Vehicles - Disposal $5,285

DR Bank Account (Asset) CR

Motor Vehicle − New Delivery Van $14,000

DR Loss on Disposal (Expense) CR

Loss on Disposal $1,135

Tutorial note: The accounts above show only the transactions in relation to the disposal. They do not show the balance
brought forward. In the case of the motor vehicles cost account, for example, the brought forward balance (not shown) would
have included the original cost of the old delivery van, which has now been disposed of.
Activity 8
Burton owns a business that operates a few shops that sell home furnishings. The balances on the tangible non-current asset
accounts at the start of the year on 1 October 20X3 were:
$

Shop fixtures and equipment: cost 125,900

Shop fixtures and equipment: accumulated depreciation 43,600

Motor vehicles: cost 36,000

Motor vehicles: accumulated depreciation 21,500

During the year ended 30 September 20X4, the following assets were purchased for cash:
• A new security alarm system for $15,000
• A new delivery van for $20,000
During the year ended 30 September 20X4, the following assets were sold for cash:
• A shelving unit for $1,000 that had initially cost $2,000 on 1 October 20X0
During the year ended 30 September 20X4, an old electronic till was part exchanged for a new one. The new till cost $2,500,
which was made up of $2,000 cash and $500 for the old till. The old till had initially cost $1,750 and had accumulated
depreciation of $750.
Burton depreciates shop fixtures and equipment at 20% straight line and motor vehicles at 25%, reducing balance. A whole
year's depreciation is recorded in the year of purchase but none in the year of sale.
Question:
1. What is the profit or loss on disposal for the asset sold for cash?
2. What are the balances on the Fixtures and Equipment − Cost and Motor Vehicles − Cost accounts at 30 September
20X4?
3. What is the balance on the accumulated depreciation accounts after accounting for disposals in the year but before
the depreciation charge for the year is recorded?
4. What is the depreciation expense for the year ended 30 September 20X4?
5. What is the profit or loss on the disposal of the old electronic till?

9.4.1 Subsequent Measurement

4.1 Subsequent Measurement
All property, plant and equipment are initially measured at cost. The cost of an asset is its purchase price and other expenses
necessary to bring the asset to working condition for its intended use. These non-current assets are depreciated, and their
carrying amount is reflected in the statement of financial position.
However, there may be assets whose market value (the price at which the asset can be sold in an open market) is
considerably higher than their carrying value. The financial statement will not correctly represent the economic substance of
the assets.
Therefore, an asset may be subsequently revalued.
4.1.1 IAS 16 and Revaluation
IAS 16 permits the value of property, plant and equipment to be measured after the initial recognition.
The two accounting policy permitted in the subsequent measurement is:
1. Depreciated Cost Model – the asset’s original purchase cost of the asset is depreciated over its useful life
2. Revaluation Model – the asset is carried at a revalued amount based on its fair value. The revaluation exercise is carried out
regularly to keep the carrying amount in line with fair value. Following a revaluation, the revalued amount of the asset is
depreciated over its remaining useful life.
4.1.2 The Revaluation Model
When a business opts for the revaluation model of its assets, the following must apply:
• Class of Assets
All assets of the same class must be revalued. For example, all buildings are revalued, or all motor vehicles are
revalued. This means that a business cannot choose only those assets that have increased in value.
• Consistent Application
The revaluation policy has to be applied consistently. This means that a business cannot revalue one year and
then revert to the original cost of the asset the next. It needs to be consistent; otherwise, a business could revalue
when market values have increased and revert to the original cost when market values have fallen.
• Fair Value can be Measured Reliably
The carrying value of an asset is revalued to the fair value only if the fair value can be measured reliably. It must
be the actual market value of the asset and can be sold for the price in an open market.
• Accounting for Revaluation
Typically when assets are first revalued, this will usually be an upward revaluation where the market value of the
assets is higher than the cost. This results in the assets being stated at a revalued amount. These assets still need
to be depreciated. The revised depreciation is calculated as the revalued amount divided by the asset’s remaining
useful life.

9.4.2 Double Entry for NCA Revaluation

4.2 Double Entry for NCA Revaluation
Five adjustments are relevant to property, plant and equipment revaluation. These adjustments are:
• Upward Revaluation of Assets
• Revised Depreciation Charge
• Excess Depreciation Transfer
• Upwards or Downwards Revaluation for assets previously revalued
• Disposal of Revalued Assets
4.2.1 Upward Revaluation of Assets
When the business revalues its assets, the double entry to be posted is:
Individual Account Category Explanation
DR NCA − Cost Asset Increase asset to its revalued amount
DR NCA − Acc. Depreciation Asset Remove the total acc. depreciation
CR Revaluation Surplus Equity Record the revaluation adjustment in the equity account
The balance on the revaluation surplus at the year-end will appear in the statement of financial position as part of capital and
reserves. Any revaluation surplus that arises during the year will be shown as part of other comprehensive income in the
statement of profit or loss and other comprehensive income.
4.2.2 Revised Depreciation Charge
After an asset has been revalued, it still needs to be depreciated.
The revised depreciation charge is calculated as = Revalued amount ÷ Remaining useful life
The double entry to record the revised depreciation is similar to any depreciation charge:
Individual Account Category Explanation
DR Depreciation Expense Expense Depreciation (Expense) increased
CR NCA − Acc. Depreciation Asset Accumulated Depreciation reduces the value of the non-current asset (Asset)
4.2.3 Excess Depreciation Transfer
IAS 16 allows excess depreciation to be transferred within the capital accounts that appear in the statement of financial
position. The transfer will be from the Revaluation Surplus account to the Retained Earnings account (which is the account that
includes the accumulated profits and losses of the business).
It is up to the business to adopt this transfer adjustment; it is not mandatory.
The excess depreciation is the difference between the revised depreciation charge and the original depreciation charge had
there been no revaluation.
The double entry to transfer the excess depreciation is:
 Individual Account Category Explanation
DR Revaluation Surplus Capital Reduces the revaluation surplus account that is created when the asset is revalued.
CR Retained Earnings Capital Retained earnings (capital) increased
This is simply a transfer between the equity accounts and has no impact on the profit for the year, as reported in the statement
of profit or loss.
Example 13
Hassan owns a business that operates a hotel. The business owns the hotel building, and on 31 December 20X2, its carrying
amount based on cost is:
Cost $ Accumulated depreciation ($) Carrying amount ($)
Hotel property 500,000 (112,500) 387,500
The hotel building is depreciated on a straight-line basis over 40 years. The building has been depreciated for nine years. On
1 January 20X3, Hassan decided to revalue his hotel building. The hotel has a market value of $600,000 on that date.
Hassan has a policy of transferring excess depreciation to retained earnings.
1. Calculate the amount of revaluation adjustment

From the revaluation adjustment of $212,500, $112,500 relates to accumulated depreciation, and $100,000
relates to cost.
The double entry to record the revaluation upwards is:
DR Property − Cost $100,000
DR Property − Acc. Depreciation $112,500
CR Revaluation Surplus $212,500
2. Revised Depreciation
Hassan's hotel building has been revalued to $600,000. The total useful life is 40 years, and nine years' worth of
depreciation has already been charged.
The revised depreciation charge is $600,000 ÷ (40 − 9 = 31 years) = $19,355
The double entry to record the revised depreciation yearly is:
DR Depreciation Expense $19,355
CR Property − Acc. Depreciation $19,355
3. Transfer Excess Depreciation
Revised Depreciation = $19,355
Original Depreciation = $500,000 ÷ 40 years = $12,500
The excess depreciation = $19,355 − $12,500 = $6,855
The double entry to transfer the excess depreciation is:
DR Revaluation Surplus $6,855
CR Retained Earnings $6,855
The balance in Hassan’s revaluation surplus account is now = CR $212,500 + DR $6,855 = CR $205,645.
4.2.4 Upwards/Downwards Revaluation on previously Revalued Assets
Under the revaluation model, assets must be revalued regularly to ensure that the asset’s carrying value is not materially
different from its fair value.
If the asset is revalued upwards, then the steps to undertake are as Point 1 (Upward Revaluation of Assets).
If the asset is revalued downwards, the revaluation adjustment is calculated by comparing the carrying value and the
revaluation amount. The double entry to adjust for the downward revaluation of a previously revalued asset is:
Individual Account Category Explanation
DR Revaluation Surplus Capital Reduce the revaluation surplus by the revaluation adjustment
DR NCA − Acc. Depreciation Asset Remove the total acc. depreciation
CR NCA − Cost Asset Reduce asset to its revalued amount
The revaluation adjustment is debited to the revaluation surplus up to the initial revaluation surplus credit. If the downward
revaluation exceeds the amount previously credited, the excess is expensed off to profit or loss.
Example 14
Continuation from Example 13 previously.
On 31 December 20X6, Hassan’s building was valued at $510,000.
 Hassan’s building will have been straight-line depreciated for four years from the initial revaluation (20X3, 20X4, 20X5 and
20X6). Therefore, the accumulated depreciation on 31 December 20X6 is $19,355 × 4 years = $77,420.
The carrying value is $600,000 − $77,420 = $522,580.
The revaluation adjustment is as follows:
Cost = $600,000 − $510,000 = $90,000
Acc. Depreciation = $77,420
The double entry to record the downward revaluation is:
DR Revaluation surplus $12,580

DR Building: accumulated depreciation $77,420

CR Building: cost/valuation $90,000

The balance in the revaluation surplus account is now CR $205,645 + DR 12,580 = CR 193,065.
What if the building needs to be reduced to $250,000 instead?
The revaluation adjustment is: $522,580 − $250,000 = $272,580
Cost portion = $600,000 − $250,000 = $350,000
Acc. Depreciation portion = $77,420
We have identified earlier that the balance in Hassan’s revaluation surplus account is CR $205,645. Therefore, the excess of
66,935 ($272,580 − $205,645) is debited to expenses in profit or loss.
DR Revaluation Surplus $205,645
DR Profit or Loss $66,935
DR Building − Acc. Depreciation $77,420
CR Building − Cost $350,000
The balance in the revaluation surplus account is now CR $205,645 + DR $205,645 = 0
4.2.5 Disposals of Revalued Assets
The disposal of a revalued asset is accounted for in the same manner as a typical asset mentioned in Section 3.2.2. The only
difference is that any balance that remains in the revaluation surplus account is transferred to the retained earnings as the gain
in revaluation can now be realised with the sale of the asset.
Example 15
Continuation from Example 13 previously. (no downward revaluation)
Hassan sold the building for $504,825 on 31 December 20X7.
At the point of the sale (31 Dec X7), these are the account balances of the building:
• Building: Cost = $600,000
• Building: Acc. Depreciation = $19,355 × 5 years = $96,775
• Carrying Value = $600,000 − $96,775 = $503,225
• Revaluation Surplus = Initial $212,500 − excess depr ($6,855 × 5 yrs) = $178,255
The Disposal account is as follows after all the relevant journal entries relating to the sale of the building have been posted:
DR Disposal CR

Building - Cost $600,000 Building - Acc. Depr $96,775

Profit on Disposal (balancing fig) $1,600 Sale Proceeds (Bank) $504,825

$601,600 $601,600

The balance of $178,255 in the revaluation surplus account is also transferred to the retained earning account now that the
sale is realised.
The double entry for the transfer is: DR Revaluation Surplus $178,255 and CR Retained Earnings $178,255.
Note - the balance on the revaluation reserve does not go through the statement of profit and loss when an asset is sold. This
is referred to as recycling and is not permitted by IAS 16.

9.5.1 Purpose and Function of Non-Current Asset Register

5.1 Purpose and Function of Non-Current Asset Register
The acquisition, depreciation and disposal of tangible non-current assets recorded in the general ledger accounts show the
transaction balance of each asset category. It does not retain any detail about individual assets once it is closed off at the end
of the year.
A business keeps track of individual assets’ cost, carrying amount, depreciation and disposal using a separate record known
as the non-current asset register.
 Definition

The Non-Current Asset Register is a memorandum document where each asset is listed, which will include information on all the activities
relating to the asset.

The non-current asset register has information on each asset:

• Date of Purchase
• Description
• Location
• Useful Economic Life
• Depreciation Method
• Depreciation Amount
• Carrying amount
• Ultimate Disposal proceeds
The non-current asset register is useful for a business as it is used to verify the existence of assets within a business. The
business can perform an asset count at each location according to the non-current asset register.
5.1.1 Elements of a Non-Current Asset Register
Example 10
Below is the non-current asset register maintained of all the non-current assets owned.
Asset No. Location Description Date of Purchase Cost ($) Accumulated Depreciation Carrying amount Disposal
3460 Shop 1 Computer 1 Feb 20X2 540 180 360
3461 Shop 1 Printer 1 Feb 20X2 150 50 100
3462 Shop 3 Display Unit 1 June 20X2 2,000 200 1,800
3463 Shop 2 Delivery Vehicle 1 June 20X2 15,000 1,500 13,500
• The asset number is an internal reference number given to each asset. These will be allocated in sequential order.
• The location reference is useful as it informs the company of where each asset is located.
• The description can be as detailed as required. The supplier name can also be noted under the description.
• The date of purchase is indicated to identify the assets‘ ages.
• The asset’s cost is recorded in the general ledger T-account (it will usually be net of sales tax).
• The accumulated depreciation and carrying amount is calculated and entered into the Non-Current Asset Register
• Any details of the disposal of assets are recorded in the Non-Current Asset Register, including sales proceeds and date of
disposal. Information on whole or part exchanges will also be detailed in the disposal column of the Asset Register.
Since the same information concerning the non-current asset is recorded in the general ledger and the asset register, the two
balances should agree. Therefore, the asset register also acts as a source of supporting documentation to verify the accuracy
of balances in the ledger accounts.
Differences between the two reports should not occur in a computerised system, as the same information automatically
updates the ledgers and the asset register simultaneously with the input of non-current assets transactions.
However, businesses with manual systems may encounter differences between these balances due to entry omissions of
purchase costs or depreciation charges from one of the reports.
Discrepancies involving omissions or errors should be corrected by posting entries into the omitted or erroneous report.

9.5.2 Property, Plant and Equipment Disclosure

5.2 Property, Plant and Equipment Disclosure
5.2.1 Disclosure Requirements
The following information is required to be disclosed in the financial statements for each class of property, plant and
equipment:
• Measurement bases used for determining gross carrying amount.
• Depreciation methods used.
• Useful lives or the depreciation rates used.
• Gross carrying amount and accumulated depreciation at the period’s beginning and end. (Comparatives are not required.)
• A reconciliation of the carrying amount at the beginning and the end of a period showing:
o Additions
o Disposals
o increases or decreases resulting from revaluations
o depreciation
o other movements
Example 11
A single figure is included in a company’s SOFP for its Property, Plant and Equipment figure. This could consist of several
types of assets and many different transactions. IAS 16, Property, Plant and Equipment, requires detailed disclosures,
including the depreciation method and the useful life estimates.
Below is an example of the detailed disclosure note for the Property, Plant and Equipment figure in the Statement of Financial
Position.
Example property, plant and equipment disclosure for the year ended 31 December 20X8

• Class of Asset – The tangible non-current assets owned will be grouped based on their type or class. One column per class is
then set up together with a total column. Typical examples of these asset groups are
o Land and Buildings
o Motor Vehicles
o Fixtures and Fittings
o Computer Equipment
• Sections of the Note – The note contains three main areas:
o Cost or valuation
o Accumulated depreciation
o Carrying amount of each class of asset
• Carrying Amount at the start of the period – Cost/valuation and accumulated depreciation at the beginning of the period are
entered for each class to calculate the opening carrying amount.
• Additions – All additions to each class of asset are recorded in the cost or valuation section.
• Disposals – The disposal of an asset will be recorded in the cost/valuation section and the accumulated depreciation section in
the disclosure notes. The cost or valuation of the asset sold is deducted from the balance for this section and the same for its
related accumulated depreciation.
 • Revaluations – The revaluation will increase the asset’s cost to the revalued amount in the cost or valuation section. The
revaluation will remove the accumulated depreciation up to the date of the revaluation from the accumulated depreciation
section.
• Charge for the year – After all additions, disposals and revaluations have been adjusted, the depreciation charge for the year
is calculated and added to the accumulated depreciation section.
• Carrying amount at the end of the period – The cost/valuation and accumulated depreciation balances at period-end are
calculated, allowing the carrying amount to be disclosed and ready for inclusion in the SOFP.
Example 12
On 1 January 20X8, Prajun Co had the following tangible non-current assets: buildings cost $200,000, motor vehicles cost
$30,000, and office equipment cost $10,000. A whole year's depreciation charge is made in the year of acquisition and none in
the year of sale. The depreciation policy for each category of asset is as follows:
• Buildings: straight line over 50 years
• Motor vehicles: straight line over five years
• Office equipment: 20% reducing balance
On 1 January 20X8, Prajun Co sold, for sale proceeds of $1,000, one of the motor vehicles that had originally cost $10,000
and had accumulated depreciation to the date of sale of $8,000.
On 31 December 20X8, office equipment was purchased for $5,000.
Buildings Motor vehicles Office equipment Total

$ $ $ $

Cost or valuation

At 1 January 20X8 200,000 30,000 10,000 240,000

Additions - - 5,000 5,000

Disposals - (10,000) - (10,000)

At 31 December 20X8 200,000 20,000 15,000 235,000

Accumulated depreciation

At 1 January 20X8 60,000 20,000 3,000 83,000

Disposals - (8,000) - (8,000)

Charge for the year 4,000 4,000 2,400 10,400

At 31 December 20X8 64,000 16,000 5,400 85,400

Carrying amount at 31 December 20X8 136,000 4,000 9,600 149,600

Carrying amount at 1 January 20X8 140,000 10,000 7,000 157,000

CHAPTER 10: Visual Overview
CHAPTER 10: Visual Overview
Objective: To prescribe the accounting treatment for intangible assets in general and to explain the accounting treatment for
expenditure on research and development (R&D) activities.

10.1.1 Introduction to Intangible Assets

1.1 Introduction to Intangible Assets
Definition

An intangible asset is a non-current asset that is identifiable and without physical substance.

An intangible asset is identifiable when it:

• is separable (it can be sold, transferred, licensed or exchanged) or
• arises from contractual or other legal rights
A non-current asset is a resource controlled due to past events, from which future economic benefits are expected to flow and
is owned for more than a year.
Intangible assets that have been purchased can be capitalised and included in the statement of financial position as non-
current assets. However, intangible assets internally generated by the business cannot be capitalised. Typically, this includes
goodwill and brands.
Once an intangible asset is capitalised, it must be amortised. The amortisation of an intangible asset is the same as the
depreciation of a tangible non-current asset. Amortisation charge measures the consumption, or usage, of the intangible
asset.

1.1.2 Examples of Intangible Assets

Examples of intangible assets include:
• Computer software
• Patents and licences (exclusive rights to use a process, product or name)
• Copyright (legal right belonging to the originator of a material which cannot be reproduced or copied)
• Trademarks (a legally registered or established symbol or word that is used to represent a company or product)
• Brands (a symbol or wording identifying a product)
• Intellectual property (technical knowledge obtained from a development activity)
• Goodwill (value of business above the value shown in the financial statement, coming from the strength of a brand and
reputation)
• Development cost (as described later in this chapter)
10.1.2 Amortisation
1.2 Amortisation
The amortizable (depreciable) amount should be allocated systematically over the best estimate of useful life. The amortisation
period:
• commences when the asset is available for use
• ceases when the asset is derecognised (if it is sold)
The carrying amount (Intangible Asset Cost – Accumulated Amortisation) is reduced to reflect the consumption of economic
benefits over time. The following factors should be considered:
• expected usage of the asset
• typical product life cycles for the asset
• technical obsolescence, etc
• stability of industry and market demand
• expected competition
• maintenance required
• period of control (e.g. the legal limit on a lease)
• dependency on the useful lives of other assets

1.2.1 Amortisation Method

The amortisation method should reflect the consumption pattern (For example, the unit of the production method). The straight-
line method should be used if a pattern cannot be determined reliably.
The amortisation charge is recognised as an expense unless included in the carrying amount of another asset.
Amortisation methods should be reviewed at least annually at each financial year-end. The amortisation charge for current and
future periods should be adjusted for any changes in the:
• period (if the expected useful life is significantly different)
• method (to reflect a changed pattern).

1.2.2 Residual Value

The residual value is assumed to be zero unless there exists:
• a commitment by a third party to purchase the asset at the end of its useful life; or
• an active market for the asset.
10.1.3 Double Entries for Intangible Assets
1.3 Double Entries for Intangible Assets
Capitalising an intangible asset means that it can be accounted for and included on the statement of financial position.
The double entry to record the purchase of an intangible asset is:
Individual Account Category Explanation
DR Intangible Asset – Cost (SFP) Asset Intangible Asset (Asset) is recognised
CR Bank/Cash (SFP) Asset Bank (Asset) has decreased
Amortisation is the systematic allocation of the depreciable amount of an intangible asset (its cost minus residual value) over
the period expected to benefit from its use.
The double entry to record the amortisation of an intangible asset is:
Individual Account Category Explanation
DR Amortisation (SPL) Expense Amortisation (Expense) increased
CR Intangible Asset – Acc. Amortisation (SFP) Asset Acc. amortisation reduces the value of IA
Activity 1

Match the incomplete statement in the left column to the corresponding statement in the right to complete each
sentence.
An internally generated brand The amortisation charges is $2,000
A patent purchased by a business The amortisation charge is $1,400
A copyright purchased for $10,000 has a five-year UL and no residual Cannot be capitalised as an intangible asset
value
An intangible asset has a cost of $12,000, a UL of eight years and no Can be capitalised as an intangible asset
residual value
A trademark has been capitalised at an amount of $16,000. It has a UL The balance on the accumulated amortisation ledger
of 10 years after which it will be sold for $2000. account after two years is $3,000
Activity 2 New Product Development
In 20X4, Brock Co spent $2m on developing a new line of foods for infant nutrition. On 1 January 20X5, the directors approved
to fund the rest of the project and a further $1m was spent in the first quarter of 20X5. On 1 April 20X5, Brock Co’s application
for an infant food licence was rejected as sugar substitutes in a milk formula did not comply with the standards of the Food
Safety Authority (FSA).
Brock Co spent a further $1m in the second quarter of 20X5 and the FSA approved Brock Co’s reapplication for a licence on 1
July 20X5. Brock Co then spent a further $1.5m developing the product range before its launch on 1 October 20X5. The new
product line is expected to generate revenues in excess of $20m and have a useful life of five years.
Required:
Explain how the development expenditure should be accounted for in the financial statements for the year ended 31
December 20X5.

10.2.1 Research and Development

2.1 Research and Development
2.1.1 Introduction of Research and Development
It may be challenging for businesses to determine a value of an internally generated intangible asset. Specifically, it is often
difficult to determine whether:
• there is an identifiable asset
• future economic benefits are probable
• cost can be measured reliably.
It isn’t easy to distinguish the cost of generating a brand, for example, from the cost of developing the business as a whole,
maintaining goodwill, or operating on a day-to-day basis.
Therefore, internally generated intangible assets such as brands, publishing titles, customer lists and items similar in
substance cannot be capitalised and recognised as intangible assets in the Statement of Financial Position.
The only exception is research and development costs.
Research: Research is an original and planned investigation undertaken to gain new scientific or technical knowledge and
understanding.
Development: Development is the application of research findings or other knowledge to a plan or design for the production
of new or substantially improved materials, devices, products, processes, systems or services before the commencement of
commercial production or use.
Research is gathering new knowledge, and development is the application of the knowledge gained before the business can
use it commercially.
For example, a company that makes medicines carries out research into the use of herbs to cure headaches. This research
results in the company finding one herb with unique properties for curing headaches. The company then uses this research
and develops a headache pill using this herb, which is tested and then made ready to sell to the public.
Typically Considered Research
Aiming to obtain new knowledge.
Seeking applications of research findings.
Seeking and evaluating product or process alternatives.
Formulating and designing possible new or improved product or process alternatives.
Typically Considered Development
Design, construction and testing of pre-production prototypes and models and chosen alternative materials, processes, etc.
Designing tools, etc., involving new technology.
Design, construction and operation of a pilot plant (not of a scale economically feasible for commercial production).
Related to, but Neither Research nor Development
Engineering follow-through in an early phase of commercial production.
Quality control during commercial production, including routine product testing.
Troubleshooting commercial production breakdowns.
Routine refining or otherwise improving existing products.
Adapting an existing capability (for example, to a particular customer's requirement)
Seasonal/periodic design changes to existing products.
Routine design of tools, etc.
10.2.2 Accounting for Research and Development
2.2 Accounting for Research and Development
Research and development expenditure includes all costs incurred directly from carrying out the R&D or can be allocated
reasonably.
Costs that may be included as a result of the research and development activities are:
• Salaries and Wages – Any employment-related costs for staff carrying out the research and development activities can be
included. For example, salaries, wages, payroll taxes, pension contributions
• Materials and Services – Any materials or services used in the research and development activity can be included. For
example, product development materials and external market research experts.
• Overhead Costs – Any overhead costs (excluding general overheads) related to the research and development activity can be
included. For example, energy and security costs.
2.2.1 Recognition of Research
Research costs are always treated as expenses and cannot be capitalised as intangible assets because it is uncertain
whether the research will generate future economic benefits.
The double entry to account for research expenditure is:
Individual Account Category Explanation
DR Research (SPL) Expense Research (Expense) has increased
CR Bank/Cash (SFP) Asset Bank (Asset) has decreased

2.2.2 Recognition of Development

Development cost can only be capitalised as an intangible asset if it meets all the following criteria below:
• Technical feasibility of completing the development of the intangible asset
• Intention to complete the development of the intangible asset
• Ability to use or sell the intangible asset
• The intangible asset will generate future economic benefit
• Sufficient resources to complete the intangible asset
• Cost can be measured reliably
•
Individual Account Category Explanation
DR Intangible Asset (SFP) Asset Intangible Asset (Asset) is recognised
CR Bank/Cash (SFP) Asset Bank (Asset) decreased to pay for development cost
The capitalised development cost will be amortised over its useful life and charged to the Statement of Profit or Loss.
Development expenditure has no residual value since no active market exists (each development will be unique).
If any of the above criteria is not met, the development cost cannot be capitalised and must be treated as an expense in the
Statement of Profit or Loss.
Individual Account Category Explanation
DR Development (SPL) Expense Development (Expense) has increased
CR Bank/Cash (SFP) Asset Bank (Asset) has decreased
 Example 1
On 1 April 20X6, Brooks established a new research and development unit to acquire scientific knowledge on the use of
synthetic chemicals for pain relief. The following expenses were incurred during the year ended 31 March 20X7.
1. Purchase of building for $400,000. The building is to be depreciated on a straight-line basis at the rate of 4% per annum on cost.
The purchase of a building is a tangible non-current asset purchase, not an intangible asset. Brooks will capitalise
the purchase cost with the following entry:

DR Building - Cost $400,000

CR Bank $400,000

At the year-end, the depreciation charge is $400,000 × 4% = $16,000 and should be expensed off by:

DR Depreciation (Expense) $16,000

CR Building – Acc. Depreciation $16,000

2. Wages and salaries of research staff are $2,355,000.

Research costs must always be expensed off. The double entry is:

DR Research (Expense) $2,355,000

CR Bank $2,355,000
3. Development cost that meets the criteria to be capitalised has been calculated to be $60,000. It is amortised using the straight-
line method of 25% per annum.
The cost to be capitalised is $60,000. The double entry is:

DR Intangible Asset $60,000

CR Bank $60,000

The amortisation charge for the year is $60,000 × 25% = $15,000

DR Amortisation (Expense) $15,000

CR Intangible Asset – Acc. Amortisation $15,000

The total amount expensed in the statement of profit or loss is:

Building depreciation ($400,000 × 4%) $16,000

Wages and salaries of research staff $2,355,000

Intangible Asset Amortisation ($60,000 × 15%) $15,000

$2,386,000

Activity 3
In its first year of trading, which ended 31 July 20X6, Eco-chem incurred the following expenditures on research and
development (none related to the cost of property, plant and equipment).
1. $12,000 on successfully devising processes for converting seaweed into chemicals X, Y and Z.
2. $60,000 on developing a headache pill based on chemical Z.
No commercial uses have yet been discovered for chemicals X or Y.
Commercial production and sales of the headache pill commenced on 1 April 20X6 and are expected to produce steady,
profitable income for five years before being replaced. Adequate resources exist to achieve this.
Determine the amount of development expenditure which may be carried forward (remain as an amortising asset) at
31 July 20X6 under IAS 38.

Activity 4 Capitalised Development Expenditure

In its first year of trading to 31 December, Eco-chem incurred the following expenditure on research and development, none of
which related to the purchase of property, plant and equipment.
1. $12,000 on successfully devising processes to convert the sap extracted from mangroves into chemicals X, Y and Z.
2. $60,000 on developing an analgesic medication based on chemical Z. No commercial uses have yet been discovered for
chemicals X and Y.
Commercial production and sales of the analgesic commenced on 1 September, and are expected to produce steady profitable
income during a five-year period before being replaced. Adequate resources exist for the company to achieve this.
Required:
Assuming no impairment, determine the maximum amount of development expenditure which may be carried forward
at 31 December under IAS 38.

10.2.3 Intangible Assets Disclosures

2.3 Intangible Assets Disclosures
2.3.1 Disclosure Requirements
IAS 38 Intangible Assets include very detailed requirements about what should be disclosed concerning non-current assets in
a set of financial statements. These disclosures will typically be included in the notes to the financial statements.
The standard requires a reconciliation between the opening and closing carrying amounts of the non-current assets prepared
and disclosed.
The financial statements should disclose each class of intangible assets:
• Useful lives or amortisation rates used.
• Amortisation methods used.
• Gross carrying amount and accumulated amortisation.
• A reconciliation of the carrying amount at the beginning and the end of the period showing additions, disposals, amortisation,
etc.
The aggregate amount of R&D expenditure recognised as an expense during the period.
Example 2
The disclosure note for intangible assets in the financial statements is as follows:
Intangible non-current assets Development project 1 Development project 2 Total

$ $ $

Cost or valuation

At 1 January 20X8 x x x

Additions x x x

At 31 December 20X8 x x x

Accumulated amortisation

At 1 January 20X8 x x x

Charge for the year x x x

At 31 December 20X8 x x x

Carrying amount at 31 December 20X8 x x x

Carrying amount at 1 January 20X8 x x x

CHAPTER 11: Visual Overview
Objective: To explain the period-end adjustments for prepayments and accruals.

1.1 Accrual Basis

The accrual basis of accounting (“accrual accounting”) concerns the timing of the recognition of transactions. Under the accrual
basis, the statement of profit or loss must include all income and expenses related to the period, regardless of the timing of cash
receipts or payments.
The mismatches between the timing of transactions and their cash flow give rise to the following in the statement of financial
position:

Key Point

Under the accrual basis, revenue and costs are both:

• accrued (recognised as earned or incurred) and
• recorded in the financial statements of the period they relate.
The matching concept requires expenses incurred in generating revenue to be matched against the revenue in determining
profit or loss for the period.
• When revenue is recognised because it has been earned, the costs incurred in generating such revenue are also recognised
(matched).
• However, a future sale cannot be recognised merely because it can be matched with costs incurred. This would be contrary to
the accrual basis and the concept of prudence (which calls for the exercise of caution so that, for example, income is not
overstated).
The accruals concept is applied to:
 • Receivables and Payables
When goods are sold or bought on credit, the sale or the purchase is recorded immediately, and receivables and
payables are created. As a result, the income (Sales) and expense (Purchases) is recognised even though there
has been no actual payment.
• Business Expenses and Income
The same logic used for credit sales and purchase transactions is applied to other expenses or income of the
business, such as rental, electricity and insurance fees.
Example 1
Desmond owns a business that makes made-to-measure wooden window frames, doors and furniture. The business is known
as DPQ Joinery, and all the wooden furniture is made at a single workshop premise that the business owns. Any painting
required is done at a separate workshop space, which the business rents.
The office where all the accounting and administrative functions are carried out is attached to the business's workshop
premises.
DPQ Joinery would most likely incur numerous expenses to operate his business, such as wages, electricity, repairs,
maintenance, telephone, insurance, rental of the painting workshop, advertising and stationery.
Broadly, expenses can be split into two categories:
• Those related to a specific transaction on a particular date, for example, stationery.
• Those related to an ongoing service received over time, for example, electricity, rent or telephone service.
For example, DPQ Joinery uses electricity daily, incurring an expense. However, the electricity supplier may only invoice DPQ
Joinery each quarter for the electricity used over the past three months.
At DPQ Joinery's year-end, the business will owe the electricity supplier for electricity used but not yet invoiced. This used but
unpaid electricity will need to be accrued to ensure that the total cost of the electricity used in the year is reflected in the profit
figure within the statement of profit or loss.
The business expense reflected in the final accounts should be based on the electricity use rather than how much has been
invoiced or paid.
Electricity was used as an example, but the same logic applies to other business expenses with ongoing use – such as
telephone service, rent or insurance.

1.2 Accruals Concept on Accruals, Prepayments, Accrued Income and Deferred Income
Payment received from income and made for expenses may be made in arrears (received/paid later) or in advance
(received/paid earlier).
This chapter discusses accruals, prepayments, accrued income and deferred income. The double entries below will only be
made at the financial year-end.
Category Explanation Asset Liability Double Entry
Accruals Expenses incurred before payment made ✓ DR Expenses
CR Accruals
Prepayments Payment made before expenses incurred ✓ DR Prepayments
CR Expenses
Accrued Income Income earned before payment received ✓ DR Accrued Income
CR Income
Deferred Income Payment received before income earned ✓ DR Income
CR Deferred Income
A business may incur expenses with payments made in arrears or in advance:
• Accruals are expenses paid in arrears. For example, electricity incurred from January to March is paid only at the
end of March. Accruals are reported as a liability in the statement of financial position.
• Prepayments are expenses paid in advance. For example, yearly business insurance is paid once at the start of
the year. Prepayments are reported as an asset in the statement of financial position.
A business may generate income with payments received in arrears or in advance:
• Accrued Income is income generated for payments received in arrears. For example, a business may rent out
additional space in an office and collect rental income at the end of the month. Accrued income is reported as
a asset in the statement of financial position.
• Deferred Income is income generated with payments received in advance. For example, a business may
collect rental income at the start of the month or quarter. Deferred income is reported as a liability in the statement
of financial position.

2.1 What is an Accrual?

Key Point

An accrual is recognised when an expense incurred has not been paid or invoiced for by the end of the financial period.

Usually, a business recognises an expense when it receives a purchase invoice (credit purchase) or makes a payment (cash
purchase); the double entry would be DR Expenses, CR Payables/Bank.
However, certain ongoing expenses may only be paid after the services have been incurred. This is known as a payment in
arrears. The expense that has yet to be paid at year-end is recognised as an accrual.
Example 2
DPQ Joinery's electricity supplier sends its invoice every quarter (three months).
The quarterly invoice will be for the electricity used in the previous quarter (three months). This means that the electricity
supplier will invoice DPQ Joinery after it has used the electricity. This is known as invoicing in arrears.
At the year-end, DPQ Joinery will owe the electricity supplier for electricity used since the last invoice date. A liability, therefore,
needs to be recorded in the statement of financial position to reflect the amount owed.
This liability is an accrual, which will also be recorded in the electricity expense account.

2.2 Accounting for Accruals

Once the accrual amount is established, the amount is recognised as an expense and a liability.
At year-end, the business will adjust for accruals creation for expenses incurred before receiving the invoice/making payment.
In the subsequent accounting period, where the business receives the invoice and makes the payment, it will reverse the
accruals and account for the expense payment. The accruals creation and the reversal of accruals are posted to the relevant
ledgers using journals.
The double entry for creating accruals at year-end to recognise the expense incurred that has not been paid is:
Individual Account Category Explanation
DR Individual Expense Expense Expenses increased
CR Accruals Liability Accruals (Liability) increased
The adjustment for accruals creation will have an impact on the business’s profits and net assets as follows:
• Profits – The double entry to create accruals is to debit the expenses account. Expenses increases, which will lead to a reduced
profit figure.
• Net Assets – The corresponding entry is to credit the Accruals liability account. Net assets or capital is the assets less liabilities
of a business. Since liability has increased, the net assets of the business will decrease.
In the next accounting period, the supplier will invoice the business for the expense, and the business will make payment. As a
result, double entries are made for:
• the accruals reversal
• the expense payment
The double entry to reverse the accruals adjustment is:
Individual Account Category Explanation
DR Accruals Liability Accruals (Liability) decreased
CR Individual Expense Expense Expense decreased
The double entry for the expense payment is:
Individual Account Category Explanation
DR Individual Expense Expense Expense is recorded (increased)
CR Bank/ Payables Asset Bank (Asset) decreased
Example 3
During the year ended 31 December 20X2, the electricity supplier sent the following invoices to DPQ Joinery, which were paid
immediately:
Date Period of electricity use $
2 May 1 January to 30 April 8,460
2 August 1 May to 31 July 6,190
2 November 1 August to 31 October 7,230
21,880
DPQ Joinery paid a total of $21,880 for electricity during the year. However, this relates only to the electricity used by the
business from 1 January to 31 October. An additional two months of electricity use (1 November to 31 December) have not
been invoiced and paid.
At year-end 31 December 20X2, DPQ Joinery needs to adjust for Accrual creation.
st

There are two options to calculate the value of the Accrual:

1. Calculate the accrual amount based on the invoice for the same period last year (This will reflect consumption at the same time
of year).
2. Calculate the accrual amount based on the last invoice received.
Note: Since there is no information on the last year's invoice for the same period, DPQ Joinery will use the previous invoice
received.
The last invoice received was $7,230 and relates to electricity use for August to October. However, we only need to make an
accrual for two months (November and December) of electricity use.
From the last invoice,
The average cost for one month: $7,230 ÷ 3 months = $2,410
Therefore, two months' worth of electricity: $2,410 × 2 months = $4,820
So, the estimated value of the accrual required to be created at year-end: $4,820
DR Electricity Expense $4,820
CR Accruals $4,820
The debit to the expense account increases the expense for the year. As a result, this accrual adjustment will reduce profits
during the year.
The impact of the Accruals creation adjustment to the general ledger accounts for the year is as follows (assuming no opening
balance in the Accruals account):
DR Accruals (Liability) CR

31-Dec-X2 Electricity Expense $4,820

DR Electricity Expense (Expense) CR

02-May-X2 Bank $8,460 31/12/X2 Statement of Profit or Loss $26,700

02-Aug-X2 Bank $6,190

02-Nov-X2 Bank $7,230

31-Dec-X2 Accruals $4,820

$26,700 $26,700

In this example, we assumed there is no opening accrual on 1 January 20X2 for electricity expenses, meaning there is no
accrual balance at 31 December 20X1.
This is slightly unrealistic because electricity expense is paid in arrears, and there should be an accrual balance at the end of
each accounting period.
In this scenario, the closing accruals balance of $4,820 is the following period’s opening accruals balance.
Example 4 (with opening balance)
DPQ Joinery’s employees are paid on an hourly basis. The employees are paid once a week in arrears for hours worked in the
previous week. The year-end is 31 December 20X2. At the end of the year, DPQ Joinery owes its employees a week's worth of
wages for the hours that they have worked.
During the year-ended 20X2, DPQ Joinery has the following information:
1. At the end of 20X1, DPQ Joinery owed its employees $1,560 for wages.
On 31 Dec 20X1, the double entry is made to create an accrual.
DR Wages Expense $1,560
CR Accruals $1,560
The accrual balance of $1,560 is brought forward in 20X2 as an opening balance. The expense is transferred to the
profit or loss for the year and not brought forward to the following period.
2. DPQ Joinery paid $1,560 due to its employees on the first week of 20X2.
Since DPQ Joinery has paid its employees in the current financial period for opening accruals balance, we will
reverse the Accrual balance in 20X2 as DPQ Joinery no longer owes that balance to its employees. The expense
payment of $1,560 is then recorded.
• The accrual adjustment is reversed:
DR Accruals $1,560
CR Wages Expense $1,560
• The payment of expenses is recorded:
DR Wages Expense $1,560
CR Bank $1,560
3. In weeks 2 to 52 of 20X2, a further $84,934 of wages was paid to the employees.
The payment of expenses is recorded as follows:
DR Wages Expense $84,934
CR Bank $84,934
4. At the end of 20X2, the business owes its employees $1,790 for wages.
At the end of 20X2, DPQ Joinery creates an accrual for the balance owed to its employees who have not been
paid.
DR Wages Expense $1,790
CR Accruals $1,790
The impact of the accruals adjustment to the general ledger accounts is as follows:
DR Accruals (Liability) CR

Week 1 Wages Expense (2) $1,560 01-Jan-X2 Balance b/d (1) $1,560

31-Dec-X2 Balance c/d $1,790 31-Dec-X2 Wages Expense (4) $1,790

$3,350 $3,350

01-Jan-X3 Balance b/d $1,790

DR Wages Expense Account (Expense) CR

Week 1 Bank (2) $1,560 Week 1 Accruals (2) $1,560

Week 2-25 Bank (3) $84,934 31-Dec-X2 Statement of Profit or Loss $86,724

31-Dec-X2 Accruals (4) $1,790

$88,284 $88,284

DR Bank Account (Asset) CR

Week 1 Wages Expense (2) $1,560

Week 2-25 Wages Expense (3) $84,934

Example 4
Anne owns a business with an accounting year-end of 30 September 20X5. A lease on office premises is taken on 1 January
20X5. Rent for the year to 31 December 20X5 is $2,400. On 1 January 20X5, $1,000 was paid regarding rent due.
For the year-ended 30 Sept 20X5 (Year 1):
The Year 1 financial period is from 1 October 20X4 to 30 Sept 20X5, while the lease rental period is from 1 Jan X5 to 31 Dec
X5.
1. On 1 Jan X5, Anne paid rent of $1,000. The double entry to record the expense payment is:
DR Rent Expense $1,000
CR Bank $1,000
2. At year-end 30 Sept X5, the portion of rental expense used but not paid is recognised as an accrual. The lease on office premises
was taken from 1 Jan X5 to 31 Dec X5. On 30 Sept X5, Anne incurred 9 months of expense ($2,400 × 9/12 months) = $1,800.
Anne paid $1,000 at the start of the lease period; the total expense incurred but not paid is $800 ($1,800 − $1,000).
The double entry to create the accrual is:
DR Rent Expense $800
CR Accruals $800
The ledger account during the financial year-end 30 Sept 20X5 will show the following after the double entries have been
recorded.
DR Accruals (Liability) CR

30-Sep-X5 Balance c/d $800 30-Sep-X5 Rental Expense (2) $800

$800 $800

01-Oct-X5 Balance b/d $800

DR Rental (Expense) CR

01-Jan-X5 Bank (1) $1,000

30-Sep-X5 Accruals (2) $800 30-Sep-X5 Profit or Loss $1,800

$1,800 $1,800
 DR Bank (Asset) CR

01-Jan-X5 Rental Expense (1) $1,000

For the year-ended 30 Sept 20X6 (Year 2):

The Year 2 financial period is from 1 October 20X5 to 30 Sept 20X6, while the rental lease period is from 1 Jan X6 to 31 Dec
X6.
1. Anne pays rent on the office building lease of $1,400 on 31 Dec 20X5.
The double entry to record the lease payment on 31 Dec X5 is:
DR Rent Expense $1,400
CR Bank $1,400
2. The rental for the lease for the first year would have been paid in total ($1,000 + $1,400) = $2,400. On 31 December 20X5, the
accruals made of $800 in the previous year would have been incurred. The accruals adjustment will be reversed:
DR Accruals $800
CR Rent Expense $800
Anne has identified that the rent for the year to 31 December 20X6 is $2,800. On 15 June 20X6, she pays rent of $1,400.
3. The double entry to account for the rental payment of $1,400 on 15 June X6 is:
DR Rent Expense $1,400
CR Bank $1,400
4. At the year-end of 30 Sept X6, Anne will adjust for accruals for rental expenses incurred but not paid. The expense incurred for the
year is $2,800 × 9/12 months = $2,100. Only $1,400 has been paid in respect of this expense. Therefore $700 ($2,100 − $1,400). The double
entry is:
DR Rent Expense $700
CR Accruals $700
The ledger accounts during the financial year-end 30 Sept 20X6 will show the following after the double entries have been
recorded.
DR Accruals (Liability) CR

31-Dec-X5 Accrual Reversal (2) $800 01-Oct-X5 Balance c/d (opening) $800

30-Sep-X6 Balance b/d $700 30-Sep-X6 Accruals (4) $700

$1,500 $1,500

01-Oct-X6 Balance c/d $700

DR Rental (Expense) CR

31-Dec-X5 Bank (1) $1,400 31-Dec-X5 Accrual Reversal (2) $800

15-June-X6 Bank (3) $1,400 30-Sep-X6 Profit or Loss $2,700

30-Sep-X6 Accruals (4) $700

$3,500 $3,500

DR Bank (Asset) CR

31-Dec-X5 Rental Expense (1) $1,400

15-June-X6 Rental Expense (3) $1,400

Activity 1

The accounting year end is 31 December 20X6. A gas bill for $300 arrives on 2 February 20X7 for the quarter to 31 January
20X7.
Show the 31 December 20X6 ledger entries for the accrued expense.
The Year 2 financial period is from 1 Jan 20X6 to 31 Dec 20X6. Therefore, the gas bill of $300 for the quarter to 31 January
20X7 is only invoiced in the following year.
This means that the gas bill is from the quarter 1 Nov X6 to 31 Jan X7.
At the year-end, 31 Dec X6, 2 months of gas expenses have been incurred but not invoiced/paid. Therefore, an accrual
adjustment is needed.
Amount accrued = $300 × 2/3 months = $200. The double entry to record the accruals is DR Gas Expense $200, CR Accruals
$200.
The ledger account will be as follows once the double entry is posted:
Gas expense a/c

$ $

31.12 Accrual 200

Accrued expense a/c

$ $

31.12 Gas 200

3.1 What is a Prepayment?

Key Point

A Prepayment is recognised when a business pays in the current financial period for an expense that relates to the next financial period.

A business recognises an expense when it receives an invoice and makes payment. However, certain expenses may be
invoiced and paid before they are incurred. This is known as a payment in advance. The amount paid for expenses not yet
incurred is recognised as a prepayment.
Example 6
DPQ Joinery rents a workshop and pays rent quarterly in advance. This means payment must be made on the first day of each
rental period. This payment is for the rental expense for the next three months.
The business started renting this workshop on 1 June 20X2. So far, the following invoices for rent have been received and paid:
Date Period invoice relates to $
1 June 1 June 20X2 to 31 August 20X2 1,200
1 September 1 September 20X2 to 30 November 20X2 1,200
1 December 1 December 20X2 to 28 Februray 20X3 1,200
3,600
In 20X2, a total of $3,600 is paid for rent covering the period from 1 June 20X2 to 28 February 20X3. Some of this payment
relates to 20X3, so if the total amount of $3,600 were included as the rent expense for 20X2, then it would be overstated.
In this situation, you need to reduce the expense. This reduction to the expense is known as a prepayment.
Example 7
The accounting year-end is 30 June. Insurance on the business property runs from 1 October to 30 September and is paid
annually in advance.
Paid:
1 October 20X5 $1,200
1 October 20X6 $1,800
What is the insurance expense for the year ended 30 June 20X7?
Consider the timeline:

The expense for the accounting period under consideration must include all the amounts which accrue to (belong in) the year to
30 June 20X7:

July X6 to September X6 (3/12 × $1,200) $300

 October X6 to June X7 (9/12 × $1,800) $1,350

Expense in profit or loss $1,650

Note: Because $1,800 was paid in advance, there will be a prepayment of $450 on 30 June 20X7. This is recognised as a
current asset, increasing net assets/capital in the statement of financial position and profit (by reducing the expense).

3.2 Accounting for Prepayments

During the year, the business makes payments for expenses not yet incurred and records expense payments. At year-end, the
business identifies which payments were made for expenses not yet incurred. Since expenses are not incurred in the year, an
adjustment for prepayment creation is made (credit/reduces expenses).
When the business continues using the expenses in the next accounting period, it will adjust for prepayment reversal.
In a financial year, a supplier sends invoices to the business, and the business makes payments for the expenses. However, at
year-end, it is identified that the amount paid does not relate to expenses incurred during the year. Therefore, a prepayment is
recognised to reduce the expense charge for the year.
During the year, two entries occur for payments of expenses not yet incurred:
• the Expense Payment
• the Prepayment Creation
The double entry for the expense payment is:
Individual Account Category Explanation
DR Individual Expense Expense Expense increased
CR Bank Asset Bank decreased
The above double entry reflects the business paying the expense in cash to the supplier.
The double entry for prepayment creation is:
Individual Account Category Explanation
DR Prepayment Asset Prepayment (Asset) increased
CR Individual Expense Expense Expense is reduced
Since expenses have been recognised earlier, although they have not yet been incurred (only incurred in the next accounting
period), a prepayment is created to reduce the expense charge during the year.
The adjustment for prepayment creation will have an impact on the business’s profits and net assets as follows:
• Profits – The double entry to create prepayment is to credit the expenses account. Expenses decrease, which will lead to an
increased profit figure.
• Net Assets – The corresponding entry is to debit the Prepayment asset account. Net Assets or Capital is the Assets less
Liabilities of a business. Since assets have increased, the business’s net assets will also increase.
In the next accounting period, the business incurs expenses as the period progresses. Therefore, the business records
the reversal of prepayment adjustment made in the previous period. Thus, the Prepayment account is reversed, and the
expense is recorded.
The double entry for the Reversal of Prepayment is:
Individual Account Category Explanation
DR Individual Expense Expense Expenses have increased
CR Prepayment Asset Prepayment (Asset) decreased
Example 8
DPQ Joinery pays rent for one of its shops quarterly in advance. This means payment is made on the first day of each rental
period. DPQ Joinery has a current year-end of 31 December 20X2.
st

DPQ Joinery started renting on 1 June 20X2. So far, the business has received and paid the following invoices in respect of
rent:
Date Period invoice relates to $
1 June 1 June 20X2 to 31 August 20X2 1,200
1 Sept 1 September 20X2 to 30 November 20X2 1,200
1 Dec 1 December 20X2 to 28 February 20X3 1,200
3,600
In 20X2, DPQ Joinery paid $3,600 for rent covering the period 1 June 20X2 to 28 February 20X3. Some of this payment relates
to the financial period 20X3 and should not be included as the rent expense for 20X2 to avoid overstatement.
DPQ Joinery will adjust for prepayment creation on 31 December 20X2 for the two months’ rent advanced payment relating to
20X3 (January and February). The last invoice received and paid of $1,200 relates to three months' rent for December, January
and February. Therefore, the rent for January and February is prepaid.
The average cost per month for the last invoice: $1,200 ÷ 3 months = $400
Therefore, two months’ worth of rental: $400 × 2 months = $800
The value of the prepayment required at the end of the year is $800
1. The supplier invoices the business for the expense not yet incurred, and the business makes a payment of $1,200 on 1
December 20X2. The double entry for the expense payment is as follows:
DR Rent Expense Account $1,200
CR Bank Account $1,200
2. At the year-end, the business has identified that only $400 relates to expenses during the year. It will reduce the expense
charge and recognise it as an asset under prepayments. The double entry to create the prepayment is:
DR Prepayment Account $800
CR Rent Expense Account $800
3. The prepayment (asset) creation reduces the expense amount. Thus, it increases profit for the year by reducing
losses.
The impact of the prepayment creation adjustment to the General Ledger Accounts should look like this (assume no opening
balance in the Prepayment Account):
DR Prepayment Account (Assets) CR

31-Dec-X2 Rent Expense (2) $800

DR Rent Expense Account (Expense) CR

01-June-X2 Bank (during year) $1,200 31-Dec-X2 Prepayment (2) $800

01-Sept-X2 Bank (during year) $1,200 31-Dec-X2 Profit or Loss $2,800

01-Dec-X2 Bank (1) $1,200

$3,600 $3,600

The expense in the statement of profit or loss is correct. The monthly rent is $400, and DPQ Joinery has rented the shop for
seven months (from June to December). Therefore, the correct rent expense is $400 × 7 = $2,800.
Example 9 (with opening balance)
DPQ Joinery pays insurance for his business once a year on 1 September. The payment on that date provides insurance
coverage from 1 September until 31 August the following year. On 1 September 20X2, DPQ Joinery paid $4,875 for insurance.
st

DPQ Joinery has a current year-end of 31 December 20X2.

st

The prepayment at the start of the year was $2,880. This is based on the 20X1 payment of $4,320 for insurance, for which DPQ
Joinery has prepaid eight months out of the twelve (8 × $4,320) ÷ 12 = $2,880
The double entry for each transaction is:
1. At the end of 20X1 (the previous year), DPQ Joinery prepaid insurance expenses of $2,880. A double entry was made to create
a prepayment adjustment. The prepayment balance of $2,880 is brought forward in 20X2 as an opening balance.
DR Prepayment $2,880
CR Insurance Expense $2,880
2. By the end of August 20X2, DPQ Joinery would have incurred the prepaid expenses of $2,880.
Since DPQ Joinery has incurred the prepaid expenses of $2,880 by August 20X2, the opening prepaid balance
from 20X1 is reversed, and expenses are finally recognised.
DR Insurance Expense $2,880
CR Prepayment $2,880
3. On 1st September 20X2, DPQ Joinery pays $4,875 for insurance expenses covering 1 September X2 to 31 August X3. The payment
of expenses is recorded as follows:
DR Insurance Expense $4,875
CR Bank $4,875
4. At the end of 20X2, DPQ Joinery notes that not all $4,875 relates to the financial period 20X2. A prepayment is created for the
payment made for expenses not yet incurred.
$4,875 was paid for insurance cover from 1 Sept 20X2 to 31 August 20X3. Out of the 12 months, 8 months
st st

(January 20X3 to August 20X3) have not been incurred at the end of the financial period 31 Dec 20X2.
Therefore, $4,875 × 8/12 months = $3,250 is recognised as prepayment.

DR Prepayment $3,250

CR Insurance Expense $3,250

The impact of the prepayment creation on the general ledger accounts is as follows:
 DR Prepayment (Assets) CR

01-Jan-X2 Balance b/d (1) $2,880 31-Aug-X2 Insurance Expense (2) $2,880

31-Dec-X2 Insurance Expense (4) $3,250 31-Dec-X2 Balance c/d $3,250

$6,130 $6,130

01-Jan-X3 Balance b/d $3,250

DR Insurance (Expense) CR

31-Aug-X2 Prepayment (2) $2,880 31-Dec-X2 Prepayment (4) $3,250

01-Sept-X2 Bank (3) $4,875 31-Dec-X2 Statement of Profit or Loss $4,505

$7,755 $7,755

DR Bank (Assets) CR

01-Sept-X2 Insurance Expense (3) $4,875

Activity 2

1. During the year ended 30 June 20X5, a business pays $5,905 for electricity to cover the opening accrual of $590 and the
invoices received during the year. The last invoice was $1,860 and covered the period from 1 March 20X5 until 31 May 20X5.
What should the expense be in the statement of profit or loss for the year ended 30 June 20X5?
2. During the year ended 30 September 20X7, a business paid $10,200 for insurance to cover the period from 1 July 20X7 to 30
June 20X8. The opening prepayment for insurance expenses was $6,850.
What should the expense be in the statement of profit or loss for the year ended 30 September 20X7?

1. The business needs to accrue for one month's electricity (June), which is $620 ($1,860 ÷ 3).
Without drawing up the ledger T-account, the expense for the year can be found:
$
Paid 5,905
Minus: Opening accrual (590)
Add: Closing accrual 620
Expense 5,935
2. The business needs to recognise prepayment.
First, calculate the closing prepayment. Nine months have been prepaid (from 1 October 20X7 to 30 June 20X8).
The closing prepayment is, therefore, $7,650 (= $10,200 ÷ 12 × 9).
Without drawing up a T-account, the expense for the year can then be found:
$
Paid 10,200
Add: Opening prepayment 6,850
Minus: Closing prepayment (7,650)
Expense 9,400
The calculation of expenses in an accrual or prepayment is,
• Amount Paid − Opening Accrual + Closing Accrual = Expense
• Amount Paid + Opening Prepayment − Closing Prepayment = Expense

4.1 What is Accrued and Deferred Income?

Key Point

Accrued income is recognised when a business receives its income in arrears after earning it. At year-end, the business
has earned income that has not been received.
 Key Point

Deferred income is recognised when a business receives its income before earning it. At year-end, the business received a
payment related to the following year.
Accruals and prepayments are liabilities and assets recognised during year-end due to payment of expenses in arrears or in
advance.
Accrued and deferred (prepaid) incomes are assets and liabilities recognised during year-end due to income receipts in arrears
or in advance.
Category Explanation Asset Liability Double Entry
Accruals Expenses incurred before payment made ✓ DR Expenses
CR Accruals
Prepayments Payment made before Expenses incurred ✓ DR Prepayments
CR Expenses
Accrued Income Income earned before payment received ✓ DR Accrued Income
CR Income
Deferred Income Payment received before Income earned ✓ DR Income
CR Deferred Income
• Accrued income is recognised as an asset to reflect the income owed to the business since revenue has been
provided but payment has not yet been received. (receipt in arrears).
• Deferred income is recognised as a liability as payment has been received for revenue not yet provided. (receipt
in advance)

4.2 Accounting for Accrued Income

At year-end, the business will adjust for accrued income creation for income generated for payments in arrears.
The double entry for the accrued income is:
Individual Account Category Explanation
DR Accrued Income Asset Accrued Income (Asset) increased
CR Individual Income Income Income has increased
The income calculated for the current financial year where payment has not been received is recognised as an asset (accrued
income).
In the next financial period where payment has been received, the business will reverse the accrued income adjustment made
in the previous period and record the income receipt.
Reversal of accrued income:
Individual Account Category Explanation
DR Individual Income Account Income Income has decreased
CR Accrued Income Account Asset Accrued Income (Asset) decreased
Record of Income Receipt:
Individual Account Category Explanation
DR Bank Account Asset Bank (Asset) increased
CR Individual Income Account Income Income has increased

4.3 Accounting for Deferred Income

At year-end, the business will adjust for deferred/prepaid income for income generated for payments in advance.
Payment has been received in the current financial period for income generated in the following financial period. The business
records the income receipt during the year, then calculates and creates the deferred income amount adjustment.
Record of income receipt:
Individual Account Category Explanation
DR Bank Account Asset Bank (Asset) increased
CR Individual Income Income Income has increased
The double entry for deferred income creation is:
Individual Account Category Explanation
DR Individual Income Income Income has decreased
CR Deferred Income Liability Deferred Income (Liability) increased
As the months progress, the business will generate income in the following accounting period. Accordingly, it will record
deferred income reversal.
The double entry for the reversal of deferred income is:
Individual Account Category Explanation
DR Deferred Income Liability Deferred Income (Liability) decreased
CR Individual Income Income Income has increased
Example 5
DAHS Co rents out two properties that it owns. Its year-end is 30 June 20X6. Payment for both properties is made every three
months (every quarter).
For property 1, the rent is received in advance. The rent is $5,400 per quarter, and the last receipt was for the three months of 1
May to 31 July 20X6.
For property 2, the rent received is in arrears. The rent is $3,600 per quarter, and the last receipt was for the three months of 1
February to 30 April 2006.

Property 1 Property 2

Rent Receipt: In advance In arrears

Rental per quarter: $5,400 $3,600

Period where 1 May 20X6 to 31 July 20X6 1 Feb 20X6 to 30 April 20X6

payment already
received:

1 month payment (July X6) relates to the following 2 months income (May & June) has not received
period payment

Recognition: Deferred Income (Liability) Accrued Income (Asset)

$5,400 × 1/3 = $1,800 $3,600 × 2/3 = $2,400

Double Entry in
20X6

Income receipt: DR Bank Account $5,400 No receipt in 20X6

CR Rent Income $5,400

Deferred/ Accrued DR Rent Income $1,800 DR Accrued Income $2,400

CR Deferred Income $1,800 CR Rent Income $2,400
Income:

Double Entry in
20X7

Reversal of DR Deferred Income $1,800 DR Rent Income $2,400

CR Rent Income $1,800 CR Accrued Income $2,400
Accrued/ Deferred
Income:

Income Receipt: Already received in 20X6 DR Bank Account $3,600

CR Rent Income $3,600

Effect on 20X6 Deferred Income reduces income and, therefore, Accrued Income increases income in the year and,
Financial Statement: reduces profits in the year. In addition, since deferred therefore, increases profits. Accrued Income is
income is recorded as a liability, the capital amount is recorded as an asset. This causes the capital amount
reduced. to increase.
CHAPTER 12: Visual Overview
Objective: To explain the accounting treatment of events after the reporting period.

1.1 Events After Reporting Period

IAS 10 defines events after the reporting period as favourable and unfavourable events that occur between the end of the
reporting period (the reporting date) and the date on which the financial statements are authorised for issue (per statutory
requirements).
The following timeline shows when the events occur:

1.1.1 Adjusting vs Non-Adjusting Events

There are two types of events after the reporting date:
Events Requiring Adjustment (Adjusting):
These events provide further evidence of conditions that existed at the reporting date. Examples of adjusting events are:
• The discovery after the year-end of a fall in the value of a property that took place before the year-end.
• The amount receivable from a customer who has become bankrupt after year-end.
• Sale of inventory for less than its cost after the year-end. After-date sales may give evidence about NRV.
 • Discovery of fraud or errors showing the financial statements to be incorrect.
• Confirmation of an amount receivable or payable in respect of a legal case that is settled after the year-end.
• Determination after the reporting date of purchase price or proceeds of an asset purchased or sold before the reporting date.
Events Not Requiring Adjustment (Non-Adjusting):
These are events indicative of conditions that arose after the reporting date. Examples of non-adjusting events are:
• The acquisition or disposal of non-current assets after the year-end.
• Fire, flood or other catastrophes that destroy assets after the year-end.
• The announcement of plans to close down part of the business.
• Lawsuits against the business, or started by the business, that begins after year-end.
• The announcement of a restructuring plan after year-end.
• Decline in the market value of investments after the reporting date.
• A major acquisition of another entity.
Activity 1
Determine which of the following events occurring after the reporting date is an adjusting or non-adjusting event.
1. Closure of one of 15 retail outlets
2. Discovery of fraud during the annual inventory count
3. Sales of inventories at less than the cost
4. Exchange-rate fluctuations
5. Nationalisation or privatisation by the government
6. Out-of-court settlement of a legal claim
7. Rights issue of equity shares
8. Strike by the workforce
9. Earthquake
1. Closure of one of 15 retail outlets: at the reporting date, the retail outlet existed. Non-Adjusting
2. Discovery of fraud during the annual inventory count: the discovery is after the year-end, but the fraud Adjusting
existed at the reporting date (when the annual inventory count was performed).
3. Sales of inventories at less than cost: sales of inventories at less than cost means NRV is less than cost. Adjusting
4. Exchange-rate fluctuations: movements in foreign exchange rates after the reporting date are in response Non-Adjusting
to changes in economic conditions, etc., after the reporting date.
5. Nationalisation or privatisation by the government: government action is after the reporting date. Non-Adjusting
6. Out-of-court settlement of a legal claim: the settlement determines the outcome of a current uncertainty Adjusting
(which is now eliminated).
7. Rights issue of equity shares: the rights are not available to shareholders until after the reporting date. Non-Adjusting
8. Strike by workforce: the strike action is after the reporting date (even if the reason for the action was an Non-Adjusting
event before the reporting date).
9. Earthquake: the natural disaster was not a condition existing at the reporting date. Non-Adjusting

1.2 Accounting Treatment for Events after Reporting Period

1.2.1 Adjusting Events
An adjusting event provides further evidence of existing conditions at the reporting date and should be retrospectively adjusted
in the financial statements.
The effect of the liability or asset is recognised or amended using journal entries.

1.2.2 Non-Adjusting Events

For non-adjusting events, no adjustments are made to the financial statements.
However, the business will identify if the event is significant or material. If it is, the event is disclosed in the financial statement
notes.
If the non-adjusting event is immaterial, no disclosure is necessary.

2.1 Disclosure Requirements

The entity should report the date of authorisation for the issue of the financial statements explicitly in the financial statements.
• Users need to know when financial statements were authorised for issue because they do not reflect events after
this date.
• Any power to amend financial statements after issue must also be disclosed.
Non-adjusting events should be disclosed if they are of sufficient importance to affect the decisions made by users of the
financial statements due to their materiality. The following information should be included:
• the nature of the event
• an estimate of the financial impact
• a statement that a reliable estimate of the financial impact is not possible.
Exhibit 1 (Disclosure of Non-Adjusting Event)
The following extract is from the Annual Report and Accounts 2015-16 of the Centre for Environment Fisheries & Aquaculture
Science (CEFAS).
Events after the reporting date:
On 23 June, the EU referendum took place, and the people of the United Kingdom voted to leave the European Union.
Cefas conducts significant work within the Defra portfolio relating to EU Directives and has significant scientific interaction
with EU colleagues. Until exit negotiations are concluded, the UK remains a full member of the European Union and all the
rights and obligations of EU membership remain in force…
In accordance with IAS 10 this is a non-adjusting event and a reasonable estimate of the financial effect of this event cannot
be made.

Exhibit 2 (Disclosure of No Events)

The following extract is from the notes to the consolidated financial statements of Bayer Group's Annual Report 2014.
19. Events After the End of the Reporting Period
Since January 1, 2015, no events of special significance have occurred that we expect to have a material impact on the
financial position or results of operations of the Bayer Group.

2.2 Going Concern

Financial statements should not be prepared on a going concern basis if, after the reporting period, management:
• intends to liquidate the entity or cease trading or
• has no realistic alternative but to do so.
In this case, the effect on the financial statements is so pervasive (affecting the financial statements as a whole) that a change
in the basis of accounting is required.
IAS 1 Presentation of Financial Statements requires further disclosures if:
• The financial statements are not prepared on a going concern basis or
• There are material uncertainties which cast significant doubt concerning the appropriateness of the basis.
Consider, for example, Activity 1:
• If seven outlets had to be closed, rather than just one, this certainly would raise doubts about the appropriateness of
the going concern basis for the whole entity.
• A similar situation would occur if an earthquake destroyed a company's only manufacturing plant after the reporting
date.
Such non-adjusting events do not give rise to adjustments to financial statements prepared on a going concern basis but to a
fundamental change in the accounting basis. This is very rare in practice.

2.3 Dividends

Dividends are payments made to shareholders (owners of companies). They are the equivalent of the drawings that the sole
trader takes out of the business profits. Dividends will be further explored in the later chapters.

Key Point

Only dividends declared to shareholders but not paid at the reporting date are a liability.

In a publicly listed company, the directors decide whether the company will pay out dividends and the amount to be paid to the
shareholders (owners).
Dividends proposed or declared after the reporting date and before the financial statements were authorised are disclosed in
the notes to the financial statements. Therefore, they are not recognised as a liability.
This may seem obvious. However, Companies Act legislation in some jurisdictions still regards dividends as appropriations to be
matched against the profits of the year for which they were declared (included in the statement of profit or loss with a
corresponding liability). IFRS explicitly prohibits this.

Activity 2
Match each Statement Start with the corresponding Statement End.
Statement Start Statement End
Inventory destroyed by a warehouse fire two days before the year-end is an event that requires adjustment.
Dividends declared after the year-end but before the accounts are issued is an event that does not require
adjustment.
An event that requires adjustment is recognised in the financial statements.
An event that is material but does not require adjustment is disclosed in the notes to the financial
statements.
A receivable written off as irrecoverable before the period-end, but the customer pays in is an event that requires adjustment.
full after the year-end
The value of an investment falls between the reporting date and the date the financial is an event that does not require
statements are issued adjustment.
Inventory destroyed by a warehouse fire two days before the year end is an event that requires adjustment.
Dividends declared after the year end but before the accounts are issued is an event that does not require adjustment.
An event that requires adjustment is recognised in the financial statements.
An event that is material but does not require adjustment is disclosed in the notes to the financial
statements.
A receivable written off as irrecoverable before the period end but the customer pays in full is an event that requires adjustment.
after the year end
The value of an investment falls between the reporting date and the date the financial is an event that does not require adjustment.
statements are issued
2.4 IAS 10 Interrelationship with IAS 37
CHAPTER 13: Visual Overview
Objective: To understand the capital structure of limited liability companies and account for capital transactions.

1.1 Limited Liability Company

A limited liability company is where investors invest in the company by buying shares and becoming shareholders.
Shareholders require profits on their investments in the form of dividend payments or share value appreciation. Directors are
hired to run the company on behalf of the shareholders, and shareholders are only liable for their investments.
The key features of a limited liability company are illustrated below:
1.2 Capital Structure
All businesses need investment (finance) to start and stay in operation. This investment is part of its capital.
A business’s capital structure refers to the composition of its finance, a combination of equity (shares) and loans (debt) and
other sources of finance that it uses as long-term financing.
For example, a company with $20 million in equity and $80 million in debt is said to be 20% equity financed and 80% debt
financed.

1.2.1 Major Sources of Capital

A limited liability company can raise finance by raising shares or through borrowings. The three primary sources of raising
finance are:
• Ordinary Shares
• Preference Shares
• Borrowings/ Loan Notes
The sources of financing may be summarised and compared as follows:

1.2.2 Winding Up
A company winds up when it has gone out of business (stops trading). On winding up of a company, the assets will be
liquidated and paid out in the below hierarchy as follows:
The settlement order by a specific group is as follows:
• Secured creditors: certain government authorities, banks and lenders
• Preferential creditors: employees (for arrears of salary, redundancy payments, etc.).
• Unsecured creditors: may include certain tax authorities (for sales tax), trade payables, auditors, and other service providers.
• Connected unsecured creditors (e.g. loans by directors/ employees).
• Preference shareholders (i.e. holders of preference shares).
• Ordinary shareholders – residue (if any)
2.1 Ordinary Shares
Ordinary shares are the most common form of capital that a company issues. The holders of ordinary shares are the
company’s ordinary shareholders. Ordinary shares are classified as equity (capital).
Ordinary shares represent ownership in the incorporated entity. The key features of an ordinary shareholder are:
• Right to Profits
Shareholders have the right to share a company’s profit after all obligations have been met (after paying all
obligations to other providers of capital).
This right is fulfilled by the company making an annual payment to shareholders. This payment is called a
dividend. The amount of dividend that a shareholder receives will vary from year to year and will depend on how
much profit and available cash a company has. The amount of the dividend also depends on the size of the
shareholder's investment.
Sometimes a company will reinvest funds within the business rather than pay the shareholders a dividend. The
company is not required to pay dividends to its ordinary shareholders.
• Right to Vote
Ordinary shares give the shareholders the right to vote on the company’s important decisions.
• Share of assets if the Entity Winds Up
Ordinary shareholders have the right to receive all remaining cash after all other obligations have been met. If a
company has been forced to wind up because it has run out of money, there is usually no cash left, and ordinary
shareholders will lose their investment.
Real-World Practice

Many companies' ordinary shares are traded on stock markets. This results in the shares being traded having a quoted share
price which reflects the value of the share on the market.
If the shareholder is unhappy with how the company is being run or the level of dividend that they are receiving, then they can
sell their shares.

2.1.1 Accounting Entry for Ordinary Share Issue

The issuance of ordinary shares to the public raises finance for the business. As a result, the equity balance increases as
ordinary share capital increases.
The double entry to record the issue of ordinary shares is:
Individual Account Category Explanation

DR Bank Asset Finance (Bank) increased.

CR Ordinary Share Equity The ordinary capital has increased (by the par value)
Capital

CR Share Premium Equity The part of the issue price exceeding par value is
recorded.
Example Accounting for Shares

1. Issue 100,000 $1 shares for $1 cash each.

Dr Cash $100,000

Cr Share capital $100,000

2. Issue 60,000 new $1 shares with rights to existing shareholders at $1.60 each.
Dr Cash $96,000

Cr Share capital $60,000

Cr Share premium $36,000

3.
2.2 Preference Shares
Preference shares are another form of capital that a company might issue, although less common than issuing ordinary shares.
The key features of a preference shareholder are:
• Right to Profits
Preference shareholders have the right to receive a fixed dividend each year. This is calculated as a fixed
percentage of the preference share’s par value (or face value). A company must pay preference share dividends
before it can pay an ordinary dividend.
For example, the holder of a 5% $1 preference share has the right to receive a dividend of 5 cents a year.
Preference shareholders do not have any rights to profit beyond this fixed dividend.
• Right to Vote
Preference shares do not have any voting rights attached. Therefore, they cannot vote on the company’s decisions
and have no say in its operations.
• Share of assets if the entity Winds Up
Preference shareholders take higher priority than ordinary shareholders if a company is wound up. This means
that the preference shareholders will be paid the face value of their investment before the ordinary shareholders
can claim any part of their investment if the entity ceases trading.

2.2.1 Redeemable Preference Shares

Redeemable preference shares will be redeemed (or repurchased) by the company. There is an obligation to redeem, which
means they are classified as a liability.
Such shares may or may not have a specific redemption date. Preference shares repaid in full are, in substance, more like
debt as there is an obligation to repurchase (redeem) in the future.
• When shares are redeemed, the shareholder receives the stated value of the shares.
• Redeemable shares must be labelled redeemable on issue.
• Shares to be redeemed in the next 12 months are reclassified as current liabilities.
• A redeemable preference share’s fixed dividend is classified as an expense, not a distribution of equity to owners.

2.2.2 Irredeemable Preference Shares

Irredeemable preference shares will never be redeemed (or repurchased) by the company unless it is wound up. Therefore,
they are a permanent form of capital categorised as equity (similar to ordinary shares), as there is no obligation to redeem
them.
Under IFRS, the substance of the capital needs to be considered before classifying irredeemable preference shares as equity
or debt.

2.2.3 Accounting Entry for Preference Share Issue

The issuance of preference shares to the public raises finance for the business.
The double entry to record the issue of redeemable preference shares is:
Individual Account Category Explanation
DR Bank Asset Finance (Bank) increased.
CR Redeemable Preference Liability The redeemable preference share will be repurchased in the future. (Liability
Share obligation)
The double entry to record the issue of irredeemable preference shares is:
Individual Account Category Explanation
DR Bank Asset Finance (Bank) increased.
CR Irredeemable Preference Share Equity The irredeemable preference share (equity) has increased

2.3 Borrowings/ Loan Notes

Instead of shares, a company can borrow from lenders or issue loan notes to raise capital for the business. Borrowings are
classified as liabilities of a business and have the following characteristics:
• carry a fixed rate of interest payable by the company to the lender each year
• principal amount will be redeemed at a fixed date in the future.
Borrowings give the holder (the lender) the right to receive a fixed return (interest), and they will be repaid at some point in the
future.
This form of finance is similar to redeemable preference shares. However, instead of dividends, the lender receives interest.
Holders of borrowings are creditors of the company, whilst redeemable preference shareholders are known as shareholders or
members of the company.
There are characteristics associated with borrowings that do not apply to other forms of capital:
• The lenders can take the company to court if they do not receive their interest. (Shareholders do not have the same power).
• Borrowings can be secured on the assets of a company. (This means that if a company does not repay the amount invested,
the lender can demand that some of the company’s assets be sold so the money can be repaid.)
2.3.1 Accounting Entry for Borrowings
The double entry to account for borrowings is:
Individual Account Category Explanation
DR Bank Asset Finance (Bank) increased.
CR Borrowings Liability Loans from lenders (liability) increased
The summary of the three sources of finance is illustrated in the diagram below:

Activity 1
State whether the statements below are True or False.
1. Ordinary shareholders are guaranteed to receive a dividend every year.
2. Irredeemable preference shares carry the right to vote in the decisions of a company, which means that they are classed as
equity in the Statement of Financial Position.
3. 10% Loan notes 20X5 means that the holder (the investor) will receive a $10 interest payment every year for every $100
invested, and the loan notes will be repaid in 20X5.
*Please use the notes feature in the toolbar to help formulate your answer.
1. False. There is no guarantee that a company will pay a dividend. Dividends can only be paid if there are profits available, and
even then, a company could choose to reinvest funds in the business rather than pay funds out to the shareholders.
2. False. Preference shares do not carry voting rights. The irredeemable preference shares are classed as equity because the
company does not have an obligation to repay the capital at a set date in the future.
3. True. The 10% interest rate is applied to the amount invested. 20X5 is the date that the loan notes will be redeemed.

3.1 Rights Issue of Ordinary Shares

A company raise funds (cash) by issuing shares through a rights issue. A rights issue is when a company offers existing
shareholders the right to buy new shares at a price below their current market value. The number of shares offered
depends on a shareholder's existing holding.
Definition

A rights issue is the issuance of new shares to existing shareholders at a price below the current market value.

3.1.1 Accounting Entries for Rights Issue

The issuance of a rights issue raises finance for the business through the issue of shares (equity). Therefore, the double entry
to account for the rights issue is:
Individual Account Category Explanation
DR Bank Asset Finance (Bank) increased.
CR Ordinary Share Capital Capital The ordinary capital has increased (by the par value)
CR Share Premium Capital The excess of par value is reflected in the share premium account
 Example 1
A business raises funds through a rights issue.
It had existing 10,000 shares in issue at a par price of $1 with their shareholders.
The business issues a rights issue at “2 for 5 at $3.00 a share”. This means that for every five shares a shareholder
owns, they may buy two new shares at $3.00 a share.
Number of shares issued = 10,000 × 2/5 = 4,000 new shares.
The double entry to record the rights issue is:
DR Bank 4,000 × $3 $12,000
CR Ordinary Share Capital 4,000 × par $1 $4,000
CR Share Premium 4,000 × ($3 − par $1) $8,000

3.1.2 Advantages of Rights Issue

• A company is more likely to raise funds needed under a rights issue rather than an issue of shares to the public. This is
because existing shareholders are already interested in the company.
• Cheaper to administer than an issue of shares to the public.
• Does not affect the balance of shareholder control if all shareholders take up the rights issue.

3.1.3 Disadvantages of Rights Issue

• More expensive to administer than taking on a bank loan.
• The market value per share (known as the share price) often initially falls because of a rights issue, as the shares are issued at
a price below market value.
• The balance of shareholder control will change if not all shareholders take up the rights issue.
Activity 2
Fonds Retail Co’s management team has decided that it needs to raise more capital to finance an expansion of the business.
It is now 20X9, and on 1 May 20X9, Fonds Retail Co decided to offer a rights issue to its ordinary shareholders. The rights
issue terms are 3 for 8 for $0.75 a share.
There were 160,000 25-cent shares in issue on 1 January 20X9. The balance on the share premium account on this dates was
$60,000.
1. This rights issue will raise how much cash?
2. What is the accounting entry to record the rights issue when the shareholders buy the shares?
3. What is the impact of the accounting entry on the financial statements?
*Please use the notes feature in the toolbar to help formulate your answer.
1. The rights terms of 3 for 8 means that 60,000 (160,000 ÷ 8) new shares will be issued. They will be issued at $0.75 each, so
$45,000 (60,000 × $0.75) of cash will be raised.
2. The double entry for the rights issue is:
DR Bank (calculated in previous screen) $45,000
CR Ordinary share capital (60,000 × $0.25) $15,000
CR Share premium (60,000 × $0.50) $30,000
3. The adjustment to ordinary share capital is at par value. The difference between the issue price and par value is
the premium ($0.75 − $0.25 = $0.50)
4. There is no effect in the statement of profit or loss.
In the statement of financial position, the balances for share capital, share premium, and bank will all increase.
In activity 2, the balances at the start of the year on the share capital and share premium accounts are $40,000
and $60,000, respectively.
The balance on the share capital account will now be $55,000 ($40,000 + $15,000). The balance on the share
premium account will now be $90,000 ($60,000 + $30,000).

3.2 Bonus Issue of Ordinary Shares

Definition

A bonus issue is the issuance of new shares by a company to its existing shareholders in proportion to their existing shareholdings for no
consideration/cash.

Shareholders receive additional shares for free or as a 'bonus'. Because no cash is raised, the overall capital in the company
will stay the same because there are no new resources. Therefore, the new shares need to be funded from existing capital.
A bonus issue is sometimes called a capitalisation issue.

3.2.1 Accounting Entries for Bonus Issue

Capital comprises share capital, share premium, preference share capital, revaluation surplus and retained earnings. If capital
does not change and shares capital increases, the decrease comes from either the share premium or retained earnings
account.
The double entry to account for the bonus issue is:
 Individual Account Category Explanation
DR Share Premium/ Retained Capital The bonus issue is taken either from the share premium or retained earning
Earnings account
CR Ordinary Share Capital Capital The ordinary capital has increased (by the par value)
Example 2
BGF Co has 300,000 $0.5 ordinary shares in issue. The balance on the share capital account is $150,000, and the
balance on the share premium account is $250,000.
The company decides to carry out a 1 for 5 bonus issue.
Number of shares to be issued = 300,000 ÷ 5/1 = 60,000 new shares
The accounting entry is:
DR Share Premium $30,000
CR Ordinary Share Capital 60,000 × par $0.50 $30,000

3.2.2 Advantages of Bonus Issues

• It increases the number of shares that a company has. This does not affect the overall market value of a company. This means
that the market value per share falls, which could make the shares more marketable.
• It increases the share capital balance in the statement of financial position, giving the appearance that the company is well-
capitalised.
• It is a return that can be made to shareholders without spending any cash.
• It increases share capital without diluting current shareholder holdings.

3.2.3 Disadvantages of Bonus Issues

• Bonus issues are costly to administer.
• If retained earnings are used instead of the share premium account, the funds available to pay dividends in the future are
reduced.
• It does not raise any cash.
Activity 3
Samrul Co has in issue 450,000 ordinary shares that have a par value of 50 cents each. These shares were all issued several
years ago at an issue price of $1.40 each. Samrul Co prepares its financial statements to 31 December each year.
• On 1 June 20X7, there was a bonus issue of 2 for 9, with the adjustment being made to the share premium account.
• On 1 September 20X7, Samrul Co offered a rights issue of 3 for 11 for $1.50 a share. The current shareholders purchased all of
the shares under the rights issue.
1. What are the balances on the share capital account and the share premium account on 1 January 20X7?
2. How many shares will be in issue after the bonus issue?
3. What are the balances on the share capital and share premium accounts after the bonus issue has been accounted
for?
4. How many shares will be issued under the rights issue?
5. What are the balances on the share capital and share premium accounts after the rights issue has been accounted for?
*Please use the notes feature in the toolbar to help formulate your answer.
1. The issue price of $1.40 can be split into a $0.50 par value and a $0.90 premium.
Balance on share capital account: $225,000 (450,000 shares × $0.50 a share). Balance on share premium
account: $405,000 (450,000 shares × $0.90 a share).
2. The bonus issue is 2 for 9. This means that there will be two new shares for every nine shares in issue. Therefore, the number of
bonus shares is 100,000 (450,000 shares ÷ 9 × 2).
The total number of issued shares is 550,000 (Existing 450,000 + New 100,000).
3. 100,000 new shares are issued with a par value of $50,000 (100,000 shares × $0.50 a share). The double entry for the bonus issue
is DR Share Premium $50,000 and CR Share Capital $50,000.
The share capital account balance is $275,000 (CR $225,000 + CR $50,000). The accounting entry is to credit this
account, which increases the balance. This reflects the increase in share capital.
The share premium account balance is $355,000 (CR $405,000 − DR $50,000). The accounting entry is to debit
this account, which decreases the balance. This reflects what we call the capitalisation of the share premium
account. The company transfers balances from the share premium to the share capital balance, which is why a
bonus issue is sometimes called a capitalisation issue.
4. The rights issue is 3 for 11 for $1.50 a share. At the date of the rights issue, there were 550,000 shares in issue (see the answer to
question 2). This means that 150,000 new shares will be issued under the rights issue. This is calculated as 150,000 (550,000
shares ÷ 11 × 3).
The total number of shares after the rights issue is 700,000 (550,000 + 150,000).
5. 150,000 new shares are issued with the rights issue. At $1.50 per share, $225,000 of cash is raised (150,000 shares × $1.50 a
share). This will be debited to the bank balance, which increases.
The credit entries are posted to share capital and share premium. As a result, the share capital account will
increase by $75,000 (150,000 shares × $0.50 a share) and the share premium account by $150,000 (150,000
shares × $1.00 a share premium).
 The double entry to record the rights issue is DR Bank $225,000, CR Share Capital $75,000 and CR Share
Premium $150,000.
The balances will be:
Share capital $350,000 ($275,000 (from question 3) + $75,000)
Share premium $505,000 ($355,000 (from question 3) + $150,000)

3.3 Terminology
The share capital of a limited liability company represents the capital invested by its shareholders through the purchase of
shares. Shares purchased by shareholders can be ordinary or preference shares. Below are some of the terminologies used in
respect of share capital:
• Par Value of Share Capital
Every share has a face value known as its par value (legal or nominal value). For example, shares can have any
par value, such as $1, 50 cents, or 10 cents. In exam questions, you will be given the par value.
For example, Tahsul Co is set up as a limited liability company. The par value of each share is set at $0.50. To
raise $400,000, Tahsul Co would need to issue 800,000 ($400,000/$0.50) shares at their par value.
• Authorised Share Capital
When a company is set up, it establishes the par value of each share and the maximum number of shares it can
issue. This maximum number of shares is the company’s authorised share capital. This authorised share capital
amount can be changed by agreement with the shareholders.
For example, Tahsul Co has authorised share capital of 1,000,000 $1 shares.
• Issued Share Capital
The issued share capital (sometimes called allotted share capital) is the number of shares a company has issued
to shareholders. The issued share capital cannot exceed the authorised share capital.
For example, Tahsul Co has issued 400,000 $1 shares to shareholders. This means that 600,000 $1 shares are
still available to be issued in the future.
• Called-Up Share Capital
A company may not necessarily sell its issued share capital at its par value. The amount issued/called up to its
shareholders may be a percentage of the par value.
For example, Tahsul Co called up 60% of the par value of the shares in an issue. This means the called-up share
capital is $240,000 (400,000 shares × $1 each × 60%). This is the value of share capital that will appear in the
statement of financial position.
• Paid-Up Share Capital
When a company calls up a fraction of the par value, shareholders may take their time to make pay. The amount of
share capital paid is the Paid-up share capital. The amount of share capital remaining unpaid is the call-in arrears.
For example, Tahsul Co has received $220,000 of the amount due for the called-up share capital. This means that
the paid-up share capital is $220,000, and there will be a receivable balance (call in arrears) of $20,000 in the
Statement of Financial Position.
The extract from Tahsul Co’s statement of financial position is as follows:
$
Current Assets:
Call in Arrears 20,000
Equity:
Called-Up Share Capital 240,000
Activity 4

Fonds Retail Co had the following transactions during the year:

1. On 31 December 20X7, Fonds Retail Co had issued ordinary share capital of 100,000 shares, each with a 25-cent par value.
80% of the issued share capital was called up and paid for based on par value.
What is the value of Fonds Retail Co's ordinary share capital and share premium account in the Statement
of Financial Position at 31 December 20X7?
2. On 1 March 20X8, Fonds Retail Co called up the remaining 20% of the issued 100,000 25-cent ordinary shares on that date. These
were paid at their par value.
What accounting entry would you create to record the transaction on 1 March 20X8?
3. On 1 July 20X8, Fonds Retail Co issued a further 40,000 25-cent ordinary shares at an issue price of $1 a share. Again, 100% of
these shares were called up and paid for.
What accounting entry would you create to record the transaction on 1 July 20X8?
4. On 1 September 20X8, Fonds Retail Co issued a further 20,000 25-cent ordinary shares at an issue price of $1.50 a share. Again,
100% of these shares were called up and paid for.
What accounting entry would you create to record the transaction on 1 September 20X8?
*Please use the notes feature in the toolbar to help formulate your answer.
 1. The par value of each share is 25 cents and therefore needs to be multiplied by the number of shares by 0.25 (the par value)
before applying the 80% call-up proportion.
Ordinary share capital (100,000 × $0.25 × 80% called up) $20,000
Share premium $0
2. The share premium balance is nil because the shares were called up at their par value.
The debit is to bank for the amount received. The credit is to ordinary share capital as this has increased.
DR Bank $5,000
CR Ordinary share capital (100,000 × $0.25 × 20% now called up) $5,000
3. The bank entry is based on the number of shares issued multiplied by the issue price, and the ordinary share capital entry is based
on the number of shares issued multiplied by the par value of each share.
The shares are issued at a premium to their par value. This premium is $0.75 a share ($1.00 − $0.25). Therefore,
the share premium is 40,000 (the number of shares) multiplied by this premium of $0.75 a share.
DR Bank (40,000 × $1 issue price) $40,000
CR Ordinary share capital (40,000 × $0.25) $10,000
CR Share premium (40,000 × $0.75) $30,000
4. Same approach as question 3. The only difference is the need to account for a larger premium per share.
DR Bank (20,000 × $1.50 issue price) $30,000

CR Ordinary share capital (20,000 × $0.25) $5,000

CR Share premium (20,000 × $1.25) $25,000

The effect of these entries on the Ordinary Share Capital and Share Premium accounts at 31 December 20X8 are as follows:
Ordinary share capital
DR CR
Date Narrative $ Date Narrative $
1 January 20X8 Balance b/d 20,000
1 March 20X8 Bank 5,000
1 July 20X8 Bank 10,000
31 December 20X8 Balance c/d 40,000 1 September 20X8 Bank 5,000
40,000 40,000
1 January 20X9 Balance b/d 40,000

The $40,000 value of share capital is 160,000 shares at $0.25 a share (Opening 80,000 + 1 March issue 20,000 + 1 July issue
40,000 + 1 Sept issue 20,000 = 160,000 shares).
Share premium account
DR CR
Date Narrative $ Date Narrative $
1 July 20X8 Bank 30,000
31 December 20X8 Balance c/d 55,000 1 September 20X8 Bank 25,000
55,000 55,000
1 January 20X9 Balance b/d 55,000

4.1 Cost of Capital for Businesses

The previous sections highlight the types of capital financing a business can gather through equity (through the issue of
shares) and liabilities (borrowings).
As the business finances its start-up and operations with the capital received, it also accounts for the associated costs.
The cost of capital for ordinary shares and preferences shares is the dividend payments, while the cost for borrowings is
the finance costs (interest).

4.2 Dividends
Definition

Dividends – An appropriation of distributable profits to shareholders in proportion to their shareholdings.

Dividends are proposed by the management (board of directors) and approved (declared) by the company at a general
meeting. This is usually the annual general meeting (AGM), at which financial statements are presented to shareholders.
4.2.1 Dividends on Ordinary Shares
Ordinary shareholders are not necessarily entitled to receive a dividend each year.
Real-World Practice

If a company usually pays a dividend, this will build an expectation that it will continue to do so. Conversely, not paying a
dividend in a year may adversely affect the company’s share price, resulting in difficulties in raising new funds for investment.
Therefore, large companies usually seek to keep dividends consistent from one year to the next.
The dividend payments of ordinary shares can be calculated using various methods:
• Percentage of Profit for the year
An ordinary share dividend should always be based on the profit after all other obligations have been accounted
for. The profit figure to be used should be the net profit for the year (after all expenses of the business, including
interest and tax) and after any preference share dividends.
For example, the profit is $30,000, of which 40% is to be paid as an ordinary dividend. Therefore, the dividend is
calculated as $30,000 × 40% = $12,000.
• Percentage of Par Value of Issued Shares
A dividend percentage may be associated with the issued shares’ par value. Therefore, the dividend payout is
calculated as the percentage multiplied by the par value of the issued shares.
For example, “a dividend of 8% will be paid”. If there are 200,000 $0.50 shares in issue, the dividend would be
200,000 shares × $0.50 × 8% = $8,000
• Dividend Per Share
The dividend payout can also be calculated based on the number of shares issued multiplied by a given amount
per share.
For example, the dividend amount per share has been announced to be $0.10 per share. If there are 100,000
shares in issue (note that it is shares in issue that are relevant), the dividend is calculated as 100,000 shares ×
$0.10 per share = $10,000

4.2.2 Accounting Entries for Dividends of Ordinary Shares

Dividends are only accounted for when they are paid. Therefore, dividends proposed at a year-end that remain unpaid are
not adjusted for in the general ledgers, although they will be disclosed in the notes to the financial statements.
When a dividend on ordinary (equity) shares is declared during year-end, the dividend will only be paid out until the next
financial period once the financial statements have been approved and published.
The double entry to record the dividend payment is:

Individual Account Category Explanation

DR Retained Earnings Equity Retained Earnings (Profits) reduce

CR Bank Asset Dividend payments reduce the cash balance

The Retained Earnings account records the business’s total past profits and losses. Dividend payments to shareholders are
made using the company’s residual profits. Hence the accounting entry is to reduce (debit) the Retained Earnings account.
The accounting entry reduces both the bank balance and the retained earnings balance in the statement of financial position,
which will reduce both net assets and capital.
Example 3
Bloomer Co is a bakery business that pays regular dividends to its ordinary shareholders. Its year-end is 31 December.
On 31 December 20X1, Bloomer Co proposed a final dividend for the year of $100,000 to its shareholders. This is not paid
until March 20X2. In September 20X2, the company then pays an interim dividend of $50,000; on December 31, it proposes a
final dividend of $130,000 (which will not be paid until 20X3).
How much dividend should Bloomer Co’s financial statements record for the year ended 31 December 20X2?
The rule is that dividends are only accounted for when they are paid. Dividends proposed at a year-end are never accounted
for, although they will be disclosed in the notes to the financial statements.
The proposed dividend payment of $100,000 is only disclosed in the 31 December 20X1 financial statements.
In 20X2, Bloomer Co has paid $150,000 ($100,000 in March and $50,000 in September). Therefore, $150,000 is the amount
of dividend that needs to be accounted for and recorded in the financial statements for the year ended 31 December 20X2.
The double entry to record the entry on 31 December 20X2 is:

DR Retained Earnings $150,000

CR Bank $150,000
Activity 5

Alamo has issued 150,000 ordinary shares with a $1.50 par value. In addition, the company declared a 5% cash dividend in
respect of 20X6 results on 17 February 20X7.
Calculate the total dividend payment and state how this will be reflected in the financial statements for the year ended
31 December 20X6.
*Please use the notes feature in the toolbar to help formulate your answer.
Total dividend = 150,000 × 1.50 × 5% = $11,250
This will not be accounted for in the financial statements for the year ended 31 December 20X6 because it was not declared
until after the reporting date/ paid in the 31 Dec X6 period.
However, if these financial statements are authorised for publication after 17 February, the dividend may be disclosed in a
note.
4.2.3 Dividends on Irredeemable Preference Shares
Irredeemable preference shares do not require the investment to be repaid and are classed as part of equity. The dividends
payable is treated as an appropriation of profit in the same way as dividends on ordinary shares.
The double entry to account for dividends on irredeemable preference shares is:
Individual Account Category Explanation
DR Retained Earnings Equity Retained Earnings (Profits) reduce
CR Bank Asset Dividend payments reduce the cash balance
Example 4
Flowers Co is a company with a chain of shops which sell flowers and potted plants. It has in issue 100,000 ordinary shares
and 20,000 5% irredeemable preference shares. The ordinary shares have a par value of 10 cents a share, and the
preference shares have a par value of $1 a share.
For the year ended 31 December 20X5, the management of Flowers Co expects to make a profit after tax of $146,000. On 31
December 20X5, Flowers Co paid an ordinary dividend of 40% of the expected profit. The preference dividend was also paid
on that date. On 1 January 20X5, the balance on the retained earnings account was $600,000.
Irredeemable Preference Share dividend:
The preference dividend is 20,000 shares × par value $1 × percentage 5% = $1,000.
Ordinary Share dividend:
First, calculate the available profit. This will be the profit minus the preference dividend calculated above. Profit after tax
$146,000 − Preference dividend $1,000 = $145,000.
Therefore, the ordinary dividend paid is $145,000 × 40% = $58,000.
Retained Earnings Account
Note: Assume the actual profit level after tax is the same as expected, of $146,000.
The Retained Earnings account will be:

Balance on 1 January 20X5 600,000

Profit after tax 146,000

Preference dividend (1,000)

Ordinary dividend (58,000)

Balance on 31 December 20X5 687,000

In the statement of profit or loss, the amount of profit for the year is $146,000. None of the preference dividend, the
irredeemable preference shares or the ordinary dividend appears in or affects the statement of profit or loss.

4.3 Finance Cost

Finance costs are the annual costs that a company incurs on funds provided to it where there is an obligation to repay those
funds in future.
This term is extensive and includes all costs arising from what would be considered by normal accounting principles to be
financing transactions. Examples are:
• Any costs incurred in respect of loans or borrowings
 • Preference dividends on redeemable preference shares (because the substance of such shares is that they are a
debt/liability)

4.3.1 Dividends on Redeemable Preference Shares

Redeemable preference shares carry an obligation to repay the investment and are classed as liabilities. Therefore, dividend
payments for redeemable preference shares are treated as finance costs, not as an appropriation of profit (reduction in
retained earnings).
Example 5

BB Co has 50,000 $1 6% redeemable preference shares in issue. The 6% represents the dividend that the company needs to
pay. This percentage is applied to the shares' par value to calculate the dividend's annual amount.
The annual finance cost for redeemable preference shares is the annual dividend of 50,000 shares × $1 par value × 6% =
$3,000.

4.3.2 Interest Costs on Borrowings

Borrowings give the holder (the lender) the right to receive a fixed return (interest), and they will be repaid at some point in the
future. The interest is the cost of borrowings capital and is treated as a finance cost.
Example 6

BB Co has $500,000 8% loan notes in issue. The 8% represents the interest that the company needs to pay each year. This
percentage is applied to the loan notes’ par value ($500,000).
The annual finance cost for loan notes is the annual interest cost of $500,000 × 8% = $40,000.

4.3.3 Accounting Entries for Finance Cost

It does not matter how a finance cost arises or what form it takes (dividend or interest) – there is only one accounting
treatment.
There will be a separate ledger account called 'Finance costs' in the general ledger.
The double entry to account for finance costs is:
Individual Account Category Explanation
DR Finance Costs Expense Finance Costs (Expense) increases
CR Bank Asset Finance cost payments reduce the cash balance
If the finance costs for the year are not paid by the end of the year, the credit entry will be to a Payables account (Liability)
instead of the Bank account (Asset).
Example 7
Continuation from Examples 5 and 6.
Assuming BB Co pays its loan note interest and preference dividend on 31 December 20X2, the company year-end. As a
result, the finance cost ledger account for BB Co will be as follows:
Finance cost account

DR CR

Date Narrative $ Date Narrative $

31 December 20X2 Bank (preference shares) 3,000 31 December 20X2 Profit or loss account 43,000

31 December 20X2 Bank (loan notes) 40,000

43,000 43,000

You will note that the balance on this account is closed off to the profit or loss account at the year-end. This is because
finance costs are an expense of the business.
Finance costs are an expense of the business and will appear in the statement of profit or loss. Therefore, the impact of
finance costs is a reduction in profit for the year.
Activity 6

In the following activity, complete each statement by matching the start of the sentence on the left-hand side to its
correct ending on the right.
Dividends on redeemable preference shares are debited to retained earnings.
An appropriation of profit does not affect the statement of profit or loss.
Dividends on irredeemable preference shares are not accounted for in the financial statements.
A finance cost are treated as finance cost in the financial statements.
Dividends proposed on ordinary shares at the end of the year does affect the statement of profit or loss.
Dividends paid on ordinary shares in the year are treated as an appropriation of profit in the financial statements.
*Please use the notes feature in the toolbar to help formulate your answer.

Activity 7
Komo Co has issued share capital comprising:
• $250,000 in 6% $1 preference shares redeemable in 20X8
• $600,000 in $0.50 ordinary shares.
In 20X6, Komo Co paid both the preference dividend and the final 20X5 ordinary dividend of $0.05 per share. In addition, the
company also paid an interim 20X6 ordinary dividend of $50,000. Profit for the year was $265,000.
Calculate the dividend payments for the year ended 31 December 20X6 and explain how they should have been
accounted for.
*Please use the notes feature in the toolbar to help formulate your answer.
Total ordinary shares = $600,000 ÷ $0.50 = 1,200,000 shares
20X5 Ordinary final dividend $60,000
20X6 Interim dividend $50,000
Total dividend payments for the year ended 31 December 20X6 $110,000
The dividend on the preference shares should have been treated as interest (as redeemable shares are of the nature of a
loan). Therefore 6% × $250,000 = $15,000 should have been deducted as an expense in determining the profit or loss for the
year.
$110,000 is an appropriation of profit for the year and will be shown as a distribution to shareholders in the Statement of
Changes in Equity.

5.1 Equity Component in the Statement of Financial Position

A company's total capital and reserves are the difference between total assets and total liabilities in the statement of financial
position. It represents the owners' (ordinary shareholders') equity interest.
• Reserves are funds that may be used for a specific purpose.
• Reserves do not represent cash.
• Reserves are not provisions (which must be liabilities).

5.1.1 Distributable and Non-distributable

A company can only pay a dividend to its ordinary shareholders if it has cleared all other obligations (such as preference
dividends) and has sufficient distributable reserves.
A distributable reserve has no restriction for its use. A non-distributable reserve is one for which there is a specific use.
A share premium account is an example of a non-distributable reserve, whilst retained earnings are a distributable reserve.
The reasons behind what is distributable and what is not are outside the scope of this course.

5.1.2 Share Premium

Share premium is not available for distribution because it is capital and not profit. Its limited uses include:
• the issue of fully paid bonus shares
• settling preliminary expenses on company formation
• paying a premium to redeem shares or borrowings.

5.1.3 Revaluation Surplus

The revaluation surplus is the cumulative unrealised gains on revaluations of non-current assets (typically land and buildings).
• It cannot be used for dividend payments (it is non-distributable) until the actual surplus is realised (from the sale of the asset)
• It can be used to issue bonus shares that are deemed to be paid in full

5.1.4 Retained Earnings

Retained earnings are accumulated profits and an essential component of shareholders' equity. This is reinvested in the
operations of the business.
• Although these are after paying out dividends, later dividends may be paid out of such retained profits (this is a distributable
reserve).
• Portions of retained earnings may also be transferred to other named reserves to be held for a specific purpose.
• When a revalued asset is sold, the profit (or loss) on disposal reported in the sale period is the difference between the sale
proceeds and the asset's carrying amount. The revaluation surplus is then realised. This realisation is not reported in the
statement of comprehensive income. Instead, the revaluation surplus on the asset is transferred to retained earnings (in the
statement of changes in equity). When a revalued asset is sold, retained earnings will effectively include the same profit on
disposal as if the asset had not been revalued.
Example 8
This example highlights the balances included within the equity section of Khasma Co’s statement of financial position.

• Called-up ordinary share capital – This is the value of the called-up ordinary share capital based on its par value and the
proportion of this that has been called up.
• Share premium account – When a company issues shares, it usually does so at a price higher than the par value of the
share. This is the issue price.
The difference between the par value and the issue price is called a premium, which is posted to the share
premium account.
In this example, Khasma Co issued 100,000 $1 ordinary shares at an issue price of $3.40. $1 is the par value,
and $2.40 is the premium. The accounting entry is:
 DR Bank $340,000

CR Called-Up Ordinary Share Capital $100,000

CR Share Premium $240,000

• Preference share capital – Irredeemable preference shares are included as equity in the Statement of Financial Position.
In this example, Khasma Co has $40,000 of $1 preference shares in issue.
• Revaluation surplus – The revaluation surplus arises when the company revalues tangible non-current assets. They
represent the difference between the revalued amount of the asset and its carrying amount at the date of revaluation (minus
any transfers for additional depreciation).
• Retained earnings –The retained earnings balance reflects the value of the accumulated profits and losses since the
company started, minus any dividends paid to shareholders.
• Reserves – The revaluation surplus and retained earnings balances are often jointly called reserves and belong to ordinary
shareholders.
• Total shareholders' equity – The total of all equity elements is known as shareholders' equity.

5.2 Statement of Changes in Equity

The purpose of the statement of changes in equity is to state the changes in equity that have occurred in the financial year. It is
a reconciliation between the balances at the start and at the end of the year for all equity accounts.
The equity section of the statement of financial position includes the following:
• share capital
• share premium
• revaluation surplus
• retained earnings.
Each of these elements will have its column in the statement of changes in equity.
Example 9
Below is the statement of changes in equity for GHI Co. for the year ended 31 December 20X7.
Share capital Share premium Revaluation surplus Retained eanings Total

$’000 $’000 $’000 $’000 $’000

Balance at 1 January 20X7 1,000 340 250 2,440 4,030

Equity shares issued 100 150 250

Revaluation surplus 200 200

Profit for the year 810 810

Dividends paid (300) (300)

Balance at 31 December 20X7 1,100 490 450 2,950 4,990

The statement of changes in equity has columns for share capital (which will include ordinary and irredeemable preference
shares), share premium, revaluation surplus, and retained earnings balances. At the end of the statement is the total column.
• Balance at 1 Jan 20X7:
The statement starts with the balance for each of these equity elements at the start of the year. These figures will
come directly from last year's statement of financial position.
There is a balance of $1,000,000 for share capital, $340,000 for share premium, $250,000 revaluation surplus,
and $2,400,000 retained earnings.
The total of $4,030,000 will be the figure that appeared in the statement of financial position last year for equity.
The movements that affected these equity balances in the year will be recorded next.
• Equity share issues – Only the par value of shares is included in share capital. Any premium will be posted to the share
premium account. The equity shares issue includes ordinary and irredeemable preference shares (because both are classed
as equity).
• Revaluation Surplus – Any revaluation adjustments affect the revaluation surplus column.
• Profit for the year – This figure will be included in the statement of profit or loss as profit for the year (after all finance costs
and tax).
 • Dividends – Dividends are appropriations of profit, and it's in the statement of changes in equity that this is captured. This will
only be for the dividends paid in the year.
Once all the movements are recorded, each column is totalled. This total will be the same as the figure in the statement of
financial position in the Equity section.
The overall total is $4,990,000, which is the balance of total equity at the end of the year in the statement of financial position.
Exam advice

FA students will need to know the presentation and the elements of the statement of changes in equity. However, they are not expected
to prepare such a statement.

Activity 8

Holmil Co had the following equity section in its Statement of Financial Position at 31 December 20X2:
Equity: $
Called-up share capital:
Ordinary shares (100,000 shares at 50 cents each) 50,000
6% irredeemable preference shares (20,000 shares at $1 each) 20,000
Share premium 100,000
Revaluation surplus 75,000
Retained earnings 1,650,000
Total equity 1,895,000
As well as the irredeemable preference shares, Holmil Co also has $60,000 of 8% loan notes that are redeemable in 20X9.
During the year ended 31 December 20X3, Holmil Co issued 20,000 new equity shares at an issue price of $1.80 a share. As a
result, Holmil Co also made a profit before tax and before deducting any finance costs of $240,000 and has decided to pay an
ordinary dividend equivalent to 50% of the available profit for the year.
1.How much will be shown as finance cost in the statement of profit or loss for the year ended 31 December 20x3?
2.How much dividend will be paid to ordinary shareholders? Assume that the tax charge for the year is $58,000.
3.Which figures will appear in the statement of changes in equity as movements in equity in the year?
1. Finance Cost of $4,800
2. Tax charge of $58,000
3. Profit for the year of $177,200
4. Issue of equity shares of $10,000 and increase in share premium account $26,000
5. Dividend paid of $88,000
6. Dividend paid of $89,200
*Please use the notes feature in the toolbar to help formulate your answer.
1. The interest payable on the loan notes (borrowings) will be treated as a finance cost. The dividend due on the preference
shares will be treated as a dividend because the preference shares are irredeemable.
The finance cost will be $60,000 × 8% = $4,800.
2. The profit for the year is calculated as follows:
3.
$
Profit before financing costs 240,000
Finance costs (answer to question 1) (4,800)
Taxation (given) (58,000)
Profit for the year 177,200
4. Preference dividend is 20,000 × $1 × 6% = $1,200. So, the available profit is $177,200 − $1,200 = $176,000. The
dividend to ordinary shareholders is $176,000 × 50% = $88,000.
3. The answer to question 3 is:
1. No. This will appear in the statement of profit or loss but is not included in the statement of changes in equity.
2. No. This will appear in the statement of profit or loss but is not included in the statement of changes in equity.
3. Yes. The profit for the year will appear in the retained earnings column in the statement of changes in equity.
4. Yes. The par value of any share issue is shown in the statement of changes in equity in the share capital column,
and the addition to share premium will be shown in its share premium column.
5. No. Dividends paid are included in the statement of changes in equity in the retained earnings column. However,
the figure should consist of the dividend to ordinary shareholders and the dividend to irredeemable preference
shareholders. The $88,000 is the dividend to ordinary shareholders only.
6. Yes. The total amount of dividend paid should be included in the statement of changes in equity. This will be
$88,000 + $1,200 = $89,200.
 CHAPTER 14: Visual Overview
Objective: To explain the trial balance’s role in bookkeeping and to prepare financial statements.

1.1 Nature

Definition

A trial balance is a list of all the closing debit and credit balances from each ledger account in the general ledger.

It lists all the debit and credit balances on the individual ledger accounts.
Generally, it is to be expected that:
• asset and expense accounts will have debit balances
• liabilities and income accounts will have credit balances.
There is no prescribed order in which the balances are listed. Businesses will adopt whatever is most
convenient. For example:
• Alphabetical order of account names; or
• Order of captions as they appear in the statement of financial position and statement of profit or loss.
Information on all business transactions travels through the accounting system to form the trial balance
used to prepare financial statements.
1.1.1 Purpose of a Trial Balance
The trial balance is a list of all the closing balances of the individual general ledgers. A trial balance is
prepared for several purposes:
• To ensure double entries are correctly posted
The concept of double entry in the general ledger states that the debit entry must equal the
credit entry. If an error occurs and only one side of the entry is posted to the general ledger,
the trial balance will not balance as the credit balances do not equal the debit balances.
• Used as a starting point for preparing the financial statements
The financial statements are the end product of the accounting process. The Trial Balance
extracted will help identify if double entries have been correctly posted. This makes the
preparation of the final accounts more efficient.

1.1.2 Limitations of a Trial Balance

• A trial balance may not identify all errors in the general ledger.
It only gives evidence of whether the total debits and credits balances or not. Although debits
and credits agree in the trial balance, there could still be errors. For this reason, the trial
balance cannot be relied upon to identify all the errors in the general ledger.
• A trial balance will not identify error corrections.
An error identified in a trial balance merely indicates the existence of an error. It does not
inform the cause of the problem and how to correct it. The trial balance is only the starting
point for investigating errors in the general ledger.

1.2 Preparing a Trial Balance

1.2.1 Process of Preparing Trial Balance and Financial Statements
To create the trial balance, the following steps are made:
1. Close Off each ledger account
Each ledger account (T-Account) is closed off, and the balance c/d is identified.
2. Prepare Initial Trial Balance
Each ledger account balance is summarised and collected to form the Initial Trial Balance.
3. Correcting Errors in the Trial Balance
The initial trial balance is analysed for errors, and appropriate corrections are made using the
journal.
4. Record any year-end Adjustments
 Year-end adjustments such as irrecoverable debt, accruals and provisions are identified and
adjusted in their relevant general ledger account.
5. Prepare a Final Trial Balance
The balances of ledger accounts are updated to reflect error corrections and year-end
adjustments. The trial balance is then updated to form the final trial balance.
6. Prepare the Financial Statements
Each ledger account in the Final Trial Balance is categorised and classified into either the
statement of profit or loss or the statement of financial position.
All ledger accounts relating to income and expenses are closed off, and the resulting profit for
the year is transferred to capital (or retained earnings in the case of a company).
The remaining closing balances in the statement of financial position for the current year
become the opening balances for next year.

1.2.2 DEAD CLIC Revisited

A trial balance is a list of all the closing balances from the ledger accounts in the general ledger. Debit or
credit balances will be determined from the category of each ledger account (DEAD CLIC mnemonic).

DEBIT Examples: CREDIT Examples:

• Telephone Bill • Loans

• Rental • Trade Payables
Expense • Sales Returns Liabilities • Output Sales Tax
• Purchases • Bank overdraft

• Motor Vehicles
• Bank balance • Sales
• Inventories • Purchase Returns
Assets • Trade Receivables Income • Bank Interest received
• Input Sales Tax • Discounts received

Drawings Capital
• Drawings • Capital investment
Activity 1
From the balances of the general ledger, prepare the opening trial balance by selecting where the
balance should appear: Debit or Credit column.
Once the trial balance has been completed, all necessary reconciliations have been made, and all
balances verified, it will be the basis of the opening trial balance for the next accounting period.

If all the balances are correctly posted, the totals at the bottom of the trial balance will equal each other.
 2.1 Types of Errors
After extracting the initial trial balance, the business will identify any errors and make adjustments to
correct them. Errors can be categorised into:
• Errors that affect the trial balance
• Errors that do not affect the trial balance.

2.1.1 Errors that Affect the Trial Balance

Errors that affect the trial balance are unbalanced double entries (the debit amount does not equal the
credit amount).
A suspense account is created to balance the differences between the debit and credit amounts in the
trial balance. The suspense account is temporary and is reversed when the business identifies and
makes the necessary error corrections.
Examples of such errors that affect the trial balance are:
• Error of Partial Omission
An error of partial omission occurs when only one side of the entry (either debit or credit) is
posted in the general ledger.
For example, a depreciation expense is calculated at year-end for office computers and
equipment and is correctly debited to the Depreciation expense account, but no credit entry is
made.
• Error of Posting
An error of posting occurs when either the debit or credit entry is posted with an incorrect
value or incorrect value posted in both the debit and credit accounts.
For example, the double entry made for an irrecoverable debt write-off worth $1,200 is DR
Irrecoverable Expense $120 and CR Trade Receivables $1,200. The debit entry is posted
with an incorrect amount.
Exam advice

With the advent of computerised systems, errors due to unbalanced double entries are eliminated.
Modern accounting systems have embedded controls that prevent these errors from occurring. However, it is still useful to learn
the nature of these errors.

Since errors that affect the trial balance (unbalanced double entries) no longer exist in a business where
computerised systems are used, is there still a need for suspense accounts?
• The suspense account still exists as businesses may deliberately post an entry into the suspense
account due to uncertainty about the correct account to use.
For example, the proceeds from a sale of a non-current asset have been recorded by
debiting cash. However, the bookkeeper is unsure of the corresponding ledger account to
make the credit entry.
Therefore, the amount is posted by crediting the Suspense account. The correct ledger
account is subsequently identified, which is the Disposal account. A correction is made by
debiting the Suspense Account (to remove its balance) and crediting the Disposal Account.

2.1.2 Errors that Do Not Affect the Trial Balance

Errors can arise that do not affect the trial balance. These errors are caused by double entries that have
debit and credit amounts that balance. These errors are usually due to posting to incorrect accounts or
wrong values used for debit and credit.
Examples of such errors are:
• Errors of commission
An error of commission occurs when a transaction has been posted to the wrong account of
the same 'type' with the correct value. Accounts of the same type are expenses, assets,
income, and liability.
For example, the purchase of a motor vehicle is recorded in the Fixture and Fittings account.
The Motor Vehicle and Fixture and Fittings accounts are asset accounts and, therefore, the
same type. The trial balance agrees, but the individual asset account balances are incorrect.
 • Errors of principle
An error of principle occurs when a transaction has been posted to an account of a different
'type'.
For example, a motor vehicle purchase is recorded in the Purchases account. These
accounts are different types, as motor vehicles are assets while purchases are expenses.
The trial balance agrees, but the individual Motor Vehicle and Purchases balances are
incorrect.
• Errors of omission
An error of omission occurs when something is 'omitted' – left out or not posted to the
accounts.
For example, a purchase invoice is received from the supplier, and the business fails to
record the invoice in its accounting system. As a result, both the Purchases account and
Trade Payables are understated due to this omission.
• Errors of reversal entry
Reversal of entry occurs when transactions are posted to the wrong sides of the accounts.
For example, an advertising payment of $50 is posted wrongly by debiting Bank $50 and
crediting Advertising Expense $50 instead of the other way round.
• Errors of transposition
An error of transposition occurs when two consecutive numbers are reversed in error.
For example, an accruals creation for $420 is adjusted by debiting expenses and crediting
accruals with $402. The digits 2 and 0 are transposed.
• Errors of original entry
An error of original entry occurs when a transaction has been posted with an incorrect
amount. Both sides of the account are posted with the wrong amount.
For example, a purchase invoice received of $50 is recorded in the purchases accounting
system as $100. As a result, the purchases and trade payables balance will be incorrect.
2.2 The Suspense Account
Definition

A suspense account is a temporary account in the general ledger.

It is temporary as this account is reversed with the necessary error corrections and, thus, does not appear
in the financial statements.
Suspense accounts are used in two situations:
• If the initial trial balance does not show the same debit and credit balance, the differences are
entered into the suspense account to balance the trial balance.
Since modern accounting systems do not allow for unbalanced double entries to be
processed, suspense accounts are no longer created from such situations. However,
transactions posted manually into the accounting systems can still cause a difference
between the debit and credit balances.
Unusual and one-off transactions are posted manually using the journal.
For example, the trial balance debit total is $400, but the credit total is $350. Therefore, the
suspense account is credited with $50 to balance the trial balance.
• If there is uncertainty over which account to record a specific transaction, a bookkeeper may
temporarily post part of the entry into the suspense account and investigate the correct account.
For example, a bank receipt appears on the bank statement, but it is unclear what it relates
to.
The bank is debited to reflect the cash inflow, and the bookkeeper will credit the suspense
account while he investigates the receipt and makes the correction later.
Activity 2
From the balances of the general ledger, prepare the trial balance by selecting where the balance
should appear: Debit or Credit column.
Once the trial balance has been completed, all necessary reconciliations have been made, and all
balances verified, it will be the basis of the opening trial balance for the next accounting period.

Accounts Balance Debit Credit

$ $ $
Bank deposit 2,900 2,900
Sales revenue 215,000 215,000
Insurance 2,000 2,000
Purchases 178,000 178,000
Trade Receivables 20,000 20,000
Drawings 8,000 8,000
Postage and stationary 800 800
Accruals 200 200
Capital 10,000 10,000
Prepayments 100 100
Opening inventory 13,000 13,000
Electricity 3,600 3,600
Trade payables 19,000 19,000
Telephone 900 900
Motor vehicle 10,000 10,000
Accumulated depreciation 6,000 6,000
Suspense 10,900
Total 250,200 250,200
Although the trial balance now balances, the balance in the Suspense account needs to be investigated and
corrected.
2.3 Correcting Errors in the Trial Balance

Once the errors have been identified, the business will make adjustments to correct the errors through
the journal. After error corrections, the updated balance in the general ledger will form the final trial
balance.
The steps to correct errors identified are:
1. Establish the correct double entry for the transaction.
2. Identify the actual double entry made in error.
3. Determine the accounting entry required to correct the error (from what was posted to what should be
posted) and make the adjustments using journal entries.
When a business makes error corrections or a year-end adjustment, the impact on the financial
statements must be considered.
Example 1
Rohan trades as a mechanic and has a mixture of individual and corporate clients. Draft financial statements for the
year ended 31 December 20X8 have been produced, and these statements have reported a profit for the year of
$35,840.
After performing year-end reconciliations and reviews, the following errors and adjustments have been discovered:
1. Rohan has treated a $900 payment for telephone service as a stationery expense.
2. The receipt from a credit customer of $2,000 has been credited to trade payables.
3. The final electricity invoice for the year arrived on 28 January 20X9. The $750 outstanding is for the quarter that
ended 31 December 20X8 but has not yet been paid.
4. In completing the year-end bank reconciliation, it was discovered that $120 of bank interest had been received and
not accounted for.
Below is the summary of corrections needed for each of the errors listed:

No Incorrect Entry Correct Entry Correction

1. DR Stationery $900 DR Telephone $900 DR Telephone $900
CR Bank $900 CR Bank $900 CR Stationery $900
This is an Error of Commission. The correction entry has no impact on the profits during the year.
2. DR Bank $2,000 DR Bank $2,000 DR Trade Payables $2,000
CR Trade Payables $2,000 CR Trade Receivables $2,000 CR Trade Receivables $2,000
This is an Error of Principle. The correction entry has no impact on the profits during the year.
3. No entry made DR Electricity $750 DR Electricity $750
CR Accruals $750 CR Accruals $750
This is not an error. The business post year-end adjustments such as this accrual. This adjustment increases expenses
and hence reduces profit.
4. No entry made DR Bank $120 DR Bank $120
CR Interest Income $120 CR Interest Income $120
This is an Error of Omission. The income will increase profits for the year.
The impact on the profits for the year due to the correcting adjustments/ year-end adjustment is as follows:
 Example 2

Puja is the bookkeeper for Harsev's business, preparing his accounts for the year ended 31 December 20X8. She
has extracted the trial balance, but the debit side totals $130,400, whereas the credit side has a total of $124,800.
Since the debit side is larger than the credit side by $5,600, a credit entry is made to the suspense account to tie the
balance.
After investigation, she discovered the following:
1. On 1 November 20X8, she was unsure of the correct account to debit for one of the purchase invoices, so she
debited the cost of $50,000 to a suspense account in April.
The debit balance of $50,000 is included in the suspense account of the trial balance.
She now discovered that it was for purchasing a machine for his workshop.
o The double entry to correct this error is: DR Plant and Machinery $50,000, CR Suspense
$50,000
2. She discovered an error in posting the cash sales in October. She correctly debited Bank but omitted to post cash
sales of $5,600 to the Sales account.
o The initial erroneous entry was DR Bank $5,600, CR nil. The credit entry in the suspense
account results from an unbalanced trial balance. The double entry to correct this error is: DR
Suspense $5,600, CR Sales $5,600
The suspense account will be as follows after correcting the errors:

DR Suspense Account CR

01-Nov-X8 Balance per TB $50,000 31-Dec-X8 To balance TB $5,600

31-Dec-X8 Sales $5,600 31-Dec-X8 Plant & Machinery $50,000

0 0

The suspense account has been reduced to $0, and Puja can now complete the preparation of Harsev's accounts.

Activity 3
For each of the errors below, decide if they will affect profit for the year.
1. The depreciation charge for motor vehicles has been incorrectly calculated using the depreciation policy
for buildings of straight line over 50 years.
2. The maintenance contract for an item of machinery has been included in the original cost of the
machinery in the statement of financial position.
3. A share issue was incorrectly recorded to share premium only instead of splitting the entry between
share capital and share premium.
1. Affects profit. The depreciation policy for buildings uses a life of 50 years, which would be considerably
longer than the typical life of motor vehicles.
When corrected, the depreciation charge for motor vehicles would increase, reducing profit.
2. Affects profit. There are two impacts on profit. Firstly, the maintenance contract is a revenue
expenditure item and should be charged to profit or loss, not capitalised. Secondly, in adjusting the
asset’s cost in the statement of financial position, the depreciation charge will need to be recalculated,
which will also impact profit, in this case, increasing it.
 3. Does not affect profits. Both share capital and share premium are in the equity section of the statement
of financial position. Therefore, moving a balance from share premium to share capital will not affect
profit for the year.

2.4 Posting Year-end Adjustments

Year-end adjustments are made to the general ledger accounts at the end of the financial year. These
adjustments are posted to ensure transactions comply with the applicable accounting framework. We
have learned each of these adjustments in the previous chapters.
Examples of year-end adjustments that are applicable include:
• Inventories
• Non-current asset transactions
• Depreciation
• Accruals, Prepayments, Accrued and Deferred income
• Allowance for receivables
• Irrecoverable debts
• Provisions
Activity 4
Sofia Co is preparing financial statements for the year ended 31 December 20X8.
The following adjustments are necessary.
1. Sofia Co has shop fittings that are depreciated on a straight-line basis over ten years. The cost of the
shop fittings recognised in the Statement of Financial Position is $5,000.
Record the journal for the shop fittings depreciation charge for the year.
2. During the year, Sofia Co sold a delivery van (Motor Vehicles) for $7,000 cash. The delivery van had
cost $15,000 and had accumulated depreciation of $8,000 on the disposal date.
Record the journal that will record the disposal of the delivery van.
3. Sofia Co had a rights issue during the year. On 1 January 20X8, there were 200,000 $1 ordinary shares
in issue. The rights issue offered one new share for every five shares held for $2.50 per share. All the
shares were taken up.
Record the correct debit and credit entries for this rights issue.
4. Sofia Co paid insurance for its premises on 30 November 20X8 of $2,400. This covers the period 1
December 20X8 to 30 November 20X9.
Record the appropriate accrual or prepayment for insurance for the year ended 31
December 20X8.
1. The depreciation charge is $5,000 ÷ 10 years = $500 per annum.

DR Depreciation $500

CR Accumulated Depreciation $500

2. The disposal of non-current assets is recorded in a disposal ledger account. The balance in the NCA –
Cost account and the NCA - Accumulated Depreciation account is transferred to the disposal account
using two separate journals.
A third journal records the receipt of the disposal proceeds. Once the profit/ loss on disposal
of NCA is recorded, the balance in the disposal account should be nil.
In this scenario, there is no profit or loss as the sales proceeds = the asset’s net book value.
The double entry to summarise the effect of the disposal on the non-current asset is:

DR Cash $7,000

DR Motor Vehicle – Acc. Depr $8,000

CR Motor Vehicle – Cost $15,000

The cost of the delivery vehicle is removed from Motor Vehicles Cost account and its related
accumulated depreciation. In effect, we are comparing the carrying amount of the delivery
 DR Cash $100,000

CR Share Capital $40,000

CR Share Premium $60,000

van with the proceeds received. They are the same amount in this case, so no profit or loss is
recorded.
If the disposal proceeds had not been the same as the carrying amount of the asset sold,
there would be an additional entry in this journal to record the profit or loss on disposal: a
credit entry if it was a profit and a debit entry if it was a loss.
3. The number of shares issued is (200,000 ÷ 5) × 1 = 40,000 new shares.
The share issue is recorded at par value in share capital (40,000 × $1). The cash proceeds
are recorded (40,000 × $2.50), and finally, a balancing figure to share premium for excess of
proceeds received above par value ($100,000 − $40,000). The double entry to record the
rights issue is:
4. Since only one month relates to the year ended 31 December 20X8 (December 20X8 itself), the amount
of insurance paid in advance is 11 months. The calculation is, therefore, ($2,400 ÷ 12 months) × 11
months = $2,200.
This will reduce the insurance expense and create a prepayment in the Statement of
Financial Position. The double entry to record the prepayment (Asset) is:

DR Prepayment $2,200

CR Insurance Expense $2,200

3.1 Reason for Incomplete Records

There are many reasons for keeping complete and accurate accounting records. Some of the common
reasons are:
• Comply with legislation, including tax regulations (For example, sales tax)
• Produce financial statements (for interested users)
• Control operations (For example, to receive amounts due from customers)
• Safeguard assets (If recorded, their existence can be confirmed by physical inspection)
However, records may be incomplete due to the following reasons:
• There is no legal requirement to keep complete records
• The cost of a bookkeeper is not justified
• Information for the preparation of financial statements can be obtained from other sources (for example,
adding up unpaid invoices kept in a drawer to determine trade payables)
• Data loss from accidents or fraud

3.1.1 Solving Incomplete Records

A sole trader may want information about profit and financial position for planning and monitoring
purposes.
There are generally few legal requirements, other than for tax purposes, for the information to be
produced. This means that a profit-for-the-year figure will satisfy this requirement even if there is no detail
for the sole trader.
For businesses, charities and other organisations, there will be strict legal guidelines about what
information should be included, when the complete financial statements should be submitted, where they
should be stored and how long records should be kept. The implications of not meeting these legal
guidelines can be severe and may result in penalties, but these are outside the scope of the syllabus.
In such cases, there are several techniques to derive missing figures or elements in the financial
statements to construct missing accounts, such as:
 • Manipulation of the accounting equation
• Derive missing figures from ledger accounts
• Markups and margins cost structure
Many sole trader businesses keep some accounting records, such as sales/ purchase invoices and bank
statements. Profit for the year and basic accounts can be constructed using this information.

3.2 Manipulation of Accounting Equation

When an accountant has incomplete records, the accounting equation can be manipulated to establish
the profit for the year. The accounting equation is Capital = Assets – Liabilities
Capital is calculated as Opening Capital + Capital Introduced + Profits − Drawings

Key Point

The expanded Accounting Equation:

(Opening Capital + Capital Introduced + Profit − Drawings) = Assets − Liabilities

To identify the missing profit amount, the equation can be rearranged to:
Profit = Assets − Liabilities − Opening Capital − Capital Introduced + Drawings
Information on Assets, Liabilities, Opening Capital, Capital introduced, and Drawings must be known to
derive the Profit amount.

Activity 5
Complete the section of the accounting equation on the right-hand side to the correct part of the
equation on the left.
Profit = Opening Capital + Profit − Drawings
Capital = Capital + Profit − Drawings + Liabilities
Assets = Assets − Liabilities − Capital + Drawings
Assets − Liabilities = Assets − Liabilities
*Please use the notes feature in the toolbar to help formulate your answer.

Assets − Liabilities = Opening capital + Profit − Drawings

Assets = Capital + Profit − Drawings + Liabilities
Profit = Assets − Liabilities − Capital + Drawings
Capital = Assets − Liabilities
Example 3
Hannah runs a restaurant selling hot food to customers. He does not keep detailed accounting records
but has supplied the following year-end balances:
Year-end balances: $
Motor van for transporting stall and supplies 3,000
Market stall including cooking facilities 2,000
Inventory of food stuff 500
Bank and cash balance 850
Amounts outstanding to suppliers 250
Capital at the end of the last year 5,000
Capital introduced this year Nil
Drawings taken 8,000
Hannah’s profit for the year based on the above information is as follows:

Profit = Assets − Liabilities − Opening − Capital + Drawings

Capital introduced
9,100 = 3,000 + 2,000 + 250 − 5,000 − 0 + 8,000
500 + 850
6,350
Activity 6
Milos started his business on 1 January with $10,000 in cash. He bought a kiosk for $9,000 and inventory
for $1,000.
He did not introduce any further capital into the business during the year.
He withdrew $100 weekly, except for the first two weeks when he drew nothing.
At the end of the year, on 31 December, he had the following assets and liabilities:
Kiosk – Estimated useful life is another two years
Trade receivables – $950
Trade payables (wholesaler) – $1,650
Inventories – $550
Cash – $370
Calculate Milos' profit for the year.
The profit for the year is $1,220.
Profit = Assets − Liabilities − Opening − Capital + Drawings
Capital introduced
1,220 = 7,870 1,650 − 10,000 − 0 + 50 weeks ×
(W1) $100
5,000
Working 1:
Non-Current Assets = Cost $9,000 − Acc. Depr ($9,000/3 years*) = $6,000
Current Assets = Receivables $950 + Inventories $550 + Cash $370 = $1,870
Total Assets = $6,000 + $1,870 = $7,870

*Note: Regarding the kiosk as of 31st December, it has a remaining useful life of 2 years after 1 year has lapsed, so
its total useful life is 3 years.

3.3 Derive Missing Figures from Ledger Accounts

Missing figures can be derived using the ledger accounts. The three main accounts used are Trade
Receivables, Trade Payables, and Bank/ Cash.

3.3.1 Trade Receivables Account

The Trade Receivables account can derive the total sales or cash received from customers.

DR Trade Receivables Account CR

Balance b/d X Cash from customers X

Total Sales X Balance c/d X

XX XX

The below pro forma template provides the same outcome:

Cash received from customers X

Add closing customer balances outstanding(receivables) X

 Less opening customer balances outstanding(receivables) (x)

Credit sales in the year x

Example 4
Naima runs a florist business. She makes cash sales to customers who come into her shop and supplies
floral arrangements to local hotels on credit terms. The hotels settle their balances in cash at her shop when
the sales invoices become due. She banks all cash remaining each day in her business bank account.
Naima works alone and has no time to maintain a complete set of accounting records. However, she does
have all her bank statements for the year. She also has a list of balances outstanding from her hotel
customers at the start and end of her accounting year, 31 December 20X9. Total cash received during the
year $183,400.

1 January 20X9 31 December 20X9

Hotel customer balances outstanding $38,600 $29,900

Naima can derive the total sales amount for the year using the Trade Receivables account as follows:

DR CR

Date Narrative $ Date Narrative $

1 January 20X9 Balance b/d 38,600 Cash received from customers 183,400

Sales 174,700

31 December 20X9 Balance c/d 29,900

213,300 213,300

The value of the sales that Naima has made during the year is $174,700.

Activity 7

Hiroto has an air-conditioning business. He makes sales mainly on credit, issuing sales invoices for every
sale.
As his business has grown, he has not kept track of the amounts owed to him by customers at the end of
his current accounting year, 31 December 20X9.
However, he kept the bank statements that recorded all receipts from his credit customers and all sales
invoices for the year.
Total cash received from credit customers during the year $136,800. Total credit sales invoices $162,400.

1 January 20X9 31 December 20X9

Customer balances outstanding $27,200 ?

How much money is Hiroto owed from his customers at 31 December 20X9?
*Please use the notes feature in the toolbar to help formulate your answer.
Hiroto can derive the total amount owed from his customers on 31 December 20X9 for the year using the
Trade Receivables account as follows:
DR CR

Date Narrative $ Date Narrative $

1 January 20X9 Balance b/d 27,200 Cash received from customers 136,800

Sales 162,400

31 December 20X9 Balance c/d 52,800

189,600 189,600

Therefore, the money owed to Hiroto by his customers at 31 December 20X9 is $52,800.
3.3.2 Trade Payables Account
The Trade Payables Account can derive the Total Purchase or Cash paid to suppliers.

DR Trade Payables Account CR

Cash to suppliers X Balance b/d X

Balance c/d X Total Purchases X

XX XX

The below pro forma template provides the same outcome:

Cash paid to suppliers X

Add closing outstanding balances to suppliers(payables) X

Less opening outstanding balances to suppliers(payables) (x)

Credit purchases in the year x

Example 5
All purchases made by Naima are made over the telephone to a supplier with whom she has a credit
account. The flowers and plants are delivered directly to her shop. She then pays for the delivery using a
direct bank transfer.
Total bank transfers during the year $124,600.

1 January 20X9 31 December 20X9

Balances outstanding to suppliers $19,800 $20,300

 Naima can derive the total purchases amount for the year using the Trade Payables account as follows:
DR CR
Date Narrative $ Date Narrative $
Cash 124,600 1 Balance 19,800
paid to January b/d
suppliers 20X9
Purchases 125,100
31 Balance 20,300
December c/d
20X9
144,900 144,900

For example, Naima spent $125,100 on flowers and plants during the year.

Activity 8
Hiroto makes purchases for his business using both cash and credit transactions. He keeps a record of
the payments made to his suppliers, but he does not specify whether they are cash purchases or for the
payment of supplier invoices. He does, however, keep all purchase invoices.
Total cash paid to suppliers $122,800. Total purchase invoices $117,300.

1 January 20X9 31 December 20X9

Balances outstanding to suppliers $19,500 ?

How much does Hiroto owe his suppliers at 31 December 20X9?

*Please use the notes feature in the toolbar to help formulate your answer.

Hiroto can derive the amount he owes to suppliers on 31 December 20X9 using the Trade Payables
account as follows:
DR CR

Date Narrative $ Date Narrative $

Cash paid to suppliers 122,800 1 January 20X9 Balance b/d 19,500

Purchases 117,300

31 December 20X9 Balance c/d 14,000

136,800 136,800

Hiroto owes $14,000 to his suppliers at 31 December 20X9.

3.3.3 Bank Ledger Account
The Bank account can be used to derive cash received from customers, cash paid to suppliers, drawings
taken by the owner and money paid for other expenses.

DR Bank and Cash Account CR

Balance b/d (deposit balance) X Balance b/d (overdraft balance) X

Cash from customers X Cash to suppliers X

 Balance c/d (overdraft balance) X Drawings X

Other expenses paid X

Balance c/d (deposit balance) X

XX XX

Example 6
Continuation from Examples 4 and 5.
Naima has kept all her bank statements for the year. From examples 4 and 5, the total cash received
during the year has been identified as $183,400, and bank transfers to suppliers were $124,600.
Naima banks all cash at the end of each day after subtracting her personal expenses (drawings) and
paying small business expenses totalling $8,840 for the year. The bank statements show that she has paid
other business expenses such as rent and electricity totalling $18,650. These bills have been paid by bank
transfer.

1 January 20X9 31 December 20X9

Bank statement balance $1,380 $6,720

Naima can derive the total amount taken as drawings using the Bank account as follows:

DR Bank Account CR

Balance b/d (deposit balance) $1,380 Cash to suppliers $124,600

Cash from customers $183,400 Drawings $25,970

Other expenses paid

($8,840 + $18,650) $27,490

Balance c/d (deposit balance) $6,720

$184,780 $184,780

Naima has taken $25,970 in drawings in total.

3.4 Mark-Up and Margin Cost Structure

For any business to continue trading, it needs to make a profit.
Most businesses will use a standard formula to calculate the selling price of goods or services based on
the cost of producing them.
The cost structure, or profit percentage, is how a business includes profit in its selling price. There are two
types of cost structures:
• Mark-up
• Margin
3.4.1 markup Cost Structure
A markup cost structure is based on cost.
The cost amount represents 100% of the cost structure.
For example, a business with a mark-up of 20% will have the following cost structure:

Trading Account %
Sales 120
Cost of Goods Sold (100)
Gross Profit 20
Example 7
Femi ensures he makes a profit on top of the cost of the motorbikes that he sells by
applying a 25% markup to all goods sold.
The total sales figure for the year is $250,000.
The cost structure of the motorbike Femi sells is as follows:

Trading Account $ %

Sales 250,000 (100 + 25) = 125

Cost of Goods Sold (200,000) always 100

Gross Profit 50,000 25

Cost of Goods Sold = $250,000 × (100/125) = $200,000

Gross Profit = $250,000 × (25/125) = $50,000 or
Gross Profit = $250,000 − $200,000 = $50,000

3.4.2 Margin Cost Structure

A Margin cost structure is based on Sales.
The sale amount represents 100% of the cost structure.
For example, a business with a margin of 20% will have the following cost structure:

Trading Account %
Sales 100
Cost of Goods Sold (80)
Gross Profit 20
Example 9
Shreya has a luxury boat business. She ensures her business will profit by applying a
margin of 25% to all goods sold.
She has kept all purchase invoices, giving a total cost of goods sold for the year of
$225,000.
The cost structure of Shreya’s goods sold is as follows:

Trading Account $ %

Sales 300,000 always 100

 Cost of Goods Sold (225,000) (100 − 25) = 75

Gross Profit 75,000 25

Sales = $250,000 × (100/75) = $300,000

Gross Profit = $225,000 × (25/75) = $75,000 or
Gross Profit = $300,000 − $255,000 = $75,000

3.4.3 Identifying Inventory figures using Cost Structures

Inventory management is vital in identifying the amount wasted each year and the inventory turnover
(before inventory is sold). In addition, such information may lead to the business ordering future inventory
more efficiently.
Example 9
SJQ Co is a soft drinks business. It applies a markup of 25% to all goods sold. It kept all purchase invoices,
which total $200,000. SJQ Co had an opening inventory of $30,000 and total sales for the year of $280,000.
What is the closing inventory?
As before, we start by inputting the figures that we have into the trading account:

Trading Account $ $ %

Sales 280,000 125

Cost of Goods Sold:

Opening Inventory 30,000

Purchases 200,000

Less: Closing Inventory ?

(224,000) 100

Gross Profit 56,000 25

Total Cost of Goods Sold = $280,000 × 100/125 = $224,000

Total Gross Profit = $280,000 × 25/125 = $56,000
Therefore, the closing inventory amount is:

Cost of Goods Sold:

Opening Inventory 30,000

Purchases 200,000
 Less: Closing Inventory (6,000)

Cost of Goods Sold 224,000

The closing inventory is $6,000 ($30,000 +$200,000 − $224,000).

Activity 9
Shreya owns a bicycle business. She applies a margin of 20% to all goods sold. She has kept all
purchase invoices, which total $253,000. Her business had an opening inventory of $23,000 and total
sales for the year of $315,000. Her business had a closing inventory value of $22,500 following a full
inventory review at the end of the year.
What is the amount of inventory lost during the year for Shreya's business?
*Please use the notes feature in the toolbar to help formulate your answer.

The cost of sales is (252,000 + 22,500 − 23,000 − 253,000) = $1,500

$ $ %
Sales 315,000 100
Less
Cost of goods sold:
Openings inventory 23,000
Purchases 253,000
Cost of inventory lost (1,500)
Less closing inventory (22,500)
(252,000) 80
Gross profit 63,000 20
Shreya has lost $1,500 of inventory throughout the year.
Activity 10
Lucas owns a grocery business. He applies a markup of 30% to all goods sold. He has kept all purchase
invoices, which total $310,000. His business had an opening inventory of $30,000 and total sales for the
year of $390,000. His business had a closing inventory value of $29,000 following a full inventory review
at the end of the year, but Lucas regularly takes food home for his own use.
What is the amount of inventory used personally by Lucas during the year?
*Please use the notes feature in the toolbar to help formulate your answer.

The cost of sales is (300,000 + 29,000 − 30,000 − 310,000) = ($11,000)

$ $ %
Sales 390,000 130
Less
Cost of goods sold:
Openings inventory 30,000
Purchases 310,000
Less drawings (11,000)
Less closing inventory (29,000)
300,000 100
Gross profit 90,000 30
Lucas has personally used $11,000 of inventory during the year.

Summary and Quiz

• A list of balances extracted from the general ledger (trial balance) assists in:
o detecting double-entry bookkeeping errors; and
o preparing draft financial statements.
• Errors not detected by a trial balance include original errors, compensating errors and errors of
omission, commission and principle.
• Errors which should be detected include single entries and transposition errors.
• An opening trial balance should reflect the end of the prior period balances (i.e. those which remain on
ledger accounts when the

• books have been closed).

• To find total profit (or loss) or drawings use the net asset approach:
o Calculate opening net assets if not known.
o Calculate closing net assets if not known.
o Use the accounting equation to finding the missing amount.
• To find specific items for the statement of profit or loss or statement of financial position use the cash
book approach.
• If sales (or purchases) are cash and credit, the distinction is not important. Include cash transactions in
the control a/c to find total sales revenue (or purchases).
• In cost structures: mark-up is on cost; gross profit is on sales.
• Routes to finding missing amounts are:
o Trade payables ledger control a/c → purchases
o Purchases + inventory movement → cost of sales
o Cost of sales + cost structure → sales revenue
o Sales revenue into trade receivables ledger control a/c → cash receipts
• Cash receipts into cash book → drawings
CHAPTER 15: Visual Overview

Objective: To describe the structure and minimum content requirements of general-

purpose financial statements per IFRS.
 1.1 General-Purpose Financial Statements

General-purpose financial statements are intended to meet the information needs of

primary users in making decisions relating to providing resources to the entity.
Financial statements are a structured financial representation of an entity's:
• Financial Position
• Financial Performance

1.1.1 Purpose of Financial Statements

Key Point

The objective of general-purpose financial statements is to provide financial information that is useful to the primary
users in making decisions relating to the provision of resources.

Primary user’s decisions depend on expectations about returns, which consider the
following:
• the amount, timing, and uncertainty of future net cash inflows
• management’s stewardship of economic resources.
The board of directors or governing body of an entity (management) is responsible for
preparing and presenting financial statements.

1.1.2 The Basic Financial Statements

A complete set of financial statements includes:
• Statement of Profit or Loss and Other Comprehensive Income (SPL&OCI)
• Statement of Financial Position (SFP)
• Statement of Changes in Equity (SOCIE)
• Statement of Cash Flows (SCF)
• Significant accounting policies and other explanatory notes
Entities may also present additional information voluntarily. For example, the following
may be presented:
• A financial review by management
• Environmental reports
• Value-added statements
The primary financial statements may differ for various entities: sole trader, partnership,
and limited liability company.

2.1 Introduction to SPL&OCI

Overall, the statement of profit or loss and other comprehensive income reports the
financial performance of an entity in two ways:
 • Profit or Loss –total income minus expenses
• Other Comprehensive Income – income/gains or expenses/losses not
recognised in profit or loss but instead recognised in reserves. For example,
revaluation surplus
IAS 1 Presentation of Financial Statements states that the statement of profit or loss
and other comprehensive income (SPL & OCI) can be prepared either as a single
statement or as two separate statements:
• single statement of comprehensive income
• two statements
o A Statement of Profit or Loss
o A Statement of Other Comprehensive Income (which begins
with profit or loss for the period)
Example 1

This example shows the statement of profit or loss for a sole trader business and the
statement of profit or loss and other comprehensive Income for a company.
Sole Trader Statement of Company Statement of Profit or Loss and
Profit or Loss Other Comprehensive Income

$ $ $

Sales X Revenue X

Less: Sales
returns (X) Cost of sales (X)

Gross profit X

Cost of goods
sold: Other income X

Opening inventory X Distribution costs (X)

Purchases X Administrative expenses (X)

Less: Purchase
returns X Finance cost (X)

X Profit before tax X

Less: Closing
inventory (X) Income tax expense (X)

(X) Profit for the year X

Gross profit X
Other income X Other comprehensive income:

Gain on revaluation of non-current

assets X

Total comprehensive income for

Less Expenses: the year X

(X)

(X)

(X)

Net profit X
• Sales/Revenue – Sales/revenue is the income generated from the ordinary
operating activities of an entity. This could be selling goods or providing a
service. The recognition of revenue is the same for both sole traders and
companies, but a sole trader may highlight sales returns separately in its
SPL.
• Cost of Goods Sold/ Cost of Sales – For a sole trader, the components
of this balance are presented on the SPL itself.
A company's SPLOCI will only show the cost of sales figure, but it includes
all expenses relating to the cost of goods sold and can include such things
as the depreciation of plant and machinery.
• Gross Profit – gross profit is the revenue surplus after deducting the cost
of sales. This represents the profit on the trading activities of the entity.
• Other Income – This is income generated by a business from anything
other than its normal trading activities. This can include any interest earned
or rental income.
• Expenses – These are costs incurred in the day-to-day running of the
business. A sole trader will list every business expense incurred separately
in the SPL, including any interest paid on borrowings.
For a company, the expenses are categorised mainly as distribution or
administrative expenses. Distribution costs include all costs to sell,
advertise and deliver goods sold. Administrative costs represent those
costs that do not fall into either cost of sales or distribution, such as
accountancy fees.
• Finance Costs – Finance costs are the interest payable on loans and loan
notes.
• Income Tax Expense – This is the tax charged on the entity's profit for the
year. The tax rate will be based on the rules of the local tax authority.
Income tax expense will not be included in the sole trader's SPL.
• Net Profit/ Profit for the year – is the excess income after all business
expenses have been paid. The Net Profit amount is transferred to the 'Profit
 for the Year' section of the Statement of Financial Position, thus increasing
capital.
(If a net loss is made, a negative amount is transferred to the SFP, thus
reducing the business’s capital).
• Other Comprehensive Income – highlights any profit or losses not
reflected in the Statement of Profit or Loss but in reserves. An example is a
revaluation of a non-current asset, which may give rise to a revaluation
gain. This type of adjustment is less likely for a sole trader.
• Total Comprehensive Income for the year – The total gains or losses
recognised in profit or loss and other comprehensive income added
together.

2.2 Revenue

2.2.1 IFRS 15 Revenue from Contracts with Customers

IFRS 15 Revenue from Contracts with Customers guides on recognising revenue
arising from an entity’s ordinary operating activities. Revenue can arise from selling
goods or providing a service.
Definitions

Revenue is defined as an income arising during an entity’s ordinary activities.

Income is the increase in economic benefits during the accounting period in the form of inflows or
enhancements of assets or decreases of liabilities.
The term economic benefit refers to cash, receivables, or other assets.
Revenue should be recorded at the fair value of the consideration received or
receivable after accounting for trade discounts. Consideration received represents cash
sales, and consideration receivable represents credit sales.

2.2.2 Recognising Revenue

IFRS 15 sets out five steps that must be gone through to recognise revenue:
1. Identify the Contract with the Customer
Definition

A contract is an agreement between two or more parties that creates enforceable rights and obligations.

Revenue should be recognised only when a contract meets all of the following criteria:
• the parties to the contract have approved it (in writing or orally)
• it identifies each party's rights regarding the goods/services
• it states the payment terms
 • the contract has commercial substance
• the supplier expects to collect the consideration due under the contract
2. Identify the performance obligations in the contract
Definition

A performance obligation is a promise in a contract with a customer to transfer:

• a good or service (or bundle of goods/services) that is distinct
• a series of goods/services that are substantially the same and are transferred in the same way

If a promise to transfer a good/service is not distinct from other goods and services in a
contract, the goods/services are combined into a single performance obligation.
A good or service is distinct if both of the following criteria are met:
• The customer can benefit from the good or service on its own or when combined with
the customer's available resources
• The promise to transfer the good or service is separately identifiable from other
goods/services in the contract
3. Determine the transaction price
Definition

The transaction price is the amount of consideration an entity expects to be entitled to in exchange for transferring
promised goods/services (excluding sales taxes).

The effects of the following are considered when determining the transaction price:
• the time value of money (unless the contract term is less than one year)
• the fair value of any non-cash consideration
• estimates of variable consideration (e.g. discounts)
• any consideration payable to the customer, which is treated as a reduction in the
transaction price (unless the payment is entirely unrelated)
4. Allocate the transaction price to the performance obligation
The transaction price is allocated to all performance obligations in proportion to the
stand-alone selling price of the goods/services.

Definition

Stand-alone selling price is the price at which an entity would sell a promised good/service separately to a
customer.

The best evidence of stand-alone selling price is the observable price of a good/service
when it is sold separately. If it is not observable, it must be estimated. The allocation is
made at the beginning of the contract and is not adjusted for later changes in the
stand-alone selling prices.
5. Recognise Revenue
Revenue is recognised when (or as) a performance obligation is satisfied by transferring
a promised good/service (an asset) to the customer.
 • An asset is transferred when (or as) the customer gains control of the asset.
• The performance obligation will be satisfied over time or at a point.
2.3 Income Tax

All businesses pay taxes on their profits.

How the tax is calculated depends on the type of business (sole trader, partnership, or
company) and the country in which they operate.
For a sole trader, the tax due is a personal liability of the owner. Therefore it is not
recognised in the sole trader's financial statements.
A company is a separate legal entity and is liable to tax on the profit for the year. The
liability will be recognised in the financial statements but will probably be paid in the
following year.
Like other business expenses, it will be recognised when incurred rather than paid.
International accounting standards refer to tax on company profits as income tax.

2.3.1 Calculation of Income Tax

The income tax expense for the year is calculated as follows:

Current Tax Estimate for the year X

Under/(Over) provision for previous year X/(X)

Income Tax Expense XX

1. Calculate the Current Tax Estimate for the year

This is the tax the business estimates it will have to pay on its profits during the year.
The current year’s tax will be paid after the year-end when the final tax expense has
been calculated. The double entry to record the estimated current year tax is:

Individual Account Category Explanation

DR Income Tax Expense Expense Income Tax (Expense) increased

CR Current Tax Payable Liability Income Tax is owed to authorities

The figure estimated may not be the final amount paid. This final amount would result
from the tax authority’s review of the information provided by the business. The tax
authority will dictate the final amount to be paid.
2. Calculate the Under or Over Provision
The actual tax will be calculated the following year once the profits have been
established. The amount a business estimates for its current tax and the final amount
paid will often differ. This results in an under or over-provision when comparing the
estimate against the actual cash flow.
An under-provision means that the estimate was too low. The double entry to record the
under provision is:

Individual Account Category Explanation

DR Income Tax Expense Expense Income Tax (Expense) increased

CR Current Tax Payable Liability Increase the liability owed

An over-provision means that the estimate was too high. The double entry to record the
over-provision is:

Individual Account Category Explanation

DR Current Tax Payable Liability Reduce the liability owed

CR Income Tax Expense Expense Income Tax (Expense) decreased

As it is impossible to adjust figures in last year's SPLOCI, the difference is adjusted in

this year's tax charge.
3. Payment of Income Tax
The actual tax calculated will be paid. The double entry to record the income tax
payment is:

Individual Account Category Explanation

DR Current Tax Payable Liability Income Tax obligation is reversed

CR Bank Asset Income Tax payment reduces cash

 Example 2

Limo Co is a chauffeur company that drives the rich and famous to award ceremonies and film openings.
The financial statements for the year ended 31 December 20X9 have just been prepared and show a
profit for the year of $123,000. Limo Co has estimated the current tax charge for the year based on these
profits as $35,000.
In July 20X9, Limo Co settled the $32,000 tax liability for the year ended 31 December 20X8. In the
financial statements for the year ended 31 December 20X8, Limo Co had estimated a current tax charge
of $30,000.
Calculate Limo Co’s income tax expense for the year ended 31 December 20X9.
Income tax expense calculation for Limo
Co

Current tax estimate for the

year 35,000

Under provision from the prior

year 2,000

Income tax expense 37,000

Example 3

The directors of Jinx estimated the company's tax expense for 20X5 to be $300.

DR Income Tax Expense $300

CR Income Tax Payable $300

In 20X6, the final tax is calculated to be $330. The earlier tax estimate of $300 is understated by $30. The
understated tax needs to be posted to reflect the final tax.

DR Income Tax Expense $30

CR Income Tax Payable $30

 Example 3

Jinx pays the tax authorities its 20X5 tax bill of $330.

DR Income Tax Payable $330

CR Bank $330

Jinx estimates the tax expense for 20X6 to be $420. The tax liability at the year-end is $420. At year-end
20X6, the income tax estimate is recorded as follows:

DR Income Tax Expense $420

CR Income Tax Payable $420

The tax account shows this outcome:

DR Income Tax Payable (Liability) CR

Income Tax Expense

20X5 Balance c/d $300 20X5 (20X5 tax estimate) $300

$300 $300

20X6 Balance b/d (opening) $300

20X6 Bank $330 20X6 Income Tax Expense (Understated) $30

Income Tax Expense

20X6 Balance c/d $420 20X6 (20X6 tax estimate) $420

$750 $750

20X7 Balance b/d (opening) $420

DR Income Tax Expense CR

 Example 3

Income Tax Payable

20X6 (Understated) $30

Income Tax Payable Transfer to Profit

20X6 (20X6 tax estimate) $420 20X6 or Loss $450

$450 $450

The expense charge to the Statement of Profit or Loss for the year comprises of:

Current Tax Estimate for the year 420

Under/(Over) provision for previous year 30

Income Tax Expense 450

The total expense charge for the year ended 20X6 is $450.

2.4 Other Comprehensive Income

IAS 16 Property, Plant and Equipment provides a choice of treatment for property, plant
and equipment. The option is between:
• carrying an asset at cost minus accumulated depreciation and accumulated
impairment losses
• carrying an asset at fair value minus accumulated depreciation and
impairment losses.
When the option to carry an asset at fair value is taken, a revaluation is performed. The
revaluation of an asset records its fair value as follows:

Individual Account Category Explanation

DR NCA – Cost Asset Difference between fair value and cost

 DR NCA – Acc. Asset Remove the total acc. depreciation
Depreciation

CR Revaluation Surplus Equity Record the revaluation adjustment in the

equity account
In effect, the amount that goes to the revaluation surplus is the difference between the
fair value and the carrying amount or net book value of the asset.

Example 4

During the year ended 31 December 20X8, Atkorp Co decided to change the policy for the valuation of its
building to fair value, per IAS 16. The building cost $300,000 on 1 January 20X5 and is being depreciated
on a straight-line basis over a useful life of 50 years. An independent valuation valued the building at
$700,000 on 30 June 20X8.
Increase in Building Value:
The original cost of the asset is $300,000, and the fair value of the asset on 30 June 20X8 is $700,000, so
we will increase the cost account by the difference of $400,000 ($700,000 − $300,000). The building cost
account will then be renamed the building valuation account.
Accumulated Depreciation:
When a revaluation is recorded, the asset’s carrying amount or net book value must be calculated at the
valuation date, in this case, 30 June 20X8. The exact period from acquisition (1 January 20X5) to
valuation (30 June 20X8) must be established = 3.5 years.
The accumulated depreciation is ($300,000 ÷ 50 years) x 3.5 years = $21,000
Double Entry for the Revaluation:
This increases the value of the building in the statement of financial position to $700,000, clears the
accumulated depreciation account to zero and creates the revaluation surplus of $421,000.

DR Building cost $400,000

DR Building accumulated depreciation $21,000

CR Revaluation surplus $421,000

It is this revaluation surplus that is recognised as other comprehensive income in the Statement of Profit
or Loss and Other Comprehensive Income as follows:

Other comprehensive income:

Gain on revaluation of building 421,000

2.5 SPL&OCI – Disclosures

Disclosures are notes that provide more detailed information for the figures in the
statement of profit or loss and other comprehensive income. They help the users of the
financial statements understand the information presented to them.
The notes accompanying a sole trader statement of profit or loss would be minimal and
at the proprietor’s discretion.
For a company, the rules are stricter due to governance and legislation requirements.
The extent and nature of the disclosures required for a company will vary from country
to country.

2.5.1 Disclosure Requirements

IAS 1 Presentation of Financial Statements requires certain items to be disclosed on the
statement of profit or loss and other comprehensive income. The ones that are
examinable in your syllabus are shown below:
• Revenue – The income generated from the ordinary operating activities of an entity
• Finance Costs – The costs incurred from borrowings
• Share of profits and losses of associates
• Tax Expense – The tax on the profits for the year of a company.
• Components of other comprehensive income
Other items are specifically required to be disclosed by IAS 1. However, these items
can be shown on the SPL&OCI itself or in the notes to the financial statements. They
include:
• Write down of Inventory
• Write down and Disposals of property, plant and equipment
• Litigation settlements
• Other reversals of provisions
2.6 Sole Trader Statement of Profit or Loss

The trial balance is the primary source of information for preparing the statement of
profit or loss.
Each income and ledger account balance is closed off and transferred to the Profit or
Loss ledger account.
The individual balance of the Income and Expense ledger is transferred and presented
in the statement of profit or loss. The statement of profit or loss is the final product of the
accounting system.
 Example 5

The below shows the final trial balance of Cake Catering and the completed statement of profit or loss. Each
income and expense ledger account balance is transferred to the statement.

Cake Catering trial balance for the year ended 31 December 20X2

DR CR

$ $

Property at cost 145,250

Property – accum depn at 31 Dec 20X2 31,955

Motor vehicles at cost 25,420

Motor vehicles – accum depn at 31 Dec 20X2 9,785

Computer and office equipment – at cost 12,510

Computer and office equipment – acc. depn at 31 Dec 20X2 5,798

Shop fixtures and fittings – at cost 33,841

Shop fixtures and fittings - acc. depn at 31 Dec 20X2 11,463

Inventory – opening at 1 Jan 20X2 37,412

Receivables control account 35,091

Allowance for receivables at 31Dec 20X2 4,750

Prepayments at 31 Dec 20X2 8,450

Cash at bank 10,674

 Example 5

Capital account at 1 Jan 20X2 172,127

Drawings 25,410

Capital introduced 4,000

Bank loan 26,950

Provision at 31 Dec 20X2 800

Payables control account 36,741

Accruals at 31 Dec 20X2 6,610

Sales tax payable 1,473

Sales 608,989

Purchases 420,974

Rent 26,700

Wages 86,724

Finance cost 1,693

Telephone, postage and stationery 2,777

Other operating expenses 29,130

Depreciation expense 15,176

Irrecoverable debt expense 4,209

 Example 5

921,441 921,441

Note: the closing inventory of cake catering is $39,125

From the trial balance, each ledger balance is ticked off and slotted into the statement of profit or loss templat
below. The completed SPL will be as follows:

Cake Catering statement of profit or loss for the year ended 31 December 20X2

$ $

Sales 608,989

Costs of goods sold:

Opening inventory 37,412

Purchases 420,974

458,386

Less: Closing inventory 39,125

(419,261)

Gross profit 189,728

Expenses:

Rent 26,700

Wages 86,724

Finance cost 1,693

 Example 5

Telephone, postage and stationery 2,777

Other operating expenses 29,130

Depreciation expense 15,176

Irrecoverable debt expense 4,209

166,409

Net profit 23,319

2.7 Company Statement of Profit or Loss and Other

Comprehensive Income

Example 6

Blue Co is a company with a year-end of 31 December 20X8.

The following trial balance was extracted at that date:

DR CR

$ $

Opening inventory 236,400

Purchases 1,748,200

Purchase returns 5,330

Delivery cost on purchases 33,100

Revenue 2,957,000

Receivables 318,000
 Example 6

Wages and salaries 282,000

Accountancy fees 5,000

Distribution costs 347,250

Sundry administrative expenses 81,000

Allowance for receivables as at 1 January 20X8 18,200

Irrecoverable debts written off during the year 14,680

Office building cost 200,000

Accumulated depreciation – office building 1 January 20X8 20,000

Office equipment cost 70,000

Accumulated depreciation – office equipment 1 January 20X8 11,300

Payables 170,000

Finance cost paid 1,000

Bank overdraft 6,000

Advertising costs 2,000

Income tax expense 2,200

Share capital 40,000

Share premium 10,000

Retained earnings 1 January 20X8 103,000

3,340,830 3,340,830
Blue Co provides the following additional notes:
1. Closing inventory was valued per international accounting standards at $219,600.
o This figure will reduce the figure for the cost of sales and be recorded
in the statement of financial position.
2. Prepayments and accruals at year-end:
3. Prepayments Accruals
 Example 6

$ $

Office insurance 600

Finance cost 400

o There is a prepayment for office insurance to be adjusted through
administrative expenses and an accrual for finance costs. Both numbers will
need to be adjusted before being entered in the SPL&OCI.
The insurance prepayment of $600 is classified as Administrative Expense, and the
finance cost has its own line expense in the Statement of Profit or Loss.
4. Wages and salaries costs are to be allocated:
-cost of sales 10%

-distribution costs 20%

-administrative expenses 70%

o The amount paid for wages and salaries has been recorded in the trial
balance. This note details the cost allocation between the three main expense
categories. All three expense categories will need to be amended due to the
information given in the question.
The allocation is as follows:
Cost of Distribution Administrative
sales costs expenses

$ $ $

(282,000 ÷ 100) ×
10 28,200

(282,000 ÷ 100) ×
20 56,400

(282,000 ÷ 100) ×
70 197,400
5. Further irrecoverable debts totalling $8,000 are to be written off. Following a review of
receivables, the allowance for receivables should be increased by $4,000. These
adjustments are to be included in administrative expenses.
o There is an opening balance for the allowance at 1 January 20X8. The
trial balance must consider the allowance for the end of the year and
additional irrecoverable debt to be written off with instruction to include all the
resulting expenses in administrative expenses.
The additional irrecoverable debt is included as an Administrative Expense.
 Example 6

6. The office building was revalued on 1 January 20X8 to $300,000. On that date, the
office building is assessed to have a remaining useful life of 40 years. Depreciation of
the building is charged to distribution costs. The office equipment is being depreciated
on a reducing-balance basis at a rate of 20% and is to be charged to administrative
expenses.
o Revaluation: The office building is to be revalued at the beginning of
the year, which will create other comprehensive income for the SPLOCI and a
revaluation surplus for the statement of financial position. The revaluation
needs to be done before calculating depreciation for the office building.
The double entry is as follows:
$

DR Office building cost 100,000

DR Accumulated depreciation 20,000

CR Revaluation surplus 120,000

o Depreciation: The depreciation for both the office building and the
office equipment will create a depreciation charge for the year, to be allocated
to the expense categories as per instructions – office building to distribution
costs and office equipment to administrative expenses. These charges will
also increase the accumulated depreciation in the statement of financial
position.
Office Building depreciation charge is $300,000 ÷ 40 years = $7,500. The
double entry is DR Depreciation (Distribution Costs), CR Accumulated
Depreciation.
Office Equipment depreciation charge is (Cost $70,000 − Acc. Depr $11,300)
× 20% = $11,740. The double entry is DR Depreciation (Administrative
Expense), CR Accumulated Depreciation.
7. The current tax estimate for the year is $110,000. The figure in the trial balance for
income tax expense represents the under/over provision for the prior year.
o The current tax estimate is given as a note to the trial balance to be
adjusted. The balance for income tax in the trial balance needs to be adjusted
in the current year's income tax expense.
The additional expense of Blue Co is classified as below:
• Opening Inventory $236,400 – Cost of Sales
• Purchases $1,748,200 – Cost of Sales
• Purchase Returns $5,330 – Cost of Sales
• Delivery Cost on Purchases $33,100 – Cost of Sales
• Accountancy Fee $5,000 – Administrative Expense
• Distribution Costs $347,250 – Distribution Cost
• Sundry Administrative expenses $81,000 – Administrative Expense
• Advertising Cost $2,000 – Distribution Cost
 Example 6

The expenses table will be as follows once Blue Co’s different expense components have been
calculated:

Cost of Distribution Administrative

Sales Cost Expense

$ $ $

Opening Inventory 236,400

Purchases 1,748,200

Purchase Returns (5,330)

Delivery Cost on Purchases 33,100

Wages and Salaries 28,200 56,400 194,400

Accountancy Fee 5,000

Distribution Cost 347,250

Sundry administrative expenses 81,000

Irrecoverable debts written off

during the year 14,680

Advertising 2,000

Closing inventory (219,600)

Insurance prepayment (600)

Additional irrecoverable debt 8,000

Increase in allowance for

receivables 4,000

Depreciation:

Building (300,000 ÷ 40 years) 7,500

Equipment 20% × (70,000 –

11,300) 11,740

1,820,970 413,150 321,220

 Example 6

The closing inventory has been deducted from the cost of sales and will be recorded in current
assets in the statement of financial position.
Insurance prepayment is deducted from administrative expenses because it represents an
expense from future periods paid in the current year. Applying the accruals concept, it must be
removed from expenses in the SPLOCI and recognised as a prepayment in the statement of
financial position.
Finance Cost:
Interest paid on borrowings, usually called finance costs, is a combination of interest paid during
the year, as per the balance in the trial balance plus any adjustments for:
• accrued finance costs, which is any interest outstanding at year-end or
• prepaid finance costs, which is any interest paid in advance at year-end
The finance cost paid (from the trial balance) is $1,000, while it has been determined that there is
a finance cost accrual to be adjusted (note 2) of $400. The final finance cost is calculated as
follows:

Finance cost calculation:

Finance costs paid as per the trial balance 1,000

Accrued finance cost at the end of the year 4,00

Finance cost 1,400

The total finance cost of $1,400 will be recognised in the SPLOCI, and the accrued finance costs
will be recognised in current liabilities in the SFP.
Income Tax Expense:
The income tax (from the trial balance) is $2,200, while the current tax estimate for the year is
$110,000. The income tax expense is calculated as follows:

Income tax expense calculatin

Current tax estimate for the year 110,000

Under provision from the prior year 2,200

Income tax expense 112,200

The income tax expense of $112,200 will be recognised in the SPL&OCI, and the current tax
liability of $110,000 will be recognised in current liabilities in the Statement of Financial Position.
 Example 6

Blue Co’s statement of profit or loss and other comprehensive income for the year ended 31
December 20X8 is as follows:

Blue Co’s statement of profit or loss and

other comprehensive income for the year
ended 31 December 20X8

Revenue 2,957,000

Costs of sales (1,820,970)

Gross profit 1,136,030

Other income

Distribution costs (413,150)

Administrative expenses (321,220)

Other expenses

Finance costs (1,400)

Profit before tax 400,260

Income tax expense (112,200)

Profit for the year 288,060

Other comprehensive income:

Gains on property revaluation 120,000

Total comprehensive income for the year 408,060

 3.1 Introduction to the Statement of Financial Position

The "financial position" can be defined as a company's net worth (Assets less liabilities).
The statement of financial position is a statement of the book value or carrying
amount at a particular date of the entity, presenting its:
• Assets (resources controlled)
• Liabilities (obligations owed)
• owners' Capital or Equity (how to business is financed)
IAS 1 Presentation of Financial Statements states that the statement of financial
position is required to have the following items:
• Property, plant and equipment
• Intangible assets
• Inventories
• Trade and other receivables
• Cash and cash equivalents
• Trade and other payables
• Provisions
• Current tax liabilities
• Share capital and reserves
Like the statement of profit or loss and other comprehensive income, the statement of
financial position of a sole trader would be different from that of a limited company. The
sole trader's version of the SOFP follows the same principles but has more detail
presented and a different capital/equity section.

Example 7

This example shows the statement of financial position for a sole trader business and a company.

Sole Trader Statement of Financial Position

Cost Depreciation Carrying value

$ $ $

Non-current assets

Property X (X) X

Motor Vehicles X (X) X

X (X) X
 Example 7

Current assets

Inventories X

Receivables X

Less: allowance for receivables (X)

Prepayments X

Cash at bank and in hand X

Total assets X

Capital

Capital brought forward X

Profit for the year X

Less: drawings (X)

Non-current liabilities

Bank loan X

Current liabilities

Payables X

Other payables X

Overdraft X

X
 Example 7

Company Statement of Financial Position

Non-current assets

Property, plant and equipment X

Intangibles X

Current assets

Inventories X

Trade and other receivables X

Cash and cash equivalents X

Total assets X

Equity

Share capital X

Retained earnings X

Other reserves X

Non-current liabilities X

Current liabilities X

Total Equity and Liabilities X

• Non-Current Assets – Non-current assets are assets that have been purchased for use within
the business and will be used to generate profits for more than 12 months.
For a sole trader, each asset category is shown separately in the SOFP, with the cost,
depreciation (accumulated depreciation) and carrying amount broken down.
 Example 7

For a company, there will be one total for property, plant and equipment and one total for
intangibles, with the detail shown in the notes.
• Inventories – Inventory is the value of the goods that a business holds at a point in time for
sale to its customers or use in its manufacturing process. The detailed breakdown of inventory
is given in a note to the SOFP for a company.
A sole trader may show this breakdown in the SOFP itself. Inventory is always presented first in
current assets because it is the least liquid asset, followed by receivables and cash.
Liquid means how easily something is converted to cash. Inventory, for example, needs firstly to
be sold and then the cash collected. This is why it is considered the least liquid or hardest to
convert to cash.
• Receivables – The sole trader SOFP shows the receivables balance and the allowance for
receivables separately. It would also show any other receivables as separate lines, as with
prepayments here.
For a company, trade and other receivables are included as a single balance. Trade receivables
are the balances credit customers owe the business and the allowance against these balances.
Other receivables include prepayments and other income receivables such as bank interest or
rental income.
• Cash at Bank and in hand/ Cash and Cash Equivalents – For a sole trader, there will be a
bank account, and probably petty cash held within the business. The addition of a savings
account would probably be the extent of cash and bank balances.
A company may have various balances that would fall under the definition of cash and cash
equivalents (details in Chapter 'Statement of Cash Flow'). Still, a single balance will be included
in the SOFP and any details provided in the notes. An overdraft is never included within this
balance; it is shown separately in current liabilities.
• Capital brought forward/ Share Capital – The most significant difference between the SOFP
of a sole trader and that of a company is the capital (sole trader) or equity (company) section.
The sole trader version shows the breakdown of the capital brought forward from last year plus
profit for the year and less drawings taken during the year.
For a company, this is replaced with share capital, retained earnings and other reserves. Share
capital is always presented first, followed by reserves.
• Non-Current Liabilities – Non-current liabilities will be settled (paid) in more than 12 months.
They are longer-term liabilities such as loans.
For a sole trader, each liability will be shown in the SOFP.
A company will have loan capital and other non-current liability categories, such as provisions.
The detailed breakdown of these amounts will be disclosed in the notes.
• Current Liabilities – Current liabilities will be settled (paid) in less than 12 months. These
include any overdraft the business has, trade payables, and accruals.
The sole trader will show each balance on the SOFP, while a company will show one total and
the content disclosed in the notes.
3.2 Retained Earnings and Other Reserves

The main difference in the format of a SOFP for a sole trader and company is in the
capital or equity section.
The sole trader’s statement of financial position shows the breakdown of the capital
balance as capital brought forward + profit for the year – drawings taken in the year.
The single owner of the business owns the resulting closing balance.
However, a company may have many owners or ordinary shareholders rather than a
single owner. The amounts that they own are summarised in share capital and
reserves.

3.2.1 Reserves
Reserves are balances representing gains or losses belonging to the business owners.
They can be split into two types:
• Statutory reserves – These are reserves that a company must set up by law and are
not available to be distributed as dividends. For example, Share Premium.
• Non-Statutory reserves – These are made up of profits that can be distributed as
dividends. For instance, Retained Earnings.
These reserve balances are shown along with share capital in the equity section of the
statement of financial position.
• Retained Earnings
This is the main reserve of a business entity. It represents the accumulated
post-tax profits of an entity. Retained earnings are a distributable reserve
which can be used to pay a dividend to ordinary shareholders.
• Share Premium
A share premium account is created when new shares are issued at a price
above their par value. The share premium account is recognised as part of
capital. The share premium is a non-distributable reserve, meaning it cannot
be used to pay dividends. However, it can be used to fund a bonus issue of
shares.
• Revaluation Surplus
The increase in value of property, plant and equipment is recorded in the
revaluation surplus. This is considered an unrealised gain because the asset
has not been sold and is still held by the entity. The revaluation surplus is
recognised as part of capital and is a non-distributable reserve, which means
that it cannot be used to pay a dividend.
• Other Reserves
Other reserves can be created for various uses and in line with accounting
standards, but it is outside the scope of this course.
 3.2.2 Statement of Changes in Equity
Example 8

Tishla Co had the following balances at 1 January 20X8:

- Share capital $1 $10,000

- Share premium $3,000

Retained
- earnings $54,860

Revaluation
- surplus $6,000

Tishla Co made a profit of $12,800 for the year, recognised a revaluation surplus of $4,000 and paid a
dividend of $2,000. In addition, a 1-for-5 bonus issue of shares was made from the share premium
account.
The completed statement of changes in equity is as follows:

Share Share Revaluation Retained

capital premium surplus earnings Total

$ $ $ $ $

At 1 January 20X8 10,000 3,000 6,000 54,860 73,860

Dividends (2,000) (2,000)

Total comprehensive
income for the year 4,000 12,800 16,800

Issue of share capital 2,000 (2,000)

At 31 December 20X8 12,000 1,000 10,000 65,660 88,660

 3.3 SFP – Disclosures

3.3.1 Purpose of Disclosures

Disclosures in the statement of financial position are essential for the users of financial
statements to understand the financial information. The statement of financial position
produced for a company includes only the totals, and all the detail is given in the
disclosure notes.
The purpose of financial statements is to provide information about a business entity’s
financial position, financial performance and cash flows.
A full set of disclosures must be completed to do this and meet the qualitative
characteristic of understandability.
Disclosures are required for the following items under the statement of financial
position:
• Property, Plant and Equipment
• Intangible Assets
• Provisions
• Events after the Reporting Period
• Inventories
The specific requirements of the items above are explained in their chapters.

3.4 Sole Trader Statement of Financial Position

Similar to preparing the statement of profit or loss, the individual assets, liabilities and
capital ledger accounts from the final trial balance are transferred and presented in the
statement of financial position.
The statement of financial position is the final product of the accounting system.

Example 9

The below shows the final trial balance of Cake Catering and the completed statement of financial
position. Each asset, liability and capital ledger account balance is transferred to the statement.

Cake Catering trial balance for the year ended 31 December 20X2

DR CR

$ $
 Example 9

Property at cost 145,250

Property – accum depn at 31 Dec 20X2 31,955

Motor vehicles at cost 25,420

Motor vehicles – accum depn at 31 Dec 20X2 9,785

Computer and office equipment – at cost 12,510

Computer and office equipment – acc. depn at 31 Dec 20X2 5,798

Shop fixtures and fittings – at cost 33,841

Shop fixtures and fittings - acc. depn at 31 Dec 20X2 11,463

Inventory – opening at 1 Jan 20X2 37,412

Receivables control account 35,091

Allowance for receivables at 31Dec 20X2 4,750

Prepayments at 31 Dec 20X2 8,450

Cash at bank 10,674

Capital account at 1 Jan 20X2 172,127

Drawings 25,410

Capital introduced 4,000

Bank loan 26,950

 Example 9

Provision at 31 Dec 20X2 800

Payables control account 36,741

Accruals at 31 Dec 20X2 6,610

Sales tax payable 1,473

Sales 608,989

Purchases 420,974

Rent 26,700

Wages 86,724

Finance cost 1,693

Telephone, postage and stationery 2,777

Other operating expenses 29,130

Depreciation expense 15,176

Irrecoverable debt expense 4,209

921,441 921,441

Note: the closing inventory of cake catering is $39,125

From the trial balance, each ledger balance is ticked off and slotted into the statement of financial
position template below. The completed SFP will be as follows:

Cake Catering statement of financial position as at 31 December 20X2

 Example 9

$ $ $

Non-current assets Cost Depreciation NBV

Property 145,250 31,955 113,295

Motor Vehicles 25,420 9,785 15,635

Computer and office equipment 12,510 5,798 6,712

Shop fixtures and fittings 33,841 11,463 22,378

217,021 59,001 158,020

Current assets

Inventory 39,125

Receivables 35,091

Less: allowance for receivables (4,750)

30,341

Prepayments 8,450

Cash at bank and in hand 10,674

88,590

Total assets 246,610

Capital brought forward 172,127

 Example 9

Capital introduced 4,000

Profit for the year 23,319

Less: drawings (25,410)

174,036

Non-current liabilities

Bank loan 26,950

Current liabilities

provision 800

Payables 36,741

Accruals 6,610

Sales tax payable 1,473

45,624

246,610
 3.5 Company Statement of Financial Statement

Example 10

Blue Co is a company with a year-end of 31 December 20X8. The following trial balance was
extracted at that date:

DR CR

$ $

Opening inventory 236,400

Purchases 1,748,200

Purchase returns 5,330

Delivery cost on purchases 33,100

Revenue 2,957,000

Receivables 318,000

Wages and salaries 282,000

Accountancy fees 5,000

Distribution costs 347,250

Sundry administrative expenses 81,000

Allowance for receivables as at 1 January 20X8 18,200

Irrecoverable debts written off during the year 14,680

Office building cost 200,000

Accumulated depreciation – office building 1 January 20X8 20,000

Office equipment cost 70,000

Accumulated depreciation – office equipment 1 January 20X8 11,300

Payables 170,000

Finance cost paid 1,000

 Example 10

Bank overdraft 6,000

Advertising costs 2,000

Income tax expense 2,200

Share capital 40,000

Share premium 10,000

Retained earnings 1 January 20X8 103,000

3,340,830 3,340,830
The following additional notes are provided by Blue Co relevant to the SFP:
1. Closing inventory was valued per international accounting standards at $219,600.
2. Prepayments and accruals at year-end:
3. Prepayments accruals

$ $

Office insurance 600

Finance cost 600

4. Further irrecoverable debts totalling $8,000 are to be written off. Following a review of
receivables, the allowance for receivables should be increased by $4,000. These
adjustments are to be included in administrative expenses.
o The trade receivables balance of $318,000 is provided in the trial
balance. In note 4, there was an additional irrecoverable debt to write off of
$8,000. There is also an allowance for receivables on 1 January 20X8 that
needs to be adjusted in line with note 4 – an increase of $4,000.
The trade payables are calculated as follows:
$ $

Trade receivables per trial balance 318,000

Less: Additional irrecoverable debt (8,000)

310,000

Allowance at 1 January 20X8 18,200

 Example 10

Additional allowance 4,000

(22,200)

Trade receivables for SOFP 287,800

This final trade receivables balance will be recorded in the SOFP.
5. The office building was revalued on 1 January 20X8 to $300,000. On that date, the office
building is assessed to have a remaining useful life of 40 years. Depreciation of the
building is charged to distribution costs. The office equipment is being depreciated on a
reducing-balance basis at a rate of 20% and is to be charged to administrative expenses.
o The workings for the property, plant and equipment for Blue Co are as
follows:
o Office building Office equipment

$ $

Cost/Valuation

At 1January 20X8 200,000 70,000

Revaluations 100,000 0

At 31 December 20X8 300,000 70,000

Accumulated depreciation at 1 January 20X8 20,000 11,300

Revaluations (20,000)

Charge for the year 7,500 11,740

At 31 December 20X8 7,500 23,040

Carrying amount at 31 December 20X8 292,500 46,960

6. The carrying amount at 31 December 20X8 is recorded in the non-current assets section
of the statement of financial position.
In Example 6, income and expense items from the trial balance have been entered into the
statement of profit or loss. The remaining items from the trial balance are:
 Example 10

Asset Equity Liabilities

Closing inventory Share capital Bank overdraft

prepayment Share premium Accrued finance cost

Trade Payables

Current tax liability

Retained Earnings:
Opening Retained earnings $103,000 + Profit for the year $288,060 − Dividends paid $0 = Closing
Retained earnings $391,060
The closing retained earnings of $391,060 is recorded in the equity section of the statement of
financial position.
Blue Co’s statement of financial position for the year ended 31 December 20X8 is as follows:

Blue Co’s Statement of Financial Position

as at 31 December 20X8

$ $

Non-current assets

Office building 292,500

Office equipment 46,960

339,460

Current assets

Inventories 219,600

Trade receivables 287,800

Prepayment 600

508,000

847,460

Equity and reserves

 Example 10

Share capital 40,000

Share premium 10,000

Revaluation surplus 120,000

Retained earnings 391,060

561,060

Non-current liabilities -

Current liabilities

Payables 170,000

Bank overdraft 6,000

Accrued finance cost 400

Current tax liability 110,000

286,400

Total Equity and Liabilities 847,460

Syllabus Coverage

This chapter covers the following Learning Outcomes.

B. The Qualitative Characteristics of Financial Information

1. The qualitative characteristics of financial information
1. Define, understand and apply qualitative characteristics
2. Define, understand and apply accounting concepts

D. Recording Transactions and Events

4. Tangible non-current assets
1. Recognise the difference between current and non-current assets.
8. Receivables and payables
1. Classify items as current or non-current liabilities in the statement of financial
position.
10. Capital structure and finance costs
1. Identify the components of the statement of changes in equity.
G. Preparing Basic Financial Statements
1. Statements of financial position
1. Identify and report reserves in a company statement of financial position
2. Prepare a statement of financial position or extracts as applicable from given
information using accounting treatments as stipulated within sections D, E and
examinable documents.
2. Statements of profit or loss and other comprehensive income
1. Prepare a statement of profit or loss and other comprehensive income or extracts as
applicable from given information using accounting treatments as stipulated within
section D, E and examinable documents.
2. Understand how accounting concepts apply to revenue and expenses.
1. Disclose items of income and expenditure in the statement of profit or loss.
2. Record income tax in the statement of profit or loss of a company including the
under- and over-provision of tax in the prior year.
3. Understand the interrelationship between the statement of financial position and
statement of profit or loss and other comprehensive income.
4. Identify items requiring separate disclosure in the statement of comprehensive
income.
3. Disclosure notes
1. Explain the purpose of disclosure notes.
 CHAPTER 16: Visual Overview

Objective: To explain how information about historical changes in cash and cash
equivalents is presented in a separate financial statement which classifies cash flows
during the period between operating, investing and financing activities.

1.1 The Need to Control Cash Flow

Definition

The statement of cash flows is a primary statement that shows an overall view of the inflows and outflows of cash
over the period.
 Keeping control of cash is a vital task for managing a business, as running out of money
could lead the company to cease being a going concern.
The statement of cash flows shows how well the business's managers have performed
in controlling this aspect of the company.
Management needs to control cash flow for various reasons:
• to be able to make timely investment decisions for surplus funds
• to plan for and negotiate an overdraft or other borrowing facilities when needed
• to maintain good relations with suppliers of goods and services by meeting
obligations when they fall due
• to ensure funds are available to invest in new or replacement assets, to meet tax
obligations and to pay dividends to shareholders.

1.2 Cash Flows vs Profits

The statement of cash flows will differ from the statement of profit or loss as the latter is
prepared using the accruals concept.
For example, under the accruals concept, a business would record a credit sale of
goods to the statement of profit or loss as DR Receivables, CR Sales. However, the
company would not record the cash receipt in the statement of cash flows until the
customer pays, which may be in the next period.
Therefore, the profit and cash for a period can differ.
This also explains how a profitable business can go out of business. It may be making
sales, but if it is not getting cash in quickly enough, it could run short of the money it
needs to pay its expenses.
The points to remember are:
• Not all profitable companies are successful; Many fail due to a lack of cash.
• Profit or loss is based on the accruals concept and includes non-cash items. For
example, depreciation. The statement of cash flows only records cash movements.
• One of the primary functions of the statement of cash flows is to inform the users of
accounts whether the reported profits are being realised in terms of cash flows. It
also plays a vital role in identifying the availability of cash to:
o finance further investment and
o make dividend payments to shareholders.
Example 1

The effect of transactions on the cash flow is as follows:

1. Credit sale – The credit sale does not affect cash flows until the cash is received later.
2. Bad debt write-off – The bad debt write-off does not affect cash flows as it is a period-end adjustment.
3. Interest accrual – Interest Accruals do not affect cash flows until the cash receipt (interest receivables)
or cash payment (interest payables) is made later.
 Example 1

4. Purchase of plant and equipment – The purchase of plant and equipment will affect cash flows if the
purchase is financed with cash. If the plant and equipment are from a credit supplier, the cash flow is
only reflected when payment is made.
5. Property revaluation – Property revaluation is an accounting entry that does not affect cash flow.
6. Receipt from a debtor previously written off – A written-off debt was subsequently received. This is a
cash receipt and affects the cash flow of the business.
7. Proceeds from the sale of a motor vehicle – The proceeds are a cash item that affects the business’s
cash flow.
Activity 1

For each statement below, state whether they are true or false.
1. The statement of cash flows includes the cash receipt from the sale of a building.
2. The statement of cash flows only includes items that are not in the statement of profit
or loss.
3. The statement of cash flows should be prepared on an accruals basis.
*Please use the notes feature in the toolbar to help formulate your answer.
1. True. The cash receipt is included.
2. False. The statement of cash flows can include items that also impact the statement
of profit or loss.
3. False. The accruals basis is not appropriate for the statement of cash flows.
The statement of cash flows and statement of profit or loss may influence readers'
decisions.
Shareholders may estimate how much dividend they should be paid based on the profit
figure. As a result, the statement of cash flows may indicate that the business may
struggle to find the cash to pay a dividend and that shareholders will have to accept a
lower amount.
Anyone owed money by the business will be more interested in whether the company
has the cash to pay them back rather than the profits it is making.

1.3 IAS 7 Statement of Cash Flows

IAS 7 Statement of Cash Flows prescribes the guidelines for preparing and presenting
information in the statement of cash flows. The standard applies to all entities preparing
financial statements under IFRS.
Users of financial statements are interested in cash generation regardless of the nature
of the entity's activities.
Entities need cash for essentially the same reasons:
• to conduct operations
• to pay obligations and
• to provide returns to investors
1.4 Benefits and Drawbacks

1.4.1 Benefits of the Statement of Cash Flows

The benefits of the statement of cash flows to the users of financial statement are:
• It provides information that enables users to evaluate:
o changes in net assets
o financial structure (including its liquidity and solvency)
o ability to affect amounts and timing of cash flows (to adapt to
changing circumstances and opportunities).
• It is useful in assessing the ability to generate cash and cash equivalents.
• Users can develop models to assess and compare the present value of future cash
flows of different entities.
• It enhances the comparability of reporting operating performance by different entities
(by eliminating the effects of alternative accounting bases).
• Historical cash flow information may indicate the amount, timing and certainty of
future cash flows.

1.4.2 Drawbacks of the Statement of Cash Flows

The drawbacks of the statement of cash flows to the users of financial statements are:
• Similarly to other financial statements, the cash flow information relates to past
performance.
• As it is a "snapshot" of the cash position at the reporting date, it may be managed
(For example, by deferring payments to the next accounting period).
• Some lack of comparability may arise (For example, due to a choice between direct
and indirect methods and alternative classifications of dividends).
• It may be misinterpreted. For example, a net decrease in cash and cash equivalents
may be assumed to indicate poor cash management.
• Highlighting a weak cash flow position may precipitate going concern problems.
2.1 Main Elements of the Statement of Cash Flows

The statement of cash flows highlights the cash movements based on the business’s
operating, investing, and financing activities.
• Operating activities – includes principal revenue-producing activities and other
activities that are not investing or financing activities.
• Investing activities – includes acquisition and disposal of long-term assets and
other investments not included in cash equivalents.
• Financing activities – results in changes in the size and composition of equity
capital and borrowings.
Examples of cash inflows and outflows across the three activities include the following:

TRANSACTIONS CFO CFI CFF

Cash Flows From Operations

1. Cash receipts from sale of goods/ rendering services x

2. Cash receipts from royalties, fees and commissions x

3. Cash payments to suppliers for goods/ services@ x

4. Cash payments to and on behalf of employees (e.g. pension

contributions) x

Non-current Asset Transaction

5. Payments to acquire/receipts from sales of property, plant and

equipment, intangibles x

6. Payments to acquire/receipts from sales of shares, loan notes, etc of

other entities x

7. Cash advances and loans made to other parties and repayments

thereof x

Non-current Liabilities and Equity Transactions

8. Cash proceeds from issuing shares/equity instruments x

9. Cash proceeds from loans and other short-term or long-term

borrowings x

10. Cash payments to owners to acquire or redeem own (i.e. the entity's)
shares x

11. Cash repayments of borrowings x

Dividends and Interest (Note)

12. Interest paid

 • when recognised as an expense or capitalised (e.g. cost of
constructing an asset) x x
• when it is a cost of obtaining financial resources

13. Interest and dividends received

• when taken into account of in the determination of profit or

loss x x
• when they are returns on investments

14. Dividends paid

• when a cost of obtaining financial resources

• when of assistance in assessing the company's ability to pay x x
dividends out of operating cash
Note: Management has discretion in classifying these cash flows as either CFO, CFI or
CFF as appropriate.
Key Point

Cash flows from interest and dividends received and paid should be disclosed separately and
classified consistently from one period to another.

2.1.1 Cash and Cash Equivalents

Cash is cash on hand and deposits. Cash equivalents are short-term (less than three
months), highly liquid investments that are:
• readily convertible to known amounts of cash
• subject to an insignificant risk of changes in value.
• Where bank overdrafts are repayable on demand and form an integral part of cash
management (For example, where the balance fluctuates from positive to
overdrawn), they are included in cash and cash equivalents.
• Cash flows exclude transfers between cash/cash equivalents because these are an
aspect of cash management rather than operating, investing, or financing activities.
Example 2

Jesstika Co is a food processing company and has prepared its statement of cash
flows for the year ended 31 December 20x6.

Jesstika Co’s statement of cash flows for the year ended 31 December 20x6

$’000 $’000
Cash flows from operating activities

Cash generated from operations 2,070

Interest paid (155)

Tax paid (375)

Net cash from operating activities 1,540

Cash flows from investing activities

Payments to acquire non-current assets (1,228)

Proceeds from sale of non-current assets 105

Interest received 84

Dividends received 162

Net cash from investing activities (877)

Cash flows from financing activities

Proceeds from issue of share capital 500

Repayment of loans (350)

Dividends paid (160)

Net cash from financing activities (10)

Net movement in cash and cash equivalents 653

Cash and cash equivalents at beginning of period 128

 Cash and cash equivalents at end of period 781

• Title – The statement of cash flows is broken down between operating, investing
and financing activities so readers can assess the impact of different cash flows
on Jesstika's cash and cash equivalents.
• Cash flows from operating activities – The cash flows that Jesstika generates
from its food processing operations sustain the business.
Surplus operating cash flows mean Jesstika has the funds to buy the non-
current assets it needs to develop its business, such as better equipment.
Jesstika can also use surplus operating cash flows to pay interest to loan
finance providers, repay loans, and pay dividends to shareholders.
• Cash flows from investing activities – Cash flows from investing activities show
how much Jesstika has invested in assets it expects to hold for the long term.
These investments should generate operating cash flows in future years.
• Cash flows from financing activities – Cash flows from financing activities show
the finance that Jesstika has received from or paid back to finance providers. The
finance Jesstika has received will result in interest or dividend payments in future.
• Net movement in cash and cash equivalents – This is the sum of the
movements in the three categories. This should be the same as the movement in
cash and cash equivalents figures included in Jesstika's statement of financial
position between 20x5 and 20x6. Cash will include cash held at Jesstika's
premises and balances held at the bank. It includes the bank overdraft but not a
bank loan. Cash equivalents are short-term, ready-to-trade investments that
Jesstika can easily convert into cash and will not change significantly over time.
• Cash and cash equivalents at end of period – Cash and cash
equivalents at the end of the period are the sum of the cash and bank
overdraft figures included in Jesstika's statement of financial position for the
year ended 31 December 20X6.

2.2 Operating Activities

Operating activities can be determined using the indirect or direct method.

2.2.2 Direct Method

The direct method highlights the primary cash receipt and payment classes to derive the
net cash flows from operating activities.

Technique Calculation

1. Cash receipts from customers. Cash receipts from customers

2. Deduct cash paid to suppliers and employees. • cash paid to suppliers

• cash paid to employees
 → Cash generated from operations → Cash generated from operations

3. Payments for interest and income taxes. • payments for interest

• income taxes paid

→ Net cash from operating activities → Net cash from operating activities

Operating activities are the core business activities of the business. The below are
elements that make up the cash flows from operating activities in the statement of cash
flows:
1. Cash receipts from customers
Cash receipts from customers are the most crucial source of business income. The
total cash receipts from customers = Opening trade receivables + Sales – Closing
trade receivables
2. Cash paid to suppliers
Businesses are not able to operate if it does not keep up their cash payments to
suppliers. The total cash paid to suppliers = Opening trade payables + Purchases –
Closing trade payables
3. Cash paid to employees
The business will not be able to function without its employees; hence, payments to
them are categorised as cash flows from operating activities. The total cash paid to
employees = Amount owed to employees at the start of the period + Wages and
salaries expenses − Amount owed to employees at the end of the period
4. Interest paid
Interest paid is included as a separate item after cash generated from operations.
The total interest paid = Opening interest payable + Interest charge − Closing
interest payables
5. Tax paid
Tax paid is included as a separate item after cash generated from operations. The
total tax paid = Opening tax payables + Tax charge − Closing tax payables

Example 3

Jesstika Co is the food processing company that prepared the statement of cash
flows for 20X6 as seen in Example 2.
In 20X7, Jesstika Co had the following transactions as part of its operations:
1. Sales revenue for 20X7 was $7,260,000. Receivables at the start of 20X7 were
$735,000 and at the end of 20X7 were $790,000.
2. Purchases for 20X7 were $3,740,000. Jesstika Co owed its suppliers $385,000 at
the start of 20X7 and $410,000 at the end of 20X7.
3. Jesstika Co had an accrual for wages and salaries at the start of 20X7 of
$105,000 and an accrual at the end of 20X7 of $120,000.
 The charge for wages and salaries in the statement of profit or loss was
$1,160,000.
4. Jesstika Co paid interest of $165,000 on its bank loan in 20X7.
5. It paid $415,000 to the tax authorities during 20X7.
The direct method is used to calculate Jesstika Co’s operating cash flows for 31
December 20X7 as follows:

Jesstika Co statement of cash flows for the year

ended 31 December 20X7

$’000

Cash receipts from customers 7,205

Cash paid to suppliers (3,715)

Cash paid to employees (1,145)

Cash generated from operations 2,345

Interest paid (165)

Tax paid (415)

Net cash from operating activities 1,765

• Cash receipts from customers is Opening receivables $7,260 + Sales $735 −

Closing receivables $790 = $7,205
• Cash paid to suppliers is Opening payables $3,740 + Purchases $385 − Closing
payables $410 = $3,715
• Cash paid to employees is Opening accrual $1,160 + Wages and salaries
expense $105 − Closing accrual $120 = $1,145
• Cash generated from operations is the subtotal of the cash receipt from customers
$7,205, cash paid to suppliers ($3,715) and cash paid to employees ($1,145) =
$2,345
• The interest paid is given in the scenario description
• The tax paid is given in the scenario description
• Net cash from operating activities is the sum of the cash generated from
operations $2,345, interest paid ($165) and tax paid ($415) = 1,765
In example 2, the net cash from operating activities of $1,540 in 20X6 is compared to
the current year of $1,765. This indicates that Jesstika Co has generated more cash
from operations in 20X7.
 Note: All amounts above are in the thousands (‘000).

Activity 2

Jesstika Co has the following information concerning its cash flows for operating
activities for the year ended 31 December 20X9:
1. Jesstika Co's sales for the year ended 31 December 20X9 were $7,680,000, and its
purchases were $4,275,000.
2. Its customers owed Jesstika Co $820,000 at the start of 20X9 and $805,000 at the
end of 20X9.
3. It owed its suppliers $470,000 at the end of 20X9, a $40,000 increase from what it
owed at the start of the year.
4. It owed its employees $140,000 at the start of 20X9 and $155,000 at the end of
20X9, with wages and salaries of $1,230,000 included in the statement of profit or
loss for wages and salaries.
5. Jesstika Co paid interest of $185,000 during 20X9 and tax of $440,000.
Calculate the net cash from operating activities for Jesstika Co for 20X9.
$’000

Cash flows from operating activities

Cash receipts from customers

Cash paid to suppliers

Cash paid to employees

Cash generated from operations

Interest paid

Tax paid

Net cash from operating activities

*Please use the notes feature in the toolbar to help formulate your answer.

$’000

Cash flows from operating activities

 Cash receipts from customers 7,695

Cash paid to suppliers (4,235)

Cash paid to employees (1,215)

Cash generated from operations 2,245

Interest paid (185)

Tax paid (440)

Net cash from operating activities 1,620

Cash receipts from customers: $7,680 + $820 − $805 = $7,695

Cash paid to suppliers: $4,275 + ($470 − $40) − $470 = $4,235
Cash paid to employees: $1,230 + $140 − $155 = $1,215
2.2.3 Indirect Method
The indirect method adjusts profit or loss for the effects of:
• Non-cash transactions
• Any deferrals or accruals of past or future operating cash receipts or payments
• Items of income or expense associated with investing or financing cash flows
Technique Calculation

1. Start with profit before tax. Profit before tax

2. Adjust for non-cash items, investing items, and

financing items accounted for on the accruals basis + non-cash expenses/losses
(e.g. interest). − non-cash income/gains

→ Operating profit before working

→ Operating profit before working capital changes capital changes

+ increases/(decreases) in
operating liabilities/(assets)
− increases/(decreases) in
3. Make working capital changes. operating assets/(liabilities)

→ Cash generated from operations → Cash generated from operations

Non-cash transactions that need to be adjusted from the profit before tax figure are:
1. Depreciation
The depreciation charge included in profit before tax is not a cash movement.
Therefore, it is added back to the profit before tax figure.
2. Profit on sale of NCA
The profit on the sale of non-current assets is not a cash movement. Therefore, the
profit on NCA sale is deducted from profit before tax.
A loss on NCA sale is added back to profit before tax.
3. Investment income and Interest charge
Investing income is a cash item. However, the investment income amount is
deducted from the profit amount as it needs to be included in the investing activities
section of the Statement of Cash Flows.
Similarly, an interest charge is a cash item. The interest charged is added to the
profit figure as interest paid is reported as a separate line item under the operating
activities section of the statement of cash flows.
4. Inventories
The profit before tax amount is adjusted for the change in the level of inventories
over the period. An increase in inventories is deducted from the profit figure as the
business has spent more cash on inventories.
A decrease in inventory level is added back to the profit figure.
5. Receivables
The profit before tax amount is adjusted for the change in the level of receivables
over the period. An increase in the level of receivables is deducted from the profit
figure as the business has more cash owed from its customers.
A decrease is added back to the profit figure.
6. Payables
The profit before tax amount is adjusted for the change in the level of payables over
the period. An increase in payables is added to the profit figure as suppliers have
allowed the business to keep more cash (not pay it to them).
A decrease is deducted from the profit figure.
Activity 3

Below are adjustments to the profit figure in the statement of profit or loss to calculate
cash flow from operating activities.
To calculate the cash flow from operating activities using the indirect method,
state whether the adjustments should be added or deducted from the profit.
1. Investment Income
2. Depreciation
3. Decrease in inventory
 4. Increase in receivables
5. Loss on sale of NCA
6. Decrease in payables
7. Interest charge
*Please use the notes feature in the toolbar to help formulate your answer.

Add Deduct

Depreciation Investment income

Decrease in inventories Increase in receivables

Loss on sale of non-current assets Decrease in payables

Interest charge

Example 4

Lishades Co is a food processing company which uses the indirect method

to prepare its statement of cash flows. Lishades Co prepares its accounts to
31 December each year. The following figures were included in its statement
of financial position for 20X6 and 20X7.

20X7 20X6

$’000 $’000

Inventories 650 675

Receivables 930 870

payables 575 530

The following figures were included in Lishades Co's statement of profit or

loss for the year ended 31 December 20X7.

$ '000

Depreciation 345
 Profit on sale of non-current assets 230

Dividend income received 40

Interest charge 225

Profit before tax 925

Tax Paid 185

The indirect method is used to calculate Lishades Co’s operating cash flows
for 31 December 20X7 as follows:

Lishades Co’s Statement of Cash Flows for the

year ended 31 December 20X7

$ 000

Profit before tax 925

Depreciation 345

Profit on sale of non-current assets (230)

Investment income (40)

Interest charge 225

Decrease in inventories 25

Increase in receivables (60)

Increase in payables 45
 Cash generated from operations 1,235

Interest Paid (225)

Tax Paid (185)

Net cash from operating activities 825

• Profit before tax – The indirect method of calculating cash flows from
operating activities starts with the profit before tax figure. Since the profit
is before tax, we know that interest payment is included in the profit
figure and should be added back. However, if the profit figure given is
profit before interest and tax, the adjustment is unnecessary.
• Depreciation is added to the profit figure.
• The profit on the sale of NCA is deducted from the calculation. (If it had
been a loss on the sale, the loss amount is added).
• Investment income is deducted because it does not belong in the
operating activities section of the statement of cash flows.
• The interest charge is added to the profit figure.
• The decrease in inventories is added as less cash is invested in
inventories.
• The increase in receivables is deducted as more cash is tied up in
receivables.
• The increase in payables is added as cash not yet paid to suppliers has
increased.
• Cash generated from operations is the total of the figures above it.
• The interest and tax paid are displayed as separate line items in the
statement of cash flows operating activities section
• The cash generated from operations and the net cash from operating
activities should have the same amount as if calculated using the direct
method.
Activity 4

The following figures were included in the statements of financial position for Lishades
Co at 31 December 20X8 and 20X9.

20X9 20X8

$ '000 $ '000

Inventories 640 635

 Receivables 980 970

Payables 580 615

The following figures were included in Lishades Co's statement of profit or loss for the
year ended 31 December 20X9.

$ '000

Depreciation 390

Loss on sale of non-current assets 30

Dividend income received 50

Interest charge 195

Profit before tax 970

Interest paid during 20X9 was $215,000, and tax paid was $290,000.
Prepare the net cash flows from operating activities of Lishades for the year
ended 31 December 20X9.
Lishades Co’s Statement of Cash Flows for the year
ended 31 December 20X9

$ '000

Cash flows from operating activities

Profit before tax

Depreciation

Loss on sale of non-current assets

 Investment income

Interest charge

Operating profit before working capital changes

Inventories

Receivables

Payables

Cash generated from operations

Interest paid

Tax paid

Net cash from operating activities

*Please use the notes feature in the toolbar to help formulate your answer.

$ '000

Cash flows from operating activities

Profit before tax 970

Depreciation 390

Loss on sale of non-current assets 30

Investment income (50)

Interest charge 195

 Operating profit before working capital changes 1,535

Inventories (5)

Receivables (10)

Payables (35)

Cash generated from operations 1,485

Interest paid (215)

Tax paid (290)

Net cash from operating activities 980

The increase in inventory is deducted: $640 − $635 = $5

The increase in receivables is deducted: $980 − $970 = $10
The decrease in payables is deducted: $580 − $615 = ($35)
2.3 Investing Activities

2.3.1 Components of Cash Flows from Investing Activities

1. Payment to Purchase NCA
Payments to acquire non-current assets may be cash outflow in the Statement of
Cash Flows. The total NCA acquisition payment = Closing NCA − Opening NCA +
Depreciation + Carrying value of NCA sold
2. Proceeds from the sale of NCA
Proceeds from NCA sale are cash inflows. The investing activities section records
the actual proceeds, not the profit or loss from the sale. The total proceeds = Cost −
Accumulated depreciation + Profit/(Loss) on sale
3. Investments
Investments in other businesses are cash outflows. The proceeds from the sale of
investments are cash inflows. The investments could be in the form of shares in, or
loans to, other businesses.
4. Interest Received
Interest received on investments is a cash inflow of the business. The interest
received may differ from the amounts shown in the statement of profit or loss
because interest is credited at the end of a period that may not be the same as the
accounting date.
 5. Dividends Received
Dividends received from share investments are cash inflows of the business.

Example 5

In 20X7, Jesstika Co has the following investing activities:

• Jesstika Co purchased new equipment for $540,000. In addition, it sold old equipment and motor
vehicles that had originally cost $350,000 for a profit of $45,000. These assets had accumulated
depreciation of $200,000.
• Jesstika Co paid $1.50 per share for 500,000 $0.50 shares in one of its suppliers, Wangravi Co.
Jesstika Co received a dividend from Wangravi Co of $27,000 in September 20X7 and another
dividend relating to 20X7 of $29,000 in February 20X8.
• Jesstika Co received annual interest on its investment account at the bank of $65,000 in August
20X7.
Jesstika Co’s investing cash flows for 31 December 20X7 are as follows:

Jesstika Co Statement of Cash Flows for the year ended 31 December 20X7

$ '000

Payments to acquire tangible non-current assets (540)

Proceeds from sale of tangible non-current assets 195

Purchase of shares (750)

Interest received 65

Dividends received 27

Net cash from investing activities (1,003)

• The purchase of tangible non-current assets is a cash outflow. If Jesstika Co had paid for these
assets using instalments, only the instalments paid during 20X7 would be included in the statement,
not the full amount.
• The cash receipt from the sale of tangible non-current assets is a cash inflow. It is calculated as Cost
$350 − Acc. Depr $200 + Profit $45 = $195
• The purchase of shares is a cash outflow. The amount paid is 500 shares × $1.50 = $750. The
share‘s par value of $0.50 is irrelevant.
• Interest received is the actual cash inflow, not the accrual amount.
 Example 5

• Even though the dividend received of $29,000 relates to 20X7, it is not included because it is not
paid until 20X8. The statement of cash flows records the actual cash movement of the business.
• The net cash from investing activities is in an outflow position and is likely to vary significantly
between years, depending on the strategic decisions made by Jesstika Co's directors.
Activity 5

In 20X9, Jesstika Co's purchases of tangible non-current assets were $740,000. The
depreciation charge for the year on these assets was $135,000.
Jesstika Co sold tangible non-current assets with a net realisable value of $210,000 for
a loss of $25,000.
Jesstika Co received a dividend of $21,000 in April 20X9 from its investment in
Wangravi.
In October 20X8, Jessika Co switched its bank investment account. Interest on this
account is paid twice yearly, relating to balances held during the previous six months.
Jesstika Co received interest relating to balances held during 20X9 of $42,000 in April
20X9, $46,000 in October 20X9 and $51,000 in April 20Y0.
Calculate the net cash from investing activities for Jesstika Co for 20X9.
Cash flows from investing activities $ '000

Payments to acquire tangible non-current assets

Proceeds from sale of tangible non-current assets

Interest received

Dividends received

Net cash used in investing activities

*Please use the notes feature in the toolbar to help formulate your answer.

Cash flows from investing activities $’000

Payments to acquire tangible non-current assets (740)

 Proceeds from sale of tangible non-current assets 185

Interest received 88

Dividends received 21

Net cash from investing activities (446)

The depreciation charge is irrelevant in calculating payments to acquire tangible non-

current assets.
The proceeds from sale of tangible non-current assets = NRV $210 − Loss $25 = $185
The interest received in 20X9 is $42 + $46 = $88 is included. There is no accrual.
2.4 Financing Activities

2.4.1 Components of Cash Flows from Financing Activities

1. Share Capital
The proceeds from the share capital are cash inflows. The par value of the shares
issued is not relevant. The proceeds of rights issues are also cash inflows.
Bonus issues are not included because they do not involve a cash receipt.
2. Loans/ Borrowings
Cash received from loans and borrowings is a cash inflow, while the repayment of
the loans is a cash outflow.
Note that interest on loans is recorded separately (in operating activities).
Watch out for questions that give a split of payments between interest and
repayment of loans (known as capital repayment).
3. Dividends Paid
Dividends paid are cash outflows as they are an appropriation of profit by
shareholders and, therefore, a withdrawal of capital from the business.
Large cash outflows from investing activities may match large cash inflows from
financing activities because new fund sources finance new investments. Therefore,
it is essential to compare all the components of the statement of cash flows and not
each section individually.

Example 6

In 20X7, Jesstika Co has the following financing activities:

• At the start of 20X7, Jesstika Co had 1.5 million $1 shares in issue.
• In November 20X7, it made a rights issue of one new share for three currently held for $2 per share.
 Example 6

• It paid a dividend of $150,000 relating to 20X6 in March 20X7 and proposed a dividend of $180,000
relating to 20X7 in December 20X7.
• At the start of 20X7, Jesstika Co had $1 million in long-term loans owing and repaid $300,000 of one
loan in June 20X7. At the end of the year, Jesstika Co had $1.2 million in long-term loans owing.
Jesstika Co’s financing cash flows for 31 December 20X7 are as follows:

Jesstika Co Statement of Cash Flows for the

year ended 31 December 20X7

$ 000

Proceeds from issue of share capital 1,000

Proceeds from loans 500

Repayment of loans (300)

Dividends paid (150)

Net cash from financing activities 1,050

• Proceeds from issue of share capital is $1,500 × 1/3 × $2 = $1,000

• Proceeds from loans is Closing $1,200 − Opening $1,000 + Repayment during the year $300 = $500
• The amount of loan repayment is given in the scenario.
• Even though the dividends paid relate to 20X6, it is paid in March 20X7. The statement of cash flows
records the actual cash movement of the business.
Jesstika Co‘s outflows from investing activities of $1,003 (Example 5) can be compared to the inflows
from financing activities of $1,050 which nearly offset each other.
Jesstika Co's completed statement of cash flows for the year ended 31 December 20X7 is as follows
once each element of the cash flows have been calculated:

Jesstika Co's Statement of Cash Flows for the year ended 31

December 20X7

$ '000 $ '000

Cash flows from operating activities

 Example 6

Cash generated from operations 2,345

Interest paid (165)

Tax paid (415)

Net cash from operating activities 1,765

Cash flows from investing activities

Payments to acquire non-current assets (540)

Proceeds from sale of non-current assets 195

Purchase of shares (750)

Interest received 65

Dividends received 27

Net cash from investing activities (1,003)

Cash flows from financing activities

Proceeds from issue of share capital 1,000

Proceeds from loans 500

Repayment of loans (300)

Dividends paid (150)

Net cash from financing activities 1,050

 Example 6

Net movement in cash and cash equivalents 1,812

Cash and cash equivalents at beginning of period 781

Cash and cash equivalents at end of period 2,593

Reviewing this Statement of Cash Flows for 20X7, Jesstika Co had strong positive operating cash flows
in 20X7. Jesstika Co has used new sources of finance to fund investments in 20X7, but because it now
has significant cash surpluses, it may use these as part of the funding of future investments.

Activity 6

In January 20X9, Jesstika Co had two million $1 shares in issue.

In May 20X9, it made a bonus issue of one new share for four shares currently held.
It paid a dividend of $160,000 relating to 20X8 in April 20X9 and proposed a dividend of
$190,000 relating to 20X9 at the end of 20X9.
At the start of 20X9, Jesstika Co had $1.2 million in long-term loans owing and took out
a new loan during 20X9 for $200,000. At the end of the year, Jesstika Co had $950,000
in long-term loans owing.
Calculate the net cash from financing activities for Jesstika Co for 20X9 using the
information provided.
Cash flows from financing activities $ '000

Proceeds from issue of share capital

Proceeds from loans

Repayment of loans

Dividends paid

Net cash from financing activities

*Please use the notes feature in the toolbar to help formulate your answer.
 Cash flows from financing activities $ 000

Proceeds from issue of share capital -

Proceeds from loans 200

Repayment of loans (450)

Dividends paid (160)

Net cash from financing activities (410)

In calculating the proceeds from the issue of share capital, bonus issues are not
considered as it does not involve any cash movement.
Repayment of loans = Opening $1,200 + 2019 New loans $200 − Closing $950 = $450
Only the dividends paid in 20X9 are included, not the dividend proposed at the end of
the year.
Activity 7

Harmlu Co. has prepared its Statement of Profit or Loss and its Statement of Financial
Position for the year ended 31 March 20X5.
Harmlu Co's has the following information:
• Depreciation expense for the year was $12,467,000.
• Assets with a carrying amount of $3,740,000 were disposed of at a loss of $186,000.
• The company did not take out any new loans during the year.
Extracts from the Statement of Profit or Loss for the
year ended 31 March 20X5

$’000

Revenue 56,755

Cost of sales (32,959)

Gross profit 23,796

Other operating expenses (8,946)

Profit before tax 14,850

Less tax (4,967)

Profit for the year 9,883

Statement of financial position as at 31 March

20X5 20X4

Non-current assets 71,166 64,325

Current assets

Inventory 14,743 11,892

Receivables 15,678 16,754

Cash 1,234 1,651

Total assets 102,821 94,622

Equity and liabilities

Capital and reserves

Ordinary share capital 15,000 12,000

Retained earnings 55,198 45,315

70,198 57,315

Non-current liabilities

Loan 12,000 14,000

Current liabilities
 Bank overdraft 850 2,467

Trade payables 14,806 17,656

Taxation 4,967 3,184

20,623 23,307

Total equity and liabilities 102,821 94,622

Complete the Statement of Cash Flows for the year ended 31 March 20X5 for
Harmlu Co.
Harmlu Co Statement of Cash Flows
for the year ended 31 March 20X5

$'000 $'000

Cash flows from operating activities:

Depreciation

Loss on disposal of non-current assets

Inventory

Receivables

Trade payables

Cash generated from operations

Tax paid

Net cash from operating activities

 Cash flows from investing activities:

Payments to acquire non-current assets

Proceeds from sale of non-current assets

Net cash from investing activities

Cash flows from financing activities:

Proceeds from issue of share capital

Repayment of loans

Net cash from financing activities

Net movement in cash and cash equivalents

Cash and cash equivalents at beginning of period

Cash and cash equivalents at end of period

*Please use the notes feature in the toolbar to help formulate your answer.

Harmlu Co Statement of Cash Flows

for the year ended 31 March 20X5

$'000 $'000

Cash flows from operating activities:

Profit Before Tax 14,850

Depreciation 12,467

Loss on disposal of non-current assets 186

Inventory (2,851)

Receivables 1,076

Trade payables (2,850)

Cash generated from operations 22,878

Tax paid (3,184 + 4,967 − 4,967) (3,184)

Net cash from operating activities 19,694

Cash flows from investing activities:

Payments to acquire non-current assets (Cl. 71,166 − (23,048)

Op. 64,325 + Depr 12,467 + NRV of NCA sold 3,740)

Proceeds from sale of non-current assets 3,554

(Carrying value 3,740 − Loss 186)

Net cash from investing activities (19,494)

Cash flows from financing activities:

Proceeds from issue of share capital (15,000 − 12,000) 3,000

Repayment of loans (14,000 − 12,000) (2,000)

 Net cash from financing activities 1,000

Net movement in cash and cash equivalents 1,200

Cash and cash equivalents at beginning of period (816)

(20X4 cash 1,651 − Bank overdraft 2,467)

Cash and cash equivalents at end of period 384

(20X5 cash 1,234 − Bank overdraft 850)

Activity 8

Anjul Co has prepared its statement of profit or loss and its statement of financial
position for the year ended 30 June 20X6.
Anjul Co has the following information:
• Non-current asset purchases for the year were $16,784,000.
• Assets with original cost of $3,120,000 and accumulated depreciation of $2,243,000
were disposed of at a profit of $224,000.
• Interest and tax paid were the same as the figures in the statement of profit or loss.
• Anjul paid a dividend of $1 million during the year.
• Anjul Co did not take out any new loans during the year.
Extracts from the Statement of Profit or Loss for the year ended 30 June 20X6

$’000

Profit before interest and tax 8,456

Interest (823)

Profit before tax 7,633

Tax (2,134)

Profit after tax 5,499

Statement of financial position as at 30 June

 20X6 20X5

Non-current assets 53,548 47,897

Current assets

Inventory 9,092 8,126

Receivables 10,872 9,786

Cash 1,786 4,930

Total assets 75,298 70,739

Equity and liabilities

Capital and reserves

Ordinary share capital 10,000 10,000

Retained earnings 38,893 34,394

48,893 44,394

Non-current liabilities

Loan 12,000 14,000

Current liabilities

Bank overdraft 1,085 0

Trade payables 13,320 12,345

14,405 12,345
 Total equity and liabilities 75,298 70,739

Prepare a Statement of Cash Flows for the year ended 30 June 20X6 for Anjul Co.
Anjul Co Statement of Cash Flows
for the year ended 30 June 20X6

$'000 $'000

Cash flows from operating activities:

Profit before tax

Depreciation

Loss on disposal of non-current assets

Interest charge

Inventory

Receivables

Trade payables

Cash generated from operations

Interest paid

Tax paid

Net cash from operating activities

Cash flows from investing activities:

 Payments to acquire non-current assets

Proceeds from sale of non-current assets

Net cash from investing activities

Cash flows from financing activities:

Repayment of loans

Dividends paid

Net cash from financing activities

Net movement in cash and cash equivalents

Cash and cash equivalents at beginning of period

Cash and cash equivalents at end of period

f
*Please use the notes feature in the toolbar to help formulate your answer.

Anjul Co Statement of Cash Flows for the year ended 30 June 20X
$'000 $'000

Cash flows from operating activities:

Profit before tax 7,633

Depreciation 10,256

Loss on disposal of non-current assets (224)

Interest charge 823

Inventory (966)

Receivables (1,086)

Trade payables 975

Cash generated from operations 17,411

Interest paid (823)

Tax paid (2,134)

Net cash from operating activities 14,454

Cash flows from investing activities:

Payments to acquire non-current assets (16,784)

Proceeds from sale of non-current assets 1,101

Net cash from investing activities (15,683)

Cash flows from financing activities:

Repayment of loans (2,000)

Dividends paid (1,000)

Net cash from financing activities (3,000)

Net movement in cash and cash equivalents (4,229)

Cash and cash equivalents at beginning of period 4,930

 Cash and cash equivalents at end of period 701

Depreciation = Opening $47,897 − NRV of assets sold ($3,120 − $2,243) + New Asset
16,784 − Closing $53,648 = $10,256
Proceeds from sale of NCA = Cost $3,120 − Depreciation $2,243 + Profit $224 = $1,101
Repayment of Loans = $14,000 − $12,000 = $2,000
Cash and cash equivalents at end of period = 20X6 Cash $1,786 − bank overdraft
$1,085 = $701
Syllabus Coverage

This chapter covers the following Learning Outcomes.

G. Preparing financial statements

5. Statement of cash flows (excluding partnerships)
1. Differentiate between profit and cash flow.
2. Describe the need for management to control cash flow.
3. Explain the benefits and drawbacks to users of the financial statements of a
statement of cash flows.
4. Classify the effect of transactions on cash flows.
5. Calculate the figures needed for the statement of cash flows in accordance with IAS
7 Statement of Cash Flows, including:
i. Cash flows from operating activities (direct and indirect methods)
ii. Cash flows from investing activities
iii. Cash flows from financing activities
6. Prepare a statement of cash flows or extracts as applicable.
7. Identify the treatment of given transactions in a statement of cash flows.
CHAPTER 17: Visual Overview
Objective: To explain the acquisition method of consolidation.

1.1 Group Accounts

Many entities carry on part of their business by controlling other companies, known as subsidiaries.
The financial statements of the investing entity will recognise the following:
• Investments in subsidiaries at cost (or per IFRS 9 Financial Instruments) in the statement of financial position and
• Dividends received from a subsidiary when its right to the dividend is established (when it is declared) in the statement of profit
or loss.
Key Point

Since IFRS 9 is not examinable in Financial Accounting, investments in subsidiaries are stated at cost in the statement of financial position of
the investing company.
Controlling interests may result in the control of assets that have a very different value to the cost of investment. In this case,
the individual accounts will not provide the owners of the parent with a true and fair view of what their investment represents.
• In Example 1 below, group accounts are needed to provide users of financial statements with more meaningful information
reflecting the investment’s substance. (This substance is not reflected in the investing entity’s separate financial statements.)
• The group accounts required by IFRS are consolidated financial statements; the relevant standard is IFRS 10 Consolidated
Financial Statements.
Example 1
A parent company invested in 80% of another company, which now makes it a subsidiary of the parent company.
Parent Subsidiary

$ $

Investment in 80% of Subsidiary 560

Other net assets (Assets less Liabilities) 400 700

1,000 700

Share capital 500 250

Retained earnings 500 450

1,000 700

The investment of $560 in P's accounts is, in substance, the cost of owning 80% of S's net assets (80% × $700 = $560).
The owners of P cannot know this from looking at P's statement of financial position alone. Therefore, a consolidated
financial statement should be prepared to present the substance of the investment.

1.1.1 Group Accounting Terms

A business combination is a transaction in which an acquirer obtains control of another business.
A parent company with subsidiaries will prepare a separate financial statement known as the consolidated financial statements.
It is the financial statements of a group presented as those of a single economic entity.
• Parent – A parent is a company, or other entity, that controls one or more subsidiaries.
• Subsidiary – A subsidiary is an entity that is controlled by another entity, known as the parent
• Control – An investor controls its investment if it may receive varying returns from its investment and can affect those returns
through its power over the subsidiary. IFRS 10 states that an investor controls an investee if it has all the following:
o power over the investee
o exposure, or rights, to variable returns from its involvement with the investee
o the ability to use its power over the investee to affect the amount of the investor's returns.
• Consolidated Financial Statements – Consolidated financial statements are the financial statements of a group where the
assets, liabilities, income, expenses and cash flows of the parent and its subsidiaries are presented as a single set of financial
statements. It is also known as group financial statements.
Both the parent and subsidiary are still distinct legal entities.
However, the group is not a separate legal entity; it exists for accounting purposes.
• Non-Controlling Interest – A non-controlling interest is the part of the equity of a subsidiary that the parent does not own. For
example, a parent invests in 60% of a subsidiary. The remaining 40% is the non-controlling interest.
• Trade Investment – A trade investment is an investment in shares of another company to gain wealth, which is not significant
enough for the investment to be classed as a subsidiary or an associate.
Typically, this investment will be less than 20% of another company's equity shares. A trade investment is also known as a
simple investment.

1.1.2 Control
For a group structure to exist, there has to be a parent and a subsidiary. IFRS uses the term "power" to consider whether an
investor is a parent having control over a subsidiary. Any of the following can achieve control:
• Ownership
The parent owns more than 50% of the voting rights of the subsidiary. Holders of equity shares have voting rights,
but holders of preference shares do not because their voting rights are restricted.
• Control by Agreement
The parent has agreed with other investors that it should control more than 50% of voting rights.
• Board Appointment
 A parent has the power to appoint and remove the board of directors of a subsidiary
• Board Voting
The parent can cast a majority of votes at board meetings of a subsidiary.
• Power over the Investee
The parent has existing rights that allow it to direct the relevant activities of the investee. It has a legal right to
govern the financial and operating policies of the investee.
Example Control
Entity A holds 40% of the voting right in entity B. It also holds share options which, if it were to exercise them, would
take its shareholding in entity B to 80%. The share options can be exercised at any time.
Ignoring any other issues, it would be probable that entity A had control over entity B through both its current share-
holding and its potential future shares. Entity B would be recognised as a subsidiary of entity A.

Exam advice

For calculation purposes in the exam, it is assumed that control exists if the parent has more than 50% of the ordinary (equity) shares (giving
them more than 50% of voting rights) unless specifically told otherwise.

Activity 1
For each statement below, state whether they are True or False.
1. A branch has separate legal authority from its owner.
2. For a business to be a subsidiary, it must be owned 100% by its parent.
3. Some companies establish operations abroad as subsidiaries to involve local investors.
Answer.

1. False. A subsidiary company has separate legal authority from its owner; a branch of a parent does not. A branch is a part of the
parent company which provides the same services in a different location from the parent company. Subsidiaries are run and
controlled by other companies.
2. False. The definition is of a wholly owned subsidiary; not all subsidiaries are wholly owned.
3. True. The companies may want to involve local investors anyway or may be required to by local law.
Many companies operate in groups. This is because they will be linked to established brands with customer loyalty or prestige.
Some businesses will operate as groups to bring together different parts of the production process.
For example, a manufacturer of electronic goods may buy the shares of a major supplier of its components.
2.1 Preparing the Consolidated SFP
2.1.1 Format of CSFP
Example 2
Pamtish Co owns a subsidiary called Sassam Co and now prepares the Consolidated Statement of Financial Position.

• Tangible non-current assets – The non-current assets (Property, plant and equipment) in the SOFPs of Pamtish Co and
Sassam Co are added together.
• Goodwill – Goodwill is the difference between the fair value of Pamtish Co’s investment in Sassam Co and the fair value
of Sassam Co’s net assets.
• Current Assets – The current assets in the SOFPs of Pamtish Co and Sassam Co are added together.
• Share Capital – Only the share capital value of Pamtish Co is reflected in the CSOFP, not Sassam Co‘s.
• Retained Earnings – The retained earnings figure = Pamtish Co's retained earnings + Pamtish Co's share of Sassam
Co's retained earnings after Pamtish Co acquired Sassam Co. (post-acquisition profits).
• Non-Controlling Interest – Non-controlling interest is the share in the group’s net assets that belong to Sassam Co's
other shareholders.
• There is a separate subtotal before non-controlling interest to emphasise how much of the group belongs to Pamtish
Co and how much to Sassam Co's other shareholders.
• Non-current liabilities – The non-current liabilities in the SOFPs of Pamtish Co and Sassam Co are added together.
• Current liabilities – The current liabilities in the SOFPs of Pamtish Co and Sassam Co are added together.
2.1.2 Steps to Prepare the CSFP
The steps to prepare the consolidated statement of financial position are as follows
1. Total the Net Assets of the Group
The assets and liabilities of the parent and subsidiary are totalled. The following adjustments are made to the assets and liabilities amount:

• Any amounts owed from/ to each other are deducted

• Adjust for inventory
• Adjust for any unrealised profit
• Adjust non-current assets to fair value if there are differences between fair value and carrying amount.
2. Include Parent’s Reserves
Only the parent’s share capital and share premium are included in the CSFP.
3. Calculate Goodwill
Goodwill is the difference between the fair value of the parent’s investment in the subsidiary and the fair value of the
subsidiary’s net assets.
4. Non-Controlling Interest
The non-controlling interest is the subsidiary’s net assets that do not belong to the parent company.
5. Retained Earnings
The retained earnings to be reflected in the CSFP are the parent's retained earnings and the parent's share of the subsidiary's
post-acquisition retained earnings.
Example 3 (Wholly Owned)
Panna Co set up a subsidiary, Sesmond Co, on 1 January 20X1 and paid cash into the subsidiary's bank account of
$100,000 for Sesmond Co's entire share capital of 100,000 $1 shares.
The SFP has been prepared for the year ended 31 December 20X1 as follows:
Panna Co Sesmond Co

$’000 $’000

ASSETS
Non-current assets
Tangible non-current assets 3,500 950

Investment in subsidiary 100

3,600 950

Current assets 750 290

Total assets 4,350 1,240

EQUITY AND LIABILITIES

Equity
Share capital 1,000 100

Retained earnings 2,900 960

Total equity 3,900 1,060

Current liabilities 450 180

Total equity and liabilities 4,350 1,240

From the available SOFP figures above, the following steps are made to prepare the consolidated CSOFP.
1. Add the Assets and Liabilities:
Tangible Non-current assets are $3,500 + $950 = $4,450
Current Assets are $750 + $290 = $1,040
Current liabilities are $450 + $180 = $630
2. Insert parent’s share capital of $1,000
3. Calculate Goodwill
Goodwill is nil in this scenario as shares were acquired at cost.
4. Calculate Non-Controlling Interest (NCI)
There is no NCI as Panna Co owns 100% of the subsidiary, Sesmond Co.
 5. Calculate Reserves:
The parent’s retained earnings are $2,900.
The parent's share of subsidiary's post-acquisition retained earnings = 100% × $960 = $960
The total retained earnings to be reflected in the CSOFP is $2,900 + $960 = $3,860
The consolidated statement of financial position is as follows:
Panna Co Sesmond Co Group

$’000 $’000 $’000

ASSETS ASSETS

Non-current assets Non-current assets

Tangible non-current assets 3,500 950 Tangible non-current assets 4,450

Investment in subsidiary 100 Investment in subsidiary

3,600 950 4,450

Current assets 750 290 Current assets 1,040

Total assets 4,350 1,240 Total assets 5,490

EQUITY AND LIABILITIES EQUITY AND LIABILITIES

Equity Equity
Share capital 1,000 100 Share capital 1,000

Retained earnings 2,900 960 Retained earnings 3,860

Total equity 3,900 1,060 Total equity 4,860

Current liabilities 450 180 Current liabilities 630

Total equity and liabilities 4,350 1,240 Total equity and liabilities 5,490

This is a simple example where the parent company sets up (not acquire) the subsidiary, which the parent owns
wholly (100%).
In reality, parent companies may acquire subsidiaries that have been trading for a while and not wholly, leading to a
non-controlling interest.

Activity 2
Passan Co set up a new subsidiary, Sinta Co, in a neighbouring country on 1 April 20X5. It contributed $500,000 for all of Sinta
Co's one million $0.50 shares. Passan Co and Sinta Co statements of financial position as at 31 March 20X6:
Panna Co Sinta Co

$’000 $’000

ASSETS
Non-current assets

Tangible non-current assets 7,150 3,420

Investment in subsidiary 500

7,650 3,420

Current assets 1,980 1,230

Total assets 9,630 4,650

EQUITY AND LIABILITIES

Equity
Share capital 2,000 500

Retained earnings 6,530 3,590

Total equity 8,530 4,090

 Current liabilities 1,100 560

Total equity and liabilities 9,630 4,650

Prepare the consolidated SOFP for the Passan Group at 31 March 20X6.
Answer.

Panna Co Sinta Co Group

$’000 $’000 $’000

ASSETS ASSETS

Non-current assets Non-current assets

Tangible non-current assets 7,150 3,420 Tangible non-current assets 10,570

Investment in subsidiary 500 Investment in subsidiary

7,650 3,420 10,570

Current assets 1,980 1,230 Current assets 3,210

Total assets 9,630 4,650 Total assets 13,780

EQUITY AND LIABILITIES EQUITY AND LIABILITIES

Equity Equity
Share capital 2,000 500 Share capital 2,000

Retained earnings 6,530 3,590 Retained earnings 10,120

Total equity 8,530 4,090 Total equity 12,120

Current liabilities 1,100 560 Current liabilities 1,660

Total equity and liabilities 9,630 4,650 Total equity and liabilities 13,780

2.1.3 Pre-Acquisition Reserves and Non-Controlling Interests

A parent company may acquire subsidiaries that have been trading for a while. The determination of pre and post-acquisition
retained earnings must be established when preparing the consolidated statement of financial position.
Parent companies may also acquire part (between 50% to 99%) of a subsidiary, which leads to the existence of a non-
controlling interest.
• Pre-Acquisition Retained Earnings
When a parent acquires a subsidiary, the subsidiary may already have retained earnings in its SOFP.
The subsidiaries retained earnings should not be included in the consolidated SOFP because it does not belong to
the group. The earnings were made before the subsidiary became part of the group and are known as pre-
acquisition profits.
The CSOFP should only include only the parent's share of post-acquisition profits. It is calculated as:
Parent’s percentage of share capital x (Retained Earnings at SOFP date
– Retained Earnings when subsidiary acquired)

This amount is then added to the parent’s retained earnings.

Exam advice

In the FA exam, students may be given a figure for post-acquisition profits. This profit will be the profit for the year if the subsidiary was
acquired at the start of the year.

• Non-Controlling Interest
The non-controlling interest (NCI) is the share of the subsidiary's net assets owned by shareholders in the
subsidiary other than the parent. It is shown as a separate figure as part of equity in the CSOFP. No adjustment
should be made to the assets and liabilities for the proportion belonging to the NCI.
The non-controlling interest (NCI) to be presented in the CSFP is calculated as follows:
 Fair value of NCI at acquisition + NCI's share of post-acquisition profits

The Fair value of NCI at acquisition is calculated as follows:

Share price of the subsidiary at acquisition × Number of shares held by NCI

The NCI's share of post-acquisition profits is calculated the same way as the parent's share but applies the
percentage of shares held by the NCI.
NCI’s percentage of share capital x (Retained Earnings at SOFP date – Retained Earnings when subsidiary acquired)

Example 4 (Partially Acquired)

Pareq Co bought 75% of the share capital of Suan Co on 1 July 20X7. In the year to 30 June 20X8, Suan Co made
profits of $480,000. The fair value of the non-controlling interest at acquisition was $350,000. There was no goodwill
arising on acquisition.
The SFP has been prepared for the year ended 30 June 20X8 as follows:

Pareq Co Suan Co
$ '000 $ '000
ASSETS
Non-current assets
Tangible non-current assets 9,150 1,590
Investment in subsidiary 1,050 -
10,200 1,590
Current assets 3,720 510
Total assets 13,920 2,100

EQUITY AND LIABILITIES

Equity
Share capital 1,000 200
Retained earnings 10,360 1,680
Total equity 11,360 1,880
Current liabilities 2,560 220
Total equity and liabilities 13,920 2,100
From the available SOFP figures above, the following steps are made to prepare the consolidated CSOFP.
1. Add the Assets and Liabilities:
Tangible Non-current assets are $9,150 + $1,590 = $10,740
Current Assets are $3,720 + $510 = $4,230
Current liabilities are $2,560 + $220 = $2,780
2. Insert parent’s share capital of $1,000
3. Calculate Goodwill: The scenario mentions that goodwill is nil.
4. Calculate Non-Controlling Interest (NCI)
5. NCI at acquisition $350 + NCI Share of post-acquisition profits (25% × $480) = $470
6. Calculate Reserves:
Parent’s reserves $10,360 + Parent's share of post-acquisition reserves (75% × $480) = $10,720
The consolidated statement of financial position is as follows:
 Pareq Group statement of financial position as at 30 June 20X8
Group
$ '000
ASSETS
Non-current assets
Tangible non-current assets 10,740
Current assets 4,230
Total assets 14,970

EQUITY AND LIABILITIES

Equity
Share capital 1,000
Retained earnings 10,720
11,720
Non-controlling interest 470
Total equity 12,190
Current liabilities 2,780
Total equity and liabilities 14,970
Activity 3
Paisley Co purchased 80% of Stranraer Co's share capital on 1 January 20X2 for $4 per share. At that date, Stranraer Co's
share capital was 500,000 $1 shares, and its retained earnings were $1,500,000. There was no goodwill arising on acquisition.
The SFP has been prepared for the year ended 31 December 20X4 as follows:

Paisley Co Stranraer Co
$ '000 $ '000
ASSETS
Non-current assets
Tangible non-current assets 11,570 2,830
Investment in subsidiary 1,600 -
13,170 2,830
Current assets 4,440 1,340
Total assets 17,610 4,170

EQUITY AND LIABILITIES

Equity
Share capital 5,000 500
Retained earnings 9,050 2,850
Total equity 14,050 3,350
Current liabilities 3,560 820
Total equity and liabilities 17,610 4,170
Prepare the consolidated SOFP for the Paisley Group at 31 December 20X4.
Answer.

Paisley Group statement of financial position as at 31 December 20X4

Group
$ '000
ASSETS
 Non-current assets
Tangible non-current assets 14,400
Current assets 5,780
Total assets 20,180

EQUITY AND LIABILITIES

Equity
Share capital 5,000
Retained earnings 10,130
10,130
Non-controlling interest 670
Total equity 10,800
Current liabilities 4,380
Total equity and liabilities 10,800
NCI = NCI at acquisition (20% × $4 × 500 shares) + NCI share of post-acquisition earnings 20% × (2,850 − 1,500) = $670
Reserves = Paisley reserves $9,050 + Paisley share of Stranraer's post-acquisition earnings 80% × ($2,850 − $1,500) =
$10,130
2.1.4 Goodwill
When a parent acquires a subsidiary, it does not just acquire the tangible assets and liabilities of the subsidiary; It also
acquires intangible assets such as the expertise and experience that are not reflected in the subsidiary’s financial statements.
The additional premium the parent pays for this expertise, experience, and other benefits is goodwill.

Key Point

Goodwill on consolidation represents the difference between the value of the investment in the subsidiary and its net asset’s
fair value.
Goodwill on consolidation can only arise if a parent acquires a subsidiary, it cannot arise if the parent sets up a subsidiary.

Goodwill arising on consolidation is included in the non-current asset section of the consolidated Statement of Financial
Position. However, goodwill is not included in the parent's SOFP. The parent's SOFP shows the cost of the investment in the
subsidiary.
The goodwill to be presented in the consolidated statement of financial position is calculated as follows:

Fair value of consideration X

Fair value of non-controlling interest X
Less fair value of subsidiary’s net assets at acquisition (X)
Goodwill at acquisition X
Goodwill is the premium paid for the subsidiary over the fair value of the subsidiary's net assets acquired.
The premium is paid for the intangible worth the purchaser places on the subsidiary it has bought. It may relate to a brand,
deemed future returns, expertise and experience of managers and staff in the subsidiary. There may also be synergies the
parent seeks to drive from the acquisition, such as shared warehousing and finance departments.
Example 5
On 1 April 20X7, Ponsonby Co acquired 60% of the share capital of Smythe Co for $4,500,000. The value of the non-
controlling interest on 1 April 20X7 was $2,600,000. The share capital figure in Smythe Co's financial statements at this
date was $2,000,000, and its retained profits were $3,240,000.
The goodwill is calculated as follows:
 $’000
Fair value of consideration 4,500
Fair value of non-controlling interest 2,600
Less fair value of net assets at acquisition (5,240)
(share capital 2,000 + retained earnings 3,240)

Goodwill at acquisition 1,860

Activity 4
On 1 September 20X7, Peterhead Co acquired 75% of the share capital of Southtown Co for cash for $5.20 per share. At this
date, Southtown Co's share capital consisted of 500,000 $1 shares, and its retained earnings were $1,890,000.
Calculate the goodwill on the acquisition of Southtown Co.
$’000
Fair value of consideration
Fair value of non-controlling interest
Less fair value of net assets at acquisition
Goodwill at acquisition
Answer.

$’000
Fair value of consideration 1,950
Fair value of non-controlling interest 650
Less fair value of net assets at acquisition (2,390)
(share capital 500 + retained earnings 1,890)
Goodwill at acquisition 210
2.1.5 Fair Value Adjustments
One of the components of the goodwill calculation is the:
• Fair Value of Consideration
The fair value of cash consideration is the cash paid for the subsidiary's shares. If the parent pays for the
subsidiary's shares by exchanging its shares for the subsidiary's shares, fair value would be calculated as follows:
Fair Value = Number of parent's shares given × Market price of parent's shares
The new share issue by the parent will increase its share capital and share premium.
• Fair Value of Subsidiary’s Net Assets
The fair value of the subsidiary’s net assets may differ from their carrying value in its financial statements. This fair
value difference is adjusted in the goodwill calculation.
The fair-value adjustment is also made to group non-current assets when they are added together.
Exam advice

Only land and buildings are considered in the subsidiary’s net assets in the FA exam.

Example 6

Potiskum Co acquired 100% of the share capital of Sokoto Co on 1 January 20X7. Sokoto Co exchanged three $0.50
shares in Potiskum Co, valued at $2.50 each, for four $1 shares in Sokoto Co.
On 1 January 20X7, Sokoto Co had 1,200,000 $1 shares in issue and retained profits of $570,000. Land and buildings
included in Sokoto Co's accounting records at $1,900,000 had a fair value of $2,180,000 on 1 January 20X7.
The goodwill is calculated as follows:

$’000
Fair value of consideration 2,250
Fair value of non-controlling interest -
Less fair value of net assets at acquisition (2,050)
 (Share capital 1,200 + retained earnings 570 + FV adjustment on land & building 280)

Goodwill at acquisition 200

The fair value of consideration is the investment in Sokoto Co held by Potiskum Co. Potiskum Co gives three shares in
exchange for four in Sokoto Co.
The FV of consideration is 1,200,000 shares × 3/4 × $2.50 = $2,250,000
The FV adjustment of land and buildings is $2,180,000 − $1,900,000 = $280,000

Activity 5
Pembridge Co purchased 80% of the share capital of Shobdon Co on 1 August 20X0.
The consideration was one share in Pembridge Co for one share in Shobdon Co plus a cash payment of $0.30 per share.
Pembridge Co has five million $1 shares in issue, and Shobdon Co has one million $0.25 shares in issue. The market value of
Pembridge Co shares on 1 August 20X0 was $1.80.
The fair value of the non-controlling interest in Shobdon Co on 1 August 20X0 was $310,000. Shobdon Co's net assets on its
statement of financial position on 1 August 20X0 were $1,650,000, but a valuation of land and buildings at that date showed
they were worth $250,000 more than their carrying value in the statement of financial position.
Calculate the goodwill on the acquisition of Shobdon Co.
$’000
Fair value of consideration
Fair value of non-controlling interest
Less fair value of net assets at acquisition
Goodwill at acquisition
Answer.

$’000
Fair value of consideration 1,680
(80% × $1.80 × 1,000) + (80% × $0.30 × 1,000)
Fair value of non-controlling interest 310
Less fair value of net assets at acquisition (1,900)
(Net Asset Value 1,650 + FV adjustment 250)
Goodwill at acquisition 90
Activity 6
On 1 January 20X5, Padiham Co acquired 80% of the share capital of Salcombe Co for $2,090,000. The retained earnings of
Salcombe Co were $740,000 on that date, and the non-controlling interest was valued at $630,000. Salcombe Co's share
capital has remained the same since the acquisition.
The following draft statements of financial position for the two companies were prepared at 31 December 20X8.

Padiham Co Salcombe Co
$ '000 $ '000
ASSETS
Investment in Salcombe Co 2,090 -
Other assets 6,780 3,650
Total assets 8,870 3,650

EQUITY AND LIABILITIES

Equity
Share capital 3,200 1,500
Retained earnings 3,220 1,010
Total equity 6,420 2,510
Liabilities 2,450 1,140
Total equity and liabilities 8,870 3,650
1. What is the fair value of the consideration (Investment in Salcombe Co held by Padiham Co)?
1. $630,000
2. $740,000
3. $1,010,000
4. $1,500,000
5. $2,090,000
2. What should be added below the FV of consideration in the goodwill calculation?
1. Retained earnings
2. Equity share capital
3. NCI as at acquisition
4. Investment in Salcombe Co held by Padiham Co
5. Other assets
3. What is the value of the non-controlling interest at acquisition?
1. $630,000
2. $740,000
3. $1,010,000
4. $1,500,000
5. $2,090,000
4. What is the value of the equity share capital to be included in the FV of the subsidiary’s net assets at acquisition?
1. $740,000
2. $1,010,000
3. $1,140,000
4. $1,500,000
5. $3,650,000
5. Other than the equity share capital amount, what else is included in the calculation for the FV of the subsidiary’s
net assets at acquisition?
1. Other assets
2. Liabilities
3. Retained earnings
6. What is the value of the retained earnings?
1. $740,000
2. $1,010,000
3. $1,140,000
4. $1,500,000
5. $3,650,000
7. What is the total goodwill at acquisition?
Answer.

1. E.
2. C.
3. A.
4. D.
5. C.
6. A.
7. The group goodwill at acquisition of Salcombe Co is $480,000.

$’000
Fair value of consideration 2,090
Fair value of non-controlling interest 630
Less fair value of net assets at acquisition (2,240)
(Share capital 1,500 + Retained Earnings 740)
Goodwill at acquisition 480
2.2 Intra-Group Trading
According to IFRS 10 Consolidated Financial Statements, any balances between the parent and the subsidiary must be
cancelled on consolidation.
• It is normal for group companies to trade with each other. For example, a subsidiary may act as a supplier of raw materials to
the parent or as a distributor of finished goods from the parent.
• The parent and subsidiary’s financial statements may have monies due to or from the other company.
These balances must be eliminated in the CSFP from the respective receivables and payables totals so that the statement
reflects only the group’s receivables and payables.
2.2.1 Intercompany Receivables and Payables
Group member A owes money to group member B for purchasing goods from B. The debt will be included in the receivables of
group member B (who sold the goods) and in the payables of group member A (who bought the goods).
The balances owing from each group member need to be deducted from the receivables and payables balance in the
consolidated financial statements.
The double entry to remove the receivables and payables in the CSFP is:

Individual Account Category Explanation

DR Payables Liability Remove the payable balance
CR Receivables Asset Remove the receivable balance

Example 7

Creditors of the parent company include $1,500 due to the subsidiary, and creditors of the subsidiary include $1,000 due to
the parent.

Parent Subsidiary Group

$ $ $
Current Assets
Receivables 2,000 1,500 (2,000 + 1,500) − 2,500 1,000

Current Liabilities
Payables 3,500 2,500 (3,500 + 2,500) − 2,500 3,500
The parent owes the subsidiary $1,500, so the balance is removed from the group figure. The subsidiary owes the parent
$1,000, so the balance is removed from the group figure.
The total balance owed to each other is $1,500 + $1,000 = $2,500, and the double entry to remove the balance in the SFP
is DR Payables $2,500 CR Receivables $2,500.

2.2.2 Intercompany Sales of Inventory

If group member C has sold goods to group member D for a profit and those goods are still in the inventory of group member D
at the SOFP date, the profit is unrealised from the group's viewpoint.
Since the goods have not yet been sold outside the group, the unrealised profit must be removed from the consolidated
financial statements.
If the parent sells goods to the subsidiary, the unrealised profit is removed in the CSFP with the below double entry:

Individual Account Category Explanation

DR Parent’s Retained Earnings Equity Eliminate the unrealised profit of the parent
CR Closing Inventory Asset Reduce the inventory amount
If the subsidiary sells goods to the parent, the unrealised profit is removed in the CSFP with the below double entry:

Individual Account Category Explanation

DR Parent’s % of Subsidiary’s Post Retained Earnings Equity Eliminate the unrealised profit of the subsidiary (parent %)
DR Non-Controlling Interest % Equity Eliminate the unrealised profit of the subsidiary (NCI %)
CR Closing Inventory Asset Reduce the inventory amount
The complication is that part of the unrealised profit belongs to the non-controlling interest. It is deducted the same way the
group's share of the unrealised profit is removed from the group’s retained earnings.
Example 8
The following figures have been taken from the accounting records of the Padstow Group. Padstow Co owns 80% of
the share capital of Saltash Co.
 Padstow Co Saltash Co
$ '000 $ '000
Inventory 480 270
Receivables 600 220
Payables 420 180
Retained earnings 1,640 -
Padstow Group share of retained earnings of Saltash Co - 1,230
Non-controlling interest in Saltash Co - 1,310
At year-end, Padstow Co owed Saltash Co $18,000 for the goods it had purchased during the year. Padstow Co also
had in inventory $15,000 of goods it had purchased from Saltash Co. Saltash Co had made a 50% markup on these
goods.
Adjustment 1:
The intercompany trade leads to a receivable (subsidiary – Saltash Co) and payables (parent – Padstow Co) of $18,000
that needs to be removed. The double entry is

DR Payables $18,000
CR Receivables $18,000
Adjustment 2:
The unrealised profit (URP) for the sale is $15,000 × 50/150% = $5,000. Note that only the profit element is deducted,
not the whole inventory.
Since the unrealised profit is from the subsidiary’s sale to the parent, the double entry is:

DR Subsidiary’s Post Retained Earnings 5,000 × 80% $4,000

DR Non-Controlling Interest 5,000 × 20% $1,000
CR Closing Inventory $5,000
The group CSFP should be as follows once the intercompany trading and unrealised profits are adjusted:

Group
$ '000
Inventory (480 + 270) − 5 (Note 2) 745
Receivables (600 + 220) − 18 (Note 1) 802
Retained earnings (1,640 + 1,230) − 4 (Note 2) 2,866
Non-controlling interest in Saltash Co 1,310 − 1 (Note 2) 1,309
Payables (420 + 180) − 18 (Note 1) 582
Activity 7
Petworth Co owns 80% of the share capital of Slindon Co. The current assets and liabilities of the two companies at 31
December 20X8 were as follows:

Petworth Co Slindon Co
$ '000 $ '000
Current assets
Inventory 670 320
Receivables 540 330
Bank and cash 240
1,450 670
Current liabilities
Payables 450 290
Bank overdraft – 140
450 430
In 20X8, Petworth Co sold goods that cost Petworth Co $70,000 to Slindon Co at a profit margin of 30%. At year-end, 40% of
these goods remained in Slindon Co's inventory. Slindon Co had not yet paid for goods sold that were 25% of the value of
20X8 sales by Petworth Co to Slindon Co.
Petworth Co uses a different bank from Slindon Co.
1. What figure would be included for inventory in the Petworth Group financial statements as at 31 December 20X8?
2. What figure would be included for receivables in the Petworth Group financial statements as at 31 December 20X8?
3. What figure would be included for bank and cash in the Petworth Group financial statements as at 31 December 20X8?
4. What figure would be included for payables in the Petworth Group financial statements as at 31 December 20X8?
Answer.

1. The sales to Slindon Co for the year = $70,000 × (100/70) = $100,000

Sales Revenue $10,000 = Cost $70,000 + Profit Margin $30,000
The unsold inventory is $100,000 × 40% = $40,000 and the unrealised profit is $40,000 × 30% = $12,000
Therefore, the total inventory is ($670,000 + $320,000) − $12,000 = $978,000
2. From question 1, the sales revenue has been determined to be $100,000. The amount owed at year-end is $100,000 × 25% =
$25,000
Therefore, the total receivables is ($540,000 + $330,000) − $25,000 = $845,000
3. Petworth Co and Slindon Co are separate legal entities and use different banks. Therefore, Petworth Co's positive bank
balance should not be offset against Slindon Co's overdraft. The bank and cash amount to be included in the CSFP is $240,000
4. From question 2, the intercompany receivables (and payables) have been determined to be $25,000.
Therefore, the total payables is ($450,000 + $290,000) − $25,000 = $715,000
2.3 Mid-Year Acquisitions
So far, it has been assumed that acquisitions occur at the start of the accounting period. In the real world, however,
acquisitions can be made at any time (mid-year).
The subsidiary’s retained earnings at the acquisition date must be determined to calculate the goodwill on acquisition.
The consolidated financial statements include the subsidiary’s profits after the acquisition only.

2.3.1 Accounting for Mid-Year Acquisition

• Subsidiary’s Profits
Unless told otherwise, it can be assumed that the subsidiary's profits accrue evenly over the period. For example, if
the acquisition takes place four months into the year, four months' profits will be pre-acquisition profits, and eight
months' profits will be post-acquisition profits.
• Goodwill
The fair value of net assets at the date of acquisition is the subsidiary’s opening share capital and reserves plus
the profits from the start of the year until the date of acquisition.
• Non-Controlling Interest
The value of non-controlling interest is the value at the start of the year plus the value of the non-controlling
interest's share in profits from the beginning of the year up to the date of acquisition.
• Post-Acquisition Profits
Only add profits of the subsidiary made after the date of acquisition to the group's retained earnings, not the profits
for the whole year. Add the non-controlling interest's share of profits after the acquisition to the non-controlling
interest at the date of acquisition.
Example 9
Powerstock Co acquired 80% of Sherborne Co's shares for $530,000 on 30 September 20X3. On 30 June 20X4,
Powerstock Co's retained earnings were $770,000. Sherborne Co's share capital on 30 June 20X3 was $200,000, and its
retained earnings were $360,000. Sherborne Co did not issue any shares for the year to 30 June 20X4.
Sherborne Co made $80,000 in profits in the year to 30 June 20X4. The value of the non-controlling interest at the date
of acquisition was $140,000. Powerstock Co has a financial year-end of 30 June 20X4.
To calculate the goodwill and retained earnings to be included in the CSFP, the pre and post-acquisition profits need
to be determined:
The pre-acquisition period is three months:
• pre-acquisition profits are ($80,000 × 3/12) = $20,000
• post-acquisition profits are ($80,000 × 9/12) = $60,000
Calculate the Goodwill:
The FV of Sherborne Co’s net asset at acquisition = Opening Share Capital $200,000 + Pre-acquisition Profits (Opening
360,000 + during the year $20,000) = $580,000.
 $’000
Fair value of consideration 530
Fair value of non-controlling interest 140
Less: Fair value of net assets at acquisition (580)
Goodwill at acquisition 90
Calculate the Retained Earnings:
The total retained earnings is Powerstock’s RE $770,000 + Powerstock’s share of Sherborne Co’s post-acquisition
profit (80% x $60,000) $48,000 = $818,000
Activity 8 (Full Working CSFP)
The following activity is presented in the style of the computer-based ACCA exam.
Pontesbury Co acquired 70% of the share capital of Stokesay Co on 1 April 20X3. The share capital of Stokesay Co was
1,800,000 $1 shares, and Pontesbury Co offered five $0.50 of its shares for every three shares in Stokesay Co.
The market price per share of Pontesbury Co's shares on 1 April 20X3 was $1.20, and the fair value of the non-controlling
interest on the date of acquisition was $710,000.
Extracts from the statements of financial position for the two companies as at 31 March 20X4 are as follows:

Pontesbury Co Stokesay Co
$ '000 $ '000
Inventory 750 240
Trade receivables 670 190
Retained earnings 5,470 1,420
Trade payables 480 230
On 31 March 20X4, Stokesay Co had goods in inventory that it had purchased from Pontesbury Co for $50,000. Pontesbury
Co charges a 25% markup on cost. Pontesbury Co had goods in inventory purchased from Stokesay Co for $100,000.
Stokesay Co has a profit margin of 20%. At the year-end, Pontesbury Co owed Stokesay Co $30,000 for goods that
Pontesbury Co had purchased.
Stokesay Co's profit for the year to 31 March 20X4 was $150,000. No adjustments have been made to retained earnings or
non-controlling interest for intra-company trading.
Complete the calculation of the goodwill on the acquisition of Stokesay Co.
$’000

Goodwill at acquisition
Complete the consolidated SOFP by entering the missing numbers.
Extracts from Pontesbury Group consolidated statement of financial position as at 31 March 20X4
$ '000
Inventory
Trade receivables
Retained earnings
Non-controlling interest
Trade payables
Answer:

$’000
Fair value of consideration 2,520
1,800 × (5/3) × 1.20 × 70%
Fair value of non-controlling interest 710
Less: Fair value of net assets at acquisition (3,070)
 SC 1,800 + RE (1,420 − 150)
Goodwill at acquisition 160
Extracts from Pontesbury Group consolidated statement of financial position as at 31 March 20X4
$
'000
Inventory 750 + 240 − (50 × 25/125) − (100 × 20/100) 960
Trade receivables 670 + 190 − 30 830
Retained earnings 5,551
(Pontesbury RE 5,470 + Share of Stokesay’s post-acq RE (70% × 150) − Interco trading adjustments [(50 ×
25/125) + (70% × 100 × 20/100)]
Non-controlling interest 749
(FV at acq 710 + Share of Stokesay’s post-acq RE (30% × 150) − Unrealised profit adjustment (30% × 100 ×
20/100)
Trade payables 480 + 230 − 30 680
Activity 9 (Full Working CSFP)
The following activity is presented in the style of the paper-based ACCA exam.
Pagham Co acquired 80% of the share capital of Sidlesham Co on 30 September 20X0. The accounting year end of both
companies is 31 December.
Pagham Co exchanged one $1 share in Pagham Co plus a cash payment of $0.30 for one share in Sidlesham Co. On 30
September 20X0, the price of Pagham Co shares was $1.50. Sidlesham Co's share capital throughout 20X0 was 2 million $1
shares and its profit for the year was $280,000.
The fair value of Sidlesham Co's land and buildings on 30 September was $250,000 more than the value shown in Sidlesham
Co's accounting records.
The fair value of the non-controlling interest at the date of acquisition was $810,000.
Pagham Co and Sidlesham Co’s statements of financial position as at 31 December 20X0 are as follows:

Pagham Co Sidlesham Co
$ '000 $ '000
ASSETS
Non-current assets
Tangible non-current assets 18,740 3,110
Investment in subsidiary 2,880 -
21,620 3,110
Current assets 3,320 640
Total assets 24,940 3,750
EQUITY AND LIABILITIES
Equity
Share capital 6,600 2,000
Share premium 1,280 -
Retained earnings 14,570 1,370
Total equity 22,450 3,370
Current liabilities 2,490 380
Total equity and liabilities 24,940 3,750
Prepare the consolidated statement of financial position for the Pagham Group for the year ended 31 December 20X0.
Answer:

1. Add the Assets and Liabilities:

Non-current assets fair value = 18,740 + 3,110 + 250 = 22,100
Current assets = 3,320 + 640 = 3,960
Current Liabilities = 2,490 + 380 = 2,870
2. Insert parent’s reserves:
Share capital = 6,600
 Share premium = 1,280
3. Calculate Goodwill:
FV of Sidlesham Co’s net asset at acquisition = Opening Share Capital 2,000 + Pre-acquisition Profits [1,370 −
(280 × 3/12)] = 3,300
FV adjustment on land and building = 250
Total FV of Sidlesham’s net assets at acquisition = 3,300 + 250 = 3,550
$’000
Fair value of consideration 2,880
2 mil × 80% × (1.5 + 0.3)
Fair value of non-controlling interest 810
Less: Fair value of net assets at acquisition (3,550)
Goodwill at acquisition 140
4. Calculate Non-Controlling Interest (NCI)
Value at acquisition 810 + Share of profits for three months to 31 December (280 × 20% × 3/12) = 824
5. Calculate Retained Earnings:
The parent’s retained earnings are 14,570
The parent's share of subsidiary's post-acquisition retained earnings = 80% × 280 × 3/12) = 56
The total retained earnings to be reflected in the CSOFP is 14,570 + 56 = 14,626
Pagham Group consolidated statement of financial position as at 31 December 20X0:
$'000
ASSETS
Non-current assets
Tangible non-current assets 22,100
Goodwill 140
22,240
Current assets 3,960
Total assets 26,200
EQUITY AND LIABILITIES
Equity
Share capital 6,600
Share premium 1,280
Retained earnings 14,626
22,506
Non-controlling interest 824
Total equity 23,330
Current liabilities 2,870
Total equity and liabilities 26,200
Activity 10 (Full Working CSFP)
Pickering Co acquired 70% of the share capital of Skipton Co on 30 June 20X4 for $2 per share. At that date, Skipton Co had
two million $1 shares in issue and had retained earnings of $1,460,000. Land and buildings shown in Skipton Co's accounting
records on 30 June 20X4 for $3,200,000 were valued at $3,340,000.
On 31 March 20X5, Pickering Co owed Skipton Co $200,000 for goods it had purchased from Skipton Co during February
20X5. 50% of those goods were still in Pickering Co's inventory on 31 March 20X5. Skipton Co makes a markup of 25% on the
goods that it sells.
The statements of financial position for Pickering Co and Skipton Co on 31 March 20X5 were as follows:

Pickering Co Skipton Co
$ '000 $ '000
ASSETS
Non-current assets
Tangible non-current assets 8,920 3,780
 Investment in subsidiary 2,800 -
11,720 3,780
Current assets 1,110 450
Total assets 12,830 4,230

EQUITY AND LIABILITIES

Equity
Share capital 5,000 2,000
Retained earnings 6,890 1,820
Total equity 11,890 3,820
Current liabilities 940 410
Total equity and liabilities 12,830 4,230
Prepare the consolidated statement of financial position for the Pickering Group for the year ended 31 March 20X5.
Answer:

1. Add the Assets and Liabilities:

Tangible NCA adjustment = 3,340 − 3,200 = 140
Tangible NCA fair value = 8,920 + 3,780 + 140 = 12,840
Current assets adjust for receivables and inventory:
Provision for unrealised profit = 200 × 50% × 25/125 = 20
Current assets = 1,110 + 450 − 200 − 20 = 1,340
Current liabilities = 940 + 410 − 200 = 1,150
2. Insert parent’s share capital = 5,000
3. Calculate Goodwill:
FV of Skipton Co’s net asset at acquisition = Opening Share Capital 2,000 + Pre- acquisition Profits 1,460 = 3,460
FV adjustment on land and building = 140
Total FV of Sidlesham’s net assets at acquisition = 3,460 + 140 = 3,600
$’000
Fair value of consideration 2,800
2,000 × 70% × $2
Fair value of non-controlling interest 1,200
2,000 × 30% × $2
Less: Fair value of net assets at acquisition (3,600)
Goodwill at acquisition 400
4. Calculate Non-Controlling Interest (NCI)
Value at acquisition 1,200 + Share of profits after 30 June X4 [30% × (1,820 − 1,460)] − Share of unrealised profits
(30% × 20) = 1,302
5. Calculate Retained Earnings:
Parent’s retained earnings are 6,890
Parent's share of subsidiary's post-acquisition retained earnings = 70% × (1,820 − 1,460) = 252
Parent’s share of unrealised profits = 70% × 20 = 14
The total retained earnings to be reflected in the CSOFP is 6,890 + 252 - 14 = 7,128
Pickering Group consolidated statement of financial position as at 31 March 20X5:
$ '000
ASSETS
Non-current assets
Tangible non-current assets 12,840
Goodwill 400
13,240
Current assets 1,340
Total assets 14,580
EQUITY AND LIABILITIES
Equity
Share capital 5,000
Retained earnings 7,128
12,128
Non-controlling interest 1,302
Total equity 13,430
Current liabilities 1,150
Total equity and liabilities 14,580
3.1 Preparing the Consolidated SPL
3.1.1 Format of CSPL
Exam advice

FA Financial Accounting (FA) requires no other comprehensive income regarding group statements.

Example 10

Penzance Co owns a subsidiary called Scarborough Co and now prepares the Consolidated Statement of Profit or
Loss.

Penzance Group consolidated statement of profit or loss for the year ended 31 December 20X3
$'000
Revenue 8,150
Cost of sales (5,790)
Gross profit 2,360
Other income 40
Distribution costs (680)
Administrative expenses (740)
Finance costs (40)
Profit before tax 940
Income tax expense (210)
Profit for the year 730

Profit attributable to:

Owners of Penzance 690
Non-controlling interest 40
Profit for the year 730
• Revenue – Revenues for Penzance Co and Scarborough Co are added together. Any revenue from sales between them
(intercompany trade) is deducted.
• Cost of Sales – The cost of sales for Penzance Co and Scarborough Co are added together. Any sales value between
them (as this is the cost of the sales for the company that has purchased the goods) is deducted.
Adjust (deduct) any provisions made for unrealised profit in the closing inventory. This will lead to lower
closing inventory figures and higher cost of sales.
• Other Income – Other income must exclude any dividends the subsidiary pays the parent.
• Expenses – Sum the parent’s and subsidiary’s figures for distribution, administrative, finance, and income tax
expenses.
Note: The tax implications of intra-group sales are ignored as it is outside the scope of the syllabus.
• Owners of Penzance – The equity owners (parent) of Penzance (subsidiary) value is = Penzance‘s (parent) profit +
Penzance Co's share of Scarborough Co's profit − Penzance Co's share of provision for unrealised profit on closing
inventory
• Non-Controlling Interest (NCI) – The NCI value is = NCI's share of Scarborough Co's profit − NCI's share of provision for
unrealised profit on closing inventory (when subsidiary sells to parent)
• Profit for the Year – This is the group’s entire profit.
3.1.2 Steps to Prepare the CSPL
1. Determine the date of the Acquisition
If the date of acquisition is at the start of the financial year, the subsidiary figures are included in the CSPL entirely.
If the subsidiary is acquired partway through the year, the subsidiary figures are pro-rated before being included in the CSPL.
2. Revenue and Cost of Sale
The revenue and cost of sales need to be adjusted for any unrealised profits on closing inventory.
Revenue = Parent’s revenue + S’s revenue − Intergroup sales
Cost of Sales = Parent’s COS + Subsidiary’s COS − Intergroup sales + Unrealised profits
3. Other figures in the SPL
Add the rest of the figures for the parent and subsidiary in the statement of profit or loss and deduct any dividends paid by the
subsidiary to the parent from other income.
4. Share of Profit
Split profit for the year between the parent and the non-controlling interest (NCI).
Example 11
Patterdale Co acquired 80% of the share capital of Seathwaite Co on 1 January 20X7.
There was no intra-group trading during 20X7.
Patterdale Co and Seathwaite Co statements of profit or loss for the year ended 31 December 20X7:

Patterdale Co Seathwaite Co
$ '000 $ '000
Revenue 8,170 1,230
Cost of sales (6,120) (810)
Gross profit 2,050 420
Other operating expenses (890) (250)
Profit before tax 1,160 170
Income tax expense (270) (40)
Profit for the year 890 130
From the available SOFP figures above, the following steps are made to prepare the consolidated CSOFP.
1. Determine the date of acquisition:
The subsidiary, Seathwaite Co, is acquired at the start of the financial period. Therefore, there is no pro-
rate of Seathwaite’s figures for the CSPL.
2. Revenue and Cost of Sale:
There is no intra-group trading after the date of acquisition.
Revenue = 8,170 + 1,230 = 9,400
Cost of Sales = 6,120 + 810 = 6,930
3. Other figures in the SPL:
There is no mention of dividends paid from Seathwaite to Patterdale Co. Add the other figures in the SPL
together.
4. Share of Profit:
Patterdale's share = Patterdale Co's profits 890 + Patterdale Co's share of Seathwaite Co's profits (80% ×
130) = 994
NCI's share = 20% × 130 = 26
The Consolidated Statement of Profit or Loss is as follows:

Consolidated
$ '000
Revenue 9,400
Cost of sales (6,930)
Gross profit 2,470
Other operating expenses (1,140)
 Profit before tax 1,330
Income tax expense (310)
Profit for the year 1,020
Profit attributable to:
Equity owners of Patterdale Co 994
Non-controlling interest 26
Profit for the year 1,020
Activity 11
Pooleybridge Co acquired 60% of the share capital of Seatoller Co on 1 January 20X9. There was no intra-group trading.
Pooleybridge Co and Seatoller Co statements of profit or loss for the year ended 31 December 20X9:

Pooleybridge Co Seatoller Co
$ '000 $ '000
Revenue 6,730 2,490
Cost of sales (4,370) (1,240)
Gross profit 2,360 1,250
Other operating expenses (770) (450)
Profit before tax 1,590 800
Income tax expense (840) (320)
Profit for the year 750 480
Prepare the consolidated SPL for the Pooleybridge Group for the year to 31 December 20X9.
Answer:

From the available SOFP figures above, the following steps are made to prepare the consolidated CSOFP.
1. Determine the date of acquisition:
The subsidiary, Seatoller Co, is acquired at the start of the financial period.
Therefore, there is no pro-rate of Seatoller Co’s figures for the CSPL.
2. Revenue and Cost of Sale:
There is no intra-group trading after the date of acquisition.
Revenue = 6,730 + 2,490 = 9,220
Cost of Sales = 4,370 + 1,240 = 5,610
3. Other figures in the SPL:
There is no mention of dividends paid from Seatoller Co to Pooleybridge Co. Add the other figures in the SPL
together.
4. Share of Profit:
Pooleybridge's share = Pooleybridge Co's profits 750 + Pooleybridge Co's share of Seatoller Co's profits (60% ×
480) = 1,038
NCI's share = 40% × 480 = 192
The Consolidated Statement of Profit or Loss is as follows:
Consolidated
$ '000
Revenue 9,220
Cost of sales (5,610)
Gross profit 3,610
Other operating expenses (1,220)
Profit before tax 2,390
Income tax expense (1,160)
Profit for the year 1,230
Profit attributable to:
Equity owners of Pooleybridge Co 1,038
Non-controlling interest 192
Profit for the year 1,230
3.2 Intra-Group Trading
Just as intra-group balances in the statement of financial position must be eliminated on consolidation, so too the effects of all
intra-group trading must be removed from the consolidated statement of profit or loss.
• If the parent sells goods to the subsidiary (or vice versa), those sales must be eliminated so that the consolidated profit or loss
reflects only those sales (and purchases) transacted with external parties.
• To cancel intra-group sales, the total amount of all intra-group sales is deducted from both consolidated revenue and costs of
sales. (The seller’s revenue will be the buyer’s purchase price.)

3.2.1 Intercompany Sales of Inventory

The sales price is deducted from the revenue and the cost of sales. The double entry to remove the intercompany sales is:

Individual Account Category Explanation

DR Revenue Income Revenue is deducted by the sale amount
CR Cost of Sales Expense COS is deducted by the sale amount
Any unrealised profit (URP) will also be removed from the closing inventory portion of the cost of sale. The double entry to
account for the unrealised profit is:

Individual Account Category Explanation

DR Cost of Sales Expense Closing inventory reduces, which increases the cost of sales (expense)
CR Closing Inventory Asset Reduce the closing inventory
• Profit Attributable to Owners
o For goods sold from parent to subsidiary: Deduct the sale’s unrealised profit
o For goods sold from subsidiary to parent: Deduct the parent’s share of the unrealised profit
• Profit Attributable to Non-Controlling Interest (NCI)
o For goods sold from parent to subsidiary: No adjustment
o For goods sold from subsidiary to parent: Deduct NCI’s share of the unrealised profit

3.2.2 Dividends Paid from Subsidiary to Parent

The parent acquires the subsidiary by purchasing a majority of the subsidiary’s ordinary shares. This may result in the parent
(owners) being paid dividends.
In the individual parent’s SPL, the dividends paid are recorded. However, per IFRS 10 Consolidated Financial Statements, the
dividend paid from the subsidiary to the parent must be removed when preparing the consolidated SPL.
The double entry to account for the dividend paid from the subsidiary is:

Individual Account Category Explanation

DR Other/Dividend Income Income Dividend Income is removed
CR Retained Earnings Equity Dividends are paid out of the RE. Thus, the reversal is to the same account.
Example 12
The following figures have been taken from the accounting records of the Pokesdown Group for the year ended 31
March 20X8. Pokesdown Co purchased 75% of the share capital of Southbourne Co on 1 April 20X7.

Pokesdown Co Southbourne Co
$ '000 $ '000
Revenue 5,740 3,120
Cost of sales 3,030 1,450
Profit for the year 730 380
During the year to 31 March 20X8, Pokesdown Co purchased goods for $120,000 from Southbourne Co and had
$40,000 of these goods in inventory at 31 March 20X8. Southbourne Co has a 25% markup on the goods it sells to
Pokesdown Co.
Southbourne Co purchased goods for $300,000 from Pokesdown Co and had $80,000 of these goods in inventory at
the year’s end. Pokesdown Co makes a 20% profit margin on the goods it sells to Southbourne Co.
From the available SOFP figures above, the following steps are made to prepare the consolidated CSOFP.
1. Determine the date of acquisition:
 The subsidiary is acquired at the start of the financial period. Therefore, there is no pro-rate of the
subsidiary’s figures for the CSPL.
2. Revenue and Cost of Sale:
There are intra-group sales of 120 (P to S) and 300 (S to P).
There is an unrealised profit (URP) of (80 × 20/100) + (40 × 25/125) = 24
Revenue = Pokesdown 5,740 + Southbourne 3,120 − Intragroup sales (120 + 300) = 8,440
Cost of Sales = Pokesdown 3,030 + Southbourne 1,450 − Intragroup sales (120 + 300) + URP 24 = 4,084
3. Other figures in the SPL:
There is no mention of dividends paid from the subsidiary to the parent company. Add the other figures in
the SPL together.
4. Profit Attributable to owners of Pokesdown Co:
Pokesdown profit = 730
Pokesdown’s share of Southbourne’s profit (75% × 380) = 285
URP [P to S: entire URP] = 16
URP [S to P: %] (75% × 8) = 6
Total profit attributable to the parent = 730 + 285 − (16 + 6) = 993
5. Profit attributable to NCI:
NCI’s share of Southbourne’s profit (25% × 380) = 95
URP [S to P: %] (25% × 8) = 2
Total profit attributable to NCI = 95 − 2 = 93
The Consolidated Statement of Profit or Loss is as follows:

Extract of Pokesdown Group’s consolidated statement of profit or loss for the year ended 31 March 20X8
Group
$'000
Revenue 8,440
Cost of sales 4,084
Profit for the year 1,086
Profit attributable to owners of Pokesdown Co 993
Profit attributable to non-controlling interest 93
Activity 12
Plaistow Co has owned 70% of the share capital of Steyning Co for several years. During the year to 31 October 20X7,
Plaistow Co made sales to Steyning Co at a value of $180,000 and with a profit margin of 40%. 50% of these goods remained
in Steyning Co's inventory at 31 October 20X7.
Steyning Co made sales to Plaistow Co at a value of $260,000 and a markup of 30%. 40% of these goods remained in
Plaistow Co's inventory at 31 October 20X7.
There was no opening inventory related to intra-group sales.
The following details are taken from the SPLs of both companies for the year ended 31 October 20X7:

Plaistow Co Steyning Co
$ '000 $ '000
Revenue 3,120 1,840
Cost of sales 1,670 1,310
Profit for the year 530 280
1. What is the revenue figure to be recorded in the consolidated SPL?
2. What is the cost of sales figure to be recorded in the consolidated SPL?
3. What figure would be included for the non-controlling interest's share of profit for the year?
4. What figure would be included for the owners of Plaistow's share of profit for the year?
Answer:

1. Revenue = Plaistow 3,120 + Steyning 1,840 − Intra-group sales (180 + 260) = $4,520
2. URP = (180 × 40/100 × 50%) + (260 × 30/130 × 40%) = 60
Cost of sales = Plaistow 1,670 + Steyning 1,310 − Intra-group sales (180 + 260) + PURP 60 = 2,600
3. Profit attributable to NCI = NCI’s share of subsidiary’s profit (30% × 280) − share of URP from S to P (30% × 24) = 76.8
4. Profit attributable to Plaistow = Plaistow 530 + Plaistow’s share of Steyning’s profit (70% × 280) − URP [P to S] 36 − URP [S to
P] (70% × 24) = 673.2
Activity 13
Poling Co acquired 75% of the share capital of Shipley Co on 1 April 20X2. During the year to 31 March 20X3, Poling Co sold
goods costing $1,200,000 to Shipley Co for $1,600,000. On 31 March 20X3, 40% of these goods remained in Shipley Co's
inventory.
The summarised statements of profit or loss for Poling Co and Shipley Co for the year ended 31 March 20X3 were:

Poling Co and Shipley Co’s statements of profit or loss for the year ended 31 March 20X3
Poling Co Shipley Co
$ '000 $ '000
Revenue 9,200 4,100
Cost of sales (5,750) (2,240)
Gross profit 3,450 1,860
Other operating expenses (1,500) (620)
Profit before tax 1,950 1,240
Income tax expense (490) (320)
Profit for the year 1,460 920
1. Which of the following calculations (expressed in $'000) should be used to calculate revenue?
1. 9,200 + 4,100
2. 9,200 + (75% × 4,100)
3. 9,200 + 4,100 + 1,200
4. 9,200 + 4,100 − 1,200
5. 9,200 + 4,100 − 1,600
6. 9,200 + (75% × 4,100) − 1,600
2. Which of the following calculations (expressed in $'000) should be used to calculate the cost of sales?
1. 5,750 + 2,240
2. 5,750 + 2,240 − 1,200
3. 5,750 + 2,240 − 1,600
4. 5,750 + 2,240 − 1,200 + (40% × 400)
5. 5,750 + 2,240 − 1,600 + (40% × 400)
6. 5,750 + 2,240 − 1,600 − (40% × 400)
3. Which of the following calculations (expressed in $'000) should be used to calculate the profit for the year
attributable to the equity shareholders of Poling?
1. 1,460 + 920
2. 1,460 + 920 − 160
3. 1,460 + 920 − 160 − (25% × 920)
4. 1,460 + 920 − 160 − (25% × 920) + (25% × 160)
5. 1,460 + 920 − 160 + (25% × 920) − (25% × 160)
6. 1,460 + 920 − 160 + (25% × 920)
Answer:

1. The correct answer is E. Parent’s 9,200 + Subsidiary’s 4,100 − Intragroup sale 1,600 = 11,700
2. The correct answer is E. Parent’s 5,750 + Subsidiary’s 2,240 − Intragroup sale 1,600 + Total unrealised profit (Profit 400 ×
unrealised 40%) = 6,550
3. The correct answer is C. Parent’s 1,460 + Subsidiary’s 920 − URP 160 − NCI’s share (25% × 920) = 1,990 or
Parent’s 1,460 + Parent’s share of subsidiary’s profit (920 × 75%) − URP 160 = 1990
The Consolidated Statement of Profit or Loss is as follows:
Poling Group’s consolidated statement of profit or loss for the year ended 31 March 20X3
Group
$ '000
Revenue 11,700
Cost of sales (6,550)
Gross profit 5,150
Other operating expenses (2,120)
Profit before tax 3,030
Income tax expense (810)
Profit for the year 2,220
Profit attributable to:
 Equity owners of Poling Co 1,990
Non-controlling interest 230
Profit for the year 2,220
3.3 Mid-Year Acquisitions
When the parent company acquires a subsidiary partway through the year:
• Only the subsidiary’s revenue and costs of the post-acquisition period will be included in the consolidated profit or loss.
• The calculation of the NCI's share of the subsidiary's profit will be based on post-acquisition profits only.
This is because the subsidiary was only a part of the group for that period. Only intragroup trading after the date of acquisition
is excluded on consolidation. For the pre-acquisition period, the subsidiary was not part of the group; Therefore, no adjustment
should be made for transactions during that period.

Exam advice

Unless otherwise instructed, always assume that revenue and costs accrue evenly over time.

Example 13

Pewsey Co acquired all the share capital of Salisbury Co on 1 April 20X4.

The SPLs for the two companies for the year ended 31 December 20X4 are shown below.

Pewsey Co Salisbury Co
$ '000 $ '000
Revenue 4,750 2,940
Cost of sales (2,890) (1,660)
Gross profit 1,860 1,280
Other operating expenses (840) (420)
Profit before tax 1,020 860
Income tax expense (280) (220)
Profit for the year 740 640
Assume Salisbury Co's income and expenses accrue evenly throughout 20X4. The revenues and cost of sales of the
two companies include sales by Pewsey Co to Salisbury Co of $120,000 and sales by Salisbury Co to Pewsey Co of
$200,000. There was no unsold inventory relating to these sales on 31 December 20X4.
From the available SOFP figures above, the following steps are made to prepare the consolidated CSOFP.
1. Determine the date of acquisition:
The financial period is from 1 January 20X4 to 31 December 20X4, and the date of acquisition is 1 April
20X4.
The pre-acquisition period is from 1 Jan to 31 March = 3/12 months
The post-acquisition period is from 1 April to 31 Dec = 9/12 months
Only subsidiary figures after the date of acquisition are included in the CSPL. Therefore, the amount is pro-
rated 9/12.
2. Revenue and Cost of Sale:
There are intra-group sales (post-acquisition) of 120 and 200, which must be excluded from the revenue
and cost of sales.
Revenue = Parent 4,750 + Subsidiary (2,940 × 9/12) − Intragroup sales [(120 × 9/12) + (200 × 9/12)] = 6,715
Cost of Sales = Parent 2,890 + Southbourne (1,660 × 9/12) − Intragroup sales [(120 × 9/12) + (200 × 9/12)]
= 3,895
3. Other figures in the SPL:
There is no mention of dividends paid from the subsidiary to the parent company. Add the other figures in
the SPL together. The subsidiary’s figures must be pro-rated to reflect only 9 out of the 12 months.
4. Profit Attributable to owners of Pewsey Co:
Pewsey profit = 740
Pewsey’s share of Salisbury’s profit (100% × 640 × 9/12) = 480
Total profit attributable to the parent = 740 + 480 = 1,220
5. Profit attributable to NCI:
Since Pewsey Co owns 100% of Salisbury Co, no NCI exists.
 The consolidated statement of profit or loss is as follows:

Pewsey Group’s consolidated statement of profit or loss for the year ended 31 December 20X4
Consolidated
$ '000
Revenue 6,715
Cost of sales (3,895)
Gross profit 2,820
Other operating expenses (1,155)
Profit before tax 1,665
Income tax expense (445)
Profit for the year 1,220
Activity 14
Pangbourne Co acquired 80% of the share capital of Sunningdale Co on 1 November 20X6. The summarised SPLs for the two
companies for the year ended 30 June 20X7 are shown below.

Pangbourne Co and Sunningdale Co statements of profit or loss for the year ended 30 June 20X7
Pangbourne Co Sunningdale Co
$ '000 $ '000
Revenue 12,980 4,770
Cost of sales (8,120) (2,430)
Gross profit 4,860 2,340
Other operating expenses (2,310) (1,440)
Profit before tax 2,550 900
Income tax expense (600) (210)
Profit for the year 1,950 690
During the year to 30 June 20X7, Pangbourne Co sold goods for $150,000 to Sunningdale Co, and Sunningdale Co sold goods
worth $105,000 to Pangbourne Co. There was no unsold inventory held by either company relating to these sales on 30 June
20X7.
Use the information provided to prepare the consolidated SPL for the Pangbourne Group for the year to 30 June 20X7.
Answer:

1. Determine the date of acquisition:

The financial period is from 1 July 20X6 to 30 June 20X7, and the date of acquisition is 1 November 20X6.
The pre-acquisition period is from 1 July X6 to 31 Oct X6 = 4/12 months
The post-acquisition period is from 1 Nov X6 to 30 June X7 = 8/12 months
Only subsidiary figures after the date of acquisition are included in the CSPL. Therefore, the amount is pro-rated 8/12.
2. Revenue and Cost of Sale:
There are intra-group sales (post-acquisition) of 150 and 105, which must be excluded from the revenue and cost of
sales.
Revenue = Parent 12,980 + Subsidiary (4,770 × 8/12) − Intragroup sales [(150 × 8/12) + (105 × 8/12)] = 15,990
Cost of Sales = Parent 8,120 + Subsidiary (2,430 × 8/12) − Intragroup sales [(150 × 8/12) + (105 × 8/12)] = 9,570
3. Other figures in the SPL:
There is no mention of dividends paid from the subsidiary to the parent company. Add the other figures in the SPL
together. The subsidiary’s figures must be pro-rated to reflect only 8 of the 12 months.
4. Profit Attributable to owners of Pangbourne Co:
Pangbourne profit = 1,950
Pewsey’s share of Sunningdale’s profit [80% × (690 × 8/12)] = 368
Total profit attributable to the parent = 1,950 + 368 = 2,318
5. Profit attributable to NCI:
NCI’s share of Sunningdale’s profit [20% × (690 × 8/12)] = 92
The Consolidated Statement of Profit or Loss is as follows:
Consolidated SPLOCI for Pangbourne Group for the year ended 30 June 20X7
Consolidated
$ '000
 Revenue 15,990
Cost of sales (9,570)
Gross profit 6,420
Other operating expenses (3,270)
Profit before tax 3,150
Income tax expense (740)
Profit for the year 2,410
Profit attributable to:
Equity owners of Pangbourne Co 2,318
Non-controlling interest 92
Profit for the year 2,410
Activity 15 (Full Working CSPL)
The following activity is presented in the style of the computer-based ACCA exam.
Pershore Co acquired 90% of the share capital of Stourport Co on 1 July 20X0. During the year to 30 June 20X1, Pershore Co
sold goods costing $900,000 to Stourport Co for $1,200,000. 35% of these goods remained in Stourport Co's inventory at 30
June 20X1. Stourport Co sold goods to Pershore Co for $1,000,000 at a profit margin of 25%. 20% of these goods remained in
Pershore Co's inventory at 30 June 20X1.
The summarised SPLs for the two companies for the year ended 30 June 20X1 are shown below:

Pershore Co Stourport Co
$ '000 $ '000
Revenue 15,440 8,000
Cost of sales (9,980) (4,460)
Gross profit 5,460 3,540
Distribution costs (1,230) (920)
Administrative expenses (670) (510)
Profit before tax 3,560 2,110
Income tax expense (860) (570)
Profit for the year 2,700 1,540
Using the information provided above, prepare the consolidated SPL for the Pershore Group for the year to 30 June
20X1.
Answer:

1. Determine the date of acquisition:

The subsidiary is acquired at the start of the financial period. Therefore, there is no pro-rate of the subsidiary’s
figures for the CSPL.
2. Revenue and Cost of Sale:
There are intra-group sales of 1,200 (P to S) and 1,000 (S to P).
Unrealised profit (URP) of P to S: [35% × (1,200 − 900)] = 105
Unrealised profit (URP) of S to P: [20% × (1,000 × 25/100)] = 50
Revenue = Parent 15,440 + Subsidiary 8,000 − Intragroup sales (1,200 + 1,000) = 21,240
Cost of Sales = Parent 9,980 + Subsidiary 4,460 − Intragroup sales (1,200 + 1,000) + UPR (105 + 50) = 12,395
3. Other figures in the SPL:
There is no mention of dividends paid from the subsidiary to the parent company. Add the other figures in the SPL
together.
4. Profit Attributable to owners of the parent:
Pershore profit = 2,700
Pershore’s share of Stourport’s profit (90% × 1,540) = 1,386
URP [P to S: entire URP] = 105
URP [S to P: %] (90% × 50) = 45
Total profit attributable to the Parent = 2,700 + 1,386 − (105 + 45) = 3,936
5. Profit attributable to NCI:
NCI’s share of Stourport’s profit (10% × 1,540) = 154
URP [S to P: %] (10% × 50) = 5
Total profit attributable to NCI = 154 − 5 = 149
The Consolidated Statement of Profit or Loss is as follows:
Consolidated SPLOCI for Pershore Group for the year ended 30 June 20X1
$ '000
Revenue 21,240
Cost of sales (12,395)
Gross profit 8,845
Distribution costs (2,150)
Administrative expenses (1,180)
Profit before tax 5,515
Income tax expense (1,430)
Profit for the year 4,085
Profit attributable to:
Equity owners of Pershore Co 3,936
Non-controlling interest 149
Profit for the year 4,085
Activity 16 (Full Working CSPL)
The following activity is presented in the style of the paper-based ACCA exam.
Penshurst Co acquired 80% of the share capital of Sandling Co on 30 June 20X8. The summarised SPLs for the two
companies for the year ended 30 September 20X8 are shown below.

Penshurst Co and Sandling Co statements of profit or loss for the year ended 30 September 20X8
Penshurst Co Sandling Co
$ '000 $ '000
Revenue 22,450 13,500
Cost of sales (14,970) (6,420)
Gross profit 7,480 7,080
Other operating expenses (2,390) (1,820)
Profit before tax 5,090 5,260
Income tax expense (1,400) (1,360)
Profit for the year 3,690 3,900
All Sandling Co's revenue and expenses accrued evenly over the year to 30 September 20X8. This included sales worth
$240,000 to Penshurst Co. Penshurst Co made sales worth $300,000 to Sandling Co between 1 October 20X7 and 30 June
20X8 and $130,000 between 1 July 20X8 and 30 September 20X8.
There was no inventory relating to these sales held by either company on 30 September 20X8.
The group revalued non-current assets during the year ended 30 September 20X8 resulting in a gain on revaluation of
$400,000.
Using the information provided above, prepare the consolidated SPL for the Penshurst Group for the year to 30
September 20X8.
Answer:

1. Determine the date of acquisition:

The financial period is from 1 October 20X7 to 30 September 20X8, and the date of acquisition is 30 June 20X8.
The pre-acquisition period is from 1 Oct X7 to 30 June X8 = 9/12 months
The post-acquisition period is from 1 July X8 to 30 Sept X8 = 3/12 months
Only subsidiary figures after the date of acquisition are included in the CSPL. Therefore, the amount is pro-rated
3/12.
2. Revenue and Cost of Sale:
There are intra-group sales (post-acquisition − after 30 June X8) of 240 and 130, which must be excluded from the
revenue and cost of sales.
Revenue = Parent 22,450+ Subsidiary (13,500 × 3/12) − Intragroup sales [(240 × 3/12) + 130) = 25,635
Cost of Sales = Parent 14,970 + Subsidiary (6,420 × 3/12) − Intragroup sales [(240 × 3/12) + 130) = 16,385
3. Other figures in the SPL:
 There is no mention of dividends paid from the subsidiary to the parent company. Add the other figures in the SPL
together. The subsidiary’s figures must be pro-rated to reflect only 3 out of the 12 months.
4. Profit Attributable to owners of Parent:
Parent profit = 3,690
Parent’s share of Subsidiary’s profit [80% × (3,900 × 3/12)] = 780
Total profit attributable to the parent = 3,690 + 780 = 4,470
5. Profit attributable to NCI:
NCI’s share of the Subsidiary’s profit (20% × 3,900 × 3/12) = 195
The Consolidated Statement of Profit or Loss is as follows:
Consolidated SPLOCI for Penshurst Group for the year ended 30 September 20X8
Group
$ '000
Revenue 25,635
Cost of sales (16,385)
Gross profit 9,250
Other operating expenses (2,845)
Profit before tax 6,405
Income tax expense (1,740)
Profit for the year 4,665
Other comprehensive income -
Gain on revaluation of non-current assets 400
Total comprehensive income for the year 5,065
Profit attributable to:
Equity owners of Penshurst Co 4,470
Non-controlling interest 195
Profit for the year 4,665
4.1 Introduction to Associates
The consolidated financial statements include the financial results of a parent and its subsidiary. A subsidiary is an entity that
can be controlled and owned by the parent.
A parent company may invest in another entity, which leads to the investor having significant influence over the company but
not a controlling interest. As the company does not control the entity, it cannot be classified as a subsidiary. Instead, this is a
relationship known as an associate.

4.1.1 Definition and Identification

Definition

An associate is an entity in which a company has invested and where the investor has significant influence over the investment entity.

Significant Influence:
Significant Influence occurs when the investor of an associate has the power to participate in the financial and operating policy
decisions of the investment. However, the investor does not have control or joint control of financial and operating policies.
Significant influence is presumed to exist if the investment is 20% or more but less than 50% of the voting rights in the
associate. It also can be argued that significant influence exists for a shareholding of less than 20%. This is usually evidenced
by the following:
• Representation on the board of directors of the investee
• Participation in the policy-making process
• Material transactions between the investor and investee
• Interchange of management personnel
• Provision of essential technical information
 Key Point

A holding of 20% or more of the voting rights of the investee indicates significant influence, unless it can be demonstrated
otherwise.
A holding of less than 20% presumes that the holder does not have significant influence, unless such influence can be clearly
demonstrated (e.g. representation on the board).

Activity 17
For each of the following statements, state whether there is evidence of significant influence.
1. Goodwill arises on the acquisition of the investment.
2. There is a non-controlling interest in the investment.
3. The investor holds 10% of equity shares in the investment.
4. The investor has the power to participate in the operating policy decisions of the investee.
5. The investor assigns one of its directors to the senior management team of the investee.
Answer:

1. No evidence of significant influence. This is a sign of a parent-subsidiary relationship.

2. No evidence of significant influence. This is a sign of a parent-subsidiary relationship.
3. No evidence of significant influence.
4. Evidence of significant influence
5. Evidence of significant influence
4.2 Equity Accounting
The method used to account for associates is called equity accounting. IAS 28 Investment in Associates requires that the
equity method of accounting be used to incorporate the results of the associate into consolidated financial statements.
Key Point

Under equity accounting, the investor includes its share of the associate's post-tax profits, whether or not the profits are
distributed as dividends.
Equity accounting is only used in consolidated financial statements. If the investor has no subsidiaries and does not prepare
consolidated financial statements, it will not use equity accounting.

4.2.1 Associates in the Financial Statements

• Investor SFP
The investor includes a single line item, ‘Investment in the Associate’, in the non-current assets section at cost in
its SOFP, the same way an investment in a subsidiary would be accounted for.
• Investor SPL&OCI
Any dividends received from the associate are included in the investor’s SPLOCI as Other Income.
• Consolidated SFP
The CSFP includes a single line item, ‘Investment in Associate’, in the non-current assets section at cost plus the
investor's share of post-acquisition profits.
The change each year will be the investor's share of post-tax profit minus dividends. Dividends are deducted
because they are an appropriation of profits. Bank and cash will increase by dividends received.
• Consolidated SPL
The investor's share of profit for the year is included in the CSPL as a single item, ‘Share of profit of the associate’
above profit before tax.
Exam advice

The FA exam will not test associate calculations using the equity accounting method. However, the principles of equity accounting are
examinable.

Example 14

Portslade Co acquired a 30% share of the equity share capital of Aldrington Co on 1 January 20X5 for $450,000.
 Aldrington Co's profits were $150,000 for the year to 31 December 20X5 and $180,000 for the year to 31 December
20X6. Portslade Co did not receive any dividends from Aldrington Co in 20X5 but received a dividend from Aldrington
Co of $20,000 on 31 August 20X6.
Portslade Co also has two subsidiaries and therefore prepares consolidated financial statements.
Portslade’s financial statement is as follows:

Portslade Co's own financial statements

DR CR
$ '000 $ '000
Statement of financial position
Non-current assets
Investment in associate 450
Statement of profit or loss and other comprehensive income
Other income 20
The associate will be reflected in the consolidated financial statement as follows:

Portslade Group's consolidated SFP

DR CR
$ '000 $ '000
Statement of financial position
Investment in associate 529

Workings:
Cost of investment 450
Share of 20X5 profits (30% × $150,000) 45
Investment in associate at 31 December 20X5 495
Share of 20X6 profits (30% × $180,000) 54
Less: Dividend received from associate (20)
Investment in associate at 31 December 20X6 529
Portslade Group's consolidated SPL&OCI
DR CR
$ '000 $ '000
Statement of profit or loss and other comprehensive income
Share of profit of associate 54

Workings:
Effectively the double entries are:
DR Investment in associate (SOFP) 54
CR Share of profit of associate (SPLOCI) with share of associate's profit for the year 54

DR Bank and cash 20

CR Investment in associate (SOFP) with dividend received from associate in year 20
Activity 18
Pevensey Co acquired 40% of the ordinary shares of Alfriston Co on 1 January 20X3 for a cash payment of $260,000.
Pevensey Co's share of Alfriston Co's profits between 1 January 20X3 and 30 June 20X6 was $170,000.
Alfriston Co made post-tax profits of $120,000 for the year ended 30 June 20X7, and Pevensey Co received a dividend of
$14,000 from Alfriston Co in November 20X6.
Use the information above to prepare Pevensey's financial statements and the consolidated financial statements for
the Pevensey Group for the year ended 30 June 20X7.

Answer:

Pevensey Co's own financial statements $’000

SOFP
Non-current assets
Investment in associate 260

SPLOCI
Other income 14

Pevensey Group’s consolidated financial statements

SPLOCI 48

Share of profit of associate

SOFP
Investment in associate 464

Workings: $ '000

Cost of investment 260

Share of profits to 30 June 20X6 170

Investment in associate at 30 June 20X6 430

Share of profit of associate for the year to 30 June 20X7 48

Less: Dividend received from associate (14)

Investment in associate at 30 June 20X7 464

Activity 19
Porchfield Co owns 30% of the equity share capital of another company, Alverstone Co. Porchfield Co prepares consolidated
financial statements, and Alverstone Co is classified as Porchfield Co's associate.
For each statement about the above scenario, determine whether it is True or False.
1. Dividends received from Alverstone Co are included in Porchfield Co’s statement of profit or loss and other comprehensive
income.
2. Alverstone Co's revenues and costs are added to the consolidated SPL on a line-by-line basis.
3. The consolidated SOFP includes an amount for 'Investment in Associate', which is the original cost of investment plus
Porchfield Co's share of Alverstone Co's profits.
Answer:

1. True. Dividends are included in Porchfield Co's SPLOCI; share of profits are included in the consolidated financial statements.
2. False. Porchfield Co's share of Alverstone Co's profits is included in a single line in the consolidated SPL.
3. True. The amount shown in the consolidated SOFP would be adjusted each year by Porchfield Co's share of profits for that
year.
CHAPTER 18: Visual Overview
CHAPTER 18: Visual Overview
Objective: To explain the use of ratio analysis in the interpretation of financial statements.

18.1.1 Process of Interpretation of Financial Statements

1.1 Process of Interpretation of Financial Statements
Interpretation and analysis involve:

• Identifying users
 • Examining financial information

• Analysing (comparison, evaluation and prediction)

• Reporting in a format to provide information for economic decision-making

18.1.2 Users of Financial Statements
1.2 Users of Financial Statements
1.2.1 Internal Users
The ability of an organisation to analyse its financial position is essential for improving its
competitive standing. Analysis of financial performance helps organisations identify opportunities
to improve performance.

1.2.2 External Users

The objective of general-purpose financial reporting is to provide information useful to the primary
users in making decisions relating to providing resources to the entity. Users external to the entity
will generally have access only to published financial statements. Whereas investors may be
most interested in growth potential, lenders will be concerned with the availability of cash (to
ensure they are paid on time) and the quality of assets provided as security.
Activity 1
Match the following users of financial statements to their corresponding opinions.

18.1.3 Ratio Analysis

1.3 Ratio Analysis
Financial statements are analysed with the use of ratios.

Definitions

A ratio is an expression of a quantitative relationship between two numbers.

Ratio analysis is determining ratios for meaningful comparisons and interpreting them.

1.3.1 Purpose of Ratio Analysis

The purpose of calculating and analysing the ratios for a company can assist users of financial
statements by:

• Providing a uniform measurement which will act as an indicator of:

o areas for further investigation in the current period

o the pattern of results over a series of periods (trend analysis)

• Summarising large quantities of financial data into information that can be used to make
qualitative judgments about an entity's financial performance.

• Reducing financial data to fewer expressions of variables which is useful when:

o the relationship between amounts is of interest (rather than absolute

monetary amounts)

o the information generated will be reviewed over time (as in trend

analysis).

• Indicating areas where the entity may be strong or weak (rather than evaluate financial
performance in "good/bad" terms).

1.3.2 Comparisons of Ratio Analysis

The results of the ratio analysis are typically compared between:

• previous and current periods (historical comparison)

• target/budgeted (or standard) and actual figures

• other companies/industry averages (similar industry comparison)

For comparisons to be meaningful, they should be based on functionally related amounts. For
example, bad debt expense is a function of accounts receivable rather than revenue (so a
percentage of accounts receivable will be preferable for analysis).
18.1.4 Classifications of Ratios
1.4 Classifications of Ratios
Ratios may be classified on several bases. For example:
 • Basis of financial statements Ratios are derived from the statement of
financial position and the statement of profit or loss. (Position ratios)

• By function Ratios consider the needs of users for information about:

o How the business is performing (Profitability and Efficiency)

o How it stands financially (Liquidity and Position)

o Its potential (market standing).

Classification is subjective for example, liquidity ratios are also position ratios.
Exam advice

Investor (market standing) ratios such as earnings per share (EPS), price-earnings ratio (P/E ratio) and
dividend yieldare NOT examinable in Financial Accounting.

18.2.1 Introduction to Profitability Ratios

2.1 Introduction to Profitability Ratios
General profitability ratios are derived from statements of profit and loss alone. In contrast,
overall profitability ratios consider the entity’s size as represented by its capital in the statement
of financial position.
Profitability ratios show how a company's income compares with its expenses. They can indicate
how well the business has been keeping control of its costs.
The types of profitability ratios are illustrated in the diagram below:

18.2.2 Gross Profit Margin

2.2 Gross Profit Margin
The gross profit margin ratio shows how profitable a company’s trading has been. It indicates
how much the company has been able to mark up the sales price of its goods above the costs it
has incurred.
This ratio is often used to compare companies in the same business sector.
Typical gross profit margins will vary across different business sectors, making comparison less
useful.
 • Revenue is net of discounts and customer returns

• Gross profit = Revenue Cost of goods sold

• Cost of goods sold (or cost of sales):

o For a trading company = Opening inventory + Purchases Closing

inventory

o For a manufacturing company, it includes conversion costs (labour,

overheads, etc.)
The margin must cover all operational expenses and meet management's requirements for
increasing reserves (retained earnings) and shareholders’ requirements (for dividends).

2.2.1 Gross Profit Margin Analysis

Gross profit percentage provides insight into the relationship between purchasing costs and
revenues.
A low or declining gross profit margin is usually an adverse sign.
The decline in the gross profit margin may be due to any of the following:

• Fall in selling prices (For example, due to increased competition)

• a change in sales mix (For example, to remain relevant and competitive)

• an increase in purchase costs (For example, due to a fall in discounts received if

management is unable to buy sufficient bulk)

• an increase in production costs such as materials, labour, or overheads

• an overstatement of opening inventories (For example, due to an error in counting or

valuing inventory or inventory losses)

• an understatement of closing inventories.

A decline may not always reflect a problem. For example, a drop may be due to the launch of a
new product at a low (penetration) price or an attempt to increase market share.
An increase in the gross profit margin may be due to the following:

• an increase in selling price without a corresponding increase in cost

• a decrease in costs which has not been passed on proportionately to customers

• an understatement of opening inventory or overstatement of closing inventory.

 Exam advice

Pay attention to inventory valuation. If allowances for obsolete or slow-moving items are understated, closing
inventory will be overstated, and the gross profit percentage will be overstated.

18.2.3 Operating or Net Profit Margin

2.3 Operating or Net Profit Margin
The net profit margin ratio indicates how much revenues exceed the costs of operating the
company, which includes the cost of goods sold, distribution, and administrative costs. It
considers all overheads.
Net profit margin shows the overall profitability of the business after deducting all expenses.
It measures how well the business has managed to control indirect costs.

2.3.1 Net Profit Margin Analysis

The net profit margin is an indicator of the control of operating expenses. Therefore, the
movement in net profit margin should be compared to the movement in gross profit margin: The
net profit margin would be expected to improve/deteriorate in line with the gross profit margin.

• A relative improvement in net profit margin could be due to good indirect cost control or a
significant one-off gain (For example, profit on disposal of an asset)

• A relative deterioration in net profit margin could be due to a weakening cost control or
high one-off costs.
This ratio may be investigated further by calculating specific expense items as a percentage of
sales, for example:

Fixed costs (such as rent) may not change in line with revenue (as they may be stepped costs)
which can cause the net profit percentage to fluctuate when revenues are unstable.
The net profit percentage would not be expected to fluctuate much if the main costs were
variable.

Example 1

The statement of profit or loss of Caixin Co for the year ended 31 March 20X5 has been prepared as
follows:

Caixin Co statement of profit or loss for the year ended 31 March 20X5

$ '000 $ '000
 Example 1

Revenue 19,350

Cost of sales:

Opening inventories 1,890

Purchases 12,340

Closing inventories (1,970)

(12,260)

Gross profit 7,090

Distribution costs (1,780)

Administrative expenses (1,630)

Profit before interest and tax 3,680

Finance costs (610)

Profit before tax 3,070

Income tax expense (780)

Profit after tax 2,290

Caixin Co’s gross profit margin = (Gross Profit 7,090 ÷ Sales 19,350) x 100% = 36.6%
Caixin Co’s net profit margin = (PBIT 3,680 ÷ Sales 19,350) × 100% = 19.0%
Shareholders can compare each company’s ratios to other years and will draw their conclusions on how
well the company has kept control of its costs for the current year. Likewise, company directors could
compare their figures against other businesses to determine how well the company performs.

18.2.4 Return on Capital Employed (ROCE)

2.4 Return on Capital Employed (ROCE)
The return on capital employed (ROCE) is the primary profitability ratio. It shows how
productively (efficiently and effectively) a business has deployed its available resources,
irrespective of how they have been financed. It relates the overall profit performance to the
amount of capital employed in the business.
The return on capital employed ratio shows how effectively a company generates profit from its
capital.

Or

• Profit before interest and tax = the profit before interest and dividends have been paid to
finance providers, such as banks and shareholders.

• Capital employed = the funds that belong to shareholders plus loans not repayable within
one year. It can be calculated as:

o Total Assets less Current Liabilities or

o Shareholder’s Equity plus Long-term Liabilities

2.4.1 Return on Capital Employed Analysis

An increase in the ROCE percentage is generally an improvement.
If the ROCE margin falls or is low, this may indicate the following:

• The entity is not using its resources efficiently. A low return may result in a loss if the
economy deteriorates.

• Management will need to investigate further as there may be a need to increase operating
profit or sell some assets and invest the proceeds elsewhere to earn a higher return.
However, any trend that emerges by making comparisons with the previous years' ROCE may be
distorted by:

• assets which are written down to low carrying amounts (overstating ROCE)

• revaluations which will depress ROCE (higher capital → higher depreciation → lower
profit)

• timing of share/debt issues

• changes in accounting policies

If a part of the business does not meet the entity's target ROCE (i.e. budget), management may
dispose of it.
The business’s return on capital employed should exceed its cost of capital for long-term
sustainability.

2.4.2 Interrelationship with other Ratios

The return on capital employed can be further analysed into operating profit margin and asset
turnover as follows:

• Profit margin is often seen as a measure of the quality of profits. A high profit margin
indicates a high profit on each unit sold.

• Asset turnover is often seen as a quantitative measure, indicating how efficiently

management uses the assets.
The interrelationship between profitability and efficiency can be used to provide insights into the
ROCE for a particular business. For example, if a company experiences a decline in ROCE, it
could be due to a fall in profitability or a drop in efficiency (or both).
18.2.5 Asset Turnover
2.5 Asset Turnover

Asset turnover shows the number of times the carrying amount of assets is turned over in
generating revenue. For businesses in the same industry, the higher the ratio, the more efficiently
the assets appear to be used.
Asset turnover shows how efficiently an entity uses its capital to generate sales.

Asset turnover is affected by the business’s accounting policy regarding depreciation and
amortisation.
For example, two companies are of equivalent size and generate the same revenue. The one
with the lower asset value will have a higher asset turnover. The lower carrying amount of assets
may be due to tangible assets being written off over shorter estimated useful lives.
18.2.6 Return on Equity (ROE)
2.6 Return on Equity (ROE)

Return on equity measures residual profit to owners' investment. It shows the extent to which the
entity has achieved its objective of earning a satisfactory net income (i.e. profit after interest and
tax).
Return on equity is the profit due to the company’s shareholders.

A prospective investor calculates ROE to determine whether the return is worthwhile.

Key Point

ROE is more relevant to existing/prospective shareholders than ROCE.

Example 2

The statement of profit or loss and the statement of financial position of Caixin Co for the year ended 31
March 20X5 has been prepared as follows:

Caixin Co statement of profit or loss for the year ended 31 March 20X5

$ '000 $ '000

Revenue 19,350

Cost of sales:

Opening inventories 1,890

Purchases 12,340

Closing inventories (1,970)

(12,260)

Gross profit 7,090

Distribution costs (1,780)

Administrative expenses (1,630)

 Example 2

Profit before interest and tax 3,680

Finance costs (610)

Profit before tax 3,070

Income tax expense (780)

Profit after tax 2,290

Caixin Co statement of financial position as at 31 March 20X5

$ '000 $ '000

ASSETS

Non-current assets

Property, plant and equipment 28,450

Current assets

Inventories 1,970

Trade receivables 2,320

Cash and cash equivalents 650

4,940

TOTAL ASSETS 33,390

EQUITY AND LIABILITIES

Equity

Share capital 1,000

Retained earnings 19,740

20,740

Non-current liabilities
 Example 2

Long-term liabilities 9,500

Current liabilities

Trade payables 2,370

Current tax payable 780

3,150

TOTAL EQUITY AND LIABILITIES 33,390

Return on Capital Employed = [PBIT 3,680 ÷ (Shareholders' equity 20,740 + Long-term liabilities 9,500)] ×
100% = 12.2%
Return on Equity = (Profit after tax and preference dividend 2,290 ÷ Equity shareholders’ funds 20,740) ×
100% = 11.0%
Asset turnover = Sales 19,350 ÷ (Shareholders' equity 20,740 + Long-term liabilities 9,500) = 0.64 X
18.3.1 Introduction to Liquidity Ratios
3.1 Introduction to Liquidity Ratios

Short-term liquidity ratios concern financial stability. If they indicate that an entity cannot meet
short-term liabilities from available assets, there will be going concern implications. The two most
common measures are the current ratio and the quick ratio.

18.3.2 Current Ratio

3.2 Current Ratio

The current ratio measures the adequacy of current assets to meet short-term liabilities (without
raising additional finance). This ratio is an overall measure of liquidity and the state of trading.
Current assets and liabilities include all items classified as such on the statement of financial
position. Current liabilities will therefore include dividends and taxation payable.
However, where a bank overdraft is permanent (maintained from year to year), it may be
excluded from current liabilities even though it is legally repayable on demand.

3.2.1 Current Ratio Analysis

The higher the current ratio, the more liquid the business is. As liquidity is essential to business
survival, a higher ratio usually is preferable to a lower one.

• If low/declining, the entity may not meet its short-term obligations as they become due.

• A high/increasing ratio might suggest over-investment in current assets (inventories,

receivables or cash).
A current ratio of 1.5:1 is usually acceptable (to maintain creditworthiness).

• A low ratio may indicate overtrading or under-capitalisation

• A high ratio may indicate under-trading or overcapitalisation

The current ratio treats all assets alike though they are not equally or readily realisable. In
particular, the nature of inventories should be considered. For example, if inventories are slow-
moving, the quick ratio is a better indicator of more immediate solvency.
18.3.3 Quick Test Ratio
3.3 Quick Test Ratio

The quick test (or acid test) ratio measures immediate liquidity by eliminating from current assets
the least liquid assets (inventories). This reflects the possibility that the company finds it
challenging to convert inventory into cash compared to other current assets.
The quick ratio is a stricter test of liquidity:

The quick ratio indicates the sufficiency of resources (receivables and cash) to settle short-term
liabilities (trade payables in particular).

3.3.1 Quick Ratio Analysis

A ratio of 1:1 is usually considered the typical acceptable quick ratio. However:

• Industries with high cash sales and high inventory turnover (for example, supermarkets)
have very low quick ratios.

• A manufacturing entity with seasonal sales but steady production is likely to have a lower
ratio when sales volume is low (lower receivables and cash) and a higher ratio when sales are
high.
When analysing the quick ratio, an entity's operating overdraft and facilities available should be
considered. For example, an entity with a low quick ratio may have no problem settling current
liabilities if it has adequate overdraft facilities.
Activity 2

The extracts of a company’s Statement of financial position show the following:

Receivables $900

Cash $500

Payables $1,000

1. Calculate the quick ratio.

2. Recalculate the ratio after $400 is paid to a trade supplier.

18.3.4 Window Dressing

3.4 Window Dressing

Window dressing is a particular type of creative accounting which is used to present financial
statements in a more favourable light to gain benefits such as:

• obtain funding/borrow money

• reduce tax payments

• smooth profits

• hide liquidity/profitability problems that might reflect poor management decisions.

Various actions may be taken to create the desired effect.
For example, to improve liquidity, trade payables may be treated as paid at the reporting date,
although they are not settled until a later date.
18.4.1 Introduction to Efficiency Ratios
4.1 Introduction to Efficiency Ratios

The efficiency ratios analyse how well a company manages its assets and liabilities internally.
The efficiency ratios calculate inventory turnover (inventory holding period), account receivables
(receivables collection period) and account payables (payables payment period) days.
18.4.2 Inventory Turnover
4.2 Inventory Turnover

Inventory turnover measures the average time a company holds unsold goods. The ratio
measures operational and marketing efficiency.

4.2.1 Inventory Turnover Analysis

A high inventory turnover ratio generally indicates efficiency in selling goods quickly. If declining,
inventories are turning over less quickly.

• Negative reasons may be:

o fall in demand for goods

o poor inventory control (storage and insurance cost increases)

o over-investment in inventory exceeding immediate requirements

o carrying obsolete inventory (possibly resulting in write-offs)

• Positive reasons may be:

o bulk buying to take advantage of trade (bulk) discounts

o increasing inventory levels to avoid stockouts (For example, due to erratic

demand or where supply is unreliable).
Days inventory can vary considerably, for example:

• A fishmonger 1 or 2 days.
 • A building contractor 200 days
Generally, higher turnover may not mean higher profits, as increased volume may be achieved
through reduced profit margins.
For manufacturing companies, inventory turnover:

• should closely relate to production time

• can be further investigated by looking at a breakdown of raw materials, work-in-progress

and finished goods.
18.4.3 Accounts Receivable Days
4.3 Accounts Receivable Days

Accounts receivable days show the average time it takes to receive payment from credit
customers (the number of calendar days over which receivables are uncollected).

4.3.1 Account Receivable Days Analysis

As a measure of the liquidity of receivables, receivable days should not exceed a reasonable
proportion of sales. The longer the period, the greater the expense of collecting slow-paying or
uncollectible accounts.

• An increasing ratio may be due to the following:

o weak credit control (For example, lack of adequate collection

procedures)

o a deliberate policy to extend credit to attract more trade

o major customers being allowed different credit terms (For example,

three months of interest-free credit).

• Although a decrease in this ratio over time is generally a positive move, occasionally, it
could signal a cash shortage.
Receivable days should be compared with the stated credit policy set out in terms and conditions
(on invoices).

• It may be negligible (For example, supermarkets, retailers and other cash-based

businesses do not have credit sales).

• It may be distorted for comparative purposes by:

o VAT or other sales taxes

o debt-factoring arrangements (where debts are sold)

 o seasonal trading (For example, a company with a year-end of
December may have lower receivables due to falling trade in the holiday period)
18.4.4 Accounts Payable Days
4.4 Accounts Payable Days

Accounts payable days represent (average) the time (i.e. number of days) it takes to pay for
supplies received on credit.

4.4.1 Account Payable Days Analysis

• An increasing ratio may be due to liquidity problems, resulting in:

o poor reputation as a slow payer (may not be able to find new suppliers);

o existing suppliers withdrawing supplies (or demanding "cash on delivery"); and

o inability to take advantage of cash discounts (an expensive finance means).

• a deliberate policy to take advantage of interest-free credit (management must not incur
late-payment penalties).
Payables days should be compared with average suppliers' credit terms (on the invoice) or the
credit terms of significant suppliers. Distortion may arise if amounts due to suppliers include
capital acquisitions.

Example 3

Continuation from Example 2 previously.

The statement of profit or loss and the statement of financial position of Caixin Co for the year ended 31
March 20X5 have been prepared.
What liquidity and efficiency ratios can be derived from Caixin Co’s financial statements?
Liquidity:
1. Current ratio = Current assets 4,940 ÷ Current liabilities 3,150 = 1.57:1

2. Quick ratio = (Current assets 4,940 Inventory 1,970) ÷ Current liabilities 3,150 = 0.94:1
Efficiency:
1. Receivables days = (Trade receivables 2,320 ÷ Credit sales 19,350) × 365 = 44 days
2. Payables days = (Trade payables 2,370 ÷ Cost of sales 12,260) × 365 = 71 days
3. Inventory turnover = (Inventory 1,970 ÷ Cost of sales 12,260) × 365 = 59 days
Looking at these figures, Caixin Co appears to be obtaining more generous terms from its suppliers than it
offers its customers. However, it may not be managing its customers very well. If customers took less time
to pay, it could pay its suppliers sooner and improve relationships with them.

18.4.5 Operating (Working Capital) Cycle

4.5 Operating (Working Capital) Cycle

The working capital cycle shows the amount of time (in days) that an entity takes to convert
resource inputs (inventory) to cash receipts. It is the period from when cash is spent on
purchases to when money is collected from customers.
The working capital cycle is derived from the previous three figures for a trading company:

Working capital cycle = Inventory days + Account receivable days − Account payable days

For a manufacturing business, inventory days include the average time raw materials are held
and the time taken to produce goods.

4.5.1 Operating Cycle Analysis

Working capital is the difference between current assets and current liabilities. If the cycle is
increasing, it may be due to the following:

• Poor working capital control

• a deliberate policy to build up finished goods inventory or attract more customers by giving
a more extended credit period.
Working capital requirements are very dependent on the type of business. For example, a
supermarket may have a negative cycle as the supermarket receives cash before paying
suppliers.
Working capital indicates whether a business can generate cash as quickly as it uses it and the
cash level required to maintain operating capacity. For example, the shorter the cycle, the less
reliance on external finance.
• Excessive working capital represents excessive interest paid (or loss of interest income) and
lost opportunities (in investing funds for a higher return).
Example 4

Continuation from Example 3 previously.

The operating cycle for Caixin Co is = Inventory period 59 + Receivables days 44 Payable days 71
= 32 days
The longer the cycle, the higher the level of working capital. However, changes in different items may be
linked. For example, if customers take longer to pay, receivables days may rise. The business may have
problems paying its suppliers, meaning that payables days rise, cancelling out the impact of the rise in
receivables days.
Caixin Co is likely to want to limit the length of the operating cycle by putting pressure on customers to
reduce the time they take to pay or agreeing to more extended credit periods with suppliers.

Activity 3

The following information is taken from the financial statements of Xincai Co for the year ended
31 December 20X5.
 $ '000

Revenue 8,790

Cost of sales (4,430)

Gross profit 4,360

Other operating expenses (1,240)

Profit before interest and tax 3,120

Inventory 670

Trade receivables 740

Trade payables 560

Note: The asset turnover ratio was 0.6.

1. Calculate the operating profit margin of Xincai Co to the nearest 0.1%.

2. Calculate the return on capital employed of Xincai Co to the nearest 0.1%.
3. Calculate the receivables days of Xincai Co to the nearest day.
4. Calculate the payables days of Xincai Co to the nearest day.
5. Calculate the inventory turnover period of Xincai Co to the nearest day.
6. Calculate the operating cycle of Xincai Co to the nearest day.

18.5.1 Introduction to Position Ratios

5.1 Introduction to Position Ratios

Position ratios focus on how a company is financed. They indicate whether its current financing
mix will likely cause problems over the longer term. The two main position ratios are the
debt/gearing ratio and interest cover.
18.5.2 Gearing Ratio (Leverage)
5.2 Gearing Ratio (Leverage)

The gearing ratio measures the proportion of borrowed funds (which earn a fixed return) to equity
capital (shareholders' funds) or total capital. This ratio provides information about the financial
risk of a company.
Borrowings incur commitments to pay future interest and capital repayments, which can be a
financial burden and increase the risk of insolvency.

Debt includes long-term loans, bonds and preferred shares, and bank overdrafts
maintained yearly (of permanent nature).

• Equity is the residual (ordinary share capital, share premium, retained earnings,
revaluation and other reserves).

5.2.1 Gearing Ratio Analysis

The level of gearing reflects the main benefit and risks of debt finance:

• Debt finance is cheaper than equity (as interest is tax deductible)

• Debt finance increases the risk to shareholders (as interest must be paid regardless of
profits earned).
For the analysis of debt and equity:

• Preferred shares are generally treated as debt if redeemable; otherwise, they are
classified as equity.

• Bank borrowings (loans and operating overdrafts) are usually considered debt.
Financial balance means having long-term capital for long-term investments. Short-term
borrowings should not finance a permanent expansion. High gearing suits entities with relatively
stable profits (to meet interest payments) and suitable assets for security (For example, those in
the hotel/leisure service industry).

Example 5

For each of the companies below, the gearing is calculated.

A B C

$ $ $

Equity 10,000 3,000 7,500

Loan notes 7,000 2,500

Capital employed 10,000 10,000 10,000

70% 25%

Gearing Ratio: No gearing highly geared low gearing

18.5.3 Interest Cover

5.3 Interest Cover

Interest cover measures the ability to pay interest on outstanding debt from profits generated
during the period. It is an indicator of the protection available to loan providers and is often used
by lenders when making loan approval decisions.

In the calculation of interest cover, profit must be before tax because interest is an allowable
expense for tax purposes.
The interest amount must be the interest expense reported in profit or loss:

Interest expense = Interest paid + Closing accrual − Opening accrual

5.3.1 Interest Cover Analysis

If profit is adequate to cover interest expense, interest cover will be greater than 1.0.

• Interest cover below 1.0 indicates that interest obligations cannot be met.

• A ratio of less than 2.0 is generally considered unsatisfactory.

Interest must be paid even if profits fall. Low or falling interest cover may indicate:
 • potential difficulty financing debts if profits fall

• doubts about going concern

• increased risk to shareholders of falling dividends

18.5.4 Overtrading
5.4 Overtrading

Overtrading arises when trade increases rapidly without securing additional long-term capital (it is
under-capitalised). Symptoms include:

• fast sales growth

• inventories, receivables, and payables increasing

• cash and cash equivalents decreasing

A short-term solution is to manage working capital better (for example, speed up the collection
from customers and maintain lower inventory levels).
Increasing capital (by a share issue) or raising long-term financing is a long-term solution.

Example 6

Continuation from Example 3 previously.

The statement of profit or loss and the statement of financial position of Caixin Co for the year ended 31
March 20X5 have been prepared.
What position ratios can be derived from Caixin Co’s financial statements?
1. Financial gearing:
Long-term debt 9,500
Gearing Ratio = × 100% = 31.4%
(Equity 20,740 + Long-term debt 9,500)

2. Financial gearing (as a proportion of equity):

Long-term debt 9,500
Gearing Ratio = × 100% = 45.8%
Equity 20,740

3. Interest cover = Profit before interest and tax 3,680 ÷ Interest charges 610 = 6.03
From the ratios, users can identify that Caixin Co appears to be able to cover its commitments to pay
finance costs comfortably. The proportion of debt to equity seems low, and debt is likely to have a lower
cost to Caixin Co than equity.
Links between elements in the ratios:

Revenue Links Sales revenue links not only to the cost of sales but also to other operating
expenses such as sales and distribution. Sales revenue is also a measure of activity, so it is worth
reviewing how much administrative costs vary with sales. This is because it may be a sign of how well the
business is controlling costs.
 Example 6

The asset turnover ratio links sales with capital. Increased asset turnover may be good because Caixin
Co's capital generates more sales. However, it may indicate that Caixin Co is slow to invest in response to
better opportunities.

Matching Comparing the level of non-current assets with long-term funding (share capital, longer-
term loans) may demonstrate how much financial risk Caixin Co faces. If long-term finance is significantly
greater than non-current assets, Caixin Co is cautious, and the financial risk will be low.
Suppose non-current assets are funded by shorter-term liabilities such as a bank overdraft. In that case,
the financing policy is aggressive, and Caixin Co may face problems when the short-term finance has to
be repaid.

Overtrading Overtrading is when a business lacks the resources to support an increased volume of
activity. Signs include significant increases in revenue, trade receivables and inventory, but also a rapidly
worsening cash position and reliance on short-term funding.

Over-capitalisation Over-capitalisation is when a business has large amounts of current assets

other than cash but relatively small trade payables. The working capital levels are higher than it needs to
be.

Example 7

The following example shows Caixin Co’s report on their financial analysis.
Report on Caixin Co for the year ended 31 March 20X5
Profitability:
Gross and operating profit margins have risen due to a change in sales mix and a greater proportion of
sales revenue from higher margin goods, resulting from the marketing initiative at the start of 20X4. Both
ratios have also risen due to changes in the supplier base and sourcing of components from cheaper
supply sources. Both gross and operating profits have increased as a result of these developments.
Returns:
All three ratios have had a one-off fall due to the investment in plant and machinery necessary to make
the new ranges launched this year outweighing the increase in profits.
The contributions from these products should mean that the ratios will increase next year.
Liquidity:
Falls in receivables days and increases in payables days have balanced the impact of increases in the
inventory turnover period.
The inventory turnover period has increased because of slow initial sales of the X range, which was
launched towards the end of the period and for which there was still substantial inventory at the year-end.
Receivables days have fallen due to work done by additional credit control staff in chasing slow payers.
This has led to a rise in administration costs and has had a limited negative impact on the operating profit
margin.
The change in supplier base has meant that Caixin Co has been able to negotiate more extended supplier
payment periods, increasing trade payables days.
 Example 7

These changes have resulted in falls in the current and quick ratios, although they are not at low enough
levels to cause concern.
Gearing:
Gearing has increased because loans were used to finance plant and machinery investments. However, it
is still lower than the industry average.
Higher finance costs have resulted in a fall in interest cover, although this is not a cause for concern.
Conclusion:
The adverse movements in some ratios are due to the investment in plant and machinery, although this is
expected to be a temporary fall.
The figures show that Caixin Co has fulfilled its objectives to improve profitability and working capital
management.
Appendices
Profitability:
20X5 20X4 20X3

Gross profit margin 36.6% 35.5% 35.0%

Operating profit margin 19.0% 17.9% 17.2%

Returns:
20X5 20X4 20X3

Return on capital employed 12.2% 12.4% 12.0%

Return on equity 11.0% 11.3% 10.7%

Asset turnover 0.64 0.69 0.70

Liquidity:
20X5 20X4 20X3

Current ratio 1.57 1.75 1.84

Quick ratio 0.94 1.28 1.38

Receivables days 44 days 55 days 59 days

 Example 7

Payable days 71 days 50 days 45 days

Inventory turnover period 59 days 47 days 43 days

Interest cover 6.03 6.50 6.81

Debt/Gearing:
20X5 20X4 20X3

Financial gearing 45.8% 36.1% 34.2%

Debt ratio 28.5% 31.1% 29.4%

The potential response of users of the financial statements are as follows:

Shareholders: “I am pleased with this report. I am particularly interested in the profitability section
because this analysis will help me better understand what kind of dividend I can expect.”
Finance Provider: “I am happy with this report. I am interested in a few different areas of the report,
particularly the gearing section. Comparing the gearing levels to other companies allows me better
understand whether Caixin Co has borrowed too much and may not be able to meet its commitments to
me.”
Manager: “I am slightly concerned by the report because of our inventory turnover period. Our investment
in the new range has hurt our working capital management. Therefore, next year, we need to make an
extra effort to increase our sales and decrease our inventory turnover period.”
An Employee of Caixin Co: “I am happy with this report because our profits have increased from last
year. As long as this continues, I know that the company will continue to trade and that my job is secure.”
Supplier: “I am interested in the liquidity section because I want to be sure that Caixin Co will pay me for
its purchases. I also want to compare the credit period I gave Caixin Co to other suppliers’ average
periods. I am also interested in the gearing section because it indicates whether Caixin Co will have
difficulty paying me in the longer term.”
Member of the public: “I can see that Caixin Co is not making excessive profits, and therefore am happy
to continue purchasing goods and services from this business.”
Activity 4

You are given the following annual financial statements of two incorporated entities in similar
business areas for the year ended 31 March.
Statements of profit or loss Kappa Lamda

$000 $000

Revenue 400 900

Cost of sales 170 530

 Gross profit 230 370

Operating expenses 160 210

Operating profit 70 160

Interest expense 30 5

Profit after interest 40 155

Income tax 15 46

Profit after tax 25 109

Statement of Financial Position Kappa Co. Lamda Co.

$000 $000 $000 $000

Non-Current Assets:

Tangible non-current assets (carrying amount) 795 1,332

Current Assets:

Inventory 28 52

Receivables 98 150

Cash 4 10

130 212

Total Assets 925 1,544

Capital and Reserves:

Equity Capital 400 600

 Share Premium 100 200

Revaluation Surplus - 200

Retained Earnings 6 300

560 1,300

Non-Current Liabilities:

Interest-bearing Borrowings 300 50

Current Liabilities:

Trade Payables 15 128

Operating overdraft 20 -

Income tax due 15 46

Dividend payable 15 20

65 194

Total Equity and Liabilities 925 1,544

Calculate EIGHT financial ratios for each of the two companies.

Activity 5

1. Which of the following is most likely to lead to an increase in a company's financial

gearing ratio?
1. A bonus issue of shares
2. Converting a bank loan into an overdraft
3. An increase in the cash operating cycle
4. A payment of dividends to shareholders
5. Converting debt into share capital
2. Drivor Co's gross profit margin for the year ended 31 December 20X3 fell from 21% to 18%.
Which of the following is MOST likely to have caused the fall?
1. Understatement of opening inventory at 1 January 20X3
2. Overstatement of closing inventory at 31 December 20X3
 3. A purchase in January 20X4 being wrongly recorded as happening in December 20X3
4. A fall in the quantity of sales
5. Bulk discounts being negotiated with suppliers
3. Dexcan Co had the following working capital ratios in the last two years:

20X1 20X0

Current ratio 1.3 1.1

Quick ratio 0.9 0.8

Receivables days 25 60

Payables days 30 40

Inventory turnover days 70 55

Which of the following statements is FALSE?

1. Dexcan Co's operating cycle was lower in 20X1
2. Dexcan Co is receiving money from customers quicker in 20X1
3. Dexcan Co is paying suppliers quicker in 20X1
4. The risk of inventory obsolescence for Dexcan Co has increased
5. The increase in inventory turnover days has resulted in Dexcan Co's quick ratio increasing