ICSA study text

Financial
Reporting
and Analysis
2nd edition

David Frederick
Financial Reporting
and Analysis
 IC S A s t ud y t e x t

Financial Reporting
and Analysis
Second edition

david frederick
First published 2012
Published by ICSA Publishing Ltd
Saffron House
6-10 Kirby Street
London EC1N 8TS

© ICSA Publishing Ltd 2014

All rights reserved. No part of this publication may be reproduced, stored in a retrieval
system or transmitted, in any form, or by any means, electronic, mechanical, photocopying,
recording or otherwise, without prior permission, in writing, from the publisher.

Designed and typeset by Paul Barrett Book Production, Cambridge

Printed by Hobbs the Printers Ltd, Totton, Hampshire

British Cataloguing in Publication Data

A catalogue record for this book is available from the British Library.

ISBN 978 1860 726224

Acknowledgements

I would like to thank all those who, in their own way, supported me in this academic and profes-
sional endeavour. In particular I am indebted to Barry Walsh for his time spent reviewing each
draft and Juliet Gardner for her patience, proofing and technical support. I would also like to
thank the ICSA for all their support and in particular Nicola Stead.
Last, but not least, I would like to thank Louisa Gerald for her understanding, patience and
support throughout the whole process.

David Frederick
Contents

How to use this study text  x

Financial Reporting and Analysis syllabus  xii
Acronyms and abbreviations  xvii

Part one: The regulatory and conceptual frameworks for financial

reporting  1

Chapter 1 The regulatory framework for the preparation and presentation of

financial statements  3
1. Introduction  3
2. The regulatory framework  4
3. National differences in financial reporting practices  4
4. Reasons for national differences in financial reporting practices  5
5. The classification of national accounting systems  5
6. The work of international standard setters  7
7. The theoretical framework of accounting  10
8. Arguments for and against accounting standards  10
9. Corporate governance and the external audit process  11
10. The emergence of environmental reporting  14
11. Eco-Management and Audit Scheme (EMAS)  15
12. Social accounting  17
13. The changing role of the accountant  19

Chapter 2 The conceptual framework for the preparation and presentation of

financial statements  20
1. Introduction  20
2. The scope of the conceptual framework  22
3. Users of financial information  23
4. Qualitative characteristics of useful financial information  24
5. The underlying assumption  26
6. Elements of financial statements  26
7. Recognising the elements of financial statements  27
8. Measuring the elements of financial statements  28
9. Capital and capital maintenance  33
10. Accounting policies and the significance of differences between them  35

Part two: The preparation and presentation of financial statements for

single companies in compliance with legal and regulatory
requirements 39

Chapter 3 Financial accounting and the preparation of financial reports  40

1. Introduction  40
2. Accountability  41
3. How accounting information helps businesses to be accountable  41
4. What is financial accounting?   43
 Contents vii

5. Reporting entities  43
6. Principal accounting statements  44
7. Users and uses of accounting information  46
8. Presentation of financial statements  47
9. Prescribed format for the statement of profit or loss and other comprehensive
income 48
10. Measurement and recognition of revenue  49
11. Reporting comprehensive income  51
12. Prescribed format for the statement of financial position  51
13. Additional information on the statement of financial position  53
14. Statement of changes in equity  54

Chapter 4 Accounting policies 1  58

1. Introduction  58
2. Accounting policies  58
3. Accounting for inventory (IAS 2)  59
4. Accounting policy and changes (IAS 8)  64
5. Accounting for events after the reporting period (IAS 10)  69
6. Fair value measurement (IFRS 13)  71
7. Accounting for property, plant and equipment (IAS 16)  73
8. Accounting for revenue (IAS 18)  78
9. Accounting for provisions (IAS 37)  81
10. Accounting for intangible assets (IAS 38)  83

Chapter 5 Accounting policies 2  89

1. Introduction  89
2. Income taxation (IAS 12)  90
3. Accounting for leases (IAS 17)  93
4. Financial instruments (IAS 32 / IFRS 7)  97
5. Earnings per share (IAS 33)  100
6. Impairment of assets (IAS 36)  101
7. Non-current assets held for sale and discontinued operations (IFRS 5)  104
8. Operating segments (IFRS 8)  107

Chapter 6 Purpose of the statement of cash flows  113

1. Introduction  113
2. Purpose of the statement of cash flows  114
3. Cash and cash equivalents  114
4. Components of the statement of cash flows  115
5. Methods for preparation of the statement of cash flows  116
6. Further guidance on statement cash flows  127
7. Interpretation of cash flow information and disclosures  127
8. Limitations of the statement of cash flows  128

Part three: The preparation and presentation of financial statements for

groups 133

Chapter 7 Group accounting  134

1. Introduction  134
2. Combinations based on assets or shares  137
3. The group  138
4. Consolidation  139
5. Other consolidation adjustments  141
6. Consolidated statement of financial position  147
viii Contents

7. Consolidated statement of profit or loss and other comprehensive

income 157
8. Investment in associates  159
9. Interest in joint ventures  163

Part four: Analysis and interpretation of accounts  171

Chapter 8 Trend analysis and introduction to ratio analysis  172

1. Introduction  172
2. Stewardship and the role of managers  172
3. Horizontal and vertical analysis of accounts  173
4. Trend analysis to a time series  179
5. Principles of ratio analysis  179
6. Primary ratios  182

Chapter 9 Analysis and interpretation of accounts 1  191

1. Introduction  191
2. Subsidiary ratios  191
3. Liquidity ratios  196
4. Asset turnover ratios  196
5. The cash operating cycle  199
6. Pyramid of ratios  205

Chapter 10 Analysis and interpretation of accounts 2  209

1. Introduction 209
2. Segmental accounting and analysis  209
3. Rate of return on shareholders’ equity  212
4. Inter-company comparison  213
5. Cash flow-based accounting ratios  214
6. Earnings per share  220

Chapter 11 Limitations of published accounts  229

1. Introduction  229
2. Limitations of accounting ratios  230
3. Subjectivity and earnings management – impact on reported figures  231
4. Creative accounting or earnings management  236
5. Substance over form  237
6. The role of audit in mitigating creative accounting  240
7. Auditors and non-audit services  241

Chapter 12 Financial reporting within the business environment  243

1. Introduction  243
2. Subscription databases and company accounts  244
3. XBRL – business reporting language and business application  247
4. CSR reports and the triple bottom line (TBL)  249
5. Nature of business ethics  251
6. The role of ethics in modern business  252
7. Ethics and accountants in practice  254
8. Professional ethics – regulations  254

Answers to end-of-chapter questions  257

Glossary 284
Directory 288
Index 291
How to use this study text

ICSA study texts were developed to support ICSA’s Chartered Secretaries Qualifying Scheme
(CSQS) follow a standard format and include a range of navigational, self-testing and illustra-
tive features to help you get the most out of the support materials.
Each text is divided into three main sections:
1. introductory material;
2. the text itself, divided into parts and chapters; and
3. additional reference information.
The sections below show you how to find your way around the text and make the most of its
features.

Introductory material
The introductory section of each text includes a full contents list and the module syllabus,
which reiterates the module aims, learning outcomes and syllabus content for the module in
question.

The text itself

Each part opens with a list of the chapters to follow, an overview of what will be covered and
learning outcomes for the part.
Every chapter opens with a list of the topics covered and an introduction specific to that
chapter. Chapters are structured to allow students to break the content down into manageable
sections for study. Each chapter ends with a summary of key content to reinforce understand-
ing, as well as end-of-chapter examination-standard questions to test your knowledge further.

Part opening Chapter opening

part one The regulatory framework 1

for the preparation and
The regulatory and presentation of financial
statements
conceptual frameworks
for financial reporting ■■ Contents
1. Introduction
2. The regulatory framework
3. National differences in financial reporting practices
4. Reasons for national differences in financial reporting practices
■■ Chapters
5. The classification of national accounting systems
1. the regulatory framework for the preparation and presentation of financial statements 6. The work of international standard setters
2. the conceptual framework for the preparation and presentation of financial statements 7. The theoretical framework of accounting
Chapters 1 and 2 in part One cover the syllabus section entitled ‘the regulatory and conceptual 8. Arguments for and against accounting standards
frameworks for financial reporting’. 9. Corporate governance and the external audit process
10. The emergence of environmental reporting
■■ overview 11. Eco-Management and Audit Scheme (EMAS)
12. Social accounting
the IFrS Framework describes the basic concepts that underlie the preparation and presentation 13. The changing role of the accountant
of financial statements for external users.
the regulatory and conceptual frameworks appear to be somewhat difficult to grasp, particularly ■■ Learning outComes
as they are not financial reporting standards. However, the frameworks are the basis for which Chapter 1 covers the syllabus section entitled ‘The regulatory framework for the preparation
guidance is sought in reviewing and developing new standards. and presentation of financial statements’. After reading and understanding the contents of the
chapter, working through all the worked examples and practice questions, you should be able to:
Chapters 1 and 2 introduce the various terminologies used and build upon various frameworks
from around the globe and related accounting issues that are pervasive and contemporary in ■■ show an understanding of the work of the International Accounting Standards Board;
nature. ■■ be familiar with the principal sources of legal regulations governing financial statements;
■■ explain the principal qualities required of external auditors if they are to contribute to effec-
to put things in context, the two chapters discuss historical issues to the development of financial tive corporate governance.
reporting standards and the difficulties faced in their global acceptability. ■■ evaluate the corporate governance implications of auditors providing consultancy services;
■■ list the main elements of the Eco-Management and Audit Scheme for environmental disclo-
part 1 contains a Worked Example on america Online (aOL). Having reviewed the material, please sure in Europe;
attempt to answer the questions that follow the aOL scenario. ■■ reveal familiarity with the activities involved in an environmental audit; and
■■ outline recent developments in corporate social responsibility (CSR) reports and triple bottom
1. the regulatory framework for the preparation and presentation of financial statements
line reporting.
■■ the work of the international standards setters
■■ Statutory framework and legal requirements 1 introduction
■■ Corporate governance and the external audit process
The past decade has witnessed an ever-increasing volume of cross-border trade and cross-listing
■■ Social and environmental reporting on the world’s capital markets, due to the breakdown of trade barriers and the formation of
international trade bodies such as the World Trade Organization (WTO). This, in turn, has
2. the conceptual framework for the preparation and presentation of financial statements
resulted in the demand for quality cross-border financial information. International Financial
■■ the objective and users of financial statements Standards are the mechanism that attempt to provide a platform for financial reporting consist-
ency and reliability, to help stakeholders to make informed economic decisions.
■■ the underlying assumptions The International Financial Reporting Standards (IFRSs) are the remit of the International
Accounting Standards Board (IASB), which seeks to achieve global comparability and consistency

01 ICSA FRA Part 1.indd 1 29/05/2014 09:03

01 ICSA FRA Part 1.indd 3 29/05/2014 09:03
x How to use this study text

Features
The text is enhanced by a range of illustrative and self-testing features to assist understanding
and to help you prepare for the examination. Each feature is presented in a standard format, so
that you will become familiar with how to use them in your study.
The texts also include tables, figures and checklists and, where relevant, sample documents
and forms.

32 Part one The regulatory and conceptual frameworks for financial reporting

8.2 Impairment of assets and value-in-use

IAS 36 (as discussed later in chapter 4) addresses the impairment of assets and aims ‘to ensure
that assets are carried at no more than their recoverable amount, and to define how recoverable
amount is determined’. IAS 36 further states that value-in-use is the discounted present value
of the future cash flows expected to arise from the continuing use of an asset, and from its dis-
posal at the end of its useful life.
The standard gives further guidance on testing assets for impairment in relation to their car-
rying amount. The calculation of value-in-use should reflect the following elements:
■■ an estimate of the future cash flows the entity expects to derive from the asset;
■■ expectations about possible variations in the amount or timing of those future cash flows;
■■ the time value of money, represented by the current market risk-free rate of interest;
■■ the price for bearing the uncertainty inherent in the asset; and
■■ other factors, such as illiquidity, that market participants would reflect in pricing the future
cash flows the entity expects to derive from the asset.

work ed ex amp l e 2.5

Worked Examples
Solar Ltd suspects its printing press, with a net book value (after depreciation) of £280,000, is
impaired. However, in the absence of a market price, Solar carries out value-in-use exercise. Its cost
of capital is 10%. Solar has determined the future cash flows arising from the continued use of the
asset as:
Worked examples present
Year
1
Cash flow
100,000
Required
Determine if the asset is impaired based on current book
value of the asset and its value-in-use.
illustrative case studies which
look at how concepts are
2 86,000
3 76,000
4 68,000
5 52,000
applied in practice.
Answer

Year Cash flow Discount PV

factor 10%

1 100,000 0.9091 90,910

2 86,000 0.8264 71,070
3 76,000 0.7513 57,099
4 68,000 0.6830 46,444
5 52,000 0.6209 32,287
Net present value 297,810
Value-in-use of the asset: 297,816
Net book value of the asset (NBV) 280,000
Carrying amount = NBV 280,000

Since the value-in-use of the asset is greater than the book value, the asset is deemed not to be
impaired and the book value remains at £280,000 net of depreciation.

01 ICSA FRA Part 1.indd 32 29/05/2014 09:11

6 Part one The regulatory and conceptual frameworks for financial reporting

taxations systems, etc, may be a barrier to complete global harmonisation. Issues relating to
the interpretation of standards will be hampered by individual interpretation of accounting
treatments at a local level. For example, the Coalition Government in the UK, led by David
Cameron, announced changes to the banking system whereby UK banks will be required to
keep their retail arms separate from their more risky investment activities, thereby protect-
ing certain investments. These changes, which came into force in 2013, may create financial
reporting difficulties in the future for UK banks (e.g. how would banks be required to report
financial information about. issues relating to group accounting?).

T E S T YO U R K N OW L E D GE 1.3

Explain how the application of a common IFRS may reduce national differences in financial reporting.

The ever-increasing use of global accounting and financial information has made it necessary to
reduce the differences in the way accounting information is prepared and reported in different

Test your Knowledge

countries. In reducing accounting differences, standard setters use two particular approaches to
standards development:
1. standardisation;
2. harmonisation.

Short, revision-style questions

5.1 Standardisation

Definitions
Standardisation is the process by which rules are developed to set standards for similar items
on a global basis. Through standardisation, many technical issues relating to the treatment

to help you re-cap on key

of accounting information have been resolved (e.g. the preparation of information relating to
earnings per share (EPS IAS 33) is now recognised globally, and is applied consistently using
appropriate measures and stated on the statement of comprehensive income).

Key terms are 5.2 Harmonisation

Harmonisation reconciles national differences and provides those who prepare accounting
information and core concepts.
information with a common framework to deal with major issues in a similar manner.

highlighted in bold on As efforts to improve comparability of financial statements have increased, the two approaches
have come closer together. Attempts have been made to standardise, or at least harmonise,
financial reporting to satisfy the needs of a number of different stakeholders. To make informed
economic decisions, investors need clear and comparable information to assess a company’s

first use and defined past or potential investment performance and its underlying economic reality.
Government agencies such as tax and customs authorities also have an interest in greater
compatibility of information between countries to trace transactions. International account-

in the end of book

ancy firms have large numbers of multinational clients, whose accounts frequently need to be
adjusted to common accounting principles before consolidations can be prepared. A reduction
in national accounting differences would reduce the training costs of these firms and increase
staff mobility (however, it would also limit the fees they could charge).

glossary. Companies seeking capital through cross-border listings may currently need to prepare finan-
cial statements under more than one set of regulations, to meet the needs of different stock
exchanges. This is both costly and time-consuming. However, almost every stock exchange
will accept accounts prepared under IFRSs. A number of international bodies are involved in
the processes of harmonisation or standardisation. These include organisations that may not
immediately be associated with accounting, such as the United Nations and the Organization
for Economic Cooperation and Development (OECD). However, the most influential organi-
sations have probably been the International Accounting Standards Board and the European
Union.
The process of standardisation and harmonisation through accounting standards has created
an accounting environment that places an obligation on companies to disclose the accounting
policies they have used to prepare their accounts.

01 ICSA FRA Part 1.indd 6 29/05/2014 09:04

 How to use this study text xi

chapter 1 The regulatory framework for the preparation and presentation of financial statements 17

Generally, environmental audits involve the collection, collation, analysis, interpretation and
presentation of information. This information is then used to:
■■ assess performance against a list of pre-set targets, related to specific issues;
■■ evaluate and assess compliance with environmental legislation as well as corporate policies;
and
■■ measure performance against the requirements of an Environmental Management System
(EMS) standard.
To facilitate a successful environmental audit, the audit process requires progression through
the following three stages:
1. Pre-audit stage
■■ full management commitment;
■■ setting overall goals, objectives, scope and priorities; and
■■ selecting a team to ensure objectivity and professional competence.
2. Audit stage
■■ on-site audit, well defined and systematic using protocols or checklists;
■■ review of documents and records;
■■ review of policies;
■■ interviews; and
Stop and Think
■■ site inspection.
3. Post-audit stage
■■ evaluation of findings;
■■ reporting with recommendations;
Stop and think boxes encourage
■■ preparation of an action plan; and

you to reflect on how your own

■■ Follow-up.

s to p a n d t h i n k 1.2

What would the economic impact for companies be if they did not report on their environmental and
experiences or common business
scenarios related to the topic
social activities?

under discussion.
The three stages provide the general framework or an environmental audit. However, depending
upon the size and nature of the entity some areas may require a more in-depth investigation.
This will, in most cases, involve specialist advice, independent verification and cooperation,
and action on any shortcomings identified during the audit stage.

t E s t YoU R k n oW L E d G E 1.9

What is an environmental audit?

12 Social accounting
Social accounting (also known as Corporate Social Responsibility or CSR) is the formal process
by which business entities communicate the impact of their economic activity to stakeholders
who have a vested interest in the entity. However, it has and is continuing to become recognised
that the wider community has a direct and indirect involvement in CSR and the behaviour of
entities. For example, the impact of the Deepwater Horizon oil spillage in 2010 has had more
than just a financial impact upon British Petroleum.
Social accounting seeks to create a balance between a company’s business activities and how
it discharges its social and environmental responsibilities. However, it is a broad term that can

01 ICSA FRA Part 1.indd 17 29/05/2014 09:04

chapter 2 The conceptual framework for the preparation and presentation of financial statements 37

IAS 8 ‘Accounting Policies, Changes in Accounting Estimates and Errors’ states that the effect of
a change in an accounting estimate should be recognised prospectively by including it in profit
or loss in:
■■ the period of the change, if the change affects that period only; or
■■ the period of the change and future periods, if the change affects both.
IAS 8 further states that:
■■ entities that exercise a change in accounting estimates must further disclose the nature and
amount of a change in an accounting estimate that has an effect in the current period, or is
expected to have an effect in future periods; or
■■ if the amount of the effect in future periods is not disclosed because estimating it is imprac-
ticable, an entity shall disclose that fact.

? END OF CHAPTER QUESTIONS

2.1 Outline the general purpose financial reporting. f) Four bases for the measurement of
2.2 True or false? elements recognised within financial
a) Financial reports are designed to show the statements are outlined in IAS1.
value of a reporting entity. 2.3 State the four enhanced characteristics that make
b) Financial reports provide information to help reporting financial information useful for its users.
existing and potential employees negotiate 2.4 Identify and explain the underlying assumption
a pay increase. identified in the conceptual framework.
c) Financial reports provide information to 2.5 Identify two financial statements in the form of
help existing and potential investors, lenders the statement of financial position (the balance

Glossary
and other creditors to estimate the value of sheet) and the statement of profit or loss and
the reporting entity. other comprehensive income (the income
d) The qualitative characteristics of useful statement)
financial information are restricted to the 2.6 Identify and explain the two concepts of capital
reporting of information in the financial maintenance.
statements.

? End of
e) Relevance and faithful representation are
the two fundamental characteristics for
useful financial information.

chapter
Accounting policies Accounting policies are Convertible loan Loan stock that can be
the specific principles, bases, conventions, converted into ordinary shares at a set
rules and practices applied by an entity date or dates at a predetermined price.
in preparing and presenting financial The conversion price is the price of

questions
statements. ordinary shares at which loan stock can
Accruals Provisions for goods and services be converted. The number of ordinary
received but not yet paid for. Accruals are shares received by a loan stock holder on
one of the main accounting principles. conversion of £100 nominal of convertible
Agency theory A theory concerning loan stock is £100 divided by the
the relationship between a principal conversion price.
(shareholder) and an agent of the principal Convertible preference shares Preference
(managers). shares that can be converted into ordinary
Asset An asset is a resource controlled by the shares. A company may issue them
enterprise as a result of past events and to finance major acquisitions without
from which future economic benefits are increasing the company’s gearing or
expected to flow to the enterprise. diluting the earnings per share (EPS) of
Associate A business entity that is partly the ordinary shares. Preference shares
owned by another business entity in potentially offer the investor a reasonable
which the stake holding is at above 20% degree of safety with the chance of capital
but below 51%. gains as a result of conversion to ordinary
Capital and capital maintenance Concept of shares if the company prospers.
financial and physical capital maintenance. Corporate governance The system by which
Financial capital relates to equity, while the companies are directed and controlled. In
physical capital relates to the increase in the UK, the corporate governance system
capital at the end of the year. is based on the UK Code on Corporate
Cash and cash equivalents The mostly Governance 2010.
liquid assets found within the asset
portion of a company’s statement of
financial affairs. Cash equivalents are
assets that are usually ready to cash
Cost of capital The cost to a company
of the return offered to different kinds
of capital. This may be in the form of:
interest (for debt capital); dividends and
Glossary 01 ICSA FRA Part 1.indd 37 29/05/2014 09:05

within three months. participation in the growth of profit (for

Companies Act A set of legal and regulatory ordinary shares); dividends alone (for
requirements that business entities, preference shares); or conversion rights
particularly limited liability entities, must (for convertible loan stock or convertible
adhere to in the course of business. preference shares).
Consolidated accounts When a number of Current asset In the entity’s normal
business entities belong to a parent either operating cycle, a current asset is held
directly or indirectly, the parent entity primarily for trading purposes. It is
prepares a set of consolidated accounts. expected to be realised within 12 months
This has the effect of showing the of the statement of financial position.
financial affairs of the group as though it It can also be cash or a cash-equivalent
were a single business entity, hence intra- asset.
group transactions are cancelled out. Current cost Assets are carried at the amount
Convergence Reducing international of cash or cash equivalent that would have
differences in accounting standards by to be paid if the same or an equivalent asset
selecting the best practice currently were currently acquired. Liabilities are
available, or, if none is available, by carried at the undiscounted amount of cash
developing new standards in partnership or cash equivalents that would be required
with national standard setters. to settle the obligation currently.

05 ICSA FRA Endmatter.indd 276 29/05/2014 09:05

Reference material
The text ends with a range of additional guidance and reference material.
Other reference material includes a glossary of key terms, a directory of further reading and
web resources, and a comprehensive index.
Financial Reporting and
Analysis syllabus

Module outline and aims

In professional practice, the Chartered Secretary has to be competent in financial accounting
and reporting. In public practice and in some other organisations, the Chartered Secretary can
also be called upon to fulfil the role of corporate accountant. There, the emphasis is normally
on accounting for purpose rather than on detailed accounting techniques.
Chartered Secretaries need to understand the significance and relevance of accounting infor-
mation and the process by which it is acquired. Core responsibilities also include compliance
with legal and stakeholder requirements, including financial statements. In the boardroom,
Chartered Secretaries contribute to the analysis, presentation and interpretation of corporate
financial performance and results, including the implications for the organisation, shareholders
and stakeholders and for effective corporate governance.
The aim of the module is to develop the knowledge and skills necessary for you to under-
stand and supervise the execution of these professional responsibilities.

Learning outcomes
On successful completion of this module, you will be able to:
■■ describe and explain the language, concepts and use of financial accounts and reports;
■■ demonstrate a sound understanding of the significance of accounting information systems
for both effective financial reporting and good corporate governance and demonstrate a sys-
tematic understanding and thorough appreciation of the regulatory framework for the prepa-
ration and presentation of financial statements;
■■ apply the skills necessary for the preparation and presentation of financial statements for
single and group companies in compliance with legal and regulatory requirements;
■■ interpret and critically analyse corporate financial accounts and reports reflecting on the
limitations of both published accounts and standard analytical techniques;
■■ describe and explain the relationship between financial reporting and corporate governance;
and
■■ prepare reports and presentations relating to financial matters for the board and senior offic-
ers of organisations.

Syllabus content
1. The regulatory and conceptual frameworks for financial reporting
– weighting 20%
The regulatory framework for the preparation and presentation of financial statements
■■ The work of the international standards setters
■■ Statutory framework and legal requirements
■■ Corporate governance and the external audit process
■■ Social and environmental reporting
The conceptual framework for the preparation and presentation of financial statements
■■ The objective and users of financial statements
■■ The underlying assumptions
 Financial Reporting and Analysis syllabus xiii

■■ The qualitative characteristics that determine the usefulness of information in financial

statements
■■ The definition of the elements of financial statements
■■ The recognition of the elements from which financial statements are constructed
■■ The measurement of assets and liabilities reported in financial statements
■■ Concepts of capital and capital maintenance

2. The preparation and presentation of financial statements for

single companies in compliance with legal and regulatory
requirements, including the relevant International Accounting
Standards – weighting 25%
■■ Criteria for information appearing in published financial statements
■■ Income statement
■■ Statement of financial position
■■ Statement of changes in equity
■■ Reporting comprehensive income
■■ Segmental reporting
■■ Accounting policies
■■ Notes to the accounts
■■ Statements of cash flow
■■ Creative accounting
■■ Accounting for inventories
■■ Off-balance sheet finance and leasing
■■ Reporting the substance of transactions
■■ Accounting for property, plant and equipment including depreciation and impairment
■■ Accounting for provisions, contingent assets and liabilities, and events after the reporting
period

3. The preparation and presentation of financial statements for

groups in compliance with legal and regulatory requirements,
including the relevant International Accounting Standards –
weighting 25%
■■ Requirements for preparation of consolidated financial statements
■■ Consolidated statement of financial position
■■ Consolidated income statement
■■ Investment in associates and joint ventures

4. Analysis and interpretation of accounts – weighting 30%

■■ Trend or horizontal analysis
■■ Common size statements
■■ Accounting ratios and ratio analysis
■■ The development of XBRL
■■ Primary investment, operative and liquidity level ratios
■■ Subsidiary ratios including investment performance indicators such as price/earnings ratio
■■ Segmental analysis
■■ Inter-firm comparisons and industrial averages
■■ Analysing a statement of cash flows
■■ Earnings per share
■■ Limitations of analytical and interpretative techniques
xiv Financial Reporting and Analysis syllabus

Commentary on the syllabus

There are four main areas in the Financial Reporting and Analysis syllabus. What follows is an
overview of each of these areas, indicating what students need to achieve in order to prepare
effectively for this examination.

The regulatory and conceptual framework

Candidates will need to demonstrate an understanding of aspects of the regulatory framework
responsible for the preparation and presentation of financial statements.
The candidate will be expected to be able to:
■■ show an understanding of the work of the International Accounting Standards Board;
■■ be familiar with the principal sources of legal regulations governing financial statements;
■■ explain the principal qualities required of external auditors if they are to contribute to effec-
tive corporate governance;
■■ evaluate the corporate governance implications of auditors providing consultancy services;
■■ list the main elements of the Eco-Management and Audit Scheme for environmental disclo-
sure in Europe;
■■ reveal familiarity with the activities involved in an environmental audit; and
■■ outline recent developments in corporate social responsibility (CSR) reports and triple bottom
line reporting.
Candidates need to be fully familiar with the content and significance of the ‘Conceptual
Framework for Financial Reporting’ issued by the International Accounting Standards Board.
The candidate will be expected to be able to:
■■ explain the objective of financial statements;
■■ list and explain the significance of each of the qualitative characteristics of financial
information;
■■ identify and distinguish between the elements of financial statements;
■■ show an understanding of the conditions that must be met to justify the recognition of assets
and liabilities;
■■ be aware of the significance of the concepts of sufficient evidence and sufficient reliability for
the recognition of assets and liabilities;
■■ describe how entity managers decide which measurement basis to adopt for financial report-
ing purposes;
■■ demonstrate an understanding of the concept of value to the business and of how the concept
is given operational effect; and
■■ reveal an understanding of the existence of different concepts of capital and capital
maintenance.

The preparation and presentation of financial statements

Candidates are expected to be able to prepare and present financial statements for single compa-
nies in compliance with legal and regulatory requirements, including the relevant international
accounting standards.
The candidate will be expected to be able to:
■■ identify the criteria which must be met for information to appear in the published income
statement and statement of financial position;
■■ construct the income statement in accordance with prescribed format 1;
■■ understand the effect of adopting different accounting policies on the content of the income
statement and statement of financial position;
■■ report in the income statement the impact of discontinued operations;
■■ account appropriately for ‘non-recurring’ items requiring separate disclosure in the income
statement;
■■ construct the statement of financial position in accordance with prescribed formats;
■■ show an understanding of the appropriate methods for valuing assets and liabilities;
■■ demonstrate familiarity with the notes that accompany financial statements;
 Financial Reporting and Analysis syllabus xv

■■ prepare the statement of changes in equity and explain why it must be published;
■■ understand the concept and be aware of the constituents of a statement of comprehensive
income;
■■ explain the importance of segmental information and be able to prepare a segmental report;
■■ demonstrate familiarity with the nature of accounting policies, the significance of differences
between them and the effects of changes in accounting policy;
■■ show an understanding of the reasons why entities are today required to publish a statement
of cash flows;
■■ prepare a statement of cash flows in accordance with standard accounting practice;
■■ demonstrate an awareness of the steps entities might take to improve their accounts so as,
for example, to reduce the reported gearing ratio, increase the published EPS, and strengthen
the balance sheet;
■■ reveal a full understanding of the opportunities for subjectivity and creative accounting when
preparing financial reports;
■■ show familiarity with the role of the audit in countering creative accounting practices;
■■ show an understanding of the treatment of inventories in financial statements;
■■ explain what is meant by off balance sheet finance and understand its significance;
■■ demonstrate the way in which leasing arrangements may be exploited to access the advan-
tages of off balance sheet finance;
■■ outline and evaluate proposals designed to counter opportunistic behaviour by management
when accounting for leases;
■■ distinguish between the economic substance and the legal form of a business transaction-
■■ demonstrate an understanding of accounting for property, plant and equipment including
accounting for depreciation and accounting for impairment; and
■■ show familiarity with end of year accounting issues including accounting for provisions, con-
tingent assets and liabilities and dealing with events after the reporting period.

Group accounting
Candidates need to be able to prepare and present consolidated financial statements in compli-
ance with legal and regulatory requirements, including the relevant international accounting
standards.
The candidate will be expected to be able to:
■■ define a reporting group in accordance with standard accounting practice;
■■ explain why parent companies are required to publish consolidated accounts and the circum-
stance in which this obligation does not apply;
■■ outline the circumstances in which a subsidiary company may be excluded from the consoli-
dated accounts and the further disclosures required in such circumstances;
■■ explain how the idea of control is applied to decide whether another entity must be included
in the consolidated accounts;
■■ prepare a consolidated statement of financial position in accordance with the purchase
method, making appropriate adjustments for fair value;
■■ compute goodwill and non-controlling interest for inclusion in the consolidated statement
of financial position;
■■ distinguish between pre- and post-acquisition profits when preparing consolidated accounts;
■■ make appropriate adjustments for inter-company balances and unrealised profits on inter-
company sales;
■■ show an appreciation of the need for uniform accounting policies and reporting dates;
■■ explain how an investment in subsidiaries should be reported in the parent’s own balance
sheet;
■■ prepare a consolidated income statement in accordance with standard accounting practice;
■■ demonstrate knowledge of the definitions of an associate and of significance influence;
■■ identify the circumstances in which a joint venture exists;
■■ make calculations to enable an associate or joint venture to be reported in accordance with
the equity method; and
■■ show familiarity with the content of a consolidated statement of cash flows.
xvi Financial Reporting and Analysis syllabus

Analysis and interpretation of accounts

Candidates need to know how to calculate the percentages and ratios used to analyse entity
performance. They must also be able to display expertise in interpreting the significance of such
calculations.
The candidate will be expected to be able to:
■■ undertake horizontal analysis of accounts between two periods based on percentage changes;
■■ take account of the effect of exceptional items on comparability;
■■ apply trend analysis to the results of a series of accounting periods;
■■ undertake vertical analysis based on common size statements;
■■ understand the nature of accounting ratios and the use that can be made of them;
■■ reveal an awareness of the existence of online subscription databases that reformat company
accounts in standardised form for comparative purposes;
■■ explain what XBRL is and how it can be used;
■■ calculate and interpret the significance of primary investment, primary operative and pri-
mary liquidity level ratios;
■■ calculate and interpret subsidiary ratios: gearing, liquidity, asset utilisation, investment and
profitability;
■■ explain the reasons for and importance of segmental accounting;
■■ undertake statement analysis based on segmental accounts;
■■ outline sources of data available for inter-firm comparisons;
■■ analyse and interpret the information contained in the cash flow statement;
■■ display an understanding of the importance of earnings per share (EPS) and its relationship
with the price/earnings ratio;
■■ explain the calculation of the basic and diluted EPS;
■■ compare and contrast the uses and limitations of EPS;
■■ make calculations of EPS that require adjustments to the number of shares used in the basic
EPS calculation;
■■ calculate the EPS where there has been a rights issue;
■■ compute and explain the significance of the fully diluted EPS;
■■ show familiarity with the disclosure requirements applying to the EPS; and
■■ explain the limitations of accounting ratios computed on the basis of the information finan-
cial statements contain.

Overview
Financial accounting and reporting is central to modern entity management ‘by the numbers’.
The Chartered Secretary is regularly required to fulfil the following ‘accounting’ functions
during his/her career:
■■ Analyse and interpret the outputs from an entity’s accounting system.
■■ Initiate and participate in decision-making based on accounting information.
■■ Initiate and suggest improvements in the entity’s accounting system and its outputs.
■■ Provide advice on the significance for the entity of contemporary accounting developments
including regulatory changes.
■■ Counsel senior management on the significance of (proposed) published information for
external user groups.
Acronyms and abbreviations

AGM annual general meeting

ASB Accounting Standards Board
ASC Accounting Standards Committee
BIS Department for Business, Innovation and Skills
CA 2006 Companies Act 2006
CFO Chief Finance Officer
CS Chartered Secretary
CSR corporate social responsibility
EC European Commission
EPS earnings per share
ESG environmental social governance reporting
EU European Union
FCA Financial Conduct Authority
FRC Financial Reporting Council
FRS Financial Reporting Standards
FRSSE Financial reporting standard for smaller entities
GAAP Generally Agreed Accounting Practices
GMM gross margin method
GRI global reporting initiative
HMRC Her Majesty’s Revenue & Customs
IAS International Accounting Standards
IASB International Accounting Standards Board
IASC International Accounting Standards Committee
IESBA International Ethics Standards Board for Accountants
IFAC International Federation of Accountants
IFRS International Financial Reporting Standards
IPC integrated pollution control
IPR intellectual property rights
KPI key performance indicators
NDAC non-discretionary accruals
NEDs non-executive directors
NGOs non-governmental organisations
NPV net present value
NRV net realisable value
OCI other comprehensive income
OFR Operating and Financial Review
OROE Operating Return on Equity
RIM retail inventory method
ROCE return on capital employed
ROE return on equity
SAN Social Audit Network
SEC Securities and Exchange Commission
SIC standing interpretations committee
SME small and medium-sized enterprises
SOFP statement of financial position
TBL triple bottom line (framework)
WTO World Trade Organization
XBRL eXtensible Business Reporting Language
 part one

The regulatory and

conceptual frameworks
for financial reporting
■■ Chapters
1. The regulatory framework for the preparation and presentation of financial statements
2. The conceptual framework for the preparation and presentation of financial statements
Chapters 1 and 2 in Part One cover the syllabus section entitled ‘The regulatory and conceptual
frameworks for financial reporting’.

■■ Overview
The IFRS Framework describes the basic concepts that underlie the preparation and presentation
of financial statements for external users.
The regulatory and conceptual frameworks appear to be somewhat difficult to grasp, particularly
as they are not financial reporting standards. However, the frameworks are the basis for which
guidance is sought in reviewing and developing new standards.
Chapters 1 and 2 introduce the various terminologies used and build upon various frameworks
from around the globe and related accounting issues that are pervasive and contemporary in
nature.
To put things in context, the two chapters discuss historical issues in the development of financial
reporting standards and the difficulties faced in their global acceptability.
Part 1 contains a Worked Example on America Online (AOL). Having reviewed the material, please
attempt to answer the questions that follow the AOL scenario.
1. The regulatory framework for the preparation and presentation of financial statements
■■ The work of the international standards setters
■■ Statutory framework and legal requirements
■■ Corporate governance and the external audit process
■■ Social and environmental reporting
2. The conceptual framework for the preparation and presentation of financial statements
■■ The objective and users of financial statements
■■ The underlying assumptions
2 Part one The regulatory and conceptual frameworks for financial reporting

■■ The qualitative characteristics that determine the usefulness of information in financial

statements
■■ The definition of the elements of financial statements
■■ The recognition of the elements from which financial statements are constructed
■■ The measurement of assets and liabilities reported in financial statements
■■ Concepts of capital and capital maintenance
The regulatory framework 1
for the preparation and
presentation of financial
statements

■■ Contents
  1. Introduction
  2. The regulatory framework
  3. National differences in financial reporting practices
  4. Reasons for national differences in financial reporting practices
  5. The classification of national accounting systems
  6. The work of international standard setters
  7. The theoretical framework of accounting
  8. Arguments for and against accounting standards
  9. Corporate governance and the external audit process
10. The emergence of environmental reporting
11. Eco-Management and Audit Scheme (EMAS)
12. Social accounting
13. The changing role of the accountant

■■ Learning outcomes
Chapter 1 covers the syllabus section entitled ‘The regulatory framework for the preparation
and presentation of financial statements’. After reading and understanding the contents of the
chapter, working through all the worked examples and practice questions, you should be able to:
■■ show an understanding of the work of the International Accounting Standards Board;
■■ be familiar with the principal sources of legal regulations governing financial statements;
■■ explain the principal qualities required of external auditors if they are to contribute to effec-
tive corporate governance.
■■ evaluate the corporate governance implications of auditors providing consultancy services;
■■ list the main elements of the Eco-Management and Audit Scheme for environmental disclo-
sure in Europe;
■■ reveal familiarity with the activities involved in an environmental audit; and
■■ outline recent developments in corporate social responsibility (CSR) reports and triple bottom
line reporting.

1 Introduction
The past decade has witnessed an ever-increasing volume of cross-border trade and cross-listing
on the world’s capital markets, due to the breakdown of trade barriers and the formation of
international trade bodies such as the World Trade Organization (WTO). This, in turn, has
resulted in the demand for quality cross-border financial information. International Financial
Standards are the mechanism that attempt to provide a platform for financial reporting consist-
ency and reliability, to help stakeholders to make informed economic decisions.
The International Financial Reporting Standards (IFRSs) are the remit of the International
Accounting Standards Board (IASB), which seeks to achieve global comparability and consistency
4 Part one  The regulatory and conceptual frameworks for financial reporting

in financial reporting. In developing the IFRSs, the IASB relies on the regulatory and conceptual
frameworks for preparing and presenting financial statements. This chapter discusses the rel-
evant issues that underpin these frameworks.

2 The regulatory framework

International Financial Reporting Standards (IFRSs) for public limited companies have been
used in the UK and the European Union (EU) since 2002. Students need to be aware of the
relevance of these and the importance attached to their use and application. The IFRS Framework
is fundamental to the development and application of IFRSs.
The IFRS Framework refers to a principle-based approach to developing a common set of
financial reporting standards. It provides a platform for accounting and financial reporting to
help demonstrate to the users of general purpose financial statements the appropriate accounting
treatment of common accounting matters, on the basis of International Accounting Standards
(IASs) and International Financial Reporting Standards (IFRSs). The former International
Accounting Standards Committee (IASC) issued IASs. However, standards issued since the
formation of the IASB in April 2001 are referred to as IFRSs.
The objective of the framework is to set out the concepts that underlie the preparation and
presentation of financial statements for external users as set out in the ‘Framework for the
Preparation and Presentation of Financial Statements’. It is important at the outset to under-
stand that the framework itself is not a standard. Its primary purpose is to help the IASB to
develop new or revised accounting standards, and to assist those who prepare financial state-
ments to apply accounting standards and to deal with any issues that the standards do not cover.
The framework covers:
■■ the objectives of financial reporting;
■■ the underlying assumptions;
■■ the qualitative characteristics;
■■ the elements of financial statements; and
■■ the concepts of capital and capital maintenance.
These are covered in the sections on the Conceptual Framework in chapter 2.
The IASB Framework was approved by the IASC Board in April 1989 for publication in July
1989, and was adopted by the IASB after its formation in April 2001. The section on the regu-
latory aspect of the framework discusses some important themes that have emerged during its
development.

3 National differences in financial reporting practices

National differences in accounting and corporate reporting continue despite IFRSs. Countries
in which the accounting profession has developed over a long period of time (such as the UK
or the US) have generally led the evolution of accounting principles. Regulations influenced by
local issues have given rise to particular accounting procedures. These rules and regulations are
referred to as Generally Accepted Accounting Principles (GAAPs).
There are many reasons for differing financial reporting practices. Some of these may ema-
nate from cultural, economic, political, religious and other internal influences. However, the
speed of change in the global business environment and the pressure for change and the con-
vergence of national GAAPs to the IFRS system have resulted in many countries adopting the
IFRSs.
Nevertheless, national implementation of IFRSs differs in the degree of convergence.
Hopwood suggests that ‘[at] the very time when there are enormous pressures for conver-
gence of forms of financial accounting, our insights into the factors resulting in earlier differ-
ences in such practices are still poorly developed’.
The basis for accountability through corporate financial reporting (annual accounts) is fun-
damental to the dissemination of financial information relevant to the economic performance
of the corporation. One view of the firm (corporation) is to look at it as a ‘nexus of contracts’, in
which the firm has legal and ethical obligations to those who provide resources (e.g. banks and
creditors) and other stakeholder groups (e.g. employees and the government).
 chapter 1  The regulatory framework for the preparation and presentation of financial statements 5

TEST YO UR K N OW LE DG E   1.1

What is the objective of the IFRS Framework?

4 Reasons for national differences in financial

reporting practices
The classification of national accounting systems has generally taken the form of ‘Anglo-Saxon’
and ‘Continental Europe’ models. However, other models have been developed by researchers
trying to understand national accounting systems from differing perspectives.
Differences in national accounting systems can generally be explained by economic, legal,
political and cultural factors. Meek and Saudagaran (1990) identify five external environmental
and institutional factors for which there is a general consensus:
■■ the legal system affecting the accounting standardisation process (common law countries
versus code law countries);
■■ business financing practices (whether financing is obtained via the stock market or from
financial institutions);
■■ the tax system, and particularly its connection with accounting;
■■ the level of inflation likely to influence valuation methods; and
■■ the political and economic relationships between countries – for example, links from
colonisation.

5 The classification of national accounting systems

The purpose of any accounting classification system is to show the similarities and differences
in various countries’ accounting systems, based on a study of either domestic regulations or
business practices.
Much of the debate on international accounting has revolved around the classification of
countries with similar accounting procedures and processes. This has, to a certain extent,
reduced the complexity in describing accounting differences and explaining similarities.
Researchers on international accounting have tried to divide countries into groups with
similar features based either on common practices, or the national regulations in force. The
differences observed in information disclosure and/or application methods undermine the
understanding and comparability of financial statements. This has resulted in a comparative
review of national practices for work on convergence, standardisation and harmonisation.
Classifying national accounting systems is a useful exercise to identify areas of concern and
helps to address such differences. However, changing and converging accounting principles has
been a long and difficult process, and has given rise to new issues and problems in accounting
that require constant monitoring.
Assuming that the standardisation exercise by the IASB will eventually lead to a common
set of globally applicable standards for all economic entities; this will, in turn, allow a departure
from national GAAPs. This will itself mean that accounting information should be easier to
understand from an international viewpoint and will extend the cross-border flow of capital.
Nevertheless, national differences on the basis of culture, national company law and different
taxations systems, etc, may be a barrier to complete global harmonisation. Issues relating to
the interpretation of standards will be hampered by individual interpretation of accounting
treatments at a local level. For example, the Coalition Government in the UK, led by David
Cameron, announced changes to the banking system whereby UK banks will be required to
keep their retail arms separate from their more risky investment activities, thereby protect-
ing certain investments. These changes, which came into force in 2013, may create financial
reporting difficulties in the future for UK banks (e.g. how would banks be required to report
financial information about issues relating to group accounting?).
6 Part one  The regulatory and conceptual frameworks for financial reporting

T E S T YO UR K N OW L E D G E   1.2

Outline the benefits derived from classifying national accounting systems.

The ever-increasing use of global accounting and financial information has made it necessary to
reduce the differences in the way accounting information is prepared and reported in different
countries. In reducing accounting differences, standard setters use two particular approaches to
standards development:
1. standardisation
2. harmonisation.

5.1 Standardisation
Standardisation is the process by which rules are developed to set standards for similar items
on a global basis. Through standardisation, many technical issues relating to the treatment
of accounting information have been resolved (e.g. the preparation of information relating to
earnings per share (EPS IAS 33) is now recognised globally, and is applied consistently using
appropriate measures and stated on the statement of comprehensive income).

5.2 Harmonisation
Harmonisation reconciles national differences and provides those who prepare accounting
information with a common framework to deal with major issues in a similar manner.
As efforts to improve comparability of financial statements have increased, the two approaches
have come closer together. Attempts have been made to standardise, or at least harmonise,
financial reporting to satisfy the needs of a number of different stakeholders. To make informed
economic decisions, investors need clear and comparable information to assess a company’s
past or potential investment performance and its underlying economic reality.
Government agencies such as tax and customs authorities also have an interest in greater
compatibility of information between countries to trace transactions. International account-
ancy firms have large numbers of multinational clients, whose accounts frequently need to be
adjusted to common accounting principles before consolidations can be prepared. A reduction
in national accounting differences would reduce the training costs of these firms and increase
staff mobility (however, it would also limit the fees they could charge).
Companies seeking capital through cross-border listings may currently need to prepare finan-
cial statements under more than one set of regulations, to meet the needs of different stock
exchanges. This is both costly and time-consuming. However, almost every stock exchange
will accept accounts prepared under IFRSs. A number of international bodies are involved in
the processes of harmonisation or standardisation. These include organisations that may not
immediately be associated with accounting, such as the United Nations and the Organization
for Economic Cooperation and Development (OECD). However, the most influential organi-
sations have probably been the International Accounting Standards Board and the European
Union.
The process of standardisation and harmonisation through accounting standards has created
an accounting environment that places an obligation on companies to disclose the accounting
policies they have used to prepare their accounts.
This inevitably helps those who use accounts to better understand the information pre-
sented. Additionally, standards allow entities to be compared due to the consistency of account-
ing procedures used in the reporting of accounting information, on the basis that accounting
standards:
■■ require companies to disclose information in the financial statements which they otherwise
would not if the standards did not exist;
 chapter 1  The regulatory framework for the preparation and presentation of financial statements 7

■■ reduce the number of choices in the method used to prepare financial statements and there-
fore should reduce the risk of creative accounting. This should help the users of financial
statements to compare the financial performance of different entities;
■■ provide a platform in the accounting profession for discussion about accounting practice and
to lobby the accounting setting bodies such as the IFRS and FRC (UK); and
■■ should increase the credibility of financial statements with the users by improving the
amount of uniformity of accounting treatment between companies.

TEST YO UR K N OW LE DG E   1.3

Identify the important contributors to harmonisation in financial reporting.

6 The work of international standard setters

The major international bodies have accelerated their programmes of work and have sought
greater cooperation in recent years. This section sets out something of their histories and struc-
tures, before relating the latest developments in their strategies and the effect this is likely to
have on the annual reports of companies.

6.1 The International Accounting Standards Board

Following a review between 1998 and 2000, the International Accounting Standards Committee
(IASC) was restructured to give an improved balance between geographical representation, tech-
nical competence and independence. The 19 trustees of the IASC represented a range of geo-
graphical and professional interests and were responsible for raising the organisation’s funds
and appointing the members of the Standing Interpretations Committee (SIC).
The International Accounting Standards Board (IASB), founded in 2001, and the successor to
the IASC, is responsible for the development of the International Financial Reporting Standards.
International Financial Reporting Standards (IFRSs) are principles-based standards for finan-
cial reporting. They have been issued by the IASB since 2001. Many accounting standards con-
tinue to be called International Accounting Standards. However, since 2001, the development
of accounting standards is referred to as International Financial Reporting Standards.
The objectives of the IASB are:
■■ to develop, in the public interest, a single set of high-quality, understandable and enforceable
global accounting standards that require high-quality, transparent and comparable informa-
tion in financial statements and other financial reporting to help participants in the world’s
capital markets and other users to make economic decisions;
■■ to promote the use and rigorous application of those standards; and
■■ to bring about convergence of national accounting standards and IFRSs.
Convergence can be defined as:
■■ reducing international differences in accounting standards by selecting the best practice cur-
rently available, or, if none is available, by developing new standards in partnership with
national standard setters. The convergence process applies to all national regimes and is
intended to lead to the adoption of the best practice currently available.
The IASB is responsible for all technical matters including the preparation and implementation
of International Accounting Standards (IASs).
The process of producing a new IFRS is similar to that of national accounting standard set-
ters. Once the need for a new (or revised) standard has been identified, a steering committee
is set up to identify the relevant issues and draft the standard. Drafts are produced at various
stages and are exposed to public scrutiny. Subsequent drafts take account of comments obtained
during the exposure period.
8 Part one  The regulatory and conceptual frameworks for financial reporting

The final standard is approved by the board and an effective date agreed. IFRSs and IASs
currently in effect are referred to throughout the rest of this book. This process assists in the
development of future accounting standards and improves harmonisation by providing a basis
for reducing the number of accounting treatments permitted by IASs. Professional accountancy
bodies have prepared and published translations of IASs, making them available to a wide audi-
ence. The IASC has itself set up a mechanism to issue interpretations of the standards.
IASs and IFRSs (referred to below simply as ‘IASs’) may be applied in one of the following
ways:
■■ An IAS may be adopted as a national accounting standard. This can be useful where there
are limited resources and an ‘off the peg’ solution is required (e.g. in Botswana, Cyprus and
Zimbabwe). The disadvantage is that the standard may not meet specific local needs, due to
the influence of the larger industrialised nations on the IASs.
■■ An IAS may be used as a national requirement but adapted for local purposes (e.g. in Fiji and
Kuwait).
■■ National requirements may be derived independently, but are adapted to conform to an IAS.
This is currently the procedure in the UK, although the programmes of the IASB and ASB
converged almost 14 years ago and developed IAS 37 and FRS 12 jointly.
It is important to note that if a company wishes to describe its financial statements as comply-
ing with IASs, IAS 1 requires the financial statements to comply with all the requirements of
each applicable standard and each applicable interpretation of the SIC. This clearly outlaws the
practice of ‘partial IAS’ reporting, where companies claim compliance with IASs while neglect-
ing some of their more onerous requirements.
The old IASC had a large number of members, so it was difficult to achieve a consensus on
many of the issues that the committee has addressed. Consequently, many IASs initially per-
mitted a range of treatments. While this was an improvement on not having a standard at all, it
was still far from ideal. In response to this criticism, the IASC began its comparability/improve-
ments project in 1987, which resulted in the revision of ten standards. The IASB adopted all
IASs in issue, but soon identified the need for further improvement.

T E S T YO UR K N OW L E D G E   1.4

What is the role of the International Accounting Standards Board in the process of financial
reporting?

6.2 The revised structure of the IFRS/IASB

6.2.1 The Trustees of the IFRS Foundation
The IFRS Foundation (known as the IASC Foundation until 2001) appoints members of the
IASB.
It is responsible for raising funding for the standards setting process.

6.2.2 The IFRS Advisory Council

The IFRS Advisory Council (previously the Standards Advisory Council) liaises with individuals
who have an interest in financial reporting.
It advises the IASB regarding its agenda and priorities.

6.2.3 The IASB

The International Accounting Standards Board was formed in 2001. It succeeded the IASC
(International Accounting Standards Committee) and inherited accounting standards already
issued.
It is responsible for issuing International Financial Reporting Standards (IFRSs).
chapter 1  The regulatory framework for the preparation and presentation of financial statements 9

6.2.4 The IFRS Interpretations Committee

The IFRS Interpretations Committee provides practical guidance on the application of IFRSs.
Its interpretations are known as IFRICs. It replaced the Standards Interpretation Committee
(SIC) in April 2001.

6.3 The European Commission

The European Commission (EC) has worked extensively in the past few years to promote IFRSs
particularly among member states. The work of the EC is directed towards promoting the qual-
ity, comparability and transparency of the financial reporting by companies.
In 2005, the EC took a significant step and made the use of IFRSs obligatory for the consoli-
dated financial statements of EU companies that are listed on the EU’s stock markets.
In relation to listed companies, the Commission’s work extends beyond the EU’s borders and
goes towards promoting the use of IFRSs as the worldwide financial reporting language, thus
enhancing the efficiency and transparency of capital markets throughout the globe.

6.4 UK GAAPs
Accounting standards have their roots in various sources. In the UK, the principal standard-
setting body is the Accounting Standards Board (ASB), which issues standards called Financial
Reporting Standards (FRS). The ASB is part of the Financial Reporting Council (FRC) that took
over from the Accounting Standards Committee (ASC), which was disbanded in 1990.
The principal legislation governing reporting in the UK is found in the Companies Act 2006,
which incorporates the requirements of European law. The Companies Act dictates certain
minimum reporting requirements for companies (e.g. it requires limited companies to file their
accounts with the Registrar of Companies, which are then available to the general public).
From 2005, this framework changed as a result of European law requiring that all listed
European companies report under IFRSs. In the UK, companies that were not listed had the
option to report either under IFRSs or under UK GAAPs. The UK’s Financial Reporting Council
(FRC) has published FRS 102 ‘The Financial Reporting Standard applicable in the UK and
Republic of Ireland’, which will replace current UK GAAPs with effect for periods beginning on
or after 1 January 2015.

6.5 US GAAPs
Accounting standards in the USA are typically referred to as US GAAPs (Generally Accepted
Accounting Principles). US GAAPs are a set of accounting standards used to prepare and present
financial reports for a range of entities, including public and private enterprises, non-profit
organisations, and government departments. US GAAPs is usually limited to the USA.
Currently, the Financial Accounting Standards Board (FASB) is the highest authority to estab-
lish GAAPs for public and private companies, as well as for non-profit entities. However, listing
requirements by the SEC call for companies to follow IFRSs.
Despite numerous attempts to adopt IFRSs, the USA has still not come on board and are
making slow progress to convergence.

stop and t hink  1.1

What is the advantage of having a single set of International Financial Reporting Standards?
10 Part one  The regulatory and conceptual frameworks for financial reporting

7 The theoretical framework of accounting

Research in various areas of accounting and finance, particularly during the past five decades,
has greatly influenced standard setting and development. Most notable is the agency theory,
which defines the characteristics of a public limited company (a company which may be listed
on a capital market).
Jensen and Meckling (1976) developed the notion of agency theory and suggested that the
modern corporation exists on the basis of the principal–agent relationship, where the owner
(shareholder) is the principal and the manager is the agent. It is envisaged that, as the custodian
over the assets of the firm, the manager will act in the best interests of the owner, and hence
look to maximise the owner’s wealth. However, due to a misalignment of common interests,
the manager may pursue their own interests at the expense of the principal. In such circum-
stances, the principal will incur monitoring costs to keep a check on the agent’s activities and
take corrective action where necessary.
The idea of a conflict of interests between the two contracting parties (principal and agent)
is the cornerstone of the agency theory. The two parties will enter into contracts that facilitate
their interests and minimise agency costs (costs incurred by the principal in monitoring the
agent). Since the agent has superior knowledge of the principal, in relation to the underlying
economic reality of the company, at any given time, a difference of information (information
asymmetry) will exist between the principal and the agent. To mitigate and minimise such dif-
ferences, the contracting parties will seek to optimise their relationship.
The monitoring processes take many forms; however, corporate governance is the mecha-
nism by which control is exercised by the board of directors over the activities of the managers.
Internally adopted mechanisms of corporate governance seek to enhance financial reporting
and give a measure of confidence to accounting information users. The UK Code on Corporate
Governance (2010) is a principles-based set of guidelines that require listed companies on the
London Stock Exchange to ‘comply or explain’ in their financial reporting.
The UK Code on Corporate Governance is overseen by the Financial Reporting Council
(FRC) and its relevancy is derived through the Financial Services Authority’s (FSA) listing
requirements. The FSA was replaced by the Financial Conduct Authority (FCA) in 2013 and
many of its responsibilities passed to the Bank of England. UK listings rules have a statutory
authority under the Financial Services and Marketing Act 2000.

8 Arguments for and against accounting standards

8.1 The arguments for accounting standards
The corporate collapse of some well-known major international companies such as Enron
(2001), Worldcom (2002), Parmalat (2003) and more recently Satyam (2009) highlighted the
need for transparency in financial reporting. These corporate collapses necessitated the need
for standardisation, harmonisation and convergence to protect stakeholder interests. However,
these corporate collapses in large part were due to fraud, with irregularities in accounting proce-
dures being pervasive and regulators being told untruths about the state of affairs of the various
companies.
Accounting standards oblige companies to disclose the accounting policies they have used to
prepare their published financial reports. This should make the financial information easier to
understand and allow both shareholders and investors to make informed economic decisions.
Accounting standards require companies to disclose information in the financial statements
that they might not disclose if the standards did not exist.
Accounting standards reduce the risk of creative accounting. This means that financial state-
ments can be used to compare either the financial performance of different entities or the same
entity over time.
Accounting standards provide a focal point for discussion about accounting practice. They
should increase the credibility of financial statements by improving the uniformity of account-
ing treatment between companies.
Various EU accounting directives have sought to create minimum reporting standards so
as to develop a common approach to financial reporting. The accounting directives com-
monly referred to are: the Fourth (Annual Accounts of Limited Companies, 1978), the Seventh
chapter 1  The regulatory framework for the preparation and presentation of financial statements 11

(Consolidated Accounts of Limited Companies, 1983) and the Eighth (Company Law, 1984).
Each directive gives separate accounting guidance on the preparation and reporting of account-
ing information and various elements that must be shown on the face of financial statements.
The aim of the accounting directives is to facilitate the commonality and hence the transpar-
ency of accounting information across the EU member states, to help the flow of capital.
Due to the global nature of capital movement, stakeholders demand quality financial reports
and accounting information which can be relied upon for consistency, commonality and overall
transparency. Accounting standards try to achieve that aim, and the IASB is constantly working
to reduce accounting differences.

8.2 The arguments against accounting standards

It is acknowledged that standards fulfil a valuable short-term role by ensuring that all com-
panies adopt the best procedures, but people in some quarters believe that the standards may
prove to be detrimental in the long term. Over the years, considerable improvements have
been made in the form and content of published accounts, and much of this has occurred as
the result of free market experiment and innovation. To place financial reporting procedures
in a standardised straitjacket might, it is argued, therefore be to the longer-term detriment of
those who use financial statements. In a nutshell, a major potential hazard of standards is that,
although they may be intended as a floor, they end up as a ceiling.
A second problem is that, as the industry itself is not standard, it seems unlikely that the
figures they produce are amenable to a large degree of standardisation. The tendency is there-
fore to enforce standards that are suitable for the average firm (the majority) but not for those
on the margins. Many areas disagree about which method should be used (e.g. whether to use
average weighted cost, LIFO or FIFO to value inventories, or whether to use the deferral method
or the flow-through method to account for deferred taxation). The choices made by accounting
standard setters, although often based on sound reasoning, can remain somewhat arbitrary.
Standards remove the need for accountants to exercise their judgment – a crucial feature of
their status as professionals. Accountants are concerned that their role will be relegated to that
of a mere technician who does no more than slot figures, calculated in accordance with account-
ing standards, into their appropriate location. This concern seems to be exaggerated because,
although numerous matters are standardised, there is still plenty of scope for accountants to
exercise their professional judgment. Indeed, an important drawback of standardisation is that
it gives an illusion of precision and comparability, which is totally unjustified in view of the
wide range of subjective decisions that still have to be made.
A final criticism directed at the standard-setting process is that there are too many regula-
tions. Forty-nine international standards have been issued and, although several have been
withdrawn, more are in the pipeline. One suggestion is that a ‘plethora of principles’ has been
replaced by a ‘surfeit of standards’.

TEST YO UR K N OW LE DG E   1.5

What are the benefits of the existence of accounting standards?

9 Corporate governance and the external audit

process
In recent years, corporate governance and the external audit process has become invariably
linked as bodyguards in the statutory reporting of financial performance. However, our primary
concern is to understand what is meant by the term ‘corporate governance’ and an ‘external
audit’. Our secondary concern is to understand how the two concepts operate in isolation and
together in the quest to safeguard the process and output of financial reporting.
12 Part one  The regulatory and conceptual frameworks for financial reporting

9.1 The audit

The external audit is a statutory requirement enshrined in the Companies Act of the UK and
other national jurisdictions. It is a process whereby an auditor appointed by the members pro-
vides an independent opinion on the financial statements. The auditor will provide an opinion
on whether the financial statements exhibit a true and fair view of the company, and whether it
has been prepared in compliance with accepted and recognised accounting and auditing stand-
ards without any material error or omissions.
In essence, the audit process can be regarded as a process whereby the auditor examines
the financial statements prepared by the company against set criteria, to provide assurance to
intended users of the financial statements in the form of an opinion.
The auditor will provide an opinion of ‘true and fair’ if the accounts are satisfactory. Otherwise
they will provide a qualified opinion, which means they are not of the opinion that the financial
statements, as presented, provide a true and fair reflection of the company. An audit opinion on
the true and fair presentation of the financial statements is required because an audit does not
involve a 100% examination of the accounting records and systems but a selected sample of the
accounting records and systems.
In the UK, it is mandatory for all public listed companies to have their financial statements
audited by an independent auditor. Private limited companies are also subject to a company
audit. However, any private limited company with a financial year end on or after 1 October
2012 can qualify for an audit exemption, if they satisfy at least two of the following conditions:
■■ an annual turnover of no more than £6.5 million;
■■ assets worth no more than £3.26 million; or
■■ 50 or fewer employees on average.
An audit-exempt company can have their financial statements subjected to an audit if share-
holders (an individual shareholder or a group of shareholders) who own at least 10% of shares
(by number or value) request an audit. The request for an audit must be made in writing and
sent to the company’s registered address.
The purpose of an audit is not to detect fraud, but to provide assurance to the users of the
financial statements that the financial statements have been prepared in accordance with an
approved standard. The assurance gained by the users from an audit is the increased confidence
and reduction in the risks associated from the use of financial statements for their own eco-
nomic decisions. The audit process is an independent examination of the accounting systems
and internal controls installed by management to facilitate effective financial reporting and
business performance. An audit includes an examination of evidence relevant to the amounts
and disclosures in the financial statements. It also includes an assessment of the significant
estimates and judgments made by the directors in preparing the financial statements. The audit
is conducted in accordance with International Standards on Auditing (UK and Ireland) issued
by the Auditing Practices Board.
Generally, however, auditors express an opinion of the true and fair view of the financial fig-
ures being reported. In so doing, they must have regard to the level of audit risk presented, and
the level of audit work that must be carried out to enable a view to be expressed.
An external audit process ensures that a company’s internal controls, processes, guidelines
and policies are adequate, effective and comply with applicable legal and accounting standards,
industry standards and the company’s own policies and procedures. The external audit also
helps ensure reporting mechanisms prevent errors in financial statements. The users of audit
reports are all parties who have a vested interest in the company, such as investors, company
management, regulators and business partners such as lenders, suppliers and creditors.
The external audit provides reassurance to all user groups who have a vested interest in the
financial affairs of a company (e.g. company management, regulators and investors). The audit
enables both the senior management and the audit committee (within plcs) of a company to
determine operating breakdowns and segments showing higher risks of loss and, where neces-
sary, to take appropriate action to safeguard the assets of the company. An auditor’s job is not to
comment on the efficiency and proficiency of a company’s financial performance, but to verify
that the financial statements are free from material error and to question management on their
judgment in various matters.
Regulators use audit reports to detect business trends and corporate practices and to ensure
that such practices comply with the law. Investors read audit opinions to gauge a company’s
economic standing and management’s short-term initiatives or long-term strategies.
chapter 1  The regulatory framework for the preparation and presentation of financial statements 13

An audit committee is a composition of the board of directors of a company, consisting of

executive and non-executive directors. It has special responsibilities for both the internal and
external audit functions. The audit committee has responsibility to provide the auditors with
guidance, support and direction.
Despite the mandatory requirement of company audits there has been the discovery of several
notable global corporate failures. Some of the notable corporate failures are set out in Table 1.1.

Table 1.1 Sample of global corporate failures 1991–2012

Company Country
Colonial Life Insurance Company Limited Trinidad & Tobago
Enron Corporation USA
Harris Scarfe Australia
HIH Insurance Australia
Madoff Investment Securities USA
Maxwell Corporation UK
MCI WorldCom USA
Olympus Corporation Japan
OneTel Australia
Polly Peck International UK
Satyam Computer Services Limited India

It is evident from Table 1.1 that corporate failures are not confined to any national or regional
jurisdiction. However, it is against this backdrop that the external audit has shifted and become
aligned with corporate governance.

TEST YO UR K N OW LE DG E   1.6

Outline the conditions that must be satisfied to allow a company an audit exemption.

9.2 Corporate governance

Corporate governance is defined in the UK Corporate Governance Code as ‘the system by
which companies are directed and controlled’. Corporate governance has grown in importance
as the interest of the company owners (shareholders) and its agents (the officers) have grown
more diverse. Companies are owned by its shareholders; however, they entrust a company’s
management to the board of directors (officers), who are in effect the agents. One of the princi-
pal roles of the officers is to safeguard the assets of the company plus a fiduciary responsibility.
However, over the years a divergence has grown in the goals of both sides. In summary, it may
be argued that shareholders possess a long-term horizon and seek to increase shareholder value,
whereas the officers have a shorter-term perspective that is driven by personal goals.
The board of directors are charged with the responsibility to install systems and internal con-
trols that ensure the effective operation of the company. Thus the board has the overall respon-
sibility for the activities and events that a company may undertake, either directly or indirectly.
Hence the chief executives or chairmen or chief operating officers will often stand down in the
face of adverse activity or events that damage the reputation of their company. Similar to corpo-
rate failure, there have been numerous noteworthy such cases in the last few decades.
Corporate governance provides a supportive framework and operating environment for
the reporting of corporate financial performance. The operation of best practices of corporate
14 Part one  The regulatory and conceptual frameworks for financial reporting

governance and supportive policies and procedures is a means of communicating with the
company’s shareholders and stakeholders to reassure them that they can rely on the financial
statements and outputs from the company.
It is this assurance and reassurance of the stakeholders that brings the audit and corporate
governance together.
Corporate governance may be regarded as the pillars that underpin all the features of the
company that impacts upon its corporate reporting and behaviour, whereas the external audit is
merely one of the pillars, with the sole focus upon the financial statement’s adherence to best
accounting and auditing practices.
The growth of the role of corporate governance across the globe has increased the promi-
nence of social and environmental reporting, as entities begin to embrace their impact upon
the environment, and the recognition of costs that is not imputed in our neo-classical model of
business and the price mechanism for goods and services.

10 The emergence of environmental reporting

10.1 Environmental Protection Act 1990
Environmental law can be traced as far back as the 1860s, when controls on air pollution from
industrial units and factories necessitated legislation due to the release of harmful substances
in the air. The Environmental Protection Act 1990 consolidated older laws into more relevant
legislation. The Act gave rise to legal implications for directors of companies. They could be
prosecuted if it could be proved that they had neglected their duty to protect the environment.
The Act was a major development in environmental protection in the UK.

10.2 Industry initiatives

ISO 14000 (International Organization for Standardization – Standard 14000) is a voluntary
code that addresses environmental management and prevention. It is an industry-led standard
that requires companies to abide by certain conditions relating to environmental issues. ISO
14000 requires companies to document and work towards reducing or eliminating pollution
and processes that can be harmful to the environment. ISO 14000 was the basis on which
the Environmental Management System (EMS) was developed. EMS is a management system
designed to achieve organisational directives and policies regarding the environmental impact
of an organisation’s activities.

10.3 Economic consequences for environmental reporting

Pressures on corporations and the demand for environmental-related information have led to a
plethora of disclosures on environmental reporting. However, environmental disclosures have
economic implications for the company. Environmental reporting can be defined as:

[t]he process of communicating externally the environmental effects of an organisation’s

economic actions through the corporate annual report or a separate stand-alone publicly
available environmental report.

Invariably, disclosures would relate to the policy, procedures and processes and environmental
audit in a company’s environmental report. Consequently, users will assess (on the basis of
information provided) the economic and reputational impact of such policies. Expenditure and
benefits that transpire will be assessed for sustainability. A report by the ACCA (Association
of Chartered Certified Accountants) on Singapore firms that disclose environmental matters
looked at the impact of environmental reporting and identified ten important issues that have
an economic impact on company environmental disclosures:
1. Risk management – in areas of financial, legal and reputation implications.
2. Marketing strategy – public image, brand enhancement such as through receiving environ-
mental awards.
3. Legal needs – to keep in pace with/anticipate regulations.
4. Competition – to get ahead of/stay with competitors.
chapter 1  The regulatory framework for the preparation and presentation of financial statements 15

5. Ethics – individual commitment, commitment to accountability and transparency.

6. Accounting requirements – in compliance with financial reporting requirements and pro-
viding a link between financial and environmental performance/reporting.
7. Investors’ interests – demands of Green (ethical) investors.
8. Employees’ interests – attracts right staff from the labour market.
9. Value-added reporting – to add value to corporate reports and communicate to a wider range
of stakeholders, addressing their environmental concerns.
10. Certification needs – to indicate compliance with ISO 14000 and other environmental regu-
latory guidelines.
Various emerging regulations and the implications for financial reports indicate that there is a
move towards ‘integrated reporting’ on CSR (corporate social responsibility) and environmental
issues that allow interactivity on web-based publication of such reports. Web-based facilities
would enhance user perceptions and that of the company by allowing users to extract specific
information that will help them to make economic decisions.

10.4 Stand-alone environmental reporting

There is now an expectation that businesses should operate in a way that reduces any adverse
impact on the environment to an absolute minimum. Measuring the impact that a company has
on the environment presents challenges to accountants. While some of the increased emphasis
on all things environmental may be due to genuine concern, some is driven by market forces,
as businesses that are considered environmentally irresponsible are likely to lose market share.
Stand-alone environmental reporting is primarily web-based disclosure. It is usually sepa-
rate from a company’s annual report and other company publications devoted to issues on the
impact of company operations on the environment. The quality and quantity of environmental
reports partly depend on the nature of the business in which a company operates. Industries
such as pharmaceuticals, chemical, petroleum and gas have attracted the most attention on
environmental issues. These industries have led the way in environmental reporting. Some
countries make it mandatory to publish environmental reports: Denmark, Sweden, Norway
and Holland all require environmental reports by law, particularly from environmentally sensi-
tive industries.

TEST YO UR K N OW LE DG E   1.7

Explain the term ‘corporate governance’.

11 Eco-Management and Audit Scheme (EMAS)

11.1 What is an environmental audit?
An environmental audit is a tool that a company can use to identify the full extent of its envi-
ronmental impact. It enables a company to determine its level of compliance with relevant
legislation and with its own environmental policies, thus enabling users of the report to under-
stand achievements and shortcomings in company environmental practice.

11.2 Eco-Management and audit scheme (EMAS)

The EMAS is an audit tool specifically designed for eco-management audits. It allows a com-
pany to determine both its environmental impact and determine ways to improve, or reduce,
such impact. As greater numbers of companies realise that not taking part in environmental
reporting has economic consequences, the EMAS assists companies to report in more or less a
standardised fashion.
16 Part one  The regulatory and conceptual frameworks for financial reporting

The EMAS was first made available as far back as 1995, with a particular emphasis on com-
panies in the industrial sector. However, the scheme has now been extended to all businesses.
In 2009 the EMAS Regulation was revised and modified for the second time. Regulation (EC)
No. 1221/2009 of the European Parliament and of the Council of 25 November 2009 on the
voluntary participation by organisations in a Community eco-management and audit scheme
(EMAS) was published on 22 December 2009 and entered into force on 11 January 2010.
The main elements of the EMAS tool require the disclosure of the following information.

a. Conduct an environmental review

The organisation needs to conduct a verified initial environmental review, considering all
environmental aspects of the organisation’s activities, products and services, methods to
assess them, the organisation’s legal and regulatory framework and existing environmental
management practices and procedures.
b. Adopt an environmental policy
Registration to EMAS requires an organisation to adopt an environmental policy and to
commit itself both to compliance with all relevant environmental legislation and to achiev-
ing continuous improvement in its environmental performance.
c. Establish an EMS
Based on the results of the environmental review and the policy (objectives), an Environmental
Management System (EMS) needs to be established. The EMS is aimed at achieving the
organisation’s environmental policy objectives as defined by the top management. The man-
agement system needs to set responsibilities, objectives, means, operational procedures,
training needs, monitoring and communication systems.
d. Carry out an internal environmental audit
After the EMS is established, an environmental audit should be carried out. The audit
assesses in particular if the management system is in place and in conformity with the
organisation’s policy and programme. The audit also checks if the organisation is in compli-
ance with relevant environmental regulatory requirements.
e. Prepare an environmental statement
The organisation needs to provide a public statement of its environmental performance. The
environmental statement lays down the results achieved against the environmental objec-
tives and the future steps to be undertaken in order to continuously improve the organisa-
tion’s environmental performance.
f. Independent verification by an EMAS verifier
An EMAS verifier accredited with an EMAS accreditation body of a Member State must
examine and verify the environmental review, the EMS, the audit procedure and the envi-
ronmental statement.
g. Register with the Competent Body of the Member State
The validated statement is sent to the appropriate EMAS Competent Body for registration
and made publicly available.
h. Utilise the verified environmental statement
The environmental statement can be used to report performance data in marketing, assess-
ment of the supply chain and procurement. The organisation can use information from the
validated statement to market its activities with the EMAS logo, assess suppliers against
EMAS requirements and give preference to suppliers registered under EMAS.
Source: http://ec.europa.eu/environment/emas/pdf/leaflet/emasleaflet_en.pdf

11.3 The environmental audit process

The format and procedural activities of an environmental audit will vary depending on the
nature of the business, geographical location and the level of environmental impact. The envi-
ronmental audit will take into account external factors such as the target audience and level of
disclosure.
 chapter 1  The regulatory framework for the preparation and presentation of financial statements 17

Generally, environmental audits involve the collection, collation, analysis, interpretation and
presentation of information. This information is then used to:
■■ assess performance against a list of pre-set targets, related to specific issues;
■■ evaluate and assess compliance with environmental legislation as well as corporate policies;
and
■■ measure performance against the requirements of an Environmental Management System
(EMS) standard.
To facilitate a successful environmental audit, the audit process requires progression through
the following three stages:
1. Pre-audit stage
■■ full management commitment;
■■ setting overall goals, objectives, scope and priorities; and
■■ selecting a team to ensure objectivity and professional competence.
2. Audit stage
■■ on-site audit, well defined and systematic using protocols or checklists;
■■ review of documents and records;
■■ review of policies;
■■ interviews; and
■■ site inspection.
3. Post-audit stage
■■ evaluation of findings;
■■ reporting with recommendations;
■■ preparation of an action plan; and
■■ follow-up.

stop and t hink  1.2

What would the economic impact for companies be if they did not report on their environmental and
social activities?

The three stages provide the general framework or an environmental audit. However, depending
upon the size and nature of the entity some areas may require a more in-depth investigation.
This will, in most cases, involve specialist advice, independent verification and cooperation,
and action on any shortcomings identified during the audit stage.

12 Social accounting
Social accounting (also known as Corporate Social Responsibility or CSR) is the formal process
by which business entities communicate the impact of their economic activity to stakeholders
who have a vested interest in the entity. However, it has and is continuing to become recognised
that the wider community has a direct and indirect involvement in CSR and the behaviour of
entities. For example, the impact of the Deepwater Horizon oil spillage in 2010 has had more
than just a financial impact upon British Petroleum.
Social accounting seeks to create a balance between a company’s business activities and how
it discharges its social and environmental responsibilities. However, it is a broad term that can
mean different things to different people. In the example given above of BP and the Deepwater
Horizon oil spillage in 2010, a variety of stakeholders have been and continue to be affected.
Some have lost their livelihoods, while others have had to move out of their homes.
The range of reporting a company can engage in with a view to reporting on social accounting
can include:
18 Part one  The regulatory and conceptual frameworks for financial reporting

1. recycling of waste;
2. education;
3. environment/pollution emission/chemicals;
4. regeneration, social inclusion and community investment;
5. workforce issues;
6. responsible behaviour in developing countries;
7. agriculture;
8. pharmaceuticals/animal testing/drug development; and
9. regeneration issues etc.
The process involves undertaking regular evaluation of what an organisation does through con-
sultation/audit. Using feedback from relevant stakeholders, a company can monitor, adjust and
plan its activities. Future performance can be more effectively targeted to achieve an organisa-
tion’s objectives. From a broader perspective, social accounting is a mechanism that adds value
to a company’s financial report by providing information about non-financial activities and the
related costs of business behaviour in society.
The Social Audit Network (SAN) is an entity that supports non-governmental organisations
(NGOs) and charitable organisations both in the UK and internationally. The SAN has well-
defined objectives to help social organisations to attain an understanding of the environment in
which these organisations operate. These should be:
■■ multi-perspective: encompassing the views of people and groups that are important to the
organisation;
■■ comprehensive: inclusive of all activities of an organisation;
■■ comparative: able to be viewed in the light of other organisations and addressing the same
issues within same organisation over time;
■■ regular: done on an ongoing basis at regular intervals;
■■ verified: checked by people external to the organisation; and
■■ disclosed: readily available to others inside and outside of the organisation.
When information is available, discerning and risk-averse investors can put pressure on compa-
nies to change or enhance their business practices to recognise the social agenda. This can only
be achieved when there is a consistent flow of relevant and useful information over a sustained
period of time.
Social accounting can be viewed from two competing perspectives: management control and
accountability, allowing organisations to pursue profits as well as social objectives for a sustain-
able future.
Management exercises control over the resources and assets of a business. Social accounting
can help management to facilitate internal corporate planning and objectives. All entities can
obtain the following benefits from implementing social accounting and reporting:
■■ commensurate sharing of information on business activities;
■■ precise transfer of costs to the consumer;
■■ reputational and corporate legitimacy;
■■ increased market presence and awareness;
■■ investor-friendly image; and
■■ awareness of social responsibilities.
Since the management control perspective is inward-looking, social accounting can be mean-
ingful through external party participation which can verify organisational commitment to soci-
ety. Some of these external parties include independent social audit, certification on standards
and compliance and periodic and consistent reviews by independent persons or organisations.

T E S T YO UR K N OW L E D G E   1.8

Explain the meaning of social accounting.

chapter 1  The regulatory framework for the preparation and presentation of financial statements 19

13 The changing role of the accountant

13.1 The modern corporation
Today’s accountant is no longer the isolated, unconnected bean counter in the back room. The
role and practice of the accountant is now very much integrated at the forefront, driving and
steering the business through unchartered waters, some which are shark infested!
The accountant is now a key player in the strategic development of an entity and no longer
reports solely on financial performance to a narrow audience. Today’s accountant has a central
and direct role in the process of business. They communicate a wide range of accounting and
financial information to internal and external stakeholders.

? END OF CHAPTER QUESTIONS

1.1 What are the objectives of the IASB? 1.4 What is the role of corporate governance in
1.2 Why is there a need for the existence of financial reporting?
accounting standards? 1.5 How can an entity benefit from social accounting
1.3 What is the purpose of the external audit? and reporting?
2 The conceptual framework
for the preparation and
presentation of financial
statements

■■ Contents
  1. Introduction
  2. The scope of the conceptual framework
  3. Users of financial information
  4. Qualitative characteristics of useful financial information
  5. The underlying assumption
  6. Elements of financial statements
  7. Recognising the elements of financial statements
  8. Measuring the elements of financial statements
  9. Capital and capital maintenance
10. Accounting policies and the significance of differences between them

■■ Learning outcomes
Chapter 2 continues our coverage of the syllabus section entitled ‘The regulatory and concep-
tual frameworks for financial reporting’.
In this chapter, we focus on the conceptual framework for the preparation and presentation
of financial statements.
After working through this chapter, you should understand and be able to explain:
■■ the objective and users of financial statements;
■■ the underlying assumption;
■■ the qualitative characteristics that determine the usefulness of information in financial
statements;
■■ the definition of the elements of financial statements;
■■ the recognition of the elements from which financial statements are constructed;
■■ the measurement of assets and liabilities reported in financial statements; and
■■ the concepts of capital and capital maintenance.

1 Introduction
The joint development of the Conceptual Framework for Financial Reporting 2010 by the
International Accounting Standards Board (IASB) and US Financial Accounting Standards Board
(FASB) was the end of the first phase in the development of an improved conceptual frame-
work for International Reporting Standards and US Generally Accepted Accounting Principles
(GAAP). This is another staging post in the ongoing journey in the development and evolution
of an internationally recognised and agreed framework for financial reporting.
The conceptual framework considers the theoretical and conceptual issues of financial report-
ing to develop a consistent platform to underpin the development of accounting standards.
Financial statements are prepared and presented for external users by many entities around
the world. Although such financial statements may appear similar from country to country,
there are differences which have arisen from a variety of social, economic and legal circum-
stances, and by different countries having in mind the needs of different users of financial
chapter 2  The conceptual framework for the preparation and presentation of financial statements 21

statements when setting national requirements.

These different circumstances have led to the use of a variety of definitions of the elements
of financial statements: for example, assets, liabilities, equity, income and expenses. They have
also resulted in the use of different criteria for the recognition of items in the financial state-
ments and in a preference for different bases of measurement. The scope of the financial state-
ments and the disclosures made in them have also been affected.
The International Accounting Standards Board is committed to narrowing these differences
by seeking to harmonise regulations, accounting standards and procedures relating to the prep-
aration and presentation of financial statements.
It believes that further harmonisation can best be pursued by focusing on financial state-
ments that are prepared for the purpose of providing information that is useful in making
economic decisions.
The Board believes that financial statements prepared for this purpose meet the common
needs of most users. This is because nearly all users are making economic decisions, for example:
a) to decide when to buy, hold or sell an equity investment;
b) to assess the stewardship or accountability of management;
c) to assess the ability of the entity to pay and provide other benefits to its employees;
d) to assess the security for amounts lent to the entity;
e) to determine taxation policies;
f) to determine distributable profits and dividends;
g) to prepare and use national income statistics; and
h) to regulate the activities of entities.
The IASB recognises that governments, in particular, may specify different or additional require-
ments for their own purposes. These requirements should not, however, adversely affect the
usability of the financial statements for any group of users.
Financial statements are most commonly prepared in accordance with an accounting model
based on recoverable historical cost and the nominal financial capital maintenance concept.
These concepts are discussed later in this chapter. Other models and concepts may be more
appropriate in order to meet the objective of providing information that is useful for making
economic decisions although there is at present no consensus for change. The conceptual
framework has been developed so that it is applicable to a range of accounting models and con-
cepts of capital and capital maintenance.

The Conceptual Framework for Financial Reporting 2010

This conceptual framework sets out the concepts that underlie the preparation and presenta-
tion of financial statements for external users. The purpose of the conceptual framework is:
a) to assist the Board in the development of future IFRSs and in its review of existing IFRSs;
b) to assist the Board in promoting harmonisation of regulations, accounting standards and
procedures relating to the presentation of financial statements by providing a basis for
reducing the number of alternative accounting treatments permitted by IFRSs;
c) to assist national standard-setting bodies in developing national standards;
d) to assist preparers of financial statements in applying IFRSs and in dealing with topics
that have yet to form the subject of an IFRS;
e) to assist auditors in forming an opinion on whether financial statements comply with
IFRSs;
f) to assist users of financial statements in interpreting the information contained in finan-
cial statements prepared in compliance with IFRSs; and
g) to provide those who are interested in the work of the IASB with information about its
approach to the formulation of IFRSs.
This conceptual framework is not an IFRS and hence does not define standards for any par-
ticular measurement or disclosure issue. Nothing in this conceptual framework overrides
any specific IFRS.
The Board recognises that in a limited number of cases there may be a conflict between
the conceptual framework and an IFRS. In those cases where there is a conflict, the require-
ments of the IFRS prevail over those of the conceptual framework.
22 Part one  The regulatory and conceptual frameworks for financial reporting

As, however, the Board will be guided by the conceptual framework in the development of
future IFRSs and in its review of existing IFRSs, the number of cases of conflict between the
conceptual framework and IFRSs will diminish through time.
The conceptual framework will be revised from time to time on the basis of the Board’s
experience of working with it.

2 The scope of the conceptual framework

The conceptual framework addresses the preparation and presentation of financial reports for
external user groups. The conceptual framework deals with:
a) the objective of financial reporting;
b) the qualitative characteristics of useful financial information;
c) the definition, recognition and measurement of the elements from which financial state-
ments are constructed; and
d) concepts of capital and capital maintenance.
The conceptual framework is the foundation for addressing the emerging challenges in account-
ing and its financial reporting. The conceptual framework provides the nature, boundaries and
functions for the effective financial reporting of accounting information.
The framework clearly recognises the general purpose of financial reporting as follows:

The objective of general purpose financial reporting is to provide financial information about
the reporting entity that is useful to existing and potential investors, lenders and other credi-
tors in making decisions about providing resources to the entity.

The framework also recognises the general purpose of financial statements:

General purpose financial reports provide information about the financial position of a report-
ing entity, which is information about the entity’s economic resources and the claims against
the reporting entity. Financial reports also provide information about the effects of transac-
tions and other events that change a reporting entity’s economic resources and claims. Both
types of information provide useful input for decisions about providing resources to an entity.

In addition, the framework also clearly states what purpose financial reports are not designed
to perform or provide:

General purpose financial reports are not designed to show the value of a reporting entity; but
they provide information to help existing and potential investors, lenders and other creditors
to estimate the value of the reporting entity.

The qualitative characteristics of useful financial information are addressed within the concep-
tual framework. In a similar manner to the bedrock (accruals and going concern) accounting
and desirable (consistency and prudence) accounting principles the conceptual framework iden-
tifies the fundamental and the enhanced qualitative characteristics of information.

2.1 The emergence of a conceptual framework

Is there a need for a conceptual framework? Practitioners and academics alike have debated this
question over the years. Without subscribing to any camp, it is necessary to examine the posi-
tion that existed within the world of accountancy and financial reporting without conceptual
frameworks:
1. Accounting standards evolved without much consistency or connectivity.
2. Standards had a tendency to evolve in a reactive rather than a proactive manner. Consider the
rise and fall in the accounting for changing prices and latterly corporate failures (scandals).
3. The lack of consistency often gave rise to the same theoretical issue being addressed across
multiple standards.
chapter 2  The conceptual framework for the preparation and presentation of financial statements 23

4. The lack of balance on some standard setting boards resulted in standards being skewed in
one particular direction.
However, the absence of a conceptual framework gave rise to a rules-based prescriptive approach
to financial reporting. Despite the prescriptive nature, the twin benefits that arise are consist-
ency and comparability in financial reporting. This contrasts with the principles-based approach
that comes from the conceptual framework evolution. The result of a financial reporting based
upon an agreed conceptual basis may be the decline in consistency and comparability for users
who rely on the information to make economic decisions.

3 Users of financial information

Within the conceptual framework, potential investors, lenders and creditors are identified as the
primary users to whom general purpose financial reports are directed. The conceptual frame-
work also highlights that users’ needs are different and may conflict.

Individual primary users have different, and possibly conflicting, information needs and
desires. The Board, in developing financial reporting standards, will seek to provide the infor-
mation set that will meet the needs of the maximum number of primary users. However,
focusing on common information needs does not prevent the reporting entity from including
additional information that is most useful to a particular subset of primary users.

Despite the identified primary group of three within the conceptual framework, the users of
financial reporting information will be widened to encompass the seven users first identified in
the Corporate Report by the Accounting Standards Steering Committee (ASSC). These are the
following.
1. Investors: The providers of risk capital are concerned with the risk inherent in, and return
provided by, their investments. They need information to help them determine whether
they should buy, hold, or sell. They are also interested in information which enables them
to assess the ability of the enterprise to pay dividends.
2. Lenders: They are interested in information that enables them to determine whether their
loans, and the interest attaching to them, will be paid when due.
3. Employees: Employees and their representative groups are interested in information about
the stability and profitability of their employers. They are also interested in information
which enables them to assess the ability of the enterprise to provide remuneration, retire-
ment benefits and employment opportunities.
4. Suppliers and other trade creditors: They are interested in information that enables them to
determine whether amounts owing to them will be paid when due. Trade creditors are likely
to be interested in an enterprise over a shorter period than lenders (unless they are a major
customer).
5. Customers: They have an interest in information about the continuance of an enterprise,
especially if they have a long-term involvement with, or are dependent on, the enterprise.
6. Government agencies: Governments and their agencies are interested in the allocation
of resources and, therefore, the activities of enterprises. They also require information to
regulate the activities of enterprises, determine taxation policies and to serve as the basis
for determining national income and similar statistics.
7. The public: Enterprises affect members of the public in a variety of ways. For example, they
may make a substantial contribution to the local economy in many ways including the
number of people they employ and their patronage of local suppliers. Financial statements
may assist the public by providing information about the trends and recent developments
in the prosperity of the enterprise and the range of its activities.

TEST YO UR K N OW LE DG E   2.1

a) Identify four user groups of financial information.

b) Outline the uses for each of the four user groups.
24 Part one  The regulatory and conceptual frameworks for financial reporting

4 Qualitative characteristics of useful financial

information
The conceptual framework (paragraph QC3) asserts that the qualitative characteristics of
useful financial information are not restricted to the reporting of information in the financial
statements.

The qualitative characteristics of useful financial information apply to financial information

provided in financial statements, as well as to financial information provided in other ways.’

The qualitative characteristics of information are classified into two tiers to meet their useful-
ness: fundamental and enhancing.

4.1 Fundamental characteristics

The conceptual framework outlines two fundamental characteristics for useful financial infor-
mation: relevance and faithful representation.

4.1.1 Relevance
Financial information is relevant when it is capable of making a difference in the decisions
made by its users. Financial information would still be relevant if some decision-makers chose
not to use the available information. Financial information is relevant in the decision-making
process of the user when it can be used to help predict the outcomes of future events, or to con-
firm the outcome of a past event. In summary, the reported financial information can provide
predictive and confirmatory values for the decision-making process of the decision-maker. For
example, profit information reported in a company’s current year financial statement may be
used to help predict future profit performance and to compare with previous predictions for the
current year. This demonstrates the interrelationship of the predictive value and confirmatory
value of financial information.
The relevance of the financial information is also dependent upon the degree of materiality
embedded in the information. Information is regarded as material if its omission or misstate-
ment would affect the decisions made by the users.

4.1.2 Faithful representation

Faithful representation is explained in paragraphs QC12–QC16 of the conceptual framework.
Financial reports represent economic phenomena in words and numbers. To be useful, financial
information must not only represent relevant phenomena, but it must also faithfully repre-
sent the phenomena that it purports to represent. To be a perfectly faithful representation, a
depiction would have three characteristics. It would be complete, neutral and free from error.
Perfection is seldom, if ever, achievable.
A complete depiction includes all information necessary for a user to understand the phe-
nomenon being depicted, including all necessary descriptions and explanations. For example,
a complete depiction of a group of assets would include, at a minimum, a description of the
nature of the assets in the group, a numerical depiction of all of the assets in the group, and a
description of what the numerical depiction represents (for example, original cost, adjusted cost
or fair value). For some items, a complete depiction may also entail explanations of significant
facts about the quality and nature of the items, factors and circumstances that might affect their
quality and nature, and the process used to determine the numerical depiction.
A neutral depiction is without bias in the selection or presentation of financial informa-
tion. A neutral depiction is not slanted, weighted, emphasised, de-emphasised or otherwise
manipulated to increase the probability that financial information will be received favourably
or unfavourably by users. Neutral information does not mean information with no purpose or
no influence on behaviour. On the contrary, relevant financial information is, by definition,
capable of making a difference in users’ decisions.
Faithful representation does not mean accurate in all respects. Free from error means there
are no errors or omissions in the description of the phenomenon, and the process used to pro-
duce the reported information has been selected and applied with no errors in the process. In
chapter 2  The conceptual framework for the preparation and presentation of financial statements 25

this context, free from error does not mean perfectly accurate in all respects. For example, an
estimate of an unobservable price or value cannot be determined to be accurate or inaccurate.
However, a representation of that estimate can be faithful if the amount is described clearly
and accurately as being an estimate, the nature and limitations of the estimating process are
explained, and no errors have been made in selecting and applying an appropriate process for
developing the estimate.
A faithful representation, by itself, does not necessarily result in useful information. For
example, a reporting entity may receive property, plant and equipment through a government
grant. Obviously, reporting that an entity acquired an asset at no cost would faithfully represent
its cost, but that information would probably not be very useful. A slightly more subtle example
is an estimate of the amount by which an asset’s carrying amount should be adjusted to reflect
an impairment in the asset’s value.
An estimate can be a faithful representation if the reporting entity has properly applied an
appropriate process, properly described the estimate and explained any uncertainties that sig-
nificantly affect the estimate.
However, if the level of uncertainty in such an estimate is sufficiently large, that estimate will
not be particularly useful. In other words, the relevance of the asset being faithfully represented
is questionable.
If there is no alternative representation that is more faithful, that estimate may provide the
best available information.

4.2 Enhanced characteristics

The fundamental characteristics are supported by four enhanced characteristics that make
reporting financial information useful for its users: comparability, verifiability, timeliness and
understandability.

4.2.1 Comparability
Users of financial information often want to make a comparison between time periods or within
the same time period for similar companies. Comparability is the qualitative characteristic
that enables users to identify and understand the similarities in, and differences among, items
in their comparative analysis. Comparability does not relate to a single item. Consistency,
although related to comparability, is not the same. Consistency refers to the use of the same
methods for the same items, either from period to period within a reporting entity or in a single
period across entities. Comparability is the goal, whereas consistency is the methodology to
achieve that goal.
Comparability is not uniformity. For information to be comparable, similar things must look
similar and different things must look different. This will be further demonstrated when under-
taking comparative financial analysis and the use of ratio analysis.

4.2.2 Verifiability
Verifiability is the quality that helps to assure users that the reported financial information
faithfully represents the economic phenomena it purports to represent. Verifiability would
permit two or more different knowledgeable and independent observers to reach consensus that
a particular depiction is a faithful representation. Verifiability may be regarded as underpinning
the granting of a true and fair view audit opinion for any set of company financial statements.
Verification can be direct or indirect. Direct verification may arise from the process of direct
observation, such as the end-of-year stock count.
Indirect verification is the process of checking using a calculation model or technique to verify
the financial information. An example of the indirect verification is the use of the cost of sales
model (opening stock plus purchases less closing stock) to verify any of the elements therein.

4.2.3 Timeliness
Timeliness is the provision of the information to decision-makers with sufficient time to allow
the information to influence their decisions. Financial information such as company financial
reports should be made available to decision-makers in a timely manner to allow them ample
time to make their decision about the company.
26 Part one  The regulatory and conceptual frameworks for financial reporting

4.2.4 Understandability
Information should be classified, characterised and presented clearly and concisely to facilitate
understanding by users. The users of financial information are deemed to have a reasonable
knowledge of business and economic activities such that the exclusion of a complex phenome-
non should not occur to ease understanding. The advantage gained from the ease of understand-
ing would result in the information being incomplete, misleading and not a full representation.
In summary, to be useful to its users reported financial information must be relevant and
faithfully represented. Neither a faithful representation of an irrelevant phenomenon nor an
unfaithful representation of a relevant phenomenon helps users to make good decisions.
A single or collection of the enhancing qualitative characteristics cannot make irrelevant
information useful or faithfully represented.

T E S T YO UR K N OW L E D G E   2.2

List and explain the role of qualitative characteristics in the preparation of financial reports.

4.3 Constraints on the provision of information

The conceptual framework recognises that cost is a constraint on the ability to provide useful
financial information. In view of the costs of reporting, it is necessary that the benefits gained
from the reported financial information is greater than the costs incurred in the reporting. The
providers of financial information expend time and money in the collecting, processing, verify-
ing and dissemination of financial information. Consequently, the trade-off for users of finan-
cial information is fewer returns as the costs being incurred become greater.
Furthermore, it is not possible for general purpose financial reports to provide all the infor-
mation that every user requires.

5 The underlying assumption

The going concern concept is the only underlying assumption identified in the conceptual
framework. This is a departure from the IFRS twin bedrock accounting principles of going con-
cern and accruals.
The assumption as set out in the conceptual framework para 4.1 is as follows. The financial
statements are normally prepared on the assumption that an entity is a going concern and will
continue in operation for the foreseeable future. Hence, it is assumed that the entity has neither
the intention nor the need to liquidate or curtail materially the scale of its operations; if such an
intention or need exists, the financial statements may have to be prepared on a different basis
and, if so, the basis used is disclosed.

6 Elements of financial statements

The financial statements in the form of the statement of financial position (the balance sheet)
and the statement of profit or loss and other comprehensive income (the income statement)
are respectively reporting on changes in an entity’s financial position and measurement of its
performance. Both these statements classify their elements to provide information to enable
users to make their economic decisions.
The five elements that are classified in the financial statements are shown in Figure 2.1 and
are:
a) income
b) expenses
c) assets
d) liabilities
e) equity.
chapter 2  The conceptual framework for the preparation and presentation of financial statements 27

Financial statements

Statement of financial position Statement of profit or loss and

(Measure of financial position) other comprehensive income
(Measure of performance)
1. Assets
2. Liabilities 1. Income
3. Equity 2. Expenses

Figure 2.1 The classification of elements in financial statements

The conceptual framework provides the following definitions for the five elements of financial
statements.
1. An asset is a resource controlled by the entity as a result of past events and from which
future economic benefits are expected to flow to the entity.
2. A liability is a present obligation of the entity arising from past events, the settlement of which
is expected to result in an outflow from the entity of resources embodying economic benefits.
3. Equity is the residual interest in the assets of the entity after deducting all its liabilities.
4. Income is an increase in economic benefits during the accounting period. Income takes
the form of inflows or enhancements of assets and decreases of liabilities that result in
increases in equity (other than those relating to contributions from equity participants).
5. Expenses are decreases in economic benefits during the accounting period. Expenses take the
form of outflows or depletions of assets or incurrences of liabilities that result in decreases
in equity (other than those relating to distributions to equity participants).

TEST YO UR K N OW LE DG E   2.3

Identify and distinguish between the elements of financial statements.

7 Recognising the elements of financial statements

Elements of financial statements become recognised when they are included in the financial
statements: the statement of financial position (the balance sheet) and the statement of profit
or loss and other comprehensive income (the income statement). To be recognised, elements
must satisfy the following conditions:
a) It is probable that any future economic benefit associated with the item will flow to or from
the entity.
b) The item has a cost or value that can be measured with reliability.
Thus recognition introduces the concepts of probability and measurement reliability. The pro-
ducers of financial statements have to make an assessment on the probability of any future
economic benefit flowing from an item. Such is often the case with the decision to write off a
debt as a bad debt or the making of a provision for a doubtful debt. The application of a reli-
able estimate in financial reporting does not serve to render the financial statement unreliable
in content. The estimate of the useful life of a fixed asset does not invalidate the statement of
financial position (the balance sheet) and the statement of profit or loss and other comprehen-
sive income (the income statement) – although both financial statements are affected by the
estimate used to calculate the annual depreciation charge.
Where an essential element is unable to meet the criteria for recognition, its disclosure is
not dismissed. Disclosure of the element may occur in the form of explanatory notes to the
financial statements when knowledge of the item would be relevant to the assessment of the
financial statements and the economic decision by the users of financial statements.
28 Part one  The regulatory and conceptual frameworks for financial reporting

8 Measuring the elements of financial statements

Items and elements recognised within financial statement reporting are measured by the assign-
ment of monetary units. The measurement basis most commonly applied in the preparation
of and reporting in financial statements is the historical cost. However, historical cost often
co-exists with other measurement bases. The conceptual framework outlines in para 4.55 the
following basis for the measurement of elements recognised within financial statements.
■■ Historical cost. Assets are recorded at the amount of cash or cash equivalents paid or
the fair value of the consideration given to acquire them at the time of their acquisition.
Liabilities are recorded at the amount of proceeds received in exchange for the obligation, or
in some circumstances (for example, income taxes), at the amounts of cash or cash equiva-
lents expected to be paid to satisfy the liability in the normal course of business.
■■ Current cost. Assets are carried at the amount of cash or cash equivalents that would have
to be paid if the same or an equivalent asset was acquired currently. Liabilities are carried
at the undiscounted amount of cash or cash equivalents that would be required to settle the
obligation currently.
■■ Realisable (settlement) value. Assets are carried at the amount of cash or cash equivalents
that could currently be obtained by selling the asset in an orderly disposal. Liabilities are
carried at their settlement values – that is, the undiscounted amounts of cash or cash equiva-
lents expected to be paid to satisfy the liabilities in the normal course of business.
■■ Present value. Assets are carried at the present discounted value of the future net cash
inflows that the item is expected to generate in the normal course of business. Liabilities are
carried at the present discounted value of the future net cash outflows that are expected to be
required to settle the liabilities in the normal course of business.

T E S T YO UR K N OW L E D G E   2.4

Explain the economic consequences of different accounting practices under current cost, realisable
cost and present value approaches.

8.1 Valuing assets and liabilities

IAS 1 states: ‘An entity shall present separately each material class of similar items. An entity
shall present separately items of a dissimilar nature or function unless they are immaterial.’
Typically, items on the face of the statement of financial position are presented as ‘assets’ or
‘liabilities’ in the form of current and non-current assets and liabilities. IAS 1 further states
that it is not permitted to offset assets or liabilities or income and expenses unless required or
permitted by an IFRS.

worked e x amp le   2.1

A manufacturer imports a new production line from France and holds a launch party in the factory.
The costs associated with the transaction are listed below.

Required
What total cost should be recognised in the asset category ‘property, plant and equipment’?

£
Purchase price 250,000
Import duties 5,600
Delivery costs 6,800
Installation costs 7,600
Cost of launch event to celebrate the new production line 3,800
chapter 2  The conceptual framework for the preparation and presentation of financial statements 29

worked e x amp le   2.1 continued

Suggested solution
The ‘cost of the launch event to celebrate the new production line’ is excluded from the computation
of the total cost of procuring the machinery, because it is not directly related to the acquisition and/
or installation of the machinery to undertake its productive function. The total cost of procurement
of the asset is £270,000 (250,000 + 5,600 + 6,800 + 7,600).

Similarly, the present obligation of a liability can be demonstrated as per the example below.

worked e x amp le   2.2

Havent plc entered into a three-year lease for a plant that had a fair value of £25,379 on 1 January
20X4. The implicit rate of interest applied half-yearly is 5%.

The terms of the lease are as follows:

a) Primary lease period: three years.
b) Frequency of rental payments: six monthly in arrears.
c) Amount of each six monthly rental payment: £5,000.
d) First payment: 30 June 20X4.

The estimated useful life of the plant is three years. Havent plc depreciates all non-current assets
using the straight-line basis.

Required
a) Prepare a schedule of lease payments for Havent plc.
b) Show how the lease would be reported in the statement of comprehensive income for the years
ended 31 December 20X4 and 20X5 and the statements of financial position as at 31 December
20X4 and 20X5.

Answer
a) Schedule of lease payments

Opening Closing

Period balance Interest Rental balance
01/01/20X4–31/06/20X4 25,379 1,269 (5,000) 21,648
01/07/20X4–31/12/20X4 21,648 1,082 (5,000) 17,730
01/01/20X5–30/06/20X5 17,730 887 (5,000) 13,617
01/07/20X5–31/12/20X5 13,617 681 (5,000) 9,298
01/01/20X6–30/6/20X6 9,298 465 (5,000) 4,763
01/07/20X6–31/12/20X6 4,763 238 (5,000) 0
30 Part one  The regulatory and conceptual frameworks for financial reporting

worked e x amp le   2.2 continued

b) Havent plc statement of comprehensive income for the year ended 31 December 20X5:

20X4 20X5
£ £
Depreciation 8,460 8,460
Interest 2,351 1,568
Havent plc statement of financial position as at 31 December 20X5
20X4 20X5
Non-current assets £ £
Property, plant and equipment-cost 25,379 25,379
Accumulated depreciation 8,460 16,920
16,919 8,459
Non-current liabilities
Lease obligation 17,730 9,298

worked e x amp le   2.3

Edgar Ltd is evaluating an investment opportunity and expects the future cash flows arising as in
the table below. Edgar requires a return of at least 10% on its investments. The expected life of the
investment is expected to be five years with no residual value.

Year Cash flow

0 (250,000)
1 80,000
2 80,000
3 72,000
4 68,000
5 45,000

Required
Calculate the net present value of all future cash flows.
chapter 2  The conceptual framework for the preparation and presentation of financial statements 31

worked e x amp le   2.3 continued

Answer

Year Cash flow Calculation of PV Discount PV

factor
Investment in year 0 0 (250,000) 250,000/(1+0.1)0 1 (250,000)
Cash inflow in year 1 1 80,000 80,000/(1+0.1)1 0.9091 72,727
Cash inflow in year 2 2 80,000 80,000/(1+0.1)2 0.8265 66,116
Cash inflow in year 3 3 72,000 72,000/(1+0.1)3 0.7513 54,095
Cash inflow in year 4 4 68,000 68,000/(1+0.1)4 0.6830 46,445
Cash inflow in year 5 5 45,000 45,000/(1+0.1)5 0.6209 27,942
Net present value (NPV) 17,325

Since the net present value of the initial investment and future cash inflows is positive, we know
the project exceeds the target 10% return. The investment opportunity should be accepted.

worked e x amp le   2.4

Tanner Ltd runs a nationwide convenience store business with many stores around the country.
Recently the company re-valued its chain of stores on a fair value basis. The fair value assessment
revealed an increase in the value of land and building by £40 million in 20X5. See extract of
statement of financial position for 20X4 below:

20X4 Required
£m Assuming all other assets and liabilities remain the
same, reflect the amended information in the extract
Non-current assets
of the balance sheet for Tanner Ltd.
PPE 412
Land and buildings 602
Equities and liabilities
Equity 1,200
Revaluation reserve 0

Answer
Extract from the statement of financial position for Tanner Ltd as amended to reflect the changes in
value to land and buildings. Land and buildings would increase by £40 million, while a revaluation
reserve would be created in equity and liabilities:

20X4 20X5
£m £m
Non-current assets
PPE 412 412
Land and buildings (602 + 40) 602 642
Equities and liabilities
Equity 1200 1200
Revaluation reserve 0 40
32 Part one  The regulatory and conceptual frameworks for financial reporting

8.2 Impairment of assets and value-in-use

IAS 36 (as discussed later in chapter 4) addresses the impairment of assets and aims ‘to ensure
that assets are carried at no more than their recoverable amount, and to define how recoverable
amount is determined’. IAS 36 further states that value-in-use is the discounted present value
of the future cash flows expected to arise from the continuing use of an asset, and from its dis-
posal at the end of its useful life.
The standard gives further guidance on testing assets for impairment in relation to their car-
rying amount. The calculation of value-in-use should reflect the following elements:
■■ an estimate of the future cash flows the entity expects to derive from the asset;
■■ expectations about possible variations in the amount or timing of those future cash flows;
■■ the time value of money, represented by the current market risk-free rate of interest;
■■ the price for bearing the uncertainty inherent in the asset; and
■■ other factors, such as illiquidity, that market participants would reflect in pricing the future
cash flows the entity expects to derive from the asset.

worked e xamp le   2.5

Solar Ltd suspects its printing press, with a net book value (after depreciation) of £280,000, is
impaired. However, in the absence of a market price, Solar carries out value-in-use exercise. Its cost
of capital is 10%. Solar has determined the future cash flows arising from the continued use of the
asset as:

Year Cash flow Required

Determine if the asset is impaired based on current book
1 100,000 value of the asset and its value-in-use.
2 86,000
3 76,000
4 68,000
5 52,000

Answer

Year Cash flow Discount PV

factor 10%

1 100,000 0.9091 90,910

2 86,000 0.8264 71,070
3 76,000 0.7513 57,099
4 68,000 0.6830 46,444
5 52,000 0.6209 32,287
Net present value 297,810
Value-in-use of the asset: 297,816
Net book value of the asset (NBV) 280,000
Carrying amount = NBV 280,000

Since the value-in-use of the asset is greater than the book value, the asset is deemed not to be
impaired and the book value remains at £280,000 net of depreciation.
chapter 2  The conceptual framework for the preparation and presentation of financial statements 33

TEST YO UR K N OW LE DG E   2.5

Describe three ways in which an asset or a liability can be measured.

9 Capital and capital maintenance

Two concepts of capital are in existence: a financial concept of capital and a physical concept
of capital. The former is usually applied in the preparation of financial statements. The finan-
cial concept of capital is synonymous with the net assets or equity of a company, whereas the
physical concept of capital, such as operating capability, concerns the productive capacity of a
company, often determined upon by its daily production or output.
The two concepts of capital generate two concepts of capital maintenance as outlined in para
4.59 of the conceptual framework.
1. Financial capital maintenance. According to this concept, a profit is earned only if the
financial (or monetary) amount of the net assets at the end of the period exceeds the finan-
cial (or monetary) amount of net assets at the beginning of the period, after excluding any
distributions to, and contributions from, owners during the period. Financial capital main-
tenance can be measured in either nominal monetary units or units of constant purchasing
power.
2. Physical capital maintenance. According to this concept, a profit is earned only if the physi-
cal productive capacity (or operating capability) of the entity (or the resources or funds
needed to achieve that capacity) at the end of the period exceeds the physical productive
capacity at the beginning of the period, after excluding any distributions to, and contribu-
tions from, owners during the period.

worked e x amp le   2.6

The following example relates to two American listed companies, America Online (AOL) and Time
Warner. AOL was engaged in internet services (i.e. provision of internet-based applications). Time
Warner was an entertainment company engaged in films and other entertainment products.
It is not typical of an examination in financial reporting and analysis, however, its purpose is to
highlight how larger companies can make detrimental mistakes.
In 2000, the merger between AOL and Time Warner (TW) was seen as one of the biggest
corporate collaboration in recent times. The TW’s strategy for the future seemed clear and
straightforward; by tapping into AOL, Time Warner would have an established customer base of
millions of home subscribers. AOL and TW could merge each other’s resources in a marriage of
convenience with high-speed cable lines to deliver to the new companies. This would have created
130 million subscription relationships.
With the advent of the worldwide web and upcoming dot.com companies, and steep demand for
online services, the growth and profitability of the AOL division declined sharply, due to advertising
and subscriber slowdowns due mainly to the burst of the dot.com bubble and the economic
recession after September 2001. The value of the America Online division dropped significantly,
not unlike the market valuation of similar independent internet companies that drastically fell. This
forced a goodwill write-off, causing AOL Time Warner to report a loss of $99 billion in 2002 – at
the time, the largest loss ever reported by a company. The total value of AOL stock subsequently fell
from $226 billion to about $20 billion.
Consequently there followed great upheaval within AOL, with internal politics being played out
among competing executives.
34 Part one  The regulatory and conceptual frameworks for financial reporting

worked e x amp le   2.6 continued

When the AOL-Time Warner merger was announced in January 2000, the combined market
capitalisation was $350 billion. It subsequently fell dramatically. Even by the time the merger was
approved by the relevant supervisory bodies, a year later on 11 February 2001, the company’s market
capitalisation had plummeted to $208.6 billion. By 2009, the company’s value had tumbled even
further, to just $65.7 billion, or approximately one-sixth of its value at the height of the dot.com
bubble era when the deal was announced.
The expected synergies between AOL and Time Warner divisions never materialised, as most Time
Warner divisions were considered to be independent companies that had rarely cooperated prior to
the merger. A new incentive programme that granted options based on the performance of AOL
Time Warner, replacing the cash bonuses for the results of their own division, caused resentment
among Time Warner division heads, who blamed AOL for failing to meet expectations and dragging
down the combined company. AOL Time Warner Chief Operating Officer (COO) Pittman, who
expected to have the divisions working closely towards convergence, instead found heavy resistance
from many division executives, who also criticised him for adhering to optimistic growth targets for
AOL Time Warner that were never met.
For the fiscal year 2002, the company reported a $99 billion loss on its income statement because
of $100 billion in non-recurring charges, almost all from a write-down of the goodwill (intangible
asset) from the merger in 2000. This loss is one of the largest in corporate history. The value of the
AOL portion of the company had dropped sharply with the collapse of the Internet boom, in the
early twenty-first century. On 4 February 2009, Time Warner posted a $16.03 billion loss for the final
quarter of 2008, compared with a $1.03 billion profit for the same three months of 2007.
AOL-Time Warner was criticised by analysts for its aggressive accounting methods and the quality
of its reported earnings figures. This was mainly related to the capitalisation of certain marketing
costs; these marketing costs, which were substantial in size, should have been expensed and hence
impacted upon the earnings figures.

Required
Having read the related issues, answer the questions that follow:

Issue: Substantial marketing costs, measuring millions of dollars, such as subscriber acquisition (costs
related to securing new and retaining old customers) and costs of subscriber kits (costs in respect of
distributing hardware and software to customers) and direct marketing expenses were capitalised.
Subscriber costs were charged to the income statement over the average lifetime of subscriptions.
This practice was seen as unusual in common accounting practice under GAAP.

1. How should the marketing and subscriber-related costs be treated by AOL?

2. What impact would the practice of capitalisation by AOL have on reported earnings?
3. What possible impact would there be on reported earnings and earnings per share (EPS) if AOL
had charged marketing expenses to the income statement in the first place?
4. Discuss the flexibility the framework allows a reporting entity in the choice it makes when using
accounting choices.
5. Under the agency theory, what factors could potentially influence managers’ choice of accounting
policy?
6. How should AOL be more transparent in its deliberation of accounting choices from a qualitative
perspective?
7. What accounting concepts should AOL declare in its annual reports to allow users of financial
information to make informed accounting decisions?
chapter 2  The conceptual framework for the preparation and presentation of financial statements 35

10 Accounting policies and the significance of

differences between them
10.1 Nature of accounting policies
Accounting policies (IFRS and IAS) essentially refer to specific accounting principles and the
methods of applying those principles adopted by a business entity in the preparation and pres-
entation of financial statements. However, there is no single list of accounting policies that
applies to every situation.
Companies operate in a diverse and complex marketplace. Choosing the appropriate account-
ing bases and the methods of applying those principles requires a certain degree of judgement
on the part of management.
Regulatory requirements together with IFRS guidance on preparing and presenting financial
statements have reduced the number of options available to management. With the level of
convergence set to increase further, particularly between IFRS and US GAAP, these alternatives
will be further eroded, with the result that greater transparency will be achieved in financial
statements. Nevertheless, the availability of alternative accounting practices of applying those
principles is not likely to be eliminated altogether in view of the differing circumstances faced
by the enterprises that may transpire over time or because of regional issues.

TEST YO UR K N OW LE DG E   2.6

Explain what is meant by the nature of accounting policies, and how different companies can treat
assets and liabilities differently.

10.2 The significance of differences in accounting policies

The following are examples of the areas in which different accounting policies may be adopted
by different business entities:
■■ impairment of assets;
■■ methods of depreciation, depletion and amortisation;
■■ treatment of expenditure during construction;
■■ conversion or translation of foreign currency items;
■■ valuation of inventory;
■■ treatment of goodwill;
■■ valuation of investments;
■■ treatment of retirement benefits;
■■ recognition of profit on long-term contracts;
■■ valuation of fixed assets; and
■■ treatment of contingent liabilities.
Changes to accounting and measuring procedures of assets and liabilities from one period to
the next may blur reality and present misinformation for users. Business entities must ensure
that economic reality is faithfully represented and that accounting and reporting principles are
followed.
As an example, if a company changes its accounting policy on the way it measures deprecia-
tion on assets, this must be declared in the narratives and an explanation provided as to why
the changes have occurred. The change may have a material impact on the book value of the
assets.
36 Part one  The regulatory and conceptual frameworks for financial reporting

worked e x amp le   2.7

Potter Ltd is engaged in the mining of coal. It has a plant, which originally cost £300,000. This is
depreciated over five years on a straight-line basis. At the start of Year 4, Potter Ltd decides to switch
to the reducing-balance method to calculate depreciation.

Required
Calculate the impact of Potter Ltd switching to the reducing-balance method at the start of Year 4
and its impact on the financial statements assuming a depreciation rate of 20%.

Calculation for depreciation on straight-line basis:

Cost Depn NBV

Year £ £ £
0 300,000
1 60,000 240,000
2 60,000 180,000
3 60,000 120,000
4 60,000 60,000
5 60,000 0

Calculation for depreciation on reducing-balance basis:

Cost Depn NBV

Year £ £ £
0 300,000
1 60,000 240,000
2 60,000 180,000
3 60,000 120,000
4 24,000 96,000
5 19,200 76,800
NBV of asset after five years 76,800

(Note: NBV = Net Book Value)

On a straight-line basis, Potter Ltd would report a depreciation charge of £60,000 per annum in the
statement for comprehensive income and a reduction in the same amount on the carrying value of
the asset in each subsequent year. After five years, the asset will have a nil residual value. The net
book value of the asset in the statement of financial position at the end of Year 4 would be £60,000.
If Potter Ltd switches to the reducing balance method at the start of Year 4, the depreciation
charge to the statement for comprehensive income in Year 4 would only be £24,000, thus inflating
income for Year 4 by £36,000. At the end of Year 4, the asset would have a carrying amount in the
statement of financial position of £76,800.
The directors of Potter Ltd would have to declare the change in accounting policy for depreciation
and demonstrate why the change was necessary in the narratives.
chapter 2  The conceptual framework for the preparation and presentation of financial statements 37

IAS 8 ‘Accounting Policies, Changes in Accounting Estimates and Errors’ states that the effect of
a change in an accounting estimate should be recognised prospectively by including it in profit
or loss in:
■■ the period of the change, if the change affects that period only; or
■■ the period of the change and future periods, if the change affects both.
IAS 8 further states that:
■■ entities that exercise a change in accounting estimates must further disclose the nature and
amount of a change in an accounting estimate that has an effect in the current period, or is
expected to have an effect in future periods; or
■■ if the amount of the effect in future periods is not disclosed because estimating it is imprac-
ticable, an entity shall disclose that fact.

? END OF CHAPTER QUESTIONS

2.1 Outline the general purpose of financial e) Relevance and faithful representation are
reporting. the two fundamental characteristics for
2.2 True or false? useful financial information.
a) Financial reports are designed to show the f) Four bases for the measurement of
value of a reporting entity. elements recognised within financial
b) Financial reports provide information to help statements are outlined in IAS1.
existing and potential employees negotiate 2.3 State the four enhanced characteristics that make
a pay increase. reporting financial information useful for its users.
c) Financial reports provide information to 2.4 Identify and explain the underlying assumption
help existing and potential investors, lenders identified in the conceptual framework.
and other creditors to estimate the value of 2.5 Identify two financial statements in the form of
the reporting entity. the statement of financial position (the balance
d) The qualitative characteristics of useful sheet) and the statement of profit or loss and
financial information are restricted to the other comprehensive income (the income
reporting of information in the financial statement)
statements. 2.6 Identify and explain the two concepts of capital
maintenance.
 part two

The preparation and

presentation of financial
statements for single
companies in compliance
with legal and
regulatory requirements
■■ List of chapters
3. Financial accounting and the preparation of financial reports
4. Accounting policies 1
5. Accounting policies 2
6. Purpose of the statement of cash flows

■■ Overview
Chapters 3, 4, 5 and 6 deal with the preparation and presentation of financial statements for
single companies in compliance with legal and regulatory requirements, including the relevant
international accounting standards.
3 Financial accounting and the
preparation of financial reports

■■ Contents
  1. Introduction
  2. Accountability
  3. How accounting information helps businesses to be accountable
  4. What is financial accounting?
  5. Reporting entities
  6. Principal accounting statements
  7. Users and uses of accounting information
  8. Presentation of financial statements
  9. Prescribed format for the statement of profit or loss and other comprehensive income
10. Measurement and recognition of revenue
11. Reporting comprehensive income
12. Prescribed format for the statement of financial position
13. Additional information on the statement of financial position
14. Statement of changes in equity

■■ Learning outcomes
Chapter 3 covers the preparation and presentation of financial statements for single companies.
After reading and understanding the contents of the chapter, and going through all the worked
examples and practice questions, you should be able to:
■■ understand and explain the purpose of financial information and accountability;
■■ understand the purpose and uses of financial information and the role of accountability;
■■ explain financial accounting and name the principal reporting entities;
■■ identify and explain the purpose of the principal accounting statements;
■■ understand and explain the uses of accounting information;
■■ demonstrate both how financial statements are presented and the prescribed format for the
financial reports;
■■ understand and apply the concept of measurement and recognition of revenue, expenses
assets and liabilities; and
■■ use additional information in the financial reports.

1 Introduction
Numerous definitions of accounting persist; however, most definitions attempt to describe
the same basic purpose of accounting. The American Accounting Association (1966) defines
accounting as:

the process of identifying, measuring, and communicating economic information to permit

informed judgements and decisions by users of the information.

For the purposes of further discussion, it would be useful to analyse the terminology used in
the above definition:
■■ It suggests that accounting is about providing information to others. Accounting information
is economic information – it relates to the financial or economic activities of the business or
organisation.
 chapter 3  Financial accounting and the preparation of financial reports 41

■■ Accounting information needs to be identified and measured in a systematic manner. This

is done by way of a set of accounts, based on a system of accounting known as double-entry
bookkeeping. The accounting system identifies and records accounting transactions.
■■ The measurement of accounting information is not a straightforward process. Accounting
involves making judgements about the value of assets and liabilities owed by a business. It is
also about accurately measuring how much profit or loss has been made by a business in a
particular period. As we will see, the measurement of accounting information often requires
subjective judgement to come to a conclusion.
■■ The above definition identifies the need for accounting information to be communicated. The
way in which this communication is achieved may vary. There are several forms of account-
ing communication (e.g. annual report and accounts, management accounting reports) each
of which serve a slightly different purpose. The communication need is about understanding
who needs the accounting information and what they need to know!

1.1 What are the purposes of the financial statements?

Accounting information is communicated using financial statements. Financial statements
have two main purposes:
1. to report on the financial position of an entity (e.g. a business, an organisation); and
2. to show how the entity has performed (financially) over a particularly period of time (an
‘accounting period’).
The most common measurement of ‘performance’ is profit. It is important to understand that
financial statements can be historical or relate to the future.

TEST YO UR K N OW LE DG E   3.1

a) What is meant by ‘accounting’?

b) Demonstrate the purpose of financial statements.

2 Accountability
Accounting is about accountability. Most organisations are externally accountable in some way
for their actions and activities. They produce reports on their activities that will reflect their
objectives and the people to whom they are accountable.
The table below provides examples of different types of organisations and how accountability
is linked to their differing organisational objectives:
All of these organisations have a significant role to play in society and have multiple stake-
holders to whom they are accountable. All require systems of financial management to enable
them to produce accounting information.

3 How accounting information helps businesses to be

accountable
As described in the introductory definition, accounting is essentially an ‘information process’
that serves several purposes. It:
■■ provides a record of assets owned, amounts owed to others and monies invested;
■■ provides reports showing the financial position of an organisation and the profitability of its
operations;
■■ helps management to manage the organisation;
■■ provides a way of measuring an organisation’s effectiveness (and that of its separate parts and
management);
42 Part two  The preparation and presentation of financial statements

Table 3.1 Accountability of different types of organisation

Organisation Objectives Accountable to (examples)

Private or public company Profit creation of wealth Shareholders
(e.g. Barclays Bank, Tesco) Other stakeholders (e.g.
employees, customers, suppliers)
Charities (e.g. Age Concern) Achievement of charitable aims Charity commissioners
Maximise spending on activities Donors
Value for money Volunteers
Local authorities (e.g. Provision of local services Local electorate
Liverpool City Council) Optimal allocation of spending Government departments
budget
Public services, such as Provision of public service (often Government ministers
transport or health (e.g. required by law) Consumers
NHS, Prison Service) High quality and reliable services
Quasi-governmental Regulation or instigation of some Government ministers
agencies (e.g. Data public action Consumers
Protection Registrar, Coordination of public sector
Scottish Arts Council) investments

■■ helps stakeholders to monitor an organisation’s activities and performance; and

■■ enables potential investors or funders to evaluate an organisation and to make any necessary
decisions.
There are many potential users of accounting information, including shareholders, lenders,
customers, suppliers, government departments (e.g. HMRC), employees and their organisa-
tions, and society at large. Anyone with an interest in the performance and activities of an
organisation is traditionally called a stakeholder.
For a business or organisation to communicate its results and position to stakeholders, it
needs a language that is understood by all in common. Hence, accounting has come to be
known as the ‘language of business’. There are two broad types of accounting information:
■■ Financial accounts are geared toward external users of accounting information.
■■ Management accounts are aimed more at internal users of accounting information.
Although there is a difference in the type of information presented in financial and manage-
ment accounts, the underlying objective is the same: to satisfy the information needs of the
user. These needs can be described in terms of the following overall information objectives:

Table 3.2 Information objectives

Objective Description
Collection Collection in money terms of information relating to transactions that
have resulted from business operations.
Recording and classifying Recording and classifying data into a permanent and logical form. This is
usually referred to as book-keeping.
Summarising Summarising data to produce statements and reports that will be useful
to the various users of accounting information – both external and
internal.
Interpreting and Interpreting and communicating the performance of the business to the
communicating management and its owners and users of financial information.
Forecasting and planning Forecasting and planning for future operation of the business by
providing management with evaluations of the viability of proposed
operations. The key forecasting and planning tool is the budget.
 chapter 3  Financial accounting and the preparation of financial reports 43

The process by which accounting information is collected, reported, interpreted, and actioned is
called financial accounting. Taking a commercial business as the most common organisational
structure, the key objectives of financial management would be to:
■■ create wealth for the business;
■■ generate cash; and
■■ provide an adequate return on investment, bearing in mind the risks that the business is
taking and the resources invested.
In preparing accounting information, care should be taken to ensure that the information pre-
sents an accurate and true view of the business performance and position. To impose some
order on what is a subjective task, accounting has adopted certain conventions and concepts
which should be applied when preparing accounts.
For financial accounts, the regulation or control of the kind of information that is prepared
and presented goes much further. UK and international companies are required to comply with
a wide range of accounting standards. These define the way in which business transactions are
disclosed and reported. These are applied by businesses through their accounting policies.

TEST YO UR K N OW LE DG E   3.2

a) On what basis is accounting information prepared?

b) Summarise the five principals for whom accounting information is prepared.

4 What is financial accounting?

A conventional division of the discipline of ‘accounting’ is into what are labelled ‘financial
accounting’ and ‘management accounting’. Under the two classifications, the following expla-
nation is used to describe both types of approaches to accounting:
■■ Financial accounting: accounting information prepared for external users, such as investors
and lenders. Financial accounting information may influence the economic decisions exter-
nal users make and is prepared under International Financial Reporting Standards (IFRSs) or
Generally Agreed Accounting Practice (GAAPs).
■■ Management accounting: accounting information for internal users. Accounting informa-
tion for management use is prepared for internal monitoring and control in making the most
efficient use of limited resources.

5 Reporting entities
Suppliers of accounting information include the following entities (these are listed in no par-
ticular order of priority).

5.1 Sole traders

These are businesses where the sole trader and the entity are the same person. The individual is
responsible for all the risks and receives all the reward. Operations are usually on much smaller
scale than limited companies. Accounts are prepared for the sole trader to help establish the
amount of income tax due to HMRC. The sole trader makes little use of accounting statements
for business decisions, which are instead based on knowledge obtained as a result of direct con-
tact with all aspects of business activity.

5.2 Partnerships
These exist where two or more individuals join together to undertake some form of busi-
ness activity. The partners share ownership of the business and the obligation to manage its
44 Part two  The preparation and presentation of financial statements

operations between them. Professional people, such as accountants, solicitors and doctors,
commonly organise their business activities in the form of partnerships. Accounting state-
ments are required as a basis for allocating profits between the partners and, again, for agreeing
tax liabilities with HMRC.

5.3 Clubs and societies

There are many thousands of clubs and societies in Britain, organised for recreational, edu-
cational, religious, charitable, and other purposes. Members pay an annual subscription and
management powers are delegated to a committee elected by the members. The final accounts
prepared for (usually large) societies are often controlled by statute. For a local club or society,
the form of the accounts is either laid down in the internal rules and regulations or decided
at the whim of the treasurer. Conventional accounting procedures are sometimes ignored in a
small organisation. Reasons for this are lack of expertise, the meagre quantity of assets belong-
ing to the organisation and the fact that the accounts are of interest only to the members.

5.4 Limited companies

A limited company is usually formed by registering with the Registrar of Companies under the
provisions of the Companies Act 2006 and complying with certain formalities. The company
may be private (indicated by the letters Ltd at the end of its name), or public (in which case
the designatory letters are ‘plc’). The main significance of the distinction is that only the latter
can make an issue of shares to the general public. In the case of public companies, there is a
further distinction between quoted companies, whose shares are listed and traded on the stock
exchange, and unquoted companies. In general, public companies are larger than private com-
panies and quoted companies larger than unquoted.
The directors of all limited companies are under a legal obligation to prepare and publish
accounts, at least once in every year, which comply with the requirements of the Companies
Act 2006 (CA 2006). A limited company may, alternatively, be formed by either a private Act
of Parliament or a Royal Charter. Before registration under the Companies Act became possible
(prior to 1844) these were the only methods of incorporation available, but they are rarely used
today. Companies formed in this way are called statutory and chartered companies, respec-
tively. The form of their accounts may be regulated by their charter or statute and they nor-
mally comply with the general requirements of the CA 2006. Additionally, the CA 2006 also
applies to charities that trade, public sector bodies such as hospital trusts and universities, local
authorities and quasi-government agencies (companies that are private yet supported by the
government). These types of organisations can be considered as reporting entities.

T E S T YO UR K N OW L E D G E   3.3

a) Define financial accounting.

b) Distinguish between partnerships and sole traders.

6 Principal accounting statements

International Accounting Standard 1 (IAS 1 ‘Presentation of Financial Statements’) is the basis
by which the primary financial statements are prepared. Limited liability companies prepare
annual reports consisting of a complete set of financial statements that include narratives
which help to further explain the financial figures. IFRS prescribed standard formats, including
IAS 1.10 ‘Complete Set of Financial Statements’, are used to prepare financial reports. These
include:
■■ a statement of profit or loss and other comprehensive income;
■■ a statement of financial position;
■■ a statement of change in equity;
 chapter 3  Financial accounting and the preparation of financial reports 45

■■ a statement of cash flows; and

■■ explanatory notes.
The narrative expands upon particular aspects of the financial reports and helps users to make
a further qualitative review of the underlying economic reality of the company.
The purpose of financial accounting statements is mainly to provide a report on the financial
position of an entity at a particular point in time and to show how that entity has performed
during the accounting period.
A statement of financial position, which replaces the balance sheet for all companies subject
to compliance with IFRSs, shows what resources are owned by a business (assets) at a particular
point in time and what it owes to other parties (liabilities). It also shows how much has been
invested in the business and what the sources of that investment finance were.
As it is synonymous with the balance sheet, the statement of financial position is a snapshot
of the financial position of the entity at a specific point in time. However, while this is a useful
picture to have, the snapshot will change every time an accounting transaction takes place.
By contrast, the statement of profit or loss and other comprehensive income which is the
new name for the profit and loss account or income statement for IFRS-compliant companies
provides a review of the performance of the entity during the accounting period. The statement
of profit or loss and other comprehensive income is usually for a period of one year, but it may
be produced for shorter accounting periods. The statement of profit or loss and other compre-
hensive income reveals the financial transactions that took place during the accounting period
and the overall performance as a result of the financial transactions. The performance of the
entity during the accounting period is measured by the accounting profit earned in the account-
ing period. Accounting profit is the amount by which income receivable for the period (sales
revenue /turnover or income) exceeds the expenses incurred in the period.
The range of financial information published by reporting entities varies according to the
nature and purpose of their operations. We will now consider the practice of limited companies.

6.1 The statement of profit or loss and other comprehensive income

Revenues are generated and costs are incurred as a result of undertaking business activity. These
are summarised in the statement of profit or loss and other comprehensive income. When total
revenue exceeds total expenses, the business has made a profit. If total revenue is the same as
total expenses, the business ‘breaks even’. If total revenue is less than total expenses, the busi-
ness suffers a loss. From the statement of profit or loss and other comprehensive income, users
gain obtain information about:
a) whether a profit (or loss) was made in the period;
b) the amount of the profit (or loss);
c) the level of corporation tax payable;
d) the amount payable to providers of finance;
e) the amount payable to shareholders; and
f) the residual amount retained by the company.

6.2 The statement of financial position

The statement of financial position (previously known as the balance sheet) sets out the finan-
cial position of the company at a particular point in time, the end of the accounting period.
A key difference between the statement of profit or loss and other comprehensive income and
the statement of financial position is that whereas the former reports inflows and outflows of
resources over a period of time, the latter sets out the assets and liabilities at a particular point
in time.
It is for this reason that the statement of financial position has been likened to a financial
photograph of a business. Like all photographs, the position just before or just afterwards may
be entirely different. This provides scope for management to undertake cosmetic exercises that
present the company’s position in the best possible light. For example, it might borrow money
just before the year end in order to inflate the cash balance and then repay it on the first day of
the next accounting period. Such devices are called ‘window dressing’ and it is part of the audi-
tor’s job to ensure that decision makers are not misled by such procedures.
46 Part two  The preparation and presentation of financial statements

6.3 The statement of changes in equity

Equity is the residual interest in the assets of the entity after deducting all its liabilities, as
defined in 4.4 of the Conceptual Framework for Financial Reporting 2010. Equity may be sub-
classified in the statement of financial position of a corporate entity into funds contributed by
shareholders, retained earnings, reserves representing appropriations of retained earnings and
reserves.
The statement of changes in equity is an important component of financial statements, since
it explains the composition of equity and how has it changed over the year.
The statement of changes in equity summarises the movement in the equity accounts during
the year, namely:
■■ share capital;
■■ share premium;
■■ retained earnings;
■■ revaluation surplus;
■■ unrealised gains on investments;
■■ issue and redemption of share capital;
■■ transfers between reserves; and
■■ profit after tax and dividends.

6.4 The statement of cash flows

This lists all cash inflows and outflows that have occurred during the accounting period under
review (this is normally a year). Chapter 12 shows that the cash flows are classified under
headings designed to maximise their informative value. Because it is based on ‘hard cash’, the
cash flow statement is considered to be less susceptible to manipulation than the other main
financial reports. As a result, it is likely to provide important insights concerning business
performance during a particular accounting period (e.g. whereas the statement of profit or loss
and other comprehensive income may show a healthy figure for operating profit, the cash flow
statement could cast doubt on the quality of reported profit if it communicates a decline in the
actual cash flow from operating activities).

7 Users and uses of accounting information

Financial statements are important, as they help show how a business has performed and pro-
vide some indication of likely future performance. A wide range of users, both inside the busi-
ness and outside it, use the financial reports to help them make decisions.
We have seen that people who use accounting information can be classified into those within
the firm and those outside. Users within the firm include managers, at any level of responsibil-
ity ranging from the shop floor to the board of directors, who use information for one or more
of the following purposes:
■■ Planning – to assess the financial effects of possible alternative courses of future action.
■■ Decision making – for example, to decide which project to undertake or whether to reallocate
resources from one use to another.
■■ Assessment and control – to monitor the performance of personnel, departments and
products.
External users also use accounting information to make decisions. In the case of an investor,
for example, they may use financial reports to assess past performance and predict future per-
formance to help decide whether to make an initial investment in the business, purchase more
shares or dispose of an existing holding. Historically, the principal external users of accounting
information were seen as comprising only the shareholder and the creditor groups, but for some
time this has been recognised as too narrow a view.
We can, therefore, see that external users require accounting information for a range of pur-
poses. The principal accounting statements are of interest to both internal and external users
but, when presented to the latter, they will normally be in a condensed form. The main factor
affecting the amount of detail contained in the accounts is the requirements of the user group.
In general, external users wish to assess the overall performance of the entity, so an enormous
 chapter 3  Financial accounting and the preparation of financial reports 47

amount of detail is inappropriate, both because it is of little interest and because it is likely
to obscure important trends. It is mainly for this reason that information is presented in a
highly summarised form in the published accounts. However, disclosing too much detail may
be useful to competitors when analysing a company’s strengths and weaknesses.
Financial statements prepared for management contain much more detail. Shareholders base
their decision to sell shares, retain their investment or buy more shares mainly on the level
of reported profit and dividends declared. Management, in contrast, has a keen interest in the
costs and revenues that make up the profit figures. They are responsible for taking decisions on:
■■ whether to expand or contract production;
■■ whether to substitute one material for another, or one type of worker for another;
■■ whether to replace labour-intensive production methods by machinery;
■■ whether to acquire property instead of renting it; and
■■ which type of power supply to use.
These decisions influence individual items of revenue and expenditure. In many instances,
reports must be specially prepared to help reach these decisions, and appraisal techniques have
been developed to help the management process. After the decisions have been made, the out-
come is monitored to see the extent to which expectations have been fulfilled.

TEST YO UR K N OW LE DG E   3.4

a) Define the seven external users of financial reports identified by the Framework for the
Preparation and Presentation of Financial Statements.
b) State and explain the nature of and purpose of the principal financial statements.

8 Presentation of financial statements

This is the subject of IAS 1 ‘Presentation of Financial Statements’.

8.1 Objectives of IAS 1

IAS 1 prescribes the basis for the presentation of general purpose financial statements, to
ensure comparability with: the entity’s financial statements of previous periods; and the finan-
cial statements of other entities.

8.2 Concepts and guidelines

IAS 1 sets out some of the basic concepts and other guidelines that that should be complied
with when preparing and presenting statements. These concepts have been covered above when
considering the content of the framework, namely: going concern; accruals; consistency; and
materiality.

8.3 Offsetting
It is important that both assets and liabilities and income and expenses, when material, are
reported separately so that users can make a proper assessment of the progress and financial
position of the entity. It is for these reasons that IAS 1 states that assets, liabilities, income and
expenses are not to be offset unless required or permitted by an IFRS.
Offsetting in either the statement of profit or loss and other comprehensive income or the
statement of financial position is required or permitted where it reflects the substance of the
transaction or event. The reporting of assets net of valuation allowances (e.g. obsolescence
allowances on inventories and doubtful debts allowance on receivables) is therefore permitted.
48 Part two  The preparation and presentation of financial statements

8.4 Comparative information

Comparative information is disclosed for all amounts reported in the financial statements,
unless an IFRS requires or permits otherwise.

8.5 Criteria for items that must be reported

The financial statements that constitute the annual reports of a company, prepared on the basis
of IFRSs, must declare a minimum number of items. The prescribed format in the presentation
of the statement of profit or loss and other comprehensive income and the accompanying finan-
cial statements must include items that are included in the various standards. These items
must also be calculated in a consistent and recommended manner.
Once a company has selected the manner and format in which it will report its financial
figures, it must use that format consistently. In the UK, companies that do not follow the IFRS
system of accounting must comply with CA 2006 as well as with UK GAAPs. These give com-
prehensive guidance on what items must be reported on the face of the financial statements
with an appropriate set of narratives.

9 Prescribed format for the statement of profit or

loss and other comprehensive income
IAS 1 allows entities to choose between two formats for reporting income and expenses. All
items of income and expense recognised in a period must be included in profit or loss unless a
standard or an interpretation dictates otherwise (IAS 1.88).
Some differences exist between the US GAAP understanding of revenue and the IFRS ver-
sion. In the UK, for listed companies, the IFRS version takes precedence. As an example of
interpretation and understanding, here is the distinction in revenue recognition between US
GAAPs and IFRSs:
■■ Earned: The earnings process must be complete and the value of the transaction can be
measured.
■■ Realisation: The revenue must have been collected OR there must be some assurance that it
will be collected.
The most popular method of reporting on the face of the statement of profit or loss and other
comprehensive income in the EU is Format 1. Format 1 analyses expenses by function (e.g.
by cost). Format 2 analyses expenses by type (e.g. employee benefits, similar type of operat-
ing expenses). For the purposes of this manual, we will illustrate income and expense using
Format 1.

worked e x amp le   3.1

NRG plc – statement of profit or loss and other comprehensive income for the years ended 31
December:

    2012 2011
Income from continuing operations Notes £,000 £,000
Revenue 1 550,000 470,000
Cost of sales 2 420,000 370,000
Gross profit   130,000 100,000
Distribution costs 3 12,000 8,000
Administrative expenses 4 24,000 18,000
 chapter 3  Financial accounting and the preparation of financial reports 49

worked e x amp le   3.1 continued

Other expenses 4 9,000 6,000

Profit from operations 5 85,000 68,000
Interest payable 6 500 300
Profit before tax   84,500 67,700
Tax 7 25,350 20,310
Profit for the period from continuing operations   59,150 47,390
Discontinued operations      
Loss for the period from discontinued operations 8 6,200 4,500
Comprehensive income   52,950 42,890
Attributable to ordinary equity holders   42,360 34,312
Attributable to minority interest   10,590 8,578
Earnings per share 9 11 9

10 Measurement and recognition of revenue

IAS 18 ‘Revenue’ prescribes the steps towards revenue recognition. IAS 18 describes revenue as:

[t]he gross inflow of economic benefits (cash, receivables, other assets) arising from the ordi-
nary operating activities of an entity (such as sales of goods, sales of services, interest, royal-
ties, and dividends).

As such, IAS 18 further describes two crucial elements in revenue recognition to enhance trans-
parency and aid in reporting. The two elements are measurement and recognition of revenue.

10.1 Measurement of revenue

IAS 18 explains measurement of revenue as follows:

Revenue should be measured at the fair value of the consideration received or receivable. An
exchange for goods or services of a similar nature and value is not regarded as a transaction
that generates revenue. However, exchanges for dissimilar items are regarded as generating
revenue.

10.2 Recognition of revenue

All revenues and expenses arising due to an entity’s business activities must be recorded and
calculated using the accruals methods. Similarly, revenue is recognised in the statement of
profit or loss and other comprehensive income as cash received for goods and services plus any
credit sales made in the same period. IAS 18 explains recognition of revenue as follows:

Recognition, as defined in the IASB Framework, means incorporating an item that meets
the definition of revenue (above) in the statement of profit or loss and other comprehensive
income when it meets the following criteria:
■■ it is probable that any future economic benefit associated with the item of revenue will
flow to the entity, and
■■ the amount of revenue can be measured with reliability.
50 Part two  The preparation and presentation of financial statements

IAS 18 further explains the process of recognising revenue. The following are IAS 1 rules for the
preparation of the statement of comprehensive income:
1. Comprehensive income for a period includes profit or loss for that period plus other com-
prehensive income (OCI) recognised in that period. As a result of the 2003 revision to IAS
1, the standard is now using ‘profit or loss’ rather than ‘net profit or loss’ as the descriptive
term for the bottom line of the statement of profit or loss and other comprehensive income.
2. The amendments to IAS 1 ‘Presentation of Financial Statements’ (June 2011) require com-
panies preparing financial statements in accordance with IFRSs to group together items
within OCI that may be reclassified to the profit or loss section of the statement of profit
or loss and other comprehensive income. The amendments also reaffirm existing require-
ments that items in OCI and profit or loss should be presented as either a single statement
or two consecutive statements.
3. All items of income and expense recognised in a period must be included in profit or loss
unless a Standard or an Interpretation requires otherwise (IAS 1.88).
4. Some IFRSs require or permit that some components to be excluded from profit or loss and
instead to be included in other comprehensive income (IAS 1.89).The components of other
comprehensive income include:
a) changes in revaluation surplus (IAS 16 and IAS 38); and
b) actuarial gains or losses on defined benefit plans recognised in accordance with IAS 19.
5. Gains and losses arising from translating the financial statements of a foreign operation
(IAS 21).
6. Gains and losses on re-measuring available-for-sale financial assets (IAS 39).
7. The effective portion of gains and losses on hedging instruments in a cash flow hedge (IAS
39).
Additionally, certain items must be disclosed separately either in the statement of comprehen-
sive income or in the notes, if material, including (IAS 1.98):
■■ write-downs of inventories to net realisable value or of property;
■■ plant and equipment to recoverable amount, as well as reversals of such write-downs;
■■ restructuring of the activities of an entity and reversals of any provisions for the costs of
restructuring;
■■ disposals of items of property, plant and equipment;
■■ disposals of investments;
■■ discontinuing operations;
■■ litigation settlements; and
■■ other reversals of provisions.
Expenses recognised in the statement of profit or loss and other comprehensive income should
be analysed either by nature (raw materials, staffing costs, depreciation, etc) or by function (cost
of sales, selling, administrative, etc) (IAS 1.99). If an entity categorises by function, then addi-
tional information on the nature of expenses; at a minimum depreciation, amortisation and
employee benefits expense; must be disclosed (IAS 1.104).

worked e x amp le   3.2

NRG plc is in the business of supplying electricity to commercial customers. NRG plc typically enters
into contracts that are worth at least £1 million and last for a minimum of two years. NRG recently
acquired two new customers. Customer A entered into a contract with NRG for the supply of
electricity for four years at a contract price of £5 million. Customer B had a similar arrangement, but
with a contract price of £8 million over eight years. The annual contract values are paid in advance
by both customers.

NRG plc has a policy to give discounts to longer running contracts.

Required
State the revenue NRG plc will recognise in relation to the contracts with customers A and B.
 chapter 3  Financial accounting and the preparation of financial reports 51

worked e x amp le   3.2 continued

Answer
The revenue NRG plc will recognise in relation to the contracts for customers A and B are as follows:

Customer A
£5 million/4 years = £1.25 million (annualised charge to revenue)

Customer B
£8 million / 8 years = £1 million (annualised charge to revenue)

Total annualised charge to revenue for customers A and B are:

Customer A £1.25 million

Customer B £1.00 million
£2.25 million

Under IFRS rules and IAS 1, the above calculations are measurable and reliable. The calcula-
tions will meet the criteria for prescribed revenue recognition whereby ‘the gross inflow of eco-
nomic benefits arising from the ordinary operating activities of an entity’ would have been met.
Additionally, the recognition to revenue would have met the criteria for revenue measurement
at ‘fair value of the consideration’.
Further, revenue is being recognised on an accruals basis. NRG is being paid in advance of the
annualised contract value; hence it will defer revenue recognition to the statement of financial
position and introduce monthly charge to revenues. The proportion of annualised contract not
yet expended will be a liability to NRG plc.

11 Reporting comprehensive income

The Financial Accounting Standards Board (USA) describes comprehensive income as:

the change in equity (net assets) of a business enterprise during a period from transactions
and other events and circumstances from non-owner sources. It includes all changes in equity
during a period except those resulting from investments by owners and distributions to owners.

As such, comprehensive income is the total of profit or loss and other items that are not recorded
through the statement of profit or loss and other comprehensive income due to their nature,
including items such as unrealised holding gain or loss from available-for-sale securities and
foreign currency translation gains or losses. These items are not part of profit or loss; neverthe-
less, if they are material they should be included in comprehensive income, thus allowing users
a more comprehensive understanding of organisational performance.
Items included in comprehensive income, but not profit or loss, are reported under the accu-
mulated other comprehensive income section of a shareholder’s equity. Comprehensive income
paints a better picture when measured on a per-share basis. This in turn reflects the effects of
events such as dilution and options. Comprehensive income mitigates the effects of equity
transactions for which shareholders would be indifferent: dividend payments, share buy-backs
and share issues at market value.

12 Prescribed format for the statement of financial

position
IAS 1 (paragraph 54) specifies the minimum line item disclosures on the face of, or in the notes
to, the statement of financial position, the statement of profit or loss and other comprehensive
income, and the statement of changes in equity.
52 Part two  The preparation and presentation of financial statements

12.1 General format

Both current and non-current assets and current and non-current liabilities are presented as
separate classifications on the face of the statement of financial position. These distinctions are
required because the extent into the future that assets and liabilities are to be realised has clear
implications for an assessment of the financial position and solvency of an entity. Any assets
and liabilities not falling within the definitions of ‘current’, as indicated below, are to be classi-
fied as non-current.
A current asset is one that:
■■ is expected to be realised, or is intended for sale or on consumption, in the entity’s normal
operating cycle;
■■ is held primarily for trading purposes;
■■ is expected to be realised within 12 months of the statement of financial position date; or
■■ is cash or a cash equivalent asset.
A current liability is one that:
■■ is expected to be settled in the normal course of the entity’s operating cycle; or
■■ is due to be settled within 12 months of the statement of financial position.
A format that covers most of the information that one might expect to appear in an entity’s
statement of financial position is given below.

T E S T YO UR K N OW L E D G E   3.5

a) What is meant by a current asset and current liability?

b) Explain the process of recognising revenue under IAS 18.

worked e x amp le   3.3

NRG plc – Statement of financial position at 31 December:

  20X2 20X1
Assets £,000 £,000
Non-current assets    
Property, plant AND equipment 607,000 602,000
Accumulated depreciation 134,000 119,000
  473,000 483,000

Goodwill 11,000 11,000

Accumulated impairment 5,000 4,000
  6,000 7,000

Other intangible assets 13,000 9,000

Investments in associates 9,000 9,000
Available-for-sale investments 13,000 6,000
Total non-current assets 35,000 24,000
 chapter 3  Financial accounting and the preparation of financial reports 53

worked e x amp le   3.3 continued

Current assets    
Inventories 34,000 24,000
Trade receivables 24,000 18,000
Cash and cash equivalents 22,000 21,000
Total current assets 80,000 63,000
Total assets 594,000 577,000

Equity and liabilities    

Share capital 50,000 50,000
Other reserves 63,000 63,000
Retained earnings 225,000 172,050
  338,000 285,050

Minority interest 103,000 92,410

Total equity 441,000 377,460

Non-current liabilities    
Long-term borrowings 52,000 56,000
Deferred tax 11,000 9,000
Long-term provisions 5,000 5,000
Total non-current liabilities 68,000 70,000

Current liabilities    
Trade and other payables 13,000 26,540
Short-term borrowings 36,000 68,000
Current portion of long-term borrowings 6,000 6,000
Taxation 25,000 20,000
Short-term provisions 5,000 9,000
Total current liabilities 85,000 129,540
Total liabilities 153,000 199,540
Total equity and liabilities 594,000 577,000

13 Additional information on the statement of

financial position
IAS 1 paragraph 54 provides the minimum line items to be included on the face of the state-
ment of financial position.
Additional line items, headings, and subtotals shall be presented on the face of the statement
of financial position if these are relevant to understanding the entity’s financial position. There
is no prescribed order or format in which items are to be presented; however, the guidelines are
as follows:
■■ Line items are included when the size, nature or function of an item or aggregation of simi-
lar items is such that separate presentation is relevant to an understanding of the entity’s
financial position.
54 Part two  The preparation and presentation of financial statements

■■ The descriptions used and the ordering of items or aggregation of similar items may be
amended according to the nature of the entity and its transactions, to provide information
that is relevant to an understanding of the entity’s financial position.

14 Statement of changes in equity

Changes in shareholders’ equity between statement of financial position dates are, of course,
equal to the increase or decrease in net assets during that period. The change comprises two
basic elements:
■■ capital injections by the shareholders or withdrawals in the form of repayment of capital and
dividends; and
■■ gains and losses.
The general rule, as noted above, is that gains and losses should go through the statement of
comprehensive income. The reasons for this are two-fold:
1. Gains and losses, whatever their source, have an identical impact on the financial position
of the enterprise.
2. The impact of a gain, or perhaps more likely a loss, is not ‘played down’ by relegating it to
a position outside the primary financial statements.
It was noted in section 11, however, that accounting standards require a restricted range of
gains and losses to be excluded from the statement of profit or loss and other comprehensive
income, but shown as other comprehensive income such as gains and losses on sale of an asset.
These, together with the profit for the year reported in the statement of profit or loss and other
comprehensive income, are reported in the statement of changes in equity. The content of this
report will depend on the nature of gains and losses arising during the year.

14.1 Other items appearing in the statement of change in equity

Transactions that are material in nature may also be reported through the statement of changes
to equity and may include items such as transfer between reserves (e.g. revaluation reserve) and
issue of shares and prior period adjustments (discussed in chapter 4).
■■ Transfers from reserves: When an asset held for sale is eventually disposed of any gain that
transpires may be transferred to the equity. Any such transfer will simply be shown in the
statement by a minus in one column and a plus in another.
■■ Share issues: companies often issues shares in various forms that have a material impact on
the capital structure. These include bonus shares, rights issues, new shares issues (seasoned
offering) and occasionally companies will buy back their own shares (in the US these are
known as treasury shares). Any share issue below the market price will have a dilutive effect
on shareholder wealth.
■■ Prior period adjustment: If prior period mistakes or errors are material, IAS 8 ‘Accounting
Policies, Changes in Accounting Estimates and Errors’ allows such misstatements to be
included in the statement of changes as adjusting item(s) brought forward from those years.
For instance, a research and development expense wrongly capitalised will have a subsequent
reducing impact on retained earnings and assets (see below).
 chapter 3  Financial accounting and the preparation of financial reports 55

worked e x amp le   3.4

Statement of changes in equity for the year ended 31 December 20X2:

Share Other Translation Retained Total

capital reserves reserve earnings £,000
£,000 £,000 £,000 £,000
Balance at 1 January 20X2 x x x x x
Change in accounting policy (IAS 8) x x
Restated balance at 1 January 20X2 x x
Changes in equity during the year
Other comprehensive income
Gain/loss on property revaluation (IAS x x
16)
Exchange differences (IAS 21) x
Available for sale investments (IAS 39) x x
Tax on above items (gains or losses) x
recognised directly in equity
Total other comprehensive income   x x   x
Profit for the period       x x
Total recognised income and expenses x x x x x
for the period
Dividends (x) (x)
Issued share capital x x
Balance at 31 December 20X2 x x x x x

worked e x amp le   3.5

Share Share Revaluation Retained

capital premium reserve earnings Total
£m £m £m £m £m
Balance at 1 January 20X2 350 50 20 640 1,060

Change in accounting policy (IAS 8) 10 10

Restated balance at 1 January 20X2 650 1,070
Changes in equity during the year
Other comprehensive income
Gain/loss on property revaluation
(IAS 6) – 10 10
Transfer on realisation – (7) 7 0
Tax on above items (gains or losses)
recognised directly in equity – (3) (3)
Total other comprehensive income 350 50 20 7 7
Profit for the period       20 20
Total recognised income and
expenses for the period 27 27
Dividends (6) (6)
Issued share capital
Balance at 31 December 20X2 350 50 20 671 1,091
56 Part two  The preparation and presentation of financial statements

sto p and t hink  3.1

Do we really need a defined and constantly evolving standard setting process?

? END OF CHAPTER QUESTIONS

3.1 Briefly discuss the principal statements and their purpose that constitute a complete set of financial
statements.
3.2 The statement of changes in equity includes reconciliation between:
a) the carrying amount of retained earnings at the beginning and the end of the period;
b) the carrying amount of total equity at the beginning and the end of the period; and
c) the carrying amount of each component of equity at the beginning and the end of the period
separately disclosing changes resulting from:
■■ profit or loss;
■■ each item of comprehensive income; and
■■ the amounts of investments by, and dividends and other distributions to, owners.
From the above statements, select which answer best reflects the statement of changes in equity.
3.3 The following items were extracted from the records of Sigma plc on 31 December 20X1.
£,000
Goodwill 400
Capitalised development expenditure 200
Brand 100
Property, plant and equipment 900
Trade and other receivables 950
Inventories 300
Cash and cash equivalent 200
Trade and other payables 300
Derivative financial assets (short term) 100
Other receivables (due to be received 20X4) 300
Investments in subsidiaries 200
Deferred tax liabilities 100
Current tax payable 100
10% bond payable 20X5 60
Provision for decommissioning of nuclear plant in 2015 50
Revaluation reserve 150
Retained earnings 300
Retirement benefit obligations 120
Capital redemption reserve 80
Share capital – £1 ordinary shares (balancing item) ?

Required
Prepare the statement of financial position of Sigma plc on 31 December 20X1. The statement should be
prepared in accordance with IAS 1.
 chapter 3  Financial accounting and the preparation of financial reports 57

? END OF CHAPTER QUESTIONS

3.4 Opal Ltd is a company which operates a number of retail shops, some of which it owns and others it rents.
The following is the company’s trial balance at 31 December 20X2:

  £,000 £,000
Sales revenue   5,100
Purchases 2,500  
Accounts payable   212
Accounts receivable 208  
Inventories at 1 January 20X2 250  
6% debenture loan   200
Administration expenses 924  
Equipment at cost 600  
Accumulated depreciation at 1 January 20X2   120
Distribution costs 540  
Ordinary shares   2,200
Share premium account at 1 January 20X2   250
Retained profit at 1 January 2012   850
Bank   15
Final dividend for 20X1 paid in July 20X2 35  
Freehold property at cost 3,890  
  8,947 8,947

You are given the following additional information:

1. The company does not depreciate its freehold property.
2. The equipment was purchased on 1 January 20X2, at which time they were expected to have a ten-
year life and a zero residual value.
3. Six months’ rent of £26,000, included in administration expenses, was paid in advance on 1 October
20X2.
4. An invoice of £5,000 for advertising during 20X2 was received in January 20X3, and is not reflected in
the above trial balance.
5. The debenture interest due for 20X2 has not yet been paid or accrued.
6. The value of inventories at 31 December 20X2 was £270,000.
7. The company has an authorised share capital of 2 million ordinary shares of £1 each and had an issued
share capital of 1.75 million ordinary shares of £1 each at 31 December 20X1.
8. On 30 June 20X2 the company issued, for cash, 250,000 shares. The entire proceeds of this issue have
been recorded as part of the balance of £2.2 million on the ordinary shares account.
9. It is estimated that the corporation tax charge for 20X2 will be £300,000 and has not been paid.
10. The directors intend to declare an ordinary dividend of 4 pence per share on each share in issue at 31
December 20X2.

Required
Prepare the following financial statements of Opal Ltd for 20X2 in accordance with the provisions of IAS 1
‘Presentation of Financial Statements’:
1. Statement of profit or loss and other comprehensive income using function of expense format.
2. Statement of changes in equity.
3. Statement of financial position.
4. Provide definitions for the following concepts/terminologies:
a) Fair value in accordance with IFRS 3 ‘Business Combinations’ (Past ICSA question).
b) Measurement and recognition of revenues in accordance with IAS 18 ‘Revenues’.
c) Other comprehensive income.
d) Reporting entities.
4 Accounting policies 1

■■ Contents
  1. Introduction
  2. Accounting policies
  3. Accounting for inventory (IAS 2)
  4. Accounting policy and changes (IAS 8)
  5. Accounting for events after the reporting period (IAS 10)
  6. Fair value measurement (IFRS 13)
  7. Accounting for property, plant and equipment (IAS 16)
  8. Accounting for revenue (IAS 18)
  9. Accounting for provisions (IAS 37)
10. Accounting for intangible assets (IAS 38)

■■ Learning outcomes
At the end of this section, students will be able to:
■■ demonstrate familiarity with the nature of accounting policies, the significance of differences
between them and the effects of changes in accounting policy;
■■ show an understanding of the treatment of inventories in financial statements;
■■ demonstrate an understanding of accounting for property, plant and equipment including
accounting for depreciation and accounting for impairment; and
■■ show familiarity with end-of-year accounting issues including accounting for provisions,
contingent assets and liabilities and dealing with events after the reporting period.

1 Introduction
The objective of financial reporting is to provide financial information to users of financial state-
ments to make their own economic decision. This is expressed in the Conceptual Framework
as follows:

The objective of general purpose financial reporting is to provide financial information about
the reporting entity that is useful to existing and potential investors, lenders and other credi-
tors in making decisions about providing resources to the entity. Those decisions involve
buying, selling or holding equity and debt instruments, and providing or settling loans and
other forms of credit.

The importance of the output from financial reporting serves as a constant reminder to man-
agement and their appointed agents why due care must be exercised with the process.
Moreover, accounting is somewhat short of being an exact science despite some of the traits;
thus the need for clarity on the accounting of items included and presented in financial state-
ments. The move towards clarity and enhanced usefulness is derived from the accounting policies.

2 Accounting policies
Accounting policies are defined in IAS 8 (Accounting Policies, Changes in Accounting Estimates
and Errors) as ‘the specific principles, bases, conventions, rules and practices applied by an
entity in preparing and presenting financial statements’.
 chapter 4  Accounting policies 1 59

Our definition reveals the multiplicity and breadth of the features of accounting policies.
These features are applied in the two stages, the preparation and the presentation of financial
statements. Implicit in the definition is to provide useful information to the users who use the
financial information to make economic decisions.
The definition gives rise to two feature concerns governing the application of the accounting
policies. These twin concerns are:
1. the selection and application; and
2. the consistency of accounting policies.

2.1 Selection and application of accounting policies

The determinant for the selection and application of the appropriate accounting policy is the
application of the standard and/or guidance issued by the IASB. However, an IASB standard
does not exist to address every transaction or item or activity to be reported by management. In
such cases the concerns for the users of reported financial information will be how they can be
assured that the reported financial information will meet their needs.
In such instances, management must display judgement in selecting accounting policies that
are relevant and reliable, as stated in IAS 8.

In the absence of a Standard or an Interpretation that specifically applies to a transaction,

other event or condition, management must use its judgement in developing and applying an
accounting policy that results in information that is:
a) relevant to the economic decision-making needs of the users; and
b) reliable.

2.2 Consistency of accounting policies

Accounting policies should be applied consistently for similar transactions, other events and
conditions. The only exception is where an IASB Standard permits or requires item categorisa-
tion and the application of different policies.
The most common example found in financial statements is the accounting for non-current
assets. Property, plant and equipment are depreciated and this is shown in the statement of
financial position. However, non-current assets may be categorised and have a particular depre-
ciation policy applied to each class rather than across the whole group.

3 Accounting for inventory (IAS 2)

Inventories have a significant position in the financial statements. Firstly, they are used in the
computation of the gross profit on the statement of profit or loss and other comprehensive
income and secondly, they are held as current assets and displayed on the statement of financial
position. Therefore the identification and measurement of inventory can have a material impact
on the reported performance and position of an entity. IAS 2 (Accounting for inventories) pro-
vides the framework and policy guidance.
Inventories are defined as assets that may exist in the following three conditions:
■■ held for sale in ordinary course of business;
■■ in the process of production for such sale; and
■■ in the form of materials or supplies to be consumed in the production process or in the ren-
dering of services.
IAS 2 applies to all inventories with the exception of:
■■ construction contracts (IAS 11 Construction Contracts);
■■ financial instruments (IAS 32 Financial Instruments: Presentation and IFRS 9 Financial
Instruments); and
■■ biological assets (IAS 41 Agriculture).
Similarly, IAS 2 does not apply to measurement of inventories held by:
■■ producers of agricultural and forest products;
■■ minerals and mineral products; or
■■ commodity brokers.
60 Part two  The preparation and presentation of financial statements

The standard outlines what items are included as inventories and which items are excluded.
The comparative outline is shown in Table 4.1.

Table 4.1 Comparative list of costs included and excluded from inventories

IAS 2 Inventories include: IAS 2 Inventories exclude:

■■ Costs of purchase, including non-recoverable ■■ Abnormal waste
taxes, transport and handling ■■ Storage costs (unless necessary for the
■■ Net of trade volume rebates production process)
■■ Costs of conversion ■■ Admin overheads not related to production
■■ Other costs to bring inventory into its present ■■ Selling costs
condition and location. ■■ Interest cost (where settlement is deferred)

The basis for the valuation of inventories is the lesser of historic cost and net realisable value
(NRV), where the NRV is the estimated selling price in the ordinary course of business, less the
estimated costs of completion and the estimated costs to make the sale.
To ensure that full provision is made for foreseeable losses, IAS 2 requires the comparison
between cost and net realisable value to be based on individual items of stock, with the proviso
that groups of similar items may be compared where the comparison of individual items is
impractical.

worked e x amp le   4.1

The following information is provided in respect of a group of items of inventory belonging to

Banbury Ltd:
Item of inventory Cost Net realisable value (NRV)
£ £
A 500 580
B 300 370
C 250 330
D 760 600

Required:
Calculations of the total value of Banbury’s inventories, based on the lower of cost and net realisable
value, assuming that cost is compared with net realisable value:
a) on an individual item basis;
b) on a group basis.

Answer
a) Individual item basis:
Item of inventory Cost NRV Lower of cost and NRV:
£ £ £ individual item basis
A 500 580 500
B 300 370 300
C 250 330 250
D 760 600 600
1,650
b) Group basis:
Item of inventory Cost NRV Lower of cost and NRV: group basis
£ £ £
A + B + C + D 1,810 1,880 1,810

Comparing cost with the NRV of individual items results in a lower inventory value (£1,650 as
compared with £1,810) and therefore a lower profit figure. This is because the comparison of total
figures for cost and NRV results in a foreseeable loss of £160 on item D (£760 cost – £600 NRV)
being offset by total unrealised gains of £230 on items A–C (£1,280 NRV – £1,050 cost).
 chapter 4  Accounting policies 1 61

The principal situations in which NRV is likely to be below cost are where there has been:
■■ a fall in selling price;
■■ physical deterioration of inventories;
■■ obsolescence of a product;
■■ a decision, as part of an entity’s marketing strategy, to manufacture and sell products for the
time being at a loss; and
■■ miscalculations or other errors in purchasing or production.
In practice, any one of the above is unlikely to apply to more than a small proportion of the
company’s inventories. For the remainder, NRV will exceed cost and can be ignored when valu-
ing inventories for inclusion in the accounts. However, the problem will remain of deciding how
to compute cost.
There are two basic areas of difficulty:
1. Whether to value inventories on the marginal cost or the total cost basis (see section 3.1
below).
2. How to identify purchases with issues to production and match finished goods with sales,
i.e. a choice has to be made between, for instance, first in first out and last in first out (see
section 3.2 below).

TEST YO UR K N OW LE DG E   4.1

Identify the principal situations in which NRV is likely to be below cost and explain the appropriate
accounting treatment of the discrepancy.

3.1 Marginal cost or total cost

The main difference between these two methods is their treatment of fixed factory costs, and
it is therefore a problem that is primarily confined to manufacturing companies. The marginal
cost basis includes only the variable costs associated with producing a single extra unit of
output, whereas the total cost basis also includes a proportion of fixed factory costs. The main
arguments for and against the total cost basis, which are the reverse of the arguments for and
against the marginal cost basis, are as follows:
For total cost:
1. Each unit manufactured benefits from the provision of facilities that result in fixed costs
being incurred, and a proportion of their cost should therefore be included in the value of
inventories.
2. The accruals concept requires costs to be matched with related revenues, and the total
cost of inventories unsold at the statement of financial performance date should therefore
be carried forward and matched against revenue arising during the following accounting
period.
Against total cost:
1. Fixed costs are a function of time rather than of production, and should therefore not be
carried forward, but should be charged against the revenue arising during the period when
they are incurred.
2. The valuation of inventories and, therefore, the level of reported profit fluctuate depending
on the level of production. This is because the quantity manufactured determines the pro-
portion of fixed cost attributed to each item, e.g. a low level of output causes each unit to be
charged with a high element of fixed cost.
3. Fixed costs cannot be directly related to particular items of inventory and are therefore
apportioned on an arbitrary basis.
IAS 2 requires companies to use the total cost basis for external reporting purposes. It defines
total cost as costs ‘incurred in bringing the inventories to their present location and condition’.
This normally means that the valuation should include a share of factory overheads (based
on normal capacity of the production facilities), but not distribution costs or administrative
expenses. The problem, implicit in the second argument against the use of total cost, listed
62 Part two  The preparation and presentation of financial statements

above, is avoided by the requirement that the calculation of the overhead element should be
based on the ‘normal level of activity, taking one year with another’.
Worked example 4.2 illustrates the difference between the marginal cost and total cost bases
of inventory valuation.

worked e x amp le   4.2

At the beginning of 20X1 Deer Ltd was incorporated. The company manufactures a single product.
At the end of the first year’s operations, the company’s accountant prepared a draft statement of
profit or loss and other comprehensive income that contained the following financial information:
Statement of profit or loss and other comprehensive income: Deer Ltd for 20X1

£ £
Sales (200,000 units) 600,000
Less: Marginal cost of units manufactured during 20X1 (500,000 units): 800,000
Deduct closing inventories 480,000
Marginal cost of goods sold 320,000
Fixed costs:
Factory expenses 200,000
General expenses 100,000 620,000
Net loss 20,000

Additional finance is required, and the directors are worried that the company’s bank manager is
unlikely to regard the financial facts shown above as a satisfactory basis for a further advance. The
company’s accountant made the following observation and suggestion:

The cause of the poor result for 20X1 was the decision to value closing inventories on the
marginal cost basis. An acceptable alternative practice would involve charging factory expenses
to the total number of units produced and carrying forward an appropriate proportion of those
expenses as part of the closing inventories value.

Required:
a) A revised statement of profit or loss and other comprehensive income, for presentation to the
company’s bank, valuing closing inventories on the total cost basis suggested by the company’s
accountant.
b) Assuming that, in 20X2, the company again produces 500,000 units, but sells 700,000 units,
calculate the expected profit using each of the two inventories valuation bases. Assume also
that, in 20X2, sales price per unit and costs incurred will be the same as for 20XI.
c) Comment briefly on the accountant’s suggestion and its likely effect on the bank manager’s
response to the request for additional finance.

Answer
a) Statement of profit or loss and other comprehensive income for 20X1 – total cost basis
£000 £000
Sales 600
Less: Marginal costs 800
Factory expenses 200
Total cost of manufacture 1,000
Deduct closing inventories (W1) 600
Cost of goods sold 400
General expenses 100 500
Net profit 100
 chapter 4  Accounting policies 1 63

worked e x amp le   4.2 continued

W1. The company produced 500,000 units but sold only 200,000 units, and so it had 300,000
units in stock. The total cost basis therefore results in a inventories valuation of (£1,000,000 ÷
500,000) x 300,000 = £600,000.
b) Forecast statement of profit or loss and other comprehensive income for 20X2

Marginal cost Total cost

£000 £000 £000 £000
Sales 2,100 2,100
Less: Opening inventories 480 600
Marginal costs 800 800
Factory expenses – 200
1,280 1,600
Deduct closing inventories (W2) 160 200
1,120 1,400
Factory expenses 200 –
General expenses 100 1,420 100 1,500
Net profit 680 600

W2. Opening inventories comprise 300,000 units and 500,000 units are expected to be
manufactured during 20X2. Assuming 700,000 units are sold, 100,000 units will remain in stock
at the end of 20X2. The closing inventories valuations are therefore:

Marginal cost basis: (£800,000 ÷ 500,000) x 100,000 = £160,000

Total cost basis: (£1,000,000 ÷ 500,000) x 100,000 = £200,000
c) Total cost is an acceptable basis for valuing inventories; indeed it is the method required for external
reporting purposes by IAS 2. Provided the resulting valuation does not exceed net realisable value,
it should be used. The use of different valuation bases does not, of course, alter the underlying
financial facts, but it can affect the allocation of profit between consecutive accounting periods.
Use of the total cost basis, which relates indirect manufacturing costs to output rather than time,
produces ‘higher’ profits than the marginal cost basis when production exceeds sales. Three-fifths
of the fixed factory costs (£200,000 X 3/5 = £120,000) are added to the value of closing inventories
for the purpose of preparing the revised statement of profit or loss and other comprehensive
income for 20X1, and this converts a reported loss of £20,000 into a reported profit of £100,000.
The situation is reversed when sales exceed production (see forecast results for 20X2 above). The
company’s bank manager should, but may not be, aware of the effect of different accounting
policies on reported profit. Therefore, it is difficult to say whether or not the bank manager will be
influenced by changing to a method that reports the underlying facts more favourably.

TEST YO UR K N OW LE DG E   4.2

Explain the difference between marginal cost and total cost.

3.2 FIFO, AVCO and LIFO

The price at which goods are purchased normally increases during the year and, consequently,
items on hand at the year-end will have been purchased at different prices. In theory, the accru-
als concept requires the cost of items sold to be matched individually against their sales proceeds
64 Part two  The preparation and presentation of financial statements

and, where such an approach is practical, it should be adopted. Usually, however, this is imprac-
ticable because of the large number of ‘interchangeable’ items bought, perhaps processed and
then sold during an accounting period. To simplify the matching process, assumptions are
made concerning the flow of goods through the firm. The eligible cost formulas for this purpose
are usually considered to be first in first out (FIFO), last in first out (LIFO) and weighted average
cost (AVCO).
■■ FIFO: This assumes that the items that have been held longest are used first, and inventories
in hand represent the latest purchases or production. The effect is that, during a period of
rising prices, cost of sales is reported at a low figure, reported profit is maximised and the
statement of financial performance figure for inventories represents most recent purchase
prices.
■■ LIFO: This assumes that the items purchased or produced most recently are used first, and
the quantities of inventories on hand represent earliest purchases or production. The result
is that cost of sales is higher than under the FIFO assumption, and reported profit is cor-
respondingly lower. In the statement of financial performance inventories are valued at a
relatively low figure, representing prices ruling weeks, months or even years earlier.
■■ AVCO: This method produces results which fall somewhere between the above two extremes.
All three approaches have their advocates. For example, some argue that FIFO is superior because
it is more likely to approximate the actual flow of goods through the company. Supporters of
LIFO argue that their method works better during a period of inflation, because it produces a
more realistic measure of profit. Although acknowledging the latter argument, IAS 2 rejects
LIFO on the grounds that it fails to produce a statement of financial performance figure for
inventories which bears a reasonable relationship to actual cost. The two eligible cost formulas
are therefore FIFO and AVCO.

4 Accounting policy and changes (IAS 8)

Consistency is one of the two desirable principles of accountancy and requires that there is
uniformity of accounting treatment of like items within each accounting period and between
periods. Consistency provides for comparable analysis and the ability to examine or monitor
trends over time.

4.1 Change in policy

In accordance with IAS 8, a change in accounting policy can be undertaken if:
1. required by an IFRS, or
2. a change will provide more relevant and reliable information.
Where a change in accounting policy is the result of a change in an accounting standard or its
interpretation, transitional provisions should be applied. If there are no transitional provisions,
the change should be made retrospectively unless it is impractical and the new policy would
require significant disclosure.
A retrospective change requires that everything changes and reporting as though the change
had always been in place. IAS 8 provides the following guidance on retrospective change.

when a change in accounting policy is applied retrospectively… the entity shall adjust the
opening balance of each affected component of equity for the earliest prior period presented
and the other comparative amounts disclosed for each prior period presented as if the new
accounting policy had always been applied.

A change in policy as a result in a change in accounting standards require full disclosure that
addresses each of the following at the end of the first accounting period in which the change
was introduced:
■■ the title of the accounting standard or interpretation that was responsible for the change;
■■ the nature of the change in policy;
 chapter 4  Accounting policies 1 65

■■ a description of the transitional provisions;

■■ for the current period and each prior period presented, the amount of the adjustment to:
a) each line item affected, and
b) earnings per share;
■■ the amount of the adjustment relating to prior periods not presented; and
■■ if retrospective application is impracticable, an explanation and description outlining how
the change in policy was applied.

worked e x amp le   4.3

The following balances relating to 20X2 have been extracted from the books of Oldham plc:
£,000
Turnover 11,170
Cost of sales 7,721
Profit on the sale of shares in Preston Ltd 500
Administration expenses 621
Distribution costs 133
Interest payable 26
Final dividend paid in respect of 20X0 600
Interim dividend paid for 20X1 250
Retained profit at 1 January 20X1 3,875

The following additional information is provided:

1. Shares in Preston Ltd were sold during the year. These shares were purchased ten years ago and
were the only investments owned by the company. It is estimated that attributable tax payable
will be £150,000.
2. The company’s cost of sales includes a £200,000 write-off of uninsured inventories damaged by
fire.
3. After the above balances were extracted, the directors decided to adopt the policy of depreciating
the company’s freehold building that has been owned for some years. This decision requires the
opening carrying amount of the building to be reduced by £700,000, and a charge for 20X1 of
£114,000 must be added to cost of sales.
4. Corporation tax on profits from normal trading operations is estimated at £1.2 million.
5. Oldham plc’s issued share capital amounted to £10 million throughout 20X1.

Required
The statement of profit or loss and other comprehensive income and statement of changes in equity
of Oldham plc for 20X1 in ‘good form’, and complying with standard accounting practice so far as
the information permits.

Note: Assume all amounts are material.

Answer
Revised cost of sales for Oldham plc 20X1
£,000
Cost of sales 7,721
Add: Additional depreciation 114
Adjusted cost of sales 7,835
Statement of profit or loss and other comprehensive income for Oldham plc 20X1
66 Part two  The preparation and presentation of financial statements

worked e x amp le   4.3 continued

£,000
Turnover 11,170
Cost of sales (Note 1) (7,835)
Gross profit 3,335
Distribution costs (133)
Administration expenses (621)
Operating profit 2,581
Other income (Note 2) 500
Finance costs (26)
Profit before tax 3,055
Taxation (1,200 + 150) (1,350)
Profit for the year 2011 1,705

Statement of changes in equity of Oldham plc for 20X1:

Share capital Retained earnings Total

£,000 £,000 £,000
Balance at 1 January 20X1 10,000 3,875 13,875
Change in accounting policy (Note 3)   (700) (700)
Balance at 1 January 20X1 as restated 10,000 3,175 13,175
Changes in equity during the year
Profit for the year 20X1 1,705 1,705
Dividends   (850) (850)
Balance at 31 December 20X1 10,000 4,030 14,030

Notes to the accounts

1. Cost of sales includes a £200,000 write-off of uninsured inventories damaged by fire. Material
amount requires disclosure.
2. During the year the company realised a profit of £500,000 on the sale of its shareholdings in
Preston Ltd purchased some years ago and also requires disclosure in view of the material amount
involved.
3. The directors have decided to change Oldham’s accounting policies so as to depreciate the
company’s freehold building, purchased some years ago, in order to give a fairer presentation of
the results and financial position of the company.

4.2 Change in accounting estimates

Financial reports are not always produced with absolute results. Often, there is a need to include
estimates because there is no certainty about an activity or an item within the financial state-
ments. A common example of this activity is the provision for doubtful debt (PDD). It is impos-
sible to measure or predict or forecast the level of trade receivables who may be unable to meet
their debt obligations. Under such conditions, it is common practice to apply an estimate of
the level of doubtful debt based upon a combination of factors such as professional judgement,
historical behaviour and current information and sector analysis. It may be the case that the
level of the PDD may be revised downwards or upwards over two accounting periods. However,
revising the PDD is not a change in accounting policy but an example of a change in account-
ing estimate.
In IAS 8, a change in accounting estimate is defined as:
 chapter 4  Accounting policies 1 67

an adjustment of the carrying amount of an asset or a liability, or the amount of the peri-
odic consumption of an asset, that results from the assessment of the present status of, and
expected future benefits and obligations associated with, assets and liabilities. Changes in
accounting estimates result from new information or new developments and, accordingly, are
not corrections of errors.

Changes in accounting estimates do not require retrospective adjustments in financial reports.

All changes in accounting estimates require a prospective adjustment. Our earlier revision of
the (PDD) will require a prospective adjustment, as the revised PDD will only be reported in the
current period’s financial report.

worked e x amp le   4.4

You have been asked to explain when a prospective and a retrospective application should be made
in financial statements to comply with IAS 8.

Solution
A retrospective application is required when there is the application of a new accounting policy
or the correction for a material prior period error. The retrospective application will require the
restatement of the comparative financial statements for each prior accounting period that is being
presented to account for the new accounting policy and/or the material error.
For completeness, the details of the changes must be disclosed in the notes to the financial
statements.
However, IAS 8 does allow for the prospective application of both a change in accounting policy
and material prior period errors to be carried out if it is impracticable to perform the retrospective
adjustment.

Examples of a retrospective application would include:

a) a change in the depreciation method from straight line to reducing balance, and
b) a material over/understatement of sales or inventory or other expenses.

A prospective application is required when there is a material change in an accounting estimate. In

such cases, the change would be disclosed in the notes to the financial statements.

Examples of a retrospective application would include:

a) a change in the estimated lifespan of a non-current asset; or

b) a change in the estimate used in the calculation of the provision of doubtful debtors.

The disclosure requirement for a change in accounting estimate is less onerous than the dis-
closure for a change in accounting policy. The only disclosure required for a change in account-
ing estimate is the nature and amount of change that has an effect in the current period (or
expected to have in future). There is an absence of disclosure of the effect of future periods
because it is impractical.

TEST YO UR K N OW LE DG E   4.3

When is a change in accounting policy permitted?

4.3 Accounting errors

Financial information may not be comparable or useful for users because of material prior
period errors.
68 Part two  The preparation and presentation of financial statements

Prior period errors are omissions from, and misstatements in, an entity’s financial statements
for one or more prior periods arising from failure to use/misuse of reliable information that:
a) was available when the financial statements for that period were issued
b) could have been reasonably expected to be taken.
The prior period errors may have arisen from:
1. mathematical mistakes;
2. mistakes in applying accounting policies;
3. oversights and misinterpretation of facts; or
4. fraud.
Errors should be corrected retrospectively in the first set of financial statements after the discov-
ery of an error. Secondly, a restatement of the comparative amounts for prior periods in which
the error occurred should be made or, if the error occurred before that date, the opening balance
of assets, liabilities and equity for the earliest period presented should be restated.
The disclosure required to address the discovery of a material prior period error must be
made in the first set of financial statements for publication following the discovery and should
provide the following:
■■ An explanation of the nature of the prior period error.
■■ For each prior period presented, if practicable, disclose the correction to:
a) each line item affected; and
b) earnings per share (EPS).
■■ Highlight the amount of the correction at the beginning of earliest period presented.
■■ If retrospective application is impracticable, explain and describe how the error was cor-
rected. An example of a prior period error that requires retrospective application is shown in
Worked example 4.4.

worked e x amp le   4.5

During the process of preparing the financial statement for the year ended 30 June 20X4, the book-
keeper at ZeeZee Retail discovered the inventory at 30 June 20X3 had been understated by £40,000.
A summary of the draft financial statement for the year ending 30 June 20X4 is shown as follows:

20X4 20X3
£,000 £,000
Turnover 800 650
Cost of goods sold 430 350
Gross profit 370 300
Operating expenses 320 260
Profit before taxation 50 40
Taxation at 20% 10 8
Post tax profit 40 32

Required
You are required to prepare:
a) a restated financial statement as at 30 June 20X3; and
b) a financial statement for the year ended 30 June 20X4.
 chapter 4  Accounting policies 1 69

worked e x amp le   4.5 continued

Solution
a) b)
Restated
20X3 20X4
£,000 £,000
Turnover 650 800
Cost of goods sold 310 470
Gross profit 340 330
Operating expenses 260 320
Profit before taxation 80 10
Taxation at 20% 16 2
Post tax profit 64 8

The restated financial statement shows that the annual gross profit before taxation has increased by
the £40,000 understatement. Consequently, the profit in 20X3 increased by 50%. Conversely, the
profit levels in 20X4 decreased by £40,000 and the level of taxation.

TEST YO UR K N OW LE DG E   4.4

When should an entity amend any errors discovered in their financial statements?

5 Accounting for events after the reporting period

(IAS 10)
It is not uncommon for a material event to occur between the reporting date and the issuance
date of the financial statements. Examples of such events may include:
■■ damage to a production plant by a fire, flood or other disaster;
■■ pollution of the environment, such as an oil spillage;
■■ disposal or acquisition of an asset;
■■ an announcement to discontinue an operation;
■■ material change in the net realisable value of inventories held at reporting date; and
■■ discovery of fraud in the financial statements.
The problem that arises from these events is deciding how to report them in the financial state-
ments, since the reporting date has passed. The litmus test for determining how to account for
such events is as follows:
1. Did the condition exist at the reporting date?
2. Did the condition exist after the reporting date?
IAS 10 ‘Events after the reporting period’ provides us with guidance to determine when an
adjustment is necessary in the financial statements for events after the reporting date. Where
the condition existed at or prior to the end of the reporting period, an adjustment is made to
the financial statements. In these cases, such events are adjusting events because the condition
was in existence at or prior to the end of the reporting period.
70 Part two  The preparation and presentation of financial statements

Where the condition arose after the reporting date, there is no adjustment to be made in the
financial statement. However, if the event is material, a disclosure is required in the financial
statement before it is issuance date. The content of the disclosure is as follows:
■■ state the nature of the event that is being disclosed;
■■ provide an estimate of the financial effect of the event; or
■■ when it is not possible to provide a financial estimate, provide a statement to that such esti-
mate cannot be made.

worked e x amp le   4.6

Bar-Zee Plc’s financial statements for the year ended 30 June 20X3 included several retail outlets
and depots with a net book value of £350 million. It has always been company policy to issue its
financial statements in week two of October. However, on 12 July 20X3, one of Bar-Zee’s main
buyers went administration owing Bar-Zee £1.23m and the tax authority over £96m. Over ten years
of trading, Bar-Zee had never made any contingencies for doubtful debt, as all buyers went through
a rigorous vetting process before being granted credit. The company was struck by more bad news
on 15 August. A disgruntled ex-employee had managed to set fire to the company’s main depot and
damage estimated at around £0.975m was caused to the building.

Required
How should Bar-Zee account for these two events in their financial statements for the year ended 30
June 20X3?

Answer
The entry into administration of its main buyers is an adjusting event, although the event occurred after
the reporting period on 12 July. The absence of any provision made and given the immateriality of Bar-
Zee’s debt in comparison to the tax authority means that the debtors’ balance at the end of the reporting
period has been overstated by £1.23m. Therefore the £1.23m debtors’ balance should be written off in
the statement of profit or loss and other comprehensive income for the year ended 30 June 20X3.
The fire damage on 15 August should be reported as a non-adjusting event in the financial
statement. As at 30 June, all the buildings were in existence at £350m. The fire damage should be
reported by way of a disclosure in the financial statements. The reporting of the fire should clearly
state that the event that gave rise to the note was a fire on 15 August 20X3, and it should also
include the estimated cost of damage.

In summary, when a material event occurs at the end of the reporting period prior to the issu-
ance of the financial statement, the route to its treatment in the financial statement is shown
in Figure 4.1.

Material event post-reporting period end but

before issuance of financial statement

The condition of the event existed at The condition of the event arose after
the reporting date. the reporting period.

Adjusting event Non-adjusting event

Figure 4.1 Adjusting or non-adjusting event

 chapter 4  Accounting policies 1 71

6 Fair value measurement (IFRS 13)

The measurement of fair value is addressed in IFRS13 (Fair Value Measurement). Fair value
is an almost pervasive concept embedded in international financial reporting standards. It is
defined as ‘the price that would be received to sell an asset or paid to transfer a liability in an
orderly transaction between market participants at the measurement date’. Fair value is essen-
tially an exit price that is applicable to assets and liabilities. It may be regarded as the cost to
receive a liability or the cost to exit the ownership of an asset. At the heart of the standard is a
hierarchy of fair value and it is non-entity specific based value. The fair value definition is appli-
cable across all other IFRS that requires a measure of fair value with notable exceptions within
IAS 2 (Inventories), IAS 36 (Impairment of assets) and IAS 17(Leases).

6.1 Features of fair value

There are four primary operational features embedded in the definition of fair value.

6.1.1 Asset/liability
When measuring fair value of an asset or liability, the specific characteristics of the item will be
taken into consideration. Consideration will be given to the existing condition of the item, its
location and any restriction on its use or sale. These considerations are not uncommon as they
are already operating when acquiring or disposing of an asset or liability.

6.1.2 Transaction
Transactions are deemed to take place orderly in the principal market for the asset or liability.
An orderly transaction occurs when the item of sale has been exposed to the market for a
reasonable time period that is appropriate for the asset or liability. For example, the disposal of
inventory may need to be exposed to its market for a shorter period than the disposal of land
and buildings. The sale transaction is not a forced sale and sufficient time has been allowed for
participants to conduct their information gathering and search process to establish the competi-
tive price and their willingness to pay.
The principal market is the market where trade for the item normally takes place. For exam-
ple, the principal market for the sale or purchase of equities is the stock market.
In the absence of a principal market, transactions are deemed to occur in the in the most
advantageous market for the asset or liability. The most advantageous market is the market
that would maximise the amount received for the sale of an asset or the exit from a liability. It
should be noted that although any transaction costs are recognised in the determination of the
most advantageous market, transaction costs are not a cost in the determination of fair value.
The transaction costs are invariably a characteristic of the transaction and not the asset or
liability. For example, the cost of transportation is a characteristic of the location of the asset or
liability and not the asset or liability itself.

6.1.3 Market participants

The fair value measurement of an asset or a liability is synonymous to that used by individual
market participants in their pricing of an asset or liability when acting in their own economic
interest. The market participants must satisfy four characteristics:
1. Independent – They must be independent and not related.
2. Knowledgeable – Market participants must possess reasonable understanding of the asset
and liability with respect to all available information.
3. Able to transact – Market participants must be able to engage in the transaction.
4. Willing to transact – Market participants must be willing to engage in the transaction.

6.1.4 Price
Fair value is the price that would be received from the sale of an asset or paid to exit or transfer
a liability in an orderly market transaction in the principal or most advantageous market, at a
measurement date under current prevailing market conditions. This price is an exit price for
the asset or liability and does not need to give any consideration to any other prevailing prices
that may arise from any alternative known or observed or estimated measures.
72 Part two  The preparation and presentation of financial statements

6.2 Fair value hierarchy of inputs

The determination of fair value is based upon on a hierarchy of inputs used by the market par-
ticipants. Three actual levels of inputs are deemed to exist.
Level one inputs exist when there is an active market for the asset or liability with observ-
able quoted prices available. For example, the fair value for office furniture could be established
using inputs from level one because there is an active market for items of office furniture, with
observable and quoted prices readily available in catalogues or obtainable from suppliers of
office furniture. When a market exists with level one inputs, these are used in the determina-
tion of fair value.
Level two inputs arise when there is a need to use adjusted quoted prices as a result of non-
observable prices for the asset or liability and there may not be an active market in existence.
This may be the case for an obsolete item. In such cases adjustments need to be made to pre-
vailing prices for similar or near similar items to derive a fair price.
Level three inputs are non-observable quoted prices used in the determination of fair value.
Such unobservable values may arise from projections or internally generated values by a
company.
In determining fair value, entities should seek to maximise the use of level one inputs and
minimise the use of level three. However, it is noteworthy that a company making use of its
own internally generated values in the determination of fair value is not excluded within IFRS
13. Nevertheless, this practice should not be promoted, as level three is the least reliable and
substantiated input into the fair value determination process.

worked e x amp le   4.7

Louigee Plc is seeking to establish the fair value for several assets and has presented you with the
following information:

a) An item of plant has been valued primarily on the basis of the discounted value of the lost sales
revenue over the next five years.
b) A total of 1,000 ex-rental computers no longer available on the market were valued with
reference to a similar brand of computers.
c) The portfolio of UK equities were valued at the closing price on the last day of trading on the
London Stock Exchange.

You are required to comment on the inputs used to determine the fair value of each item.

Suggested solution
Item (a) has used level three inputs; item (b) has used level two and item (c) has used level one inputs
to derive the respective fair values.
On that basis, the valuation of item (c) has used the most reliable inputs and item (a) the least
reliable inputs to derive their fair values.

6.3 Valuation
IFRS 13 recognises that the objective of using a valuation technique is to estimate the price
at which an orderly transaction to sell the asset or to transfer the liability would take place
between market participants and the measurement date under current market conditions.
The fair value measurement for a non-financial asset is its highest and best use. This should
take into consideration a market participant’s ability to generate economic benefits from their
use of the asset in its highest and best use, whether the asset is used as a standalone item or in
combination with other assets.
Three valuation techniques are recognised and identified in IFRS 13:
1. market approach – uses prices and other relevant information generated by market transac-
tions involving identical or comparable (similar) assets, liabilities or a group of assets and
liabilities (e.g. a business);
 chapter 4  Accounting policies 1 73

2. cost approach – reflects the amount that would be required currently to replace the service
capacity of an asset (current replacement cost); and
3. income approach – converts future amounts (cash flows or income and expenses) to a single
current (discounted) amount, reflecting current market expectations about those future
amounts.

TEST YO UR K N OW LE DG E   4.5

What is the meaning of fair value?

7 Accounting for property, plant and equipment

(IAS 16)
Property, plant and equipment are non-current assets and they are defined in IAS16 as:

tangible items that are held for use in the production or supply of goods or services, for rental
to others or for administrative purposes; and are expected to be used during more than one
period.

For the purpose of clarity and IAS16 provides the definitions for the following terms.
■■ Cost – The amount of cash or cash equivalents paid or the fair value of the other considera-
tion given to acquire an asset at the time of its acquisition or construction or, where appli-
cable, the amount attributed to that asset when initially recognised in accordance with the
specific requirements of other IFRSs.
■■ Impairment loss – The amount by which the carrying amount of an asset exceeds its recover-
able amount.
■■ Carrying amount – The amount at which an asset is recognised after deducting any accumu-
lated depreciation and accumulated impairment losses.
The cost of an item of property, plant and equipment are only recognised as an asset if they
meet the following two conditions:
a) it is probable that future economic benefits associated with the item will flow to the entity;
and
b) the cost of the item can be measured reliably.

7.1 Initial measurement

The measurement to be applied for the initial recognition of property, plant and equipment is
their cost. The initial recognition cost of property, plant and equipment would include the fol-
lowing three elements:
a) the cost price of the asset;
b) any costs that may be required to get the asset to its destination or operational state as
deemed intended; and
c) any estimated costs of dismantling, removing and restoring the site where the asset is
located, providing these cost obligations are incurred on acquisition of the asset.
74 Part two  The preparation and presentation of financial statements

worked e x amp le   4.8

On 28 February 20X3, ZeZe industrial manufacturing company received a formal quotation from a
supplier for a new item of plant which ZeZe’s Production Executive had seen at a recent exhibition.
The detailed quotation read as follows:

£
a) Machinery cost price 350,000
b) Delivery fee 2,750
c) Annual servicing 20,000
d) Installation fee 15,750
e) VAT @ 25% 97,125
f) Total cost 466,200

ZeZe’s financial year end is 31 March and they are VAT registered.

Required
Determine the actual cost of the new plant for the Production Executive in accordance with the
requirements of IAS16.

Solution
The only items of the received quotation that will be included in the cost of the new plant to comply
with IAS 16 is as follows:

a) Machinery cost: £350,000

b) Delivery charge: £2,750
d) Installation fee: £15,750

Thus a total cost of £368,500

The servicing charged is a revenue expense and should be charged to the accounts in accordance
with the accruals concept.
The VAT should not be considered because as a VAT-registered company it is an expense that ZeZe
can recover in its accounting for VAT.

The accounting and reporting for property, plant and equipment is important in financial
reporting because over last two decades there has been some catastrophic corporate failures
centred around fraudulent accounting of property, plant and equipment. One of the least dis-
cussed cases is Waste Management in USA, where over a five-year period a range of inappropri-
ate accounting treatments were used. These included not depreciating their waste collection
vehicles by assigning unsupported and inflated salvage values and extending their useful lives,
and assigning arbitrary residual values to other assets that previously had no residual value.

sto p and t hink  4.1

ZeZe acquired a new plant at a cost of £5m. The legal fees incurred were 1% of the purchase price,
and the combined buildings and contents insurance were £25,650.
What would be the cost that of plant recorded in the books of ZeZe to comply with IAS 16?

a) £5,000,000
b) £5,050,000
c) £5,075,650
 chapter 4  Accounting policies 1 75

7.2 Subsequent measurement

IAS 16 provides us with two methods of measuring property, plant and equipment after its ini-
tial recognition. The two methods are the cost model and the revaluation model.
The cost model measures property, plant and equipment after initial recognition on the basis
of the cost of acquisition less accumulated depreciation and any impairment losses.
The revaluation model measures property, plant and equipment after recognition on the
basis of its fair value revaluation based fair value less any accumulated depreciation and any
impairment losses.
However, when applying the revaluation measurement, it is necessary to take some consid-
erations into account.
When applying the revaluation model to any item of property, plant and equipment, the
revaluation must be applied to the entire class of items. If one item of machinery or one build-
ing is being revalued, then all machinery and buildings must be revalued.
All items of property, plant and equipment in the same class must be revalued at the same
time. This provides consistency in valuation dates and prevents the selective revaluations of
items at sporadic revaluation dates. Furthermore, to ensure that the fair value and the carry-
ing amount of property, plant and equipment are not materially different, revaluations should
be undertaken at sufficient regularity. IAS 16 does not state frequency of property, plant and
equipment revaluation. However, it does state that ‘the frequency of revaluations depends upon
the changes in fair values of the items of property, plant and equipment being revalued’. It is
usually the case that property has a tendency to experience more frequent changes in its fair
value than plant or equipment, therefore the revaluation of property, plant and equipment may
be driven by rate of change in the fair value of property. It may be sufficient to undertake annual
revaluations, but in exceptional circumstances (such as in inflationary or deflationary periods),
a shorter time interval may be selected.

7.3 Revaluation gains and losses

IAS 16 paragraphs 39 and 40 provides guidance on the accounting treatment of any revaluation
gains or losses arising from the revaluation of items of property, plant and equipment.

If an asset’s carrying amount is increased as a result of a revaluation, the increase shall be

recognised in other comprehensive income and accumulated in equity under the heading of
revaluation surplus. However, the increase shall be recognised in profit or loss to the extent
that it reverses a revaluation decrease of the same asset previously recognised in profit or loss.
If an asset’s carrying amount is decreased as a result of a revaluation, the decrease shall be
recognised in profit or loss. However, the decrease shall be recognised in other comprehen-
sive income to the extent of any credit balance existing in the revaluation surplus in respect
of that asset. The decrease recognised in other comprehensive income reduces the amount
accumulated in equity under the heading of revaluation surplus.

worked e x amp le   4.9

Cud-Joe reporting year is 31 March and on 1 April 20X0 purchased a property for £950,000. On 31
March 20X2 the property was revalued at £800,000 and Cud-Joe decided not to sell. On 31 March
20X4, the property was revalued prior to its disposal and it was revalued at £1,050,000. Cud-Joe
always uses the revaluation model for all property, plant and equipment.

Required
a) How should Cud-Joe account for the revaluation of the property in 20X2 and 20X4?
b) What additional advice would you offer the company?
76 Part two  The preparation and presentation of financial statements

worked e x amp le   4.9 continued

Suggested solution
a) 31 March 20X2
The £150,000 decrease should be recognised as an expense in the profit or loss for 20X2.
31 March 20X4
The £100,000 increase should be credited to a revaluation reserve and shown as other
comprehensive income in the statement of profit or loss and other comprehensive income.
b) Cud-Joe should be advised that in compliance with IAS 16, all other property held should have
also been revalued at the same dates.

Any increase in the carrying amount arising from the revaluation of property, plant and equip-
ment is credited to a revaluation reserve and shown reported as other comprehensive income.
Such treatment of an increase in revaluation is to ensure that the revaluation is not treated as
revenue in line with the IAS 18 definition of revenue (see next section). Secondly, as the revalu-
ation has arisen from a non-operating activity, it is not distributable as dividends except in the
exceptional case of a winding-up of the company.

7.4 Depreciation
Depreciation is defined in IAS 16 as the systematic allocation of the depreciable amount of an
asset over its useful life. In addition, IAS 16 provides clarity with the accounting and under-
standing of depreciation with the definition of the following elements of depreciation:
■■ Depreciable amount – ‘the cost of an asset or other amount substituted for cost, less its
residual value’.
■■ Residual value – ‘the estimated amount that an entity would currently obtain from disposal
of the asset, after deducting the estimated costs of disposal, if the asset were already of the
age and in the condition expected at the end of its useful life’.
■■ Useful life – ‘the period over which an asset is expected to be available for use by an entity;
or the number of production or similar units expected to be obtained from the asset by an
entity’.
When depreciating property, plant and equipment, each part of an item of property, plant and
equipment with a cost that is significant in relation to the total cost of the item shall be depre-
ciated separately. A modified extract from the ‘John Lewis annual reports and accounts 2012’
shown below demonstrates this components approach.
Assets in
Land and Fixture course of
buildings and fittings construction Total
Consolidated £m £m £m £m
Cost
At 29 January 2011 3,391.00 1,575.00 230.90 6,771.90
Additions 0.00 1.50 427.90 429.40
Transfers 373.20 194.00 (567.20) 0.00
Disposals (21.50) (174.60) (2.70) (198.80)
At 28 Jan 2012 3,742.70 1,595.90 88.90 7,002.50
Accumulated depreciation
At 29 January 2011 582.20 992.10 0.00 1,574.30
Charges for the year 81.90 159.10 0.00 241.00
Disposals (12.50) (173.70) 0.00 (186.20)
At 28 Jan 2012 651.60 977.50 0.00 1,629.10
Net book value at 28 January
2012 3,091.10 618.40 88.90 3,798.40
 chapter 4  Accounting policies 1 77

The annual depreciation charge is charged to the profit or loss, unless it is included in the car-
rying amount of another asset.

7.5 Depreciation methods

The depreciation methods used to depreciate property, plant and equipment should reflect the
pattern in which their future economic benefits are expected to be consumed by the entity.
The depreciation method applied should be reviewed at least at the end of each financial year
and, if there has been a significant change in the expected pattern of consumption of the future
economic benefits embodied in the asset, the method should be changed to reflect the changed
pattern. Any such a change should be accounted for as a change in an accounting estimate in
accordance with IAS 8. It is necessary to review the useful life and residual values at least once
per annum.
IAS 16 states that ‘a variety of depreciation methods can be used to allocate the depreciable
amount of an asset on a systematic basis over its useful life’. The three methods of deprecia-
tion identified in IAS 16 reflect the consumption pattern of the future economic benefits of the
assets. The methods are:
■■ straight-line method;
■■ reducing balance method; and
■■ units of production method.
The straight-line depreciation charge for an accounting period is the depreciable amount of
property, plant and equipment spread over their useful life. This provides a constant deprecia-
tion charge per accounting period.
The reducing balance depreciation charge for an accounting period is a fixed percentage
applied to the carrying amount of the property, plant and equipment. Unlike the straight-line
method, this method produces a reducing depreciation charge per accounting period.
The units of production depreciation charge for an accounting period is derived by applying
a depreciation consumption rate to the annual level of production. The depreciation consump-
tion rate is determined by spreading the depreciable amount over the asset’s lifetime productive
capacity.

worked e x amp le   4.10

A manufacturing company is planning on purchasing a new machine at the start of the financial
year commencing 1 April 20X4 for £67,876. The machine is expected to produce 120,000 units over
its five-year life span and to have a residual value of £7,876. The production for the five years is as
follows.
In previous years, the company has depreciated similar items using a
Year Units
reducing balance basis.
1 24,000
Required
2 26,000 You are required to calculate the annual depreciation charge for the
3 34,000 life of the new machine using the following depreciation methods:

4 24,000 a) units of production;

b) reducing balance at 40% per annum; and
5 12,000
c) straight line method ay 20% per annum

Answer
Notes to answer:

Depreciable amount = 67,876 – 7,876 = 60,000

78 Part two  The preparation and presentation of financial statements

worked e xamp le   4.10 continued

a) Units of production

The depreciation consumption per unit of production is £0.50

Depreciable amount = £0.50

Units of production
Units of Annual depreciation at £0.50 per unit
Year production £
1 24,000 12,000
2 26,000 13,000
3 34,000 17,000
4 24,000 12,000
5 12,000 6,000

b) Reducing balance
Carrying Annual depreciation at 40% Carrying amount c/f
Year amount b/f £ £
1 67,876 23,757 44,119
2 44,119 15,442 28,678
3 28,678 10,037 18,640
4 18,640 6,524 12,116
5 12,116 4,241 7,876

c) Straight-line method

Depreciable amount
= £12,000 per annum
Life span

IAS 16 also provides clear guidance on the treatment any accumulated depreciation following
the revaluation of property, plant and equipment. IAS 16 states that any accumulated deprecia-
tion at the date of the revaluation should be treated in one of the following ways:
a) Restated proportionately with the change in the gross carrying amount of the asset so that
the carrying amount of the asset after revaluation equals its revalued amount. This method
is often used when an asset is revalued by means of applying an index to determine its
depreciated replacement cost.
b) Eliminated against the gross carrying amount of the asset and the net amount restated to
the revalued amount of the asset. This method is often used for buildings.

T E S T YO UR K N OW L E D G E   4.6

Identify and explain the the three methods of depreciation in IAS 16.

8 Accounting for revenue (IAS 18)

Revenue is often the first figure that readers of financial statements look at. This may be asso-
ciated with the fact that it is the first figure that appears in the statement of profit or loss and
 chapter 4  Accounting policies 1 79

other comprehensive income. Despite its presence in financial statements and reporting, it is
necessary to establish what revenue is. IAS 18 provides an operational definition of revenue:

Revenue is the gross inflow of economic benefits during the period arising in the course of the
ordinary activities of an entity when those inflows result in increases in equity, other than
increases relating to contributions from equity participants.

For the purposes of the preparation of financial statements and the subsequent reporting of
financial statements, it is necessary to understand fully and be able to determine and separate
revenue from all the inflows into an entity. Monies collected or received on behalf of third par-
ties, such as sales taxes or value added taxes, are not economic benefits that flow to the entity
and do not result in increases in equity. Therefore these items should never be included as part
of the revenue of a company’s financial reporting.
This distinction between gross sales and revenue is clearly evident when reading financial
reports such as the John Lewis Partnership plc consolidated income statements. The John Lewis
consolidated income statements (unlike many other companies’ consolidated income state-
ment) begin with the gross sales. The second line of the John Lewis consolidated income state-
ment is the revenue, gross sales less VAT.
In addition to sales tax, where there is an agency relationship such that a company acting as
an agent collects monies on behalf of its principal, the amounts collected on behalf of the prin-
cipal are not revenue. Revenue is only the commission due and payable to the agent.

worked e x amp le   4.11

For the year ended 31 December 20X3, a tour operator’s gross fees from its holiday sold during the
year was £2.4m. The tour operator receives commission equal 35% of holiday sales plus 20% sales
tax from the travel companies.

Required
What is the revenue that the tour operator should recognise in the financial year ended 31
December 20X3?

Suggested solution
Revenue recognised = gross sales × 35%
= £2.4m × 35%
= £768,000

The gross sales less the commission is the money that is collected on behalf of the principal – in this
case, the travel companies.

The sales tax, £153,600, is money repayable to the government and this is also excluded from the
revenue of the tour operator.

IAS 18 provides guidance on the measurement of revenue. Revenue should be measured at the
fair value of the consideration received or receivable. The fair value is the amount for which
an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an
arm’s length transaction. However, in transactions where revenue is deferred, the present value
should be the basis for the revenue measurement.
Revenue therefore only originates from the trading activity of an entity. Other revenue inflows
such as capital injection from the issue of shares or borrowings are not classified as forming part
of an entity’s revenue. Revenue flows from the sale of goods or services. The only other source of
revenue is from the use of the assets of an entity. An example of such a revenue inflow is the roy-
alty or management fee that a franchisee pays to a franchisor for the use of the franchisee’s name.
Although fair value is the deemed measurement basis for revenue, if the revenue is deferred,
the future revenue inflows should be discounted to its present value using an appropriate dis-
count rate to reflect the current expectations of the future periods.
80 Part two  The preparation and presentation of financial statements

worked e x amp le   4.12

Java Plc sells cloud-based accounting and integrated client costing and CRM systems to small
legal practices at the cost of £20,000. Law firms are given the opportunity to pay in three annual
instalments of £8,000 in year one and £6,000 on the anniversary in one and two years’ time
respectively. For the split payment terms, Java’s appropriate discount rate is 7% per annum.
If a new law firm purchases a system on 15 March 20X4, how much revenue should Java
recognise on sale?

Answer
The revenue recognised on 15 March 20X4 is £18,848 as shown below is the present value of the
revenue inflows over the annual anniversaries for the three years.
Students should note that the difference, £1,152, is the notional interest recognised by Java.

Revenue Present value

Date £ Discount factor £
15 Mar 20X4 8,000 1.0000 8,000
15 Mar 20X5 6,000 0.9346 5,608
15 Mar 20X6 6,000 0.8734 5,240
Total 20,000 18,848

Some transactions between parties involve the exchange of similar or dissimilar goods/services,
i.e. a barter or a swap. In such cases there is a two-part test. The test is based upon whether the
goods/services that are the subject of the exchange are of a similar nature and value.
Where the items are similar in nature and value, the exchange is not regarded as a revenue
generating transaction. However, if the items are dissimilar in nature and value, a revenue gen-
erating transaction is deemed to have taken place. In such cases, the revenue is measured at
its fair value basis. The revenue is measured at the fair value of the goods or services received,
adjusted by the amount of any cash or cash equivalents transferred.
When the fair value of the goods or services received cannot be measured reliably, the revenue
is measured at the fair value of the goods or services given up, adjusted by the amount of any
cash or cash equivalents transferred.

8.1 Revenue recognition

The conditions to be satisfied for the recognition of revenue from the sale of goods are different
from the conditions to be satisfied for the sale of services.
IAS 18 outlines the following five conditions that need to be satisfied to enable the recogni-
tion of the sale of goods:
a) the entity has transferred to the buyer the significant risks and rewards of ownership of the
goods;
b) the entity retains neither continuing managerial involvement to the degree usually associ-
ated with ownership nor effective control over the goods sold;
c) the amount of revenue can be measured reliably;
d) it is probable that the economic benefits associated with the transaction will flow to the
entity; and
e) the costs incurred or to be incurred in respect of the transaction can be measured reliably.
The recognition of revenue from the sale of a service must recognise the completion stage of the
service at the end of the reporting period. In addition, four revenue recognition conditions must
be satisfied for the purpose of revenue recognition, as set out in IAS 18:
a) the amount of revenue can be measured reliably;
b) it is probable that the economic benefits associated with the transaction will flow to the entity;
c) the stage of completion of the transaction at the end of the reporting period can be measured
reliably; and
 chapter 4  Accounting policies 1 81

d) the costs incurred for the transaction and the costs to complete the transaction can be
measured reliably.

worked e xamp le   4.13

On 15 September 20X3, a training company with a financial year ended 30 June secured a new
18-month contract to deliver 15 days’ external training from 1 November 20X3 to 30 April 20X5.
The value of the 18-month contract is £324,000.

Required
How should the training company recognise the value of the contract in their financial statements?

Suggested answer
The total contract value of £324,000 is apportioned to each financial year on the basis of the
number of training days within each financial year ended 30 June.
Year ended Income recognised
30 June 20X4 1 Nov 20X3 – 30 Jun 20X4
= 15 × 8 × £324,000
15 × 18
= £144,000

30 June 20X5 = £324,000–144,000

= £180,000
To check 30 June 20X5 = 15 × 10 × £324,000
270
= £180,000
£180,000 + £144,000 = £324,000

9 Accounting for provisions (IAS 37)

Provision is a word commonly found within financial reports – provision for doubtful debt,
annual provision for depreciation and provision for an unknown liability. Examples of provi-
sions for unknown liabilities are monies set aside by UK banks for PPI claims, or the provisions
made by Microsoft several years ago as it awaited the outcome of a US anti-trust court case.
Despite these three forms of reference to provisions in financial statements, IAS 37 provides
clarity on the meaning of a provision.
IAS 37 provides a definition of a provision and the conditions under which it should be rec-
ognised. A provision is defined as ‘a liability of uncertain timing or amount’. It should only be
recognised when all of the following three conditions are satisfied:
a) an entity has a present obligation (legal or constructive) as a result of a past event;
b) it is probable that an outflow of resources embodying economic benefits will be required to
settle the obligation; and
c) a reliable estimate can be made of the amount of the obligation.
IAS 37 is therefore not concerned with a provision for a doubtful debt or annual provision for
depreciation. These are primarily the reduction in an entity’s asset and not a liability. It is not
unusual to have these types of provisions termed as allowances.
A provision is only possible because of a past event that has given rise to the provision. Such
past events are known as obligating events. An example of this is the BP oil spillage off the coast
of the USA.
A past event becomes an obligatory event for an entity if either of the following conditions
are satisfied:
a) the obligation is legally enforceable; or
b) a constructive obligation was created as a result of the event.
82 Part two  The preparation and presentation of financial statements

IAS 37 defines constructive obligation as:

an obligation that derives from an entity’s actions where:

a) by an established pattern of past practice, published policies or a sufficiently specific cur-
rent statement, the entity has indicated to other parties that it will accept certain respon-
sibilities; and
b) as a result, the entity has created a valid expectation on the part of those other parties that
it will discharge those responsibilities.

Furthermore, the requirement for an obligatory event resolves use of the word ‘provision’ in
relation to the provision for a future activity. It is set out in IAS 37 that a provision cannot be
made for an unknown or known future activity or cost.

worked e x amp le   4.14

Zorex Motors sold 24,000 cars during the year to 31 March 20X4. It is customary for the industry
to recall 5% of its sales. A historic trend of recalls has revealed that the cost of recalls exhibit the
following behaviour:

Cars recalled Max repair bill

% €
20 200
25 150
55 100

Required
Calculate the Zorex Motors provision for the year ended 31 March 20X4.

Suggested solution
The provision for the year is as follows:

Recalled cars 24,000 × 5% = 1,200

Cars € €’000
240 200 48
300 150 45
660 100 66
1,200 Total 159

Zorex Motors provision for the year ended 31 March 2004 should be €159,000.

The solution in the above example demonstrates an important feature of the recognition of
a provision as outlined in IAS 37. The amount of a provision should be the best estimate of
expenditure required to settle the present obligation at the end of the reporting period. In Worked
example 4.14, Zorex Motors has historic trend information on the maximum repair costs and
the percentage of recalls within each expenditure class. Therefore this information provides the
best estimate for the computation of the provision. However, it may be questioned whether the
past is any guide to the future. In the absence of any additional information, the available infor-
mation is sufficient to provide the best estimate for the computation of the provision.
The use of the statistical estimation technique, expected value, as applied in Worked example
4.14, is recognised in IAS 37 as applicable to handle uncertainties in the determination of the
provision where there is a large population of data.
Where it is not possible to provide a reliable estimate for a present obligation liability, the lia-
bility must be disclosed as a contingent liability. The inability to determine a reliable measure
of the liability is only one element of a contingent liability. Furthermore, a contingent liability
 chapter 4  Accounting policies 1 83

arises where there is not expected to be any outflow of economic benefits to meet an obligation.
For example, where there is a joint obligation and one part is to be met by a third party, that ele-
ment which a third party meets is a contingent liability. IAS 37 does not permit the recognition
of contingent liabilities in the statement of financial position. IAS 37 states:

unless the possibility of any outflow in settlement is remote, an entity shall disclose for each
class of contingent liability at the end of the reporting period a brief description of the nature
of the contingent liability and, where practicable:
a) an estimate of its financial effect,
b) an indication of the uncertainties relating to the amount or timing of any outflow; and
c) the possibility of any reimbursement.
In addition, for each class of provision, the following disclosures are required:
a) a brief description of the nature of the obligation and the expected timing of any resulting
outflows of economic benefits;
b) an indication of the uncertainties about the amount or timing of those outflows. Where it
is necessary to provide adequate information, an entity shall disclose the major assump-
tions made concerning future events, as addressed in paragraph 48; and
c) the amount of any expected reimbursement, stating the amount of any asset that has been
recognised for that expected reimbursement.

In contrast to a contingent liability, under IAS 37, a contingent asset usually arises from
unplanned or other unexpected events which may give rise to the possibility of an inflow of
economic benefits to the entity. The example from IAS 37 is as follows, a claim that an entity
is pursuing through legal processes, where the outcome is uncertain.
Contingent assets are not recognised in financial statements, as they may give rise to the
recognition of income that an entity may never realise. However, IAS 37 states clearly: ‘when
the realisation of income is virtually certain, then the related asset is not a contingent asset and
its recognition is appropriate.’
In such circumstances, the same disclosure rules are applicable to contingent assets as con-
tingent liabilities.

TEST YO UR K N OW LE DG E   4.7

Outline the conditions that must be satisfied to allow the recognition of a provision.

10 Accounting for intangible assets (IAS 38)

An intangible asset is defined in IAS 38 as ‘an identifiable non-monetary asset without physical
substance’. Embedded in this definition is a complexity of issues for the reporting entity and
the reader of financial reports.
An intangible asset is identifiable when it can be separated from an entity and moved to
another either via sale, transfer, licence or rent. This gives rise to a challenge for the popular
concept of goodwill that generally arises from and is associated with the reputation and status
of the entity, because goodwill is thus not separable from the entity. Goodwill is fully covered
in chapter 7, section 6.1 (p. 148).
Intangible assets by their nature are non-monetary, as monetary assets by definition are finan-
cial assets. Furthermore, intangible assets have no physical substance or existence unlike items
of plant property and equipment, which one is able to view and touch in their physical format.
Underpinning all of the above, intangible assets must meet the base condition for an asset:
the ability to generate future economic benefits to the entity and controllable by entity. This
condition provides clarity or not on whether certain items are creating an intangible asset for
the entity. It is sometimes mooted that, in some sectors, employees are the intellectual prop-
erty of the entity. However, when exposed to the test of entity control, it is self-evident that an
84 Part two  The preparation and presentation of financial statements

entity cannot really exercise any control over the movement of its workforce, irrespective of the
monies spent on their development and the expectation of the entity. However, an entity has
and can exercise control over its trademarks, patents and copyrights.
The recognition of an intangible asset is only possible if satisfies the following two conditions
outlined in IAS 38:
a) it is probable that the expected future economic benefits that are attributable to the asset
will flow to the entity; and
b) the cost of the asset can be measured reliably.
IAS 38 provides guidance on the measurement of intangible assets. The initial measurement
of an intangible fixed asset should be its cost. Its cost is either the cost incurred on acquisition
or the cost incurred in its generation where the intangible asset has been internally generated.
Intangible assets may arise from three sources: acquired separately; via a business combina-
tion; or internally generated. It is the latter that presents the greatest challenge. An individual
acquisition or through a business combination will have resulted in a price being paid for the
asset, therefore the expectation is a future economic benefit will flow to the entity. However, the
internally generated intangible asset presents a greater test, especially as IAS 38 states: ‘inter-
nally generated goodwill shall not be recognised as an asset’ (see page 148, chapter 7). Goodwill
usually arises during the course of a business combination, when one entity acquires another
entity.

10.1 Internally generated intangible assets

To address the problem of internally generated goodwill, IAS 38 requires the separation of inter-
nally generated assets into a research and a development phase.
An intangible asset cannot be born out of the research phase because this is the exploratory
phase when all the planning and investigation occurs. IAS 38 lists examples of the research
phase as follows:
a) activities aimed at obtaining new knowledge;
b) the search for, evaluation and final selection of, and applications of research findings or
other knowledge;
c) the search for alternatives for materials, devices, products, processes, systems or services;
and
d) the formulation, design, evaluation and final selection of possible new or improved
alternatives.
Consequently, all such expenditure is written off as an expense when incurred by an entity.
Activities in the development phase go beyond the foundation-laying activities and as such
can give rise to the generation of an intangible asset. However, an intangible asset is only recog-
nised from the development stage if all of the following conditions are satisfied:
a) The technical feasibility of completing the intangible asset so that it will be available for use
or sale.
b) The entity intends to complete the intangible asset and use or sell it.
c) The entity’s ability to use or sell the intangible asset.
d) The intangible asset will generate probable future economic benefits.
e) The availability of adequate technical, financial and other resources to complete the devel-
opment and to use or sell the intangible asset.
f) The entity can measure reliably the expenditure attributable to the intangible asset during
its development.
If all these conditions are satisfied, the expenditure incurred can be capitalised. However, if any
of these six conditions are not met, the expenditure must be written off as an expense.
 chapter 4  Accounting policies 1 85

worked e x amp le   4.14

Piton Plc spent £900,000 during the year to 30 June 20X4 on two internal projects, Acezar and
Beezar. Acezar consumed 60% of the total expenditure and £216,000 total expenditure was
incurred on pure research plus an additional £18,000 was spent on staff training. The remainder of
Acezar’s expenditure was applied to the development phase. The expenditure on Beezar was for the
development phase of a prototype. However, new information has cast a doubt over whether Piton
Plc will be able to sell the Beezar.

Required
How should Piton Plc account for the £900,000 expenditure on:

a) Acezar
b) Beezar?

Suggested solution
a) Acezar

£900,000 × 60% = £540,000

R & D 216,000
Staff Training 18,000 excluded from development phase
————
Total 234,000
————
Residual 306,000

Piton should write-off the £234,000 to its statement of profit or loss and other comprehensive
income for the year ending 30 June 20X4.
The residual £306,000 should be capitalised and recognised as an intangible asset if Acezar can
satisfy all the six conditions.
If all the six conditions are not satisfied, the £306,000 should also be expensed to its SOCI for the
year to 30 June 20X4.

b) Beezar

£900,000 × 40% = £360,000

The expenditure on Beezar should not be capitalised and recognised as an intangible asset if Piton
Plc cannot meet the six conditions of the development phase, including if the item cannot be
used internally or sold.
If Piton Plc cannot sell the asset, but can use it internally and it will generate future economic
benefits to the company, the £360,000 should be capitalised and Beezar recognised as an
intangible asset for the year ended 30 June 20X4.
The uncertainty of a possible sale is not sufficient on its own to prevent Beezar from being
classified as an intangible asset. IAS 38 provides for an entity’s ability to sell or use the asset
internally among its six conditions test at the development phase.

Similar to IAS 16, IAS 38 outlined the same two models for the subsequent measurement of
an intangible asset. Furthermore, the guidance for the accounting treatment of revaluation for
gains or losses of an intangible asset is identical to the treatment for property, plant and equip-
ment outlined in IAS 16.
86 Part two  The preparation and presentation of financial statements

worked e x amp le   4.15

During the accounting period ended 31 December 20X4, Zolvix plc spent £265,000 on research and
development costs of a new multimedia project as follows:

a) Feasibility study: £30,000

b) Overhead costs: £50,000
c) Domain name: £10,000
d) Software development: £75,000
e) Maintenance costs: £25,000
f) Web page development: £40,000
g) Administration costs: £35,000

Required
How should the £265,000 research and development costs be accounted for in Zolvix plc financial
statement at the end of the accounting period 31 December 20X4?

Suggested solution
The following £140,000 research and development costs should be charged to the statement of
profit or loss and other comprehensive income:

a) Feasibility study: £30,000

b) Overhead costs: £50,000
c) Maintenance costs: £25,000
d) Administration costs: £35,000

The residual £125,000 of research and development costs should be capitalised and recognised as
intangible assets in the statement of financial position, if each item can satisfy all six conditions set
out in IAS 38.

a) Domain name: £10,000

b) Software development: £75,000
c) Web page development: £40,000

If any of the six conditions cannot be satisfied by any of the above three items, they should also be
charged to the statement of profit or loss and other comprehensive income.

sto p and t hink  4.2

What were the two models for the subsequent measurement of property, plant and equipment
identified in IAS 16?

IAS 16 provides for the depreciation of property, plant and equipment. However, IAS 38 does
not provide for the depreciation of intangible assets. Instead, intangible assets are amortised.

10.2 Amortisation
Amortisation is the equivalent to the depreciation of property, plant and equipment, but for
intangible assets. Amortisation is defined as the systematic allocation of the depreciable amount
of an intangible asset over its useful life. However it is only applicable to intangible assets with
finite lives. Therefore it is necessary to be able to determine the useful life of an intangible asset.
IAS 38 set out a list of seven factors to be considered and assist in the process of determination
of the useful life of a finite intangible asset. The list from IAS 38 is set out below:
 chapter 4  Accounting policies 1 87

a) the expected usage of the asset by the entity and whether the asset could be managed effi-
ciently by another management team;
b) typical product life cycles for the asset and public information on estimates of useful lives
of similar assets that are used in a similar way;
c) technical, technological, commercial or other types of obsolescence;
d) the stability of the industry in which the asset operates and changes in the market demand
for the products or services output from the asset;
e) expected actions by competitors or potential competitors;
f) the level of maintenance expenditure required to obtain the expected future economic ben-
efits from the asset and the entity’s ability and intention to reach such a level;
g) the period of control over the asset and legal or similar limits on the use of the asset, such
as the expiry dates of related leases; and
h) whether the useful life of the asset is dependent on the useful life of other assets of the
entity.
The determination of whether an asset has a finite or indefinite life is determined by whether
there is a foreseeable limit to the period over which the asset is expected to generate net cash
inflows for the entity. Where there is no foreseeable limit, the intangible asset will be deemed to
have an indefinite life. Conversely, all other assets will have a definite useful life, as there will
be a foreseeable limit to the period over which the asset is expected to generate net cash inflows
for the entity.
It suffices to assert that the accounting for amortisation mirrors that of depreciation account-
ing for plant, property and equipment. The useful life of an intangible asset that is not being
amortised shall be reviewed each period to determine whether events and circumstances con-
tinue to support an indefinite useful life assessment for that asset. Any change in the useful
life assessment from indefinite to finite shall be accounted for as a change in an accounting
estimate in accordance with IAS 8.

TEST YO UR K N OW LE DG E   4.8

When can an entity capitalise its expenditure on research and development?

? END OF CHAPTER QUESTIONS

4.1 Alibi Ltd bought (and capitalised as a non-current and a deposit of £38,211 paid to the lessor. The
asset) an ‘off-the-shelf’ computer system at initial direct cost incurred in negotiating the lease
a cost of £1 million. A few months later, the amounted to £4,000.
manufacturer dropped the price of the same The lease agreement provides for four equal
system to £700,000. payments of £230,010 due on 31 December
What accounting action should Alibi Ltd take as a annually, with the first payment due on 31
result of this action? December 20X3. The fair value of the machine
a) Increase the depreciation of the computer on 1 January 20X3 was £800,000. The estimated
system. useful life of the machine is four years.
b) Impair the carrying amount of the computer Ken Wood is expected to insure and maintain
system. the printing machine over the lease period. Ken
c) Recognise the reduction as an impairment Wood’s similarly owned assets are depreciated
indicator and carry out an impairment test. on a straight-line basis. The implicit interest rate
d) No action required. within the lease is 8%.
4.2 Reporter plc, a newspaper publisher, entered into
Required
a four-year lease agreement with Admac plc for
Using the information given above, calculate the
a printing machine on 1 January 20X3, on which
amounts to be shown in the financial statements
date the machine being leased was delivered
88 Part two  The preparation and presentation of financial statements

? END OF CHAPTER QUESTIONS

of Reporter plc for the years ended 31 December uncovered a fraud that had taken place,
20X3 and 20X4. which had resulted in errors in the financial
4.3 The broad principles of accounting for tangible statements for the year to 31 December 20X2.
non-current assets involve distinguishing between The company’s sales had been overstated by
capital and revenue expenditure, measuring the £150,000 as a result of several ex-employees’
cost of assets, determining how they should attempts to manipulate their bonus payments,
be depreciated and dealing with the problems and a non-approved supplier had been paid
of subsequent measurement and subsequent for an invoice totalling £45,500. The retained
expenditure. IAS 16 ‘Property, plant and earnings at 31 December 20X1 were £85,000.
equipment’ seeks to improve consistency in these A draft of an extract from the statement of
areas. profit or loss and other comprehensive income for
the year to 31 December 20X3 is shown below.
Required
Explain: 20X3 20X2
a) how the initial cost of tangible non-current £,000 £,000
assets should be measured; and
Sales 850 750
b) the circumstances in which subsequent
Cost of goods sold 365 300
expenditure on those assets should be
capitalised. Gross profit 485 450
4.4 Alphabet Ltd secures a long-term loan agreement Expenses 460 335
from its bankers. The purpose of the loan is to Pre-tax profit 25 115
invest in the land and buildings owned by the
Taxation @ 20% 5 23
company to bring them within the requirements
of the relevant health and safety legislation. Profit after taxation 20 92
The loan is for £1.5 million over 13 years with Dividends distribution 5 12
an annual payment (in arrears) of £170,000;
a) Produce a revised statement of profit or
however, the final payment in year 13 will be a
loss and other comprehensive income for
reduced amount of £154,396. The implied rate of
the year to 31 December 20X3 after the
interest is 5%.
amendment showing a restatement of
Required the statement of profit or loss and other
Prepare a schedule of repayments clearly showing comprehensive income for the year to 31
capital and interest payments and the balance December 20X2.
reducing after each annual payment. b) Show the closing retained earnings as at 31
4.5 Explain the difference between an adjusting and December 20X3.
a non-adjusting event to comply with IAS 10.
4.6 During the preparation of the financial statement
for the year ended 31 December 20X3, Simpark
Accounting policies 2 5
■■ Contents
1. Introduction
2. Income taxation (IAS 12)
3. Accounting for leases (IAS 17)
4. Financial instruments (IAS 32 / IFRS 7)
5. Earnings per share (IAS 33)
6. Impairment of assets (IAS 36)
7. Non-current assets held for sale and discontinued operations (IFRS 5)
8. Operating segments (IFRS 8)

■■ Learning outcomes
At the end of this section, students will be able to:
■■ demonstrate an understanding of accounting for property, plant and equipment including
accounting for depreciation and accounting for impairment;
■■ demonstrate the way in which leasing arrangements may be exploited to access the advan-
tages of off-statement of financial position finance;
■■ outline and evaluate proposals designed to counter opportunistic behaviour by management
when accounting for leases;
■■ distinguish between the economic substance and the legal form of a business transaction;
■■ report in the statement of profit or loss and other comprehensive income the impact of dis-
continued operations;
■■ show an understanding of the appropriate methods for valuing assets and liabilities;
■■ explain the importance of segmental information and be able to prepare a segmental report;
■■ demonstrate familiarity with the nature of accounting policies, the significance of differences
between them and the effects of changes in accounting policy;
■■ demonstrate an awareness of the steps entities might take to improve their accounts so as,
for example, to reduce the reported gearing ratio, increase the published EPS, and strengthen
the statement of financial position;
■■ reveal a full understanding of the opportunities for subjectivity and creative accounting when
preparing financial reports;
■■ show familiarity with the role of the audit in countering creative accounting practices;
■■ show an understanding of the treatment of inventories in financial statements; and
■■ explain what is meant by off-statement of financial position finance and understand its
significance.

1 Introduction
This chapter will examine seven additional accounting policies with reference to the appropri-
ate international accounting standards to enable a greater understanding of the financial state-
ments. The accounting policies that will be discussed throughout this chapter are as follows:
■■ Income taxes
■■ Lease
■■ Financial instruments
■■ Earnings per share
■■ Impairment of assets
■■ Non-current assets held for sale and discontinued operations
■■ Operating segments
90 Part two  The preparation and presentation of financial statements

2 Income taxation (IAS 12)

Taxation and the level of income tax paid by entities has become a global subject in recent years,
particularly after the financial crisis that began in 2007. Even before this increase in profile,
taxation was recognised as an important issue by those who prepare financial statements and
those who rely on them.
UK readers may be familiar with the distinction in the UK tax system between income tax
(which is levied upon individuals) and corporation tax (which is levied on companies). However,
for our purposes, when we refer to ‘income tax’ we are referring to the taxation levied on the
profit of an entity, rather than the narrower UK interpretation of income tax.
This fits with the definition provided in IAS 12. Current tax is defines as ‘the amount of
income taxes payable (recoverable) in respect of the taxable profit (tax loss) for a period’.
It should be noted that the taxable profit (loss) for a period is not synonymous with the
accounting profit (loss) for a period. IAS 12 provides guidance on this matter and defines taxable
profit (tax loss) as ‘the profit (loss) for a period, determined in accordance with the rules estab-
lished by the taxation authorities, upon which income taxes are payable (recoverable)’.
Income tax is an expense that, in accordance with IAS 1, is reported within the statement of
profit or loss and other comprehensive income. Any income tax unpaid at the end of the period
is reported as a liability in the statement of financial position.

worked e x amp le   5.1

A global company generated an accounting profit of £900,000 in the period ended 30 September
20X4. The accounting profit for the period included £25,000 of expenditure, which is not allowable
for income tax purposes and excluded £150,000 expenditure on plant, property and equipment,
which is an allowable income tax expense for this year only. During the year, the company made four
quarterly income payments of £25,000 each. The prevailing income tax rate in the region is 20%.
Required
Calculate the following for the company:

a) the income tax liability for the year; and

b) the income tax liability reported in the statement of financial position.
Suggested solution
a) The income tax liability for the year is £155,000. The computation is as follows.
£
Accounting profit 900,000
Plus non tax deductible expense 25,000
Less expenditure on PPE (150,000)
Taxable profit 775,000
Annual income tax @ 20% 155,000

This is the amount that is shown in the company’s statement of profit or loss and other
comprehensive income.

b) The income tax liability that is reported in the statement of financial position is the total income
tax that is still unpaid due and payable at the end of the year. The income tax unpaid at the year
end reported in the statement of financial position is £55,000. The computational workings are as
follows:

£
Income tax liability for the year 155,000
Income tax paid £25,000 × 4 100,000
Income tax unpaid at year end 55,000
 chapter 5  Accounting policies 2 91

As previously stated and demonstrated in Worked example 5.1, an entity’s tax payable for an
accounting period is always based upon its taxable profit and not its accounting profit.
Accounting profit is profit or loss for a period before deducting tax expense. Please note that
IAS 12 defines accounting profit as a before-tax figure (rather than the more common after tax
figure), to remain consistent with the definition of a taxable profit.
Taxable profit (or taxable loss) is the profit (or loss) for a period determined in accordance
with the rules established by the taxation authorities upon which income taxes are payable.
The differences between accounting and taxable profit arise from two sources:
1. The statement of profit or loss and other comprehensive income will include ‘disallowable
items’. These are expenses incurred but not allowable for taxation purposes. These items
generate what is known as a ‘permanent difference’ between accounting and taxable profit.
Permanent differences are not reversed in any future accounting periods.
2. There may be items in the statement of profit or loss and other comprehensive income that
incur a different treatment for accounting purposes than the treatment they receive for taxa-
tion purposes. The most common example is the treatment or accounting for non-current
assets. For accounting purposes, depreciation is applied to non-current assets, but for income
taxation purposes, capital allowances are applied. No adjustment is required if depreciation
charges and capital allowance charges are the same. However, they do often differ. These
differences give rise to ‘temporary differences’. Temporary differences are reduced to nil over
the life of an asset, but the financial statements will reflect the differences between the two
treatments at reporting date. The annual distortion from temporary differences will impact
upon any accounting ratio that utilises the post-tax figure (see Chapter 10), and if not
adjusted, would give an incorrect impression of performance. Deferred tax is an account-
ing measure used to match the tax effect of transactions with their accounting impact and
thereby produce less distorted results.

2.1 Deferred tax

In accordance with IAS 12, deferred tax is the amount of income tax payable in future periods
in respect of taxable temporary differences. This can be illustrated with the following worked
example.

worked e x amp le   5.2

A company purchased an item of plant on 15 July 20X0 for £300,000. The prevailing national
company tax legislation allows a company to write off £500,000 of expenditure on property, plant
and equipment in the year of purchase. The company results for the three years to 30 June 20X3
produced the following results:
20X3 20X2 20X1
£,000 £,000 £,000
Pre-tax profit 500 500 500
Annual depreciation charge 100 100 100
Capital allowances 0 0 300

With a corporation tax rate of 25%, the following results will arise:

20X3 20X2 20X1

£,000 £,000 £,000
Taxable profit (W1) 600 600 300
Pre-tax profit 500 500 500
Tax @ 25% 150 150 75
Post-tax profit 350 350 425
92 Part two  The preparation and presentation of financial statements

worked e x amp le   5.2 continued

W1 Taxable profit is the pre-tax profit plus the annual depreciation charge. The annual depreciation
charge is not a tax deductible expense, therefore it must be added back to the pre-tax profit to
enable the derivation of the taxable profit.
In 20X1, the pre-tax profit is £300,000 because the total amount of the cost of acquisition is a tax
deductible expense.

Worked example 5.2 demonstrates the impact of the temporary timing differences. Over the
three years, despite the company pre-tax profits and annual depreciation charges being con-
stant, the company has shown a reduced level of post-tax profit.
It is evident that this distortion has been the result of the temporary difference as a result of
the different accounting and taxation treatment of the new plant purchased in 20X0–X1. The
temporary differences between the accounting and taxation treatment of property, plant and
equipment in accordance with IAS 12 is accounted for as follows:
a) When there is a periodic temporary difference that gives rise to a taxable profit greater than
the accounting profit, the income tax reported in the statement of profit or loss and other
comprehensive income should be reduced by a transfer from the deferred tax account.
b) Conversely, when there is a periodic temporary difference that gives rise to a taxable profit
less than the accounting profit, the income tax reported in the statement of profit or loss
and other comprehensive income should be increased by a transfer to a deferred tax account.

Tax base
Under IAS 12, at the end of each reporting period, the tax base and carrying amount of each
asset and liability should be calculated. A deferred tax adjustment will be required when the tax
base and carrying base are not equal.
The tax base of an asset/liability is defined in IAS 12 as ‘the amount attributed to that asset
or liability for tax purposes’. The carrying amount is the amount shown for each item in the
financial statements.
The differences between the two bases are temporary differences in accordance with the fol-
lowing definitions as set out in IAS 12, where it states that temporary differences are differences
between the carrying amount of an asset or liability in the statement of financial position and
its tax base. Temporary differences may be either:
a) taxable temporary differences, which are temporary differences that will result in taxable
amounts in determining taxable profit (tax loss) of future periods when the carrying amount
of the asset or liability is recovered or settled; or
b) deductible temporary differences, which are temporary differences that will result in
amounts that are deductible in determining taxable profit (tax loss) of future periods when
the carrying amount of the asset or liability is recovered or settled.

worked e x amp le   5.3

Yazzu plc’s statement of financial position for the year ended 31 December 20X3 had plant at a cost
of £50,000 and accumulated depreciation to date of £24,000. The written-down value of the plant
for tax purposes was £16,000. The plant had a residual value of nil at the end of its useful life. The
prevailing tax rate is 25%.

Required
a) Determine the carrying amount of the plant as at 31 December 2013.
b) Determine whether a temporary tax difference exists.
c) Calculate the level of any deferred tax.
 chapter 5  Accounting policies 2 93

worked e x amp le   5.3 continued

Suggested solution
£
a) Plant at cost 50,000
Accumulated depreciation 24,000
Carrying amount 26,000
b) Tax base 16,000
Temporary difference (26,000 – 16,000) 10,000
c) Tax at 25% 2,500

TEST YO UR K N OW LE DG E   5.1

What is deferred tax?

3 Accounting for leases (IAS 17)

A lease is a legal contract between a supplier (lessor) of an item and a user of an item (lessee).
IAS 17 defines a lease as ‘an agreement whereby the lessor conveys to the lessee in return for a
payment or series of payments the right to use an asset for an agreed period of time’.
A lease may be classified as a finance lease or an operational lease and IAS 17 provides us
with a definition of each type.
A finance lease is a lease that transfers substantially all the risks and rewards incidental to
the ownership of an asset. Title may or may not eventually be transferred.
An operating lease is a lease other than a finance lease. The classification of a lease as
‘finance’ or ‘operating’ is determined not by the contract but by the substance of the contract.
In essence, the transfer of ‘risks and rewards’ to the lessee is the principal difference between
a finance and operational lease. This will also determine the differences in accounting for two
types of leases. IAS 17 provides us with several conditions when a finance lease would come
into existence. Only one of these conditions needs to be satisfied for a finance lease to exist:
a) the lease transfers ownership of the asset to the lessee by the end of the lease term;
b) the lessee has the option to purchase the asset at a price that is expected to be sufficiently
lower than the fair value at the date the option becomes exercisable for it to be reasonably
certain, at the inception of the lease, that the option will be exercised;
c) the lease term is for the major part of the economic life of the asset even if title is not
transferred;
d) at the inception of the lease the present value of the minimum lease payments amounts to
at least substantially all of the fair value of the leased asset; or
e) the leased assets are of such a specialised nature that only the lessee can use them without
major modifications.

TEST YO UR K N OW LE DG E   5.2

Outline the difference between an operational and a finance lease.

94 Part two  The preparation and presentation of financial statements

3.1 Accounting for leases

The principal difference between an operational and a finance lease is the transfer of risks and
rewards associated with ownership to the lessee under a financial lease. This therefore reflects
in the accounting for each lease.

3.2 Operational lease

The lessee does not have any of the risks or rewards associated with ownership and is solely
making payments to the lessor for use of the item for a period of time. As a result, the lease
payments by the lessee are an expense over the term of the lease on a straight-line basis.

3.4 Financial lease

Legally, a finance lease is a rental agreement. However, if the substance of the agreement means
the lessee has access to the risks and rewards of the asset, the asset is recognised in the lessee’s
own accounts. The item is shown in the lessee’s financial statements as an asset and the out-
standing debt to the lessor is shown in the lessee’s financial statements as a liability.
However, the potential problem of the asset and liability valuation is resolved in IAS 17
because the guidance provides that at the valuation at the start of the lease term, the lessee
should recognise the asset and liability in their statement of financial position at the lower of
the fair value of the leased item or the present value of the minimum lease payments. In cal-
culating the present value of the minimum lease payments, the discount factor to be used is
the interest rate implicit in the lease, where practicably determinable. Where this may not be
determinable, then the lessee’s incremental borrowing rate shall be used.
In addition, any initial direct costs of the lessee should be added to the amount recognised as
an asset. It is wholly incorrect and unacceptable to net off the lease liability against the leased
asset in the financial statements. The asset and liability arising from any finance lease agree-
ment must be shown under its appropriate class in the financial statements.
Guidance already exists in the form of IAS 16, regarding how to account for the depreciation
of an asset that arises from a financial lease. Guidance on the accounting for the finance charge
is provided in IAS 17: ‘the finance charge shall be allocated to each period during the lease term
so as to produce a constant periodic rate of interest on the remaining balance of the liability.’ In
addition, lAS 17 allows for the use of some form of approximation.
The lessee may choose to adopt a straight-line basis and apply the lease payments evenly over
the term of the lease. However, such practice is not wholly realistic, because one would expect
the lease payments to decline as the liability to the lessor is reduced.
A more practical and realistic technique is the sum of digits method. This exhibits traits of
the reducing balance method of depreciation as the annual finance charge applied declines each
year.

worked e x amp le   5.4

A company acquired an item of plant on a finance lease on 1 July 20X0 and its fair value was
£300,000. The company are required to make five annual lease payments of £76,489 each
commencing on 30 June 20X1 and annually thereafter.

Required
You are required to calculate the annual finance charge payable over lease term by the lessee using
the sum of digits and straight-line methods.
 chapter 5  Accounting policies 2 95

worked e x amp le   5.4 continued

Solution
The total repayment is £76,489 × 5 = 382,445

Fair value = £300,000

Total finance charge = 382,445 – 300,000

= 82,445
a) Sum of digits:

Year ended Finance charge apportionment Finance charge

£ £
5 30 Jun X1 5/15 × 82,445 27,482
4 30 Jun X2 4/15 × 82,445 21,985
3 30 Jun X3 3/15 × 82,445 16,489
2 30 Jun X4 2/15 × 82,445 10,993
1 30 Jun X5 1/15 × 82,445 5,496
15 82,445

The sum of digits method requires the summation of the number of annual payments (or, in the
case of depreciation, the life of the non-current asset). In this case that means 15 years derived
from the summation of five yearly payments as follows: 1 + 2 + 3 + 4 + 5 = 15. The sum of the
individual years is regarded as the total parts of lease payments.
Each year, from the first year to the last year, the lease payments will be discharged in a
decreasing manner, with the largest payment being in the first year and the smallest payment in
the final year.
This is achieved by dividing each year (beginning with the final year) by the total number of
years multiplied by the total lease payments.

We therefore achieve this as follows:

Year 1 5/15 × lease payments

Year 2 4/15 × lease payments
Year 3 3/15 × lease payments
Year 4 2/15 × lease payments
Year 5 1/15 × lease payments

Therefore the general rule is:

Year 1: nth year / total number of years × lease payments

Year n: 1 / total number of years × lease payments

b) Straight-line method

Total finance charge

—————————
=
Term of lease (years)

£82,445
————
=
5
= £16,489 per year
96 Part two  The preparation and presentation of financial statements

The ‘fair value’ of an asset (usually the price of the asset if purchased outright) is capitalised
(debit entry) and also recorded as a liability (credit entry).
The problem concerns the accounting treatment of the lease payments, as these comprise
two elements:
1. the payment of the cash price; and
2. the interest charged by the lessor (the ‘interest rate implicit in the lease’).
That is, the lessor will charge rentals that are sufficient to cover repayment of the capital, in
stages, and charge interest at a given rate on the balance of capital outstanding. As lease pay-
ments progress, the interest element therefore diminishes and the capital repayment element
increases – it works like a repayment mortgage or an annuity.
The allocation of lease payments is shown in Figure 5.1.

Fair value
Rental
(cash price)

Statement of
Capital element Revenue element
financial position

Statement of profit or loss and

Asset Liability
other comprehensive income

Figure 5.1: Allocation of lease rental payments

Calculations based on:
■■ actuarial method
■■ sum of digits
■■ straight line.

worked e x amp le   5.5

Alpha Ltd leases a machine to Beta Ltd on 1 January 20X1.

Beta Ltd makes four annual payments of £35,000 commencing 1 January 20X1.
Alpha Ltd sells the machine for cash: £108,728.
The life of a fixed asset is estimated at four years and the residual value as zero.
The rate of interest implicit in the rental payments is 20%.

Required:
Show how these transactions are to be recorded in the books of the lessee, Beta Ltd.

Suggested solution
The rental payments may be split between interest and capital as follows:

20X1 20X2 20X3 20X4

£ £ £ £
1 Total outstanding, 1 January 108,728 88,473 64,167 35,000
2 Rental paid, 1 January 35,000 35,000 35,000 35,000
73,728 53,473 29,167 0
3 Interest expense for year, 20% 14,745 10,694 5,833
4 Total outstanding, 31 December 88,473 64,167 35,000
 chapter 5  Accounting policies 2 97

worked e x amp le   5.5 continued

Statement of profit or loss and other comprehensive income entries, 31 December

20X1 20X2 20X3 20X4

£ £ £ £
Depreciation charge 27,182 27,182 27,182 27,182
Interest expense 14,745 10,694 5,833 0

Statement of financial position entries, 31 December

20X1 20X2 20X3 20X4

£ £ £ £
Machine at cost 108,728 108,728 108,728 108,728
Less: Accumulated depreciation 27,182 54,364 81,546 108,728
81,546 54,364 27,182 0
A Ltd. – lease creditor 88,473 64,167 35,000 0
The lease creditor should be separated as follows:

Current liability 35,000 35,000 35,000

Non-current liability 53,473 29,167 0
88,473 64,167 35,000

4 Financial instruments (IAS 32 / IFRS 7)

As the banking collapse of the first decade of this century showed, financial instruments are not
only very technical but can result in financial catastrophe if misused and misunderstood. The
former Governor of the Bank of England was attributed with the statement:

the most alarming fact that arose when the system collapsed was the fact that some banking
and financial institutions only then began to understand the complex financial instruments
in which they had invested, as they literally collapsed overnight!

IAS 32 seeks to provide clarity where none previously existed and defines a financial instrument
as follows: ‘any contract that gives rise to a financial asset of one entity and a financial liability
or equity instrument of another entity.’ This is further enhanced by the defining of a financial
asset as any asset that is:
a) cash;
b) an equity instrument of another entity; or
c) a contractual right to receive cash or another financial asset from another entity or to
exchange financial assets or financial liabilities with another entity under conditions that
are potentially favourable to the entity.
Consequently, it is self-evident that virtually all business transactions give rise to a financial
instrument, from a cash or credit sale to the raising of capital via new issues.
Conversely, a financial liability is defined as any liability that is ‘a contractual obligation
to deliver cash or another financial asset to another entity; or to exchange financial assets or
financial liabilities with another entity under conditions that are potentially unfavourable to
the entity’.
Financial instruments may be further separated into equity instruments or liabilities. A
financial instrument is only an equity instrument if the following two conditions are fully
satisfied:
98 Part two  The preparation and presentation of financial statements

a) The instrument includes no contractual obligation:

(i) to deliver cash or another financial asset to another entity; or
(ii) to exchange financial assets or financial liabilities with another entity under conditions
that are potentially unfavourable to the issuer.
b) The instrument will or may be settled in the issuer’s own equity instruments.
This definition of equity instrument provides a clarity that enables a clear separation of items
commonly considered within a single group. For example, ordinary shares and preference shares
are by definition not in the same class, on account of the simple fact that a preference share
imposes a contractual obligation to deliver cash in the future renders it a liability and not an
equity instrument.

sto p and t hink  5.1

Explain why a credit sale and a credit purchase give rise to a financial instrument.

4.1 Variations in issue value, redemption value and coupon rate

The accounting treatment of capital instruments sometimes needs to reflect the following
circumstances:
■■ Where the issue proceeds are less than nominal value due to the issue having being made at
a discount and/or because there are material issue costs which, in accordance with required
practice, must be deducted from issue proceeds (see Worked example 5.6).
■■ Where interest is payable in some years but not in others.
■■ Where interest is payable at different rates in different years (see Worked example 5.7).
In all cases, the difference between the net issue proceeds and the amount payable to the sup-
plier of debt finance represents the total interest cost which must be allocated between years in
order to achieve the two following objectives:
1. Interest must be charged at a constant rate based on the carrying amount – that is, the
actuarial method must be applied.
2. At the debt redemption date, the carrying amount must be equal to the amount payable at
that time.

worked e x amp le   5.6

On 1 January 20X0, Bergerac plc issues a debt instrument for £475m which is repayable at its
nominal value of £500m at the end of four years. Interest is payable at 8% per annum on nominal
value and the costs incurred in issuing the securities, a total of £30m. The effective rate of interest –
annual payment plus amortisation of discount on the issue price – is 11.59%.

Required:
Calculate for each of the years 20X0–X3:

a) the annual finance charge to be debited to the statement of profit or loss and other
comprehensive income; and
b) the carrying value of the liability in the statement of financial position.

Note: Calculations should be to the nearest £0.1m.

 chapter 5  Accounting policies 2 99

worked e x amp le   5.6 continued

Answer
Interest charge in the Amortisation
Interest statement of profit or loss of discount Carrying value
paid, and other comprehensive and issue in the statement of
8% income, 11.59% costs financial position
Year £m £m £m £m
445.0
20X0 40.0 51.6 11.6 456.6
20X1 40.0 52.9 12.9 469.5
20X2 40.0 54.4 14.4 483.9
20X3 40.0 56.1 16.1 500.0

worked e x amp le   5.7

On 1 January 20X0, Castlenaud plc issues non-equity shares for £50m which are redeemable for the
same amount at the end of ten years. Dividends are payable of £4m per annum for the first three
years, £5m for the next three years and £6.5m for the remaining four years. The actuarial rate of
return over the issue period is 10.06%.

Required:
Calculate for each of the years 20X0–20X9:

a) the annual amount to be debited to the statement of profit or loss and other comprehensive
income; and
b) the carrying value of the non-equity shares in the statement of financial position.

Note: Calculations should be to the nearest £m.

Answer
a) b)
Interest charge in Carrying
the statement of value in the
profit or loss and Adjustment statement
Interest other comprehensive to carrying of financial
paid income, 10.06%* value position
Year £m £m £m £m
50.0
20X0 4.0 5.0 1.0 51.0
20X1 4.0 5.1 1.1 52.2+
20X2 4.0 5.2 1.2 53.4
20X3 5.0 5.4 0.4 53.8
20X4 5.0 5.4 0.4 54.2
20X5 5.0 5.5 0.5 54.6
20X6 6.5 5.5 (1.0) 53.6
20X7 6.5 5.4 (1.1) 52.5
20X8 6.5 5.3 (1.2) 51.3
20X9 6.5 5.2 (1.3) 50.0
* The non-equity shares meet the definition of a liability – obligation to transfer economic resources
– so return on the securities should be charged to the statement of profit or loss and other
comprehensive income above the line.
+ Difference due to rounding.
100 Part two  The preparation and presentation of financial statements

IAS 32 does not address the recognition or measurement of financial instruments. These are
embodied in IAS 39, where the initial measurement for financial assets and liabilities should be
measured at fair value. IAS 39 provides four classifications of financial assets after their initial
recognition. These four classes are reduced to just two by IFRS 9. The two classes of financial
assets are those measured at amortised cost and those measured at fair value. The classifica-
tion into these two classes should take place when the financial asset is initially recognised.
After its initial recognition, IFRS 9 confirms IAS 39 two measurement classification of fair
value through profit or loss (FVTPL) and amortised cost. Financial liabilities held for trading
are measured at FVTPL, and all other financial liabilities are measured at amortised cost unless
the fair value option is applied.
IAS 32 requires the interest and dividends payable to financial instruments to be recog-
nised as an expense in an entity’s statement of profit or loss and other comprehensive income.
Consequently, unpaid dividends to preference shareholders are deemed to be accrued expenses.

5 Earnings per share (IAS 33)

Earnings per share is a ratio used to analyse the comparative performance of an entity and/or
groups of entities. The use of EPS to compare performance of different entities requires that the
measure is calculated the same way each time to ensure consistency.
To this end, IAS 33 provides a prescriptive measurement for users and readers of financial
statements. The basic earnings per share is a ratio calculated as follows: the profit or loss attrib-
utable to ordinary equity holders of the parent entity divided by the weighted average number of
ordinary shares outstanding during the period. Earnings per share is calculated as follows and
is examined in greater depth in chapter 10, section 6.1.

Earnings
No of equity shares in issue

worked e xamp le   5.8

The following information has been extracted from the financial statement of Gee company for the
year ended 31 December 20X3:

Distributable earnings of £500,000

£20,000 issued 10p shares

You are required to calculate the EPS for Gee company as at 31 December 20X3.

EPS =
Earnings
No of equity shares in issue

£500,000
£20,000 ÷ £0.10

£500,000
200,000

= £2.50 per share

EPS is the only ratio defined and set out in the International Accounting Standards and differs
from all the other standards governing financial reporting. In keeping with the format of the
book, EPS will be covered in detail in our examination of accounting ratios (see chapter 10).
 chapter 5  Accounting policies 2 101

6 Impairment of assets (IAS 36)

It has not been unknown for an entity to hold assets that are reported in their financial state-
ments at a value greater than their recoverable value. Such positions often come to light during
periods of economic downturns or financial crisis as witnessed at the start of this century. IAS
36 seeks to ensure that financial statements do not include assets at a value for which they
cannot be recovered.
However, our traditional prudence concept should have prevented this practice. Prudence
here is the accounting concept that requires the exercise of caution in the preparation of finan-
cial statements such that the assets and income of an entity are not overstated, and conversely
liability and expenses are not understated. The underlying rationale of prudence is that an
entity should not recognise an asset at a value that is higher than the amount which the entity
expects to recover from its sale or use. The recoverable amount of an asset or a cash-generating
unit is the higher of its fair value less costs of disposal and its value in use.
Fair value is the price that would be recovered on the disposal of an asset or paid to transfer a
liability in an orderly transaction between market participants at the measurement date. Costs
of disposal are the costs directly attributable to the disposal of an asset or cash-generating unit,
excluding finance costs and income tax expense. Value in use is the present value of the future
cash flows expected to be derived from an asset or cash-generating unit.

worked e x amp le   5.9

A company acquired a new machine on 1 July 20X0 and has projected its cash flows for the next five
accounting periods as follows:

Year ended Cash inflows Cash outflows

£ £
30 Jun X1 16,500 6,950
30 Jun X2 21,900 10,995
30 Jun X3 27,480 12,500
30 Jun X4 12,500 10,900
30 Jun X5 5,500 4,500

The machine is not expected to have any residual or resale value at the end of its five years. However,
the cost to dispose of the machine environmentally is expected to be £2,500. The company applies a
standard 10% discount rate.

Required
a) Determine the value in use of the new machine for the company.
b) Comment on the cash inflows and cash outflows supplied by the company.

Suggested solution
a) The value in use of the new machine is shown below.

Year Cash Cash Net cash Discount Present

ended inflows outflows flows factor value
£ £ £ 10% £
30 Jun X1 16,500 6,950 9,550 0.9091 8,682
30 Jun X2 21,900 10,995 10,905 0.8264 9,012
30 Jun X3 27,480 12,500 14,980 0.7513 11,255
30 Jun X4 12,500 10,900 1,600 0.6830 1,093
30 Jun X5 5,500 7,000 (1,500) 0.6209 (931)
Value in use 29,110
102 Part two  The preparation and presentation of financial statements

worked e x amp le   5.9 continued

The value in use is based on the discounted net cash flows of the machine at a 10% discount factor.
The disposal cost of the machine at the end of the fifth year was added to the cash outflow,
because this is borne by the company.

b) The cash flows provided by the company must satisfy the requirements of IAS 36:
■■ They should be based upon the machine in its current condition and exclude any cash flows
that may arise from any enhancements to its performance.
■■ The cash flows should exclude any obligations that have already been recognised.
■■ Cash inflows and outflows arising from financing activities should be excluded from any tax
payments or receipts.
■■ The cash flows should have supportive, reliable and reasonable evidence, preferably obtained
from an independent external source.

When an asset suffers an impairment loss, the carrying amount of the asset is reduced to its
recoverable amount. The impairment loss is recognised as an expense. However, when an asset
is revalued and an impairment loss arises, the resulting impairment loss is recognised as a reduc-
tion in the revaluation reserve. Therefore the revaluation is debited with the impairment loss and
reflected in the statement of profit or loss and other comprehensive income as a negative amount.

worked e x amp le   5.10

A company has five assets recorded in their non-current assets as follows.

Asset Value in use Fair value less disposal costs Carrying amount
£ £ £
A01 25,000 22,500 30,000
A02 16,000 17,950 14,000
A03 35,000 40,000 43,750
A04 18,500 18,500 18,500
A05 23,500 19,500 12,000

Required
a) Advise the company whether they have any impairment loss in their non-current stock assets.
b) Explain what is impairment loss.

Suggested solution
a) The company has a total of £8,750 impairment loss arising from assets A01 and A03 as shown below.

Asset Carrying amount Recoverable amount Impairment loss

£ £ £
A01 30,000 25,000 5,000
A02 14,000 17,950 0
A03 43,750 40,000 3,750
A04 18,500 18,500 0
A05 12,000 19,500 0
8,750

b) Impairment loss is the loss that arises when an asset held by a company has a carrying amount
greater than its recoverable amount (where the recoverable amount is the greater of the fair value
less disposal costs and its value in use).
 chapter 5  Accounting policies 2 103

6.1 Cash-generating units

It may not always be possible to determine the recoverable amount of an individual asset. If
this is the case, then the recoverable amount of the cash-generating unit (CGU) to which the
asset belongs should be determined. In accordance with IAS 36, a cash-generating unit is ‘the
smallest identifiable group of assets that generates cash inflows that are largely independent of
the cash inflows from other assets or groups of assets’.
When a CGU incurs an impairment loss, this loss should be allocated to reduce the carrying
amount of the asset in the following order:
1. reduce the carrying amount of any goodwill allocated to the cash-generating unit (group of
units); then
2. reduce the carrying amounts of the other assets of the CGU on a pro-rata basis.
The carrying amount of an asset should not be reduced below the highest of:
■■ its fair value less costs of disposal (if measurable);
■■ its value in use (if measurable); or
■■ zero.

worked e x amp le   5.11

On 1 July 20X0, a company had a cash-generating unit with the following assets:

Carrying
amount
£,000
Goodwill 300 Notes
1. On 30 June 20X1, the recoverable amount of the
Property 750
plant and machinery was £475,000.
Plant and machinery 500 2. On 30 June 20X1, the CGU recoverable amount
1,550 was £1,010,000.

Required
Produce the impairment loss as at 30 June 20X1, and show how it should be allocated across the
items within the CGU.

Suggested solution

Carrying amount Carrying amount Impairment

1 July 20X0 30 June 20X1 loss
£,000 £,000 £,000

Goodwill 300 0 300

Property 750 535 215

Plant and machinery 500 475 25

Total 1,550 1,010 540

The carrying amount on 30 June was £1,010,000 and generated an impairment loss of £540,000.
The first £300,000 must be suffered by goodwill as per IAS 36.
The remaining £240,000 should be shared between the two remaining assets on a pro-rata basis:
£324,000 and £216,000 respectively.
However, this would result in plant and machinery having a carrying amount of £284,000 and
note (1) advises us that the carrying amount of plant and machinery at the year was £475,000.
Therefore the residual impairment loss suffered by the property is £215,000: £540,000 less
£(300,000 + 25,000).
104 Part two  The preparation and presentation of financial statements

7 Non-current assets held for sale and discontinued

operations (IFRS 5)
Traditionally, non-current assets are not held for sale, as they are employed to generate revenue
over their lifespan. However, there may be occasions when a single non-current asset or a group
of them are held for sale. This may arise when a business operation is being discontinued.
IFRS 5 classifies a non-current asset (or disposal group) as held for sale ‘if its carrying amount
will be recovered principally through a sale transaction rather than through continuing use’. It
is imperative to note that to be treated as a disposal group, the whole group of assets must be
subject to disposal in a single transaction, not in a series of piecemeal disposal transactions.
In addition, the asset (or disposal group) must be available for immediate sale in its present
condition subject only to the usual sale terms associated with such assets and the sale is highly
probable.
A highly probable sale will be deemed to exist under the following conditions:
a) management is committed to a plan to sell the asset (or disposal group), and have taken
action to locate a buyer and the disposal;
b) the asset (or disposal group) must be actively marketed for sale at a price that is reasonable
in relation to its current fair value;
c) the sale should be expected to qualify for recognition as a completed sale within one year
from the date of classification, unless there are conditions beyond the control of the entity;
and
d) it is unlikely that decision to sell will be subject to changes or withdrawn.
Non-current assets cannot and should not be transferred to current assets or non-current assets
for resale at the end of the reporting period if the conditions outlined above have not been satis-
fied. Only if these conditions are fulfilled can the assets be reclassified and a disclosure made in
the financial statements. Non-current assets held for sale should be presented in the statement
of financial position, but must be shown separately from other assets.

worked e x amp le   5.12

At the end of its accounting year on 30 June 20X1, a company has the following non-current assets
in their portfolio:

■■ A01HQ – The company’s head office in the city centre that the board of directors has agreed
should be sold. The new head office on the outskirts of the city is still under construction and
completion is not expected for at least another nine months. On completion, the relocation will
commence as will the marketing of the building to prospective buyers.
■■ A02PP – The unused small processing plant is still occupied but is currently being viewed by
prospective buyers following successful marketing by the selling agent. Vacation of the premises
is not expected to take more than the customary four weeks following the agreement of the sale
price by both parties.
■■ A03LV – A fleet of former leased vehicles that the board of directors has recently agreed to sell.
This fleet will be marketed within the next month with an expectation of their disposal within
three months.

Required
Advise the management whether the three assets listed above can be classified as non-current assets
for sale.

Suggested solution
To be classified as non-current assets for sale in accordance with IFRS 5, the assets should be able to
recover their carrying value through a sale and the fulfilment of all four conditions outlined in the
previous section.
Asset A01HQ should not be classified as a non-asset held for sale, because it is not available for
immediate sale as it has not been marketed and this cannot commence until the new building has
 chapter 5  Accounting policies 2 105

worked e x amp le   5.12 continued

been completed and relocation is underway. The completion of the new building may overrun the
expected nine months and this may result in the sale not being possible within twelve months.
Assets A02PP and A03LV should be classified as non-current assets held for sale as they meet
required conditions. Although A02PP is currently occupied, vacation will not extend beyond four
weeks and hinder the sale.

It is important to recognise that a non-current asset held for sale should not be subject to depre-
ciation as the non-current asset is no longer held for the purposes of generating revenue for the
entity over its useful life. A non-current asset held for sale should be measured at the lower of
its carrying amount and fair value less costs to sell.
If the carrying amount of an asset held for sale exceeds its fair value less costs to dispose of
the asset, then an impairment loss should be recognised. In addition, any subsequent reduc-
tion in the fair value less disposal costs of an asset held for sale should also be recognised as an
impairment loss. Conversely, any increase in the fair value less disposal costs of an asset held
for sale should also be recognised as a gain. However, the gain cannot exceed the cumulative
amount of any previously recognised loss of the asset.
Non-current assets held for sale may arise from the discontinuation of a business operation.
Under IFRS 5, a discontinued operation is defined as:

a component of an entity that either has been disposed of or is classified as held for sale and:
a) represents a separate major line of business or geographical area of operations;
b) is part of a single coordinated plan to dispose of a separate major line of business or geo-
graphical area of operations; or
c) is a subsidiary acquired exclusively with a view to resale.

If there is any gain or loss from the sale of assets, this should be recognised in the statement of
profit or loss and other comprehensive income.
Financial reporting regulations require that continuing operations are reported separately in
the statement of profit or loss and other comprehensive income from discontinued operations,
and that any gain or loss from the disposal of a segment (an entity whose activities represent a
separate major line of business or market segment) be reported along with the operating results
of the discontinued segment.
The results of operations of a component of a company that either has been disposed of, or
is classified as being held for sale, are reported in discontinued operations only if both the fol-
lowing conditions are met:
■■ the operations and cash flows of the component have been (or will be) eliminated from the
ongoing operations as a result of the disposal decision, and
■■ the company will not have any significant continuing involvement in the operations of the
component after the disposal decision.
A component, as described under IFRS 5, consists of operations and cash flows that can be
clearly distinguishable, operationally and for financial reporting purposes, from the rest of the
entity. However, due to the subjectivity of the above definition, the IASB has aligned the defini-
tion with that used in IFRS 8 ‘Operating Segments’.
The importance of understanding changes over time in the various segments of activity that
make up the whole of the company is illustrated in Figure 5.1.

Segment 20X0 20X1

1 Operational Discontinued
2 Operational Operational
3 Operational Operational

Figure 5.1 Changing activities over time

106 Part two  The preparation and presentation of financial statements

This shows that in 20X0 the company had three main segments of activity – 1, 2 and 3 and
in 20X1 segment 1 was discontinued. Any predictions made for 20X2 based on the results of
20X1 would be wrong to the extent that activity 1 no longer contributes towards the overall
performance of the enterprise.
Similarly, comparisons between the actual results for 20X2 and those of the previous year
should take account of the fact that the business has downsized. As the name indicates, IFRS 5
‘Non-current Assets Held for Sale and Discontinued Operations’ deals with a number of issues.
Here we are concerned with the last-mentioned item.

7.1 Disclosure – statement of profit or loss and other

comprehensive income
The impact of accounting for discontinued operations is that regulations require separate dis-
closure from continuing operations on the face of the statement of profit or loss and other com-
prehensive income. Business entities are required to show, as a minimum, the following items
on the face of the statement of profit or loss and other comprehensive income:
■■ the post-tax profit or loss of discontinued operations;
■■ the post-tax gain or loss recognised on the measurement to fair value less cost of sale of the
discontinued component(s).
Additionally, the quality of disclosure can be enhanced through further analysis of discontinued
operations either in the statement of profit or loss and other comprehensive income or in the
narratives to the financial reports:
■■ the revenue, expenses and pre-tax profit or loss of discontinued operations;
■■ the related income tax expense as required under IAS 12;
■■ the gain or loss recognised on the measurement to fair value less cost of sale of the discon-
tinued component(s); and
■■ the related income tax expense, subject to IAS 12.

The disclosure for discontinued operations may be disclosed via two methods:
1. Method I on the face of the statement of profit or loss and other comprehensive income,
using columnar format; or
2. Method II in a note to the accounts.
If the information is shown in a note to the accounts, the ‘Profit for the period from discontin-
ued operations’ must appear as a single item on the face of the statement of profit or loss and
other comprehensive income.
Method I
Statement of profit or loss and other comprehensive income for Crux plc for year ended 31
December 20X2 (comparatives omitted)

Continuing Discontinued
operations operations Total
£m £m £m
Turnover 750 150 900
Cost of sales (500) (168) (668)
Gross profit 250 (18) 232
Distribution costs (72) (5) (77)
Administrative expenses (63) (9) (72)
Finance costs (8) 0 (8)
Profit for the period before tax 107 (32) (75)
Taxation 31 0 31
Profit for the period 76 (32) 44
 chapter 5  Accounting policies 2 107

Method II
Statement of profit or loss and other comprehensive income for Crux plc for year ended 31
December 20X2

Continuing operations
20X2 20X1
£m £m
Turnover 750 720
Cost of sales (500) (481)
Gross profit 250 239
Distribution costs (72) (72)
Administrative expenses (63) (59)
Finance costs (8) (8)
Profit for the period before tax 107 100
Taxation 31 28
Profit for the period from continuing operations 76 72
Profit (loss) for the period from discontinued operations* (32) 25
Profit for the period 44 97

* Required analysis (consisting of the information appearing on the face of the statement of profit or loss
and other comprehensive income under Method I) given in the notes to the accounts.

We can see (Method II) that there has been a substantial reduction in the profit generated by
Crux plc in 20X2 compared with the previous year. Profit has fallen by more than 50%, from
£97m to £44m. The analysed statement of profit or loss and other comprehensive income
shows that the decline in profit is entirely attributable to the discontinued operation, which
suffered a loss of £32m in 20X2 compared with a profit of £25m in the previous year. Profits
from continuing operations are in fact slightly up, at £76m compared with £72m in the previ-
ous year. The analysed statement of profit or loss and other comprehensive income therefore
provides grounds for a deeper, and perhaps more optimistic, assessment of Crux plc’s future
prospects than would otherwise have been possible.

TEST YO UR K N OW LE DG E   5.3

a) What do you understand by the term ‘discontinued operation’?

b) What constitutes a ‘discontinued operation’ under IFRS 5?

8 Operating segments (IFRS 8)

In the distant past the single-product firm dominated, but such specialisation gradually gave
way to horizontal integration and vertical integration.
Horizontal integration is the process whereby an entity will acquire one or more other enti-
ties in the same sector engaged in the same stage of production/service. An example in the
accounting software sector has been Sage’s acquisition over the years of smaller accounting
software companies. This may be undertaken to reduce competition and improve economies
of scale. Vertical integration is the process where an entity acquires or merges with other enti-
ties at different stages in the production or supply chain, to either guarantee supply or access
to the market. A notable example was when Boeing bought the supplier of its 787 airplane to
overcome any problem of supply.
The move towards diversification (i.e. the increasing engagement in different types of busi-
ness) gained pace during the 1960s with the growth of the multinational enterprise. The result
108 Part two  The preparation and presentation of financial statements

is that companies today, or more usually groups of companies, engage in a wide range of activi-
ties, where:
■■ there are significant variations in rates of profitability;
■■ the activities involve different degrees of risk (e.g. different geographical areas raise problems
of movements in exchange rate, political upheaval, expropriation of assets and high inflation
rates); and
■■ there are differential opportunities for growth.
These are, of course, often the very reasons for diversifying. However, the result is that aggregated
performance data are of limited use for decision-making. Empirical research has shown that,
for such companies, segmental data improves the shareholders’ ability to make effective assess-
ments of past results that can be used to predict future enterprise profits and developments.
Disaggregated data is also of greater use to the government for planning purposes. It enables
the accumulation of industry statistics that can be used for policy-making (e.g. to encourage
inward investment to certain industries, or to provide financial assistance for depressed areas).
Equally, more detailed information on the profitability of various parts of the business may
be helpful to trade unions and employees for wage and salary bargaining purposes. The move
towards segmental reporting in Britain started with the Companies Act 1967. This required the
directors’ report to provide turnover and profit by ‘class’ of activity. Today, the Companies Act
2006 requires this information to be given in the notes to the accounts so that it is specifically
covered by the audit report. In addition, disclosure of turnover by geographical area is required.
Segmental reporting is the subject of IFRS 8 ‘Operating Segments’. The objective of this
standard is to establish principles for reporting financial information. This helps users of finan-
cial statements to:
■■ understand the enterprise’s past performance better;
■■ assess the enterprise’s risks and returns better; and
■■ make more informed judgements about the enterprise as a whole.

8.1 Identification of reportable segments

A business or geographical segment can be identified as reportable if a majority of its revenue is
earned from sales to external customers and:
■■ its revenue is 10% or more of total revenue, external and internal, of all segments; or
■■ its result (either profit or loss) is 10% or more of the combined result of all segments in profit
or the combined result of all segments in loss, whichever is the greater in absolute amount;
or
■■ its assets are 10% or more of the total assets of all segments.

8.2 Disclosures
The following must be disclosed for each primary reportable segment:
■■ revenue (disclosing separately sales to external customers and inter-segment revenue);
■■ the basis of inter-segment pricing;
■■ results (before interest and taxes) from continuing operations and, separately, the result from
discontinued operations;
■■ carrying amount of segment assets;
■■ carrying amount of segment liabilities; and
■■ cost incurred in the period to acquire property, plant and equipment, and intangibles.

8.3 Nature of reportable segments

There are two types of reportable segments:
1. A business segment (one based on supply of products or services) is a distinguishable com-
ponent of an enterprise that is engaged in providing an individual product or service or a
group of related products or services and that is subject to risks and returns that are differ-
ent from those of other business segments.
Statement of profit or loss and other
comprehensive income Paper products Office products Publishing Other operations Eliminations Consolidated
20X1 20X0 20X1 20X0 20X1 20X0 20X1 20X0 20X1 20X0 20X1 20X0
External sales 55 50 20 17 19 16 7 7
Inter-segment sales 15 10 10 14 2 4 2 2 (29) (30)    
Total revenue 70 60 30 31 21 20 9 9 (29) (30) 101 90

Results
Segment result 20 17 9 7 2 1 0 0 (1) (1) 30 24
Unallocated corporate expenses (7) (9)
Operating profit 23 15
interest expense (4) (4)
interest income 2 3
Share of net profits of associates 6 5 2 2 8 7
Income taxes (7) (4)
Profit on ordinary activities 22 17
Uninsured earthquake damage to factory   (3)                 0 (3)
Net profit 22 22 14

Statement of financial position Paper products Office products Publishing Other operations Eliminations Consolidated
20X1 20X0 20X1 20X0 20X1 20X0 20X1 20X0 20X1 20X0 20X1 20X0
Segment assets 54 50 34 30 10 10 10 9 108 99
Investment in equity methods associates 20 16 12 10 32 26
Unallocated corporate assets                     35 30
Consolidated total assets 175 155

Segment liabilities 25 15 8 11 8 8 1 1 42 35
Unallocated corporate liabilities                     40 55
Consolidated total liabilities 82 90
chapter 5  Accounting policies 2

Capital expenditure 12 10 3 5 5 4 3
Depreciation 9 7 9 7 5 3 3 4
Non-cash expenses other than depreciation 8 2 7 3 2 2 2 1

Figure 5.2 Pro-forma statements for business with multiple segments

109
110 Part two  The preparation and presentation of financial statements

2. A geographical segment is a distinguishable component of an enterprise that is engaged

in providing products or services within a particular economic environment and that is
subject to risks and returns that are different from those of components operating in other
economic environments.
Segmental information must be prepared for both business and geographical segments, with
one treated as the primary segment and the other as the secondary segment. The primary
segment is determined on the basis of whether particular products or services or particular
geographical areas are more important in affecting the entity’s risks and rates of return. Rather
more information must be published in the primary segmental reports, but the differences are
minor and are not considered further here.
Figure 5.2 sets out the treatment of inter-segment sales, which must be cancelled as they do
not represent transactions with external parties.
The presentation of all the information from Figure 5.2 in a single statement may not work
well in terms of improving the readability of annual reports. Sometimes companies will use a
number of tables, each focusing on a different item to be reported.

8.3 Limitations of segmental reporting

A major problem associated with the preparation of segmental reports is the treatment of
common costs relating to more than one segment. Entities often apportion some of their
common costs for the purpose of internal reporting (perhaps based on sales). In such cases, it
may be reasonable for these costs to be treated in the same way for external reporting purposes.
If the apportionment would be misleading, however, common costs should not be apportioned
to the segments, but should be deducted from the total segment result.
A similar situation arises in the case of assets and liabilities that cannot be directly linked
with the activities of individual segments. The arbitrary allocations of such items would distort
the financial information published, and undermine the usefulness of any accounting ratios
that make use of figures for assets and/or liabilities (e.g. rate of return on capital employed).
Common assets and liabilities must also, therefore, remain unallocated and be reported at
the level of the group. At the same time, it must be realised that common costs, assets and
liabilities do benefit the individual segments, so their true segmental values will inevitably be
understated. This bias in reported data should be borne in mind when comparing segmental
results with other companies, particularly those entities undertaking no other activities with
the consequence that their reported results will take account of all costs, assets and liabilities.
One further factor affecting the reliability of segmental data arises where inter-segment sales
take place. Here, there is the possibility of creative accounting if, for some reason, management
wishes to inflate the reported results of one segment and deflate those of another. Even where
best efforts are made to use realistic transfer prices, the possible error resulting from the sub-
jective nature of this exercise should be borne in mind. Transfer prices should be fixed for this
purpose.

T E S T YO UR K N OW L E D G E   5.4

a) What is segmental accounting?

b) What are the two segmental bases for reporting segments?
 chapter 5  Accounting policies 2 111

? END OF CHAPTER QUESTIONS

5.1 How should companies determine an entity’s reportable segments?
5.2 Buffalo Ltd runs a chain of stationery stores providing three main products, namely copiers, paper and
printing services, to its business customers. The current financial statements contain the following:

Statement of financial position of Buffalo Ltd as at 31 December 20X4:

Assets £,000
Non-current assets at book value 2,443
Current assets
Inventories 57
Receivables 44
Bank 225
Total assets 2,769

Equities and liabilities

Equity
Share capital 1,000
Retained earnings 1,449

Non-current liabilities
Long-term borrowing 210
Current liabilities
Payables 78
Short-term borrowing 32
Total equities and liabilities 2,769

Statement of profit or loss and other comprehensive income of Buffalo Ltd as at 31 December
20X4:
£,000 £,000
Revenue 1,110
Less: Cost of sales 574
Administration expenses 96
Distribution costs 142
Finance costs 10 (822)
Net profit 288

The following table contains a breakdown of the company’s financial results.

Copiers Paper Printing HO

£,000 £,000 £,000 £,000
Revenue 611 395 104 –
Cost of sales 384 146 44 –
Administration expenses 47 9 18 22
Distribution costs 101 17 24 –
Finance costs 6 1 1 2
Non-current assets at book value 1,012 767 432 232
Inventories 31 14 12 –
Bank 148 46 31 –
Payables 32 20 16 10
Short-term borrowing 13 7 4 8
Long-term borrowing 210 – – –
112 Part two  The preparation and presentation of financial statements

? END OF CHAPTER QUESTIONS

Required
Prepare a segmental statement of profit or loss and other comprehensive income for Buffalo Ltd complying,
so far as information permits, with the provisions of IFRS 8 ‘Operating Segments’ indicating revenues and
expenses for each segment and the business as a whole:
a) revenue;
b) profit; and
c) net assets.
5.3 Identify the circumstances in which IAS 8 enables a company to change its accounting policy and indicate
how the change must be treated in the accounts.
5.4 The issued share capital of Hawkestone Ltd at 1 July 20X2 consisted of 20 million ordinary shares of £1 each
issued at par. On 1 January 20X3, the directors made a rights issue of one share for every two shares held at
£2.80 per share. The following further information is provided for Hawkestone Ltd for the year to 30 June
20X3:

£,000
Turnover 74,400
Cost of sales (Note 1) 49,200
Loss on closure of manufacturing division (Note 2) 14,600
Distribution costs 7,200
Administrative expenses 12,400
Bad debts write off arising from prior period error (Note 3) 4,280
Retained profit at 1 July 20X2 25,200

Notes
1. The cost of sales figure includes closing inventories of finished goods valued at £4.74 million. The
company’s auditors have drawn attention to the fact that £1.04 million of these inventories is obsolete
and should be written off.
2. In the past, the company’s activities consisted of a manufacturing division and a service division. The
service division has been making healthy profits in recent years, but the manufacturing division has been
making losses. The manufacturing division was closed down during the year to 30 June 20X3.
3. It has been discovered that last year’s accounts were wrongly prepared. Owing to a clerical error, a debt
due to Hawkestone of £4,280,000 that was known to be bad was wrongly classified as cash at bank.

Required
a) Define a material item in accordance with the provisions of IAS 8.
b) Prepare the statement of profit or loss and other comprehensive income and statement of changes in
equity of Hawkestone Ltd in accordance with good accounting practice and complying with standard
accounting practice so far as the information permits.
Note: Ignore taxation.
5.5 Explain the nature of a non-recurring item and how it should be reported in the financial statements.
5.6 State and explain the conditions that must be met for an asset to be classified as being held for sale.
5.7 IFRS 5 explains the criteria for determining a discontinued operation. Explain the criteria.
5.8 What is an operating segment? Explain the criteria in identifying an operating segment.
Purpose of the statement 6
of cash flows

■■ Contents
1. Introduction
2. Purpose of the statement of cash flows
3. Cash and cash equivalents
4. Components of the statement of cash flows
5. Methods for preparation of the statement of cash flows
6. Further guidance on statement cash flows
7. Interpretation of cash flow information and disclosures
8. Limitations of the statement of cash flows

■■ Learning outcomes
Chapter 6 is the final chapter related to the syllabus section ‘financial statements for single
companies’. After reading and understanding the contents of the chapter, working through all
the worked examples and practice questions, you should be able to:
■■ appreciate the purpose of a statement of cash flows and its usefulness to users of financial
information;
■■ discuss and explain the concept of cash and cash equivalents in light of IAS 7 and the limita-
tions of classifying items under cash and cash equivalents;
■■ explain the components of a statement of cash flow statement under IAS 7;
■■ understand and prepare a statement of cash flow statement under both the direct and indi-
rect methods as guided by IAS 7;
■■ be able to interpret a cash flow statement together with the other financial statements; and
■■ understand the limitations of statements of cash flows and be able to recommend other
useful information that would reduce the impact of these limitations.

1 Introduction
The statement of cash flows is one of the principal financial statements that must be disclosed
together with the other principal statements, namely, a statement of profit or loss and other
comprehensive income for the period and the statement of changes in equity. IAS 7 ‘Statement
of Cash Flows’ provides the basis under which the cash flow statement is to be prepared and
the items to be disclosed.
The statement of cash flows reports the cash generated and used during the reporting period.
While the statement of cash flows is referred to in this chapter over a 12-month reporting
period, companies can and do prepare an interim statement of cash flows for quarterly and
half-yearly reporting. IAS 7 requires the disclosure of cash flows under three main headings:
operating, investing and financing activities, plus any supplemental information supporting the
statement:
■■ Operating activities: Converts the items reported on the statement of profit or loss and other
comprehensive income from the accrual basis of accounting to cash.
■■ Investing activities: Reports the purchase and sale of long-term investments and property,
plant and equipment (PPE).
■■ Financing activities: Reports the issuance and repurchase of the company’s own bonds and
stock and the payment of dividends.
114 Part two  The preparation and presentation of financial statements

The statement of cash flows explains the changes in cash and cash equivalents. Reporting enti-
ties can choose between the ‘direct’ or ‘indirect’ method of cash flows disclosure on the basis of
IAS 7. The various terminologies used in preparing and presented the statement of cash flows
will be discussed as they arise.

T E S T YO UR K N OW L E D G E   6.1

Describe the four elements of a statement of cash flows and how they might be useful to users.

2 Purpose of the statement of cash flows

Financial statements are prepared under the accruals basis, rather than reflecting actual move-
ments of cash. For example, some of the revenue reported in the statement of profit or loss and
other comprehensive income may not have been collected at the reporting date. This uncol-
lected revenue would contribute to the trade receivables figure reported in the statement of
financial position. Similarly, although the expenses reported on the statement of profit or loss
and other comprehensive income have been incurred, they are unlikely to have all been paid.
These unpaid expenses would also be reflected in the statement of financial position.
The statement of cash flows facilitates an assessment of a company’s liquidity as well as
determining both the use of cash within a company and the ability of a company to generate
cash. Movements in cash flows can impact the liquidity position of a company in various ways:
1. The cash from operating activities is compared to the company’s net income. If the cash
from operating activities is consistently greater than the net income, the company’s net
income or earnings are said to be of a ‘high quality’. If the cash from operating activities is
less than net income, this raises issues as to why the reported net income is greater than
cash flows generated.
2. In business, ‘cash is king’. Cash is the oxygen of any business because in its absence the
business cannot meet its daily obligations. The cash flow statement identifies the cash that
is flowing into and out of the company. If a company is consistently generating more cash
than it is using, it will be able to increase its dividend, buy back some of its shares, reduce
debt or acquire another company/asset/investment. All of these are perceived to be good for
shareholder value.
3. Some financial models are based upon cash flow. In the short term, a company’s perfor-
mance may be measured on a profitability basis. However, in the long term, investors and
stakeholders assess the financial health of a company on the present value of all future cash
flows.

3 Cash and cash equivalents

IAS 7 states that:

The objective of IAS 7 is to require the presentation of information about the historical
changes in cash and cash equivalents of an entity by means of a statement of cash flows,
which classifies cash flows during the period according to operating, investing, and financing
activities.

Cash equivalents are said to be highly liquid short-term assets that are readily convertible to
known cash amounts (IAS 7 para. 7). Additionally, there must be little risk of change in value to
cash equivalents. IAS 7 further suggests that, to qualify as cash equivalents, investments should
normally have a maturity of three months or less.
Technically speaking, items that do not fall under the banner of operating, investing and
financing activities do not get reported in the statement of cash flows. However, items that are
 chapter 6  Purpose of the statement of cash flows 115

deemed to be cash or cash equivalents are included in the statement of cash flows, as these
items form part of the cash management of the business. Cash management includes the
investment of excess cash in cash equivalents.

worked e x amp le   6.1

Exel Ltd’s financial year end is 31 December 20X1. The company purchased some high-quality
corporate bonds as a short-term investment. The bonds were purchased on 1 September 20X1 with
a maturity date of 31 December 20X1.

Required
The CEO of Exel has included the corporate bonds in the cash and cash equivalent statement of
financial position. Advise the CEO if this is correct.

Answer
At the date of purchase of the corporate bonds, 1 September 20X1, the bonds had a maturity date
of four months. However, this does not comply with the three months or less rule in on the basis of
IAS 7, so the bonds should not be classified as cash equivalent.

4 Components of the statement of cash flows

4.1 Cash flows from operating activities
Cash inflow and outflow generated by the normal course of business activity comes under
operating activities. These include the revenues generated through production and the expenses
incurred due to delivery of the company’s product(s) resulting in cash transactions. Cash inflows
are generated by sales, while cash outflows are incurred by expenses. The expenses may include
production costs and distribution costs, as well as expenses for administration and taxes. Under
IAS 7, operating cash flows include:
■■ operating profit;
■■ receipts from the sale of goods or services;
■■ receipts for the sale of loans, debt or equity instruments in a trading portfolio;
■■ interest received on loans;
■■ dividends received on equity securities;
■■ payments to suppliers for goods and services;
■■ payments to employees or on behalf of employees; and
■■ interest payments (alternatively, this can be reported under financing activities in IAS 7).
Items that are added back to (or subtracted from, as appropriate) the net income figure (which
is found on the statement of profit or loss and other comprehensive income) to arrive at cash
flows from operations generally include:
■■ depreciation (loss of tangible asset value over time);
■■ deferred tax;
■■ amortisation (loss of intangible asset value over time); and
■■ any gains or losses associated with the sale of a non-current asset, because associated cash
flows do not belong in the operating section (unrealised gains/losses are also added back from
the statement of profit or loss and other comprehensive income).
The above adjustments are only necessary if the indirect method is used, in which case the fol-
lowing adjustments will also be required:
■■ any increases/decreases in inventory; and
■■ any increase/decrease in receivables and payables.
These will also need to be added back. Having regard to the above items, the net cash flows
generated account for the cash used in normal business activity.
116 Part two  The preparation and presentation of financial statements

4.2 Cash flows from investing activities

Non-current assets purchased and cash payments made are reported in the investing activities.
Cash receipts on disposal of non-current assets are also disclosed in this section. Non-current
assets may include, but are not limited to, such items as:
■■ purchase or sale of an asset (assets can be land, building, equipment, securities, etc.);
■■ financial investments (equities and loans); and
■■ acquisition of other businesses.
Loans made outside the company will generate cash inflow in the form of interest received.
Investment in other companies will generate cash inflow in the form of dividends received. In
both cases, the actual receipt of cash will be disclosed in the statement of cash flows.

4.3 Cash flows from financing activities

Financing activities typically include long-term bank loans and cash from investors such as new
share issue, debentures and bonds. The company will also make cash payments to shareholders
in the form of dividends representing an outflow of cash. Company taxes paid will be disclosed
in this section and represent actual cash payments made by the reporting date. IAS 7 gives some
guidance on what can be included under financing activities:
■■ proceeds from issuing short-term or long-term debt;
■■ payments of dividends;
■■ payments for repurchase of company shares;
■■ repayment of debt principal, including capital leases; and
■■ for non-profit organisations, receipts of donor-restricted cash that is limited to long-term
purposes.
The reason for segregating how cash flows arise in a business is to create a level of transparency
for users. It is expected that the finances of companies should be generated through normal
day-to-day activities (i.e. operating activities). This indicates how the business is performing
and its long-term prospects.

T E S T YO UR K N OW L E D G E   6.2

Explain why users of cash flow information would find it useful to have disclosure under the three
headings of operating, investing and financing activities.

5 Methods for preparation of the statement of cash

flows
IAS 7 provides clear guidance on how the operating cash flows should be prepared. Two alterna-
tive methods are provided: the ‘direct’ and ‘indirect’ methods. The two methods only differ in
their reporting of cash generated from operating activities. However, IAS 7 clearly states that
‘entities are encouraged to report cash flows from operating activities using the direct method’.
Despite this statement, most companies elect to report their operating activities cash flows
using the indirect method.

5.1 Direct method

When an entity uses the direct method for reporting cash generated from its operating activi-
ties, the disclosures address the major classes of gross cash receipts and gross cash payments.
The disclosure under the direct method for reporting the cash generated from operations is
shown in Table 6.1.
 chapter 6  Purpose of the statement of cash flows 117

Table 6.1 Cash flows from operating activities

Cash flows from operating activities £ £

Cash receipts from customers xxxx
Cash paid to suppliers of goods and services (xxxx)
Cash paid to employees (xxxx)
Cash generated from operations xxxx

Under IAS 7, dividends received may be reported either under operating activities or investment
activities. If taxes paid are directly linked to operating activities, they are reported under operat-
ing activities. If the taxes are directly linked to investment activities or financing activities, they
are reported under investment or financing activities (see below).

worked e x amp le   6.2

Louisa-Ann Plc – statement of profit or loss and other comprehensive income for the year ended 30
September 20X4:
£
Sales 85,455
Cost of sales 51,275
Gross profit 34,180
Administrative and selling expenses 27,380
Interest payable –
Profit before taxation 6,800
Taxation 2,040
Profit after tax 4,760

Louisa-Ann Plc – statement of financial position as at 30 September:

20X4 20X3
£ £
Assets
Non-current assets
Land and buildings 22,400 14,000
Plant and machinery 14,800 7,000
37,200 21,000
Current assets
Inventories 11,200 6,400
Trade receivables 8,600 3,200
Bank – 4,400
19,800 14,000
Total assets 57,000 35,000
Equity
Share capital 25,000 20,000
Retained earnings 8,760 4,000
33,760 24,000
118 Part two  The preparation and presentation of financial statements

worked e x amp le   6.2 continued

Liabilities
Non-current
Long-term loans – 4,000
Current
Trade payables 11,800 7,000
Taxation 2,040 –
Bank 9,400 –
23,240 7,000
Total equity and liabilities 57,000 35,000

Notes
1. The administrative and selling expenses includes £17,600 employee-related expenses.
2. During the year, £8,600 was sent on additional plant and machinery and £8,400 was spent on
the acquisition of land.
3. The annual depreciation charge of £800 is included in the administrative and selling expenses.

Requirement
Prepare a statement of cash flows for Louisa-Ann Plc using the IAS 7 direct method.

Suggested answer
Louisa-Ann Plc – statement of cash flows for the year ended 30 September 20X4:
Cash flows from operating activities
£ £
Cash receipts from customers (W1) 80,055
Cash paid to suppliers of goods and services (W2) (60,255)
Cash paid to employees (W3) (17,600)
Cash generated from operations 2,200

Interest paid 0
Taxation paid 0
Net cash generated from operating activities 2,200

Cash flows from investing activities £

Acquisition of subsidiary 0
Purchase of non-current asset (W4) (17,000)
Proceeds from sale of non-current asset 0
Interest received 0
Dividends received 0
Net cash applied in investing activities (17,000)

Cash flows from financing activities £

Issued share capital (W5) 5,000
Long-term borrowing (W6) (4,000)
Payment of finance lease 0
Dividends paid
Net cash applied in financing activities 1,000
Net cash increase/decrease in cash and cash equivalents (13,800)
 chapter 6  Purpose of the statement of cash flows 119

worked e x amp le   6.2 continued

Cash and cash equivalents at 1 October 20X3 4,400

Cash and cash equivalents at 30 September 20X4 (9,400)

Workings

W1. Receipt from customers

£
Sales 85,455
Plus opening trade receivables 3,200
Less closing trade receivables (8,600)
80,055

W2. Payment to suppliers

£
Cost of sales 51,275
Less opening inventory (6,400)
Plus closing inventory 11,200
Plus administrative and selling expenses 27,380
Plus opening payables 7,000
Less closing payables (11,800)
Less depreciation (800)
Employees expense (17,600)
60,255
W3. Cash paid to employees
Note 1 Administrative and selling expenses includes £17,600 employee-related expenses.

W4. Purchase of non-current assets

Note 2
Plant and machinery 8,600
Land 8,400
Total 17,000
W5. Issued share capital
As at 30 September 20X4 25,000
As at 1 October 20X3 20,000
Increase in share capital 5,000
W6. Long-term borrowing
As at 30 September 20X4 0
As at 1 October 20X3 4,000
Increase in long-term borrowing (4,000)
120 Part two  The preparation and presentation of financial statements

5.2 Indirect method

The operating profit before taxation is the starting point when using the indirect method to
determine the cash flows from operating activities. The profit has to be adjusted for all non-cash
transactions that were included in its computation. These adjustments are usually as follows:
■■ Non-cash expenses, such as depreciation, and non-cash income, such as reduction in provi-
sions for doubtful debt;
■■ Income or expenses that have arisen from investing or financing activities, such as dividends
or interest that are payable or received. The income is always deducted as they have not
arisen from trading activities and conversely the expenses are added.
■■ Changes in the working capital items, inventories, payables and receivables that have arisen
during the accounting period. The adjustment to the operating profit before taxation for the
respective working capital elements is set out below.

Working capital items Increase Decrease

Inventories Deduction Addition
Trade payables Addition Deduction
Trade receivables Deduction Addition

worked e x amp le   6.3

Louisa-Ann Inc – statement of profit or loss and other comprehensive income for the year ended
30 September 20X4:
£
Sales 85,455
Cost of sales 51,275
Gross profit 34,180
Administrative and selling expenses 27,380
Interest payable –
Profit before taxation 6,800
Taxation 2,040
Profit after tax 4,760

Louisa-Ann Plc – statement of financial position as at 30 September:

20X4 20X3
£ £
Assets
Non-current assets
Land and buildings 22,400 14,000
Plant and machinery 14,800 7,000
37,200 21,000
Current assets
Inventories 11,200 6,400
Trade receivables 8,600 3,200
Bank – 4,400
19,800 14,000
Total assets 57,000 35,000
 chapter 6  Purpose of the statement of cash flows 121

worked e x amp le   6.3 continued

Equity
Share capital 25,000 20,000
Retained earnings 8,760 4,000
33,760 24,000
Liabilities
Non-current
Long-term loans – 4,000
Current
Trade payables 11,800 7,000
Taxation 2,040 –
Bank 9,400 –
23,240 7,000
Total equity and liabilities 57,000 35,000

Notes
1. The administrative and selling expenses includes £17,600 employee-related expenses.
2. During the year, £8,600 was sent on additional plant and machinery.
3. The annual depreciation charge of £800 is included in the administrative and selling expenses.

Requirement
Prepare a statement of cash flows for Louisa-Ann Plc using the IAS 7 indirect method.

Suggested answer
Cash flows from operating activities £ £
Profit from operations 6,800
Adjustments
Depreciation 800
Bad debt 0
7,600
Inventories increase (4,800)
Receivables increase (5,400)
Payables decrease 4,800
(5,400)
Cash generated from operations 2,200
Interest paid
Tax paid
Net cash generated from operating activities 2,200

Cash flows from investing activities £

Acquisition of subsidiary 0
Purchase of non-current asset (17,000)
Proceeds from sale of non-current asset 0
Interest received 0
Dividends received 0
Net cash applied in investing activities (17,000)
122 Part two  The preparation and presentation of financial statements

worked e x amp le   6.3 continued

Cash flows from financing activities £

Issued share capital 5,000
Long-term borrowing (4,000)
Payment of finance lease 0
Dividends paid
Net cash applied in financing activities 1,000

Net cash increase/decrease in cash and cash equivalents (13,800)

Cash and cash equivalents at 1 October 20X3 4,400

Cash and cash equivalents at 30 September 20X4 (9,400)

Worked examples 6.2 and 6.3 demonstrate that both methods produce identical net increase/
decrease in cash and cash equivalents.

5.3 Rules for calculating cash flows under operating activities

The suggested answer in Worked example 6.3 demonstrates how to derive cash flows from
operating activities when a two-year comparative statement of financial position and the net
income figures are given. Cash flows from operating activities can be calculated by adjusting net
income relative to the change in start and end balances of cash at bank/overdraft, inventories/
receivables and payables, and sometimes non-current assets. When comparing the change in
non-current assets over a year, we must be certain that these changes were caused entirely by
their depreciation/devaluation rather than purchases or sales (i.e. they must be operating items
not providing or using cash, or they are non-operating items).

worked e x amp le   6.4

Indirect method

Cash generated from operating activities £

Profit from operations 6,800
Add: Depreciation 800
7,600
Deduct: Increase in inventories (4,800)
Deduct: Increase in receivables (5,400)
Add: Decrease on payables 4,800
(5,400)
Cash generated from operations 2,200

Rules for calculating the cash generated from operations under the indirect method are as
follows.
 chapter 6  Purpose of the statement of cash flows 123

■■ Depreciation: Since depreciation represents an accounting expense and is a non-cash item, it

has to be added back to net profit.
■■ Inventory: An increase in inventory means the business has used cash and hence represents
a cash outflow, to be deducted from net profit. A decrease in inventory represents a cash
inflow, to be added to net profit.
■■ Receivables: Receivables represent goods and services sold to customers on credit. If receiva-
bles increase from one period to the next, this has an effect of decreasing cash to the business,
which is deducted from net profit. If receivables decrease from one period to the next, this
represents a cash inflow, which would be added to net profit.
■■ Payables: Payables represent payments outstanding to suppliers. If payables increase from
one period to the next, this represents an inflow of cash to the business, which is added to
the net profit. If payables decrease, we must deduct the difference from the net profit.
Other items:
■■ Interest expense is an accounting figure that should be added back to net profit; if this is a
positive figure in the statement of profit or loss and other comprehensive income, it should
be deducted. Interest actually paid in cash should be deducted from profits for the period.
■■ Tax expenses shown on the face of the statement of profit or loss and other comprehensive
income must be must be added back to the net profit, as they represent an accounting tax
estimate. However, taxes actually paid in cash must be deducted from the net profit figure.
■■ Dividends paid will be deducted from the net profit as these represent cash outflow from a
business. However, dividends can be shown under ‘cash from financing activities’.

worked e x amp le   6.5

The following information is relevant to Gamma Ltd for the year ended 31 December 20X4.

Notes:
1. During the year, depreciation of £17,000 was charged to cost of sales and £23,000 to
administrative expenses.
2. Plant and equipment disposed of during the year had an original cost of £90,000 and
accumulated depreciation of £84,000. Cash received on disposal was £21,500. Additions to
property, plant and equipment were purchased for cash.
3. The 20X4 dividend of £50,000 was paid during the year ended 31 December 20X4.
4. A cash issue of 20,000 £1 ordinary shares were made during the year for £2.10 per share.
5. All finance costs were paid in the year.

The financial statements of Gamma Ltd are as follows.

Statement of profit or loss and other comprehensive income for the year ended 31 December 20X4:

£
Revenue 900,000
Cost of sales (Note 1) (670,000)
Gross profit 230,000
Administration expenses (Note 2) (87,800)
Distribution costs (1,300)
Operating profit 140,900
Finance costs (Note 5) (17,600)
Profit before taxation 123,300
Taxation (34,000)
Profit for the period 89,300
124 Part two  The preparation and presentation of financial statements

worked e x amp le   6.5 continued

Statement of financial position as at 31 December:

20X4 20X3
£ £
Assets
Non-current assets
Property, plant and equipment at cost (Note 2) 350,000 334,000
Accumulated depreciation (110,000) (154,000)
240,000 180,000
Current assets
Inventory 82,000 83,900
Trade receivables 54,500 68,000
Cash 43,500 10,000
180,000 161,900
Total assets 420,000 341,900
Equity and liabilities
Equity
Ordinary share capital (£1 ord. shares – Note 4) 120,000 100,000
Share premium (Note 4) 72,000 50,000
Revaluation reserve 20,000 10,000
Retained earnings 55,400 16,100
Total equity 267,400 176,100
Non-current liabilities
Long-term loans 90,000 100,000
Current liabilities
Trade payables 38,200 40,000
Taxation 24,400 7,000
Bank overdraft 0 18,800
Total liabilities 152,600 165,800
Total equity and liabilities 420,000 341,900

Required
Prepare a statement of cash flows for Gamma Ltd for the year ended 31 December 20X4, using the
indirect method in accordance with IAS 7.

Answer
Gamma Ltd – statement of cash flows for the year ended 31 December 20X4:
Cash flows from operating activities Item £
Profit for the period 89,300
Add: depreciation 1 40,000
Gain on disposal of asset 2 (15,500)
Inventory 5 1,900
Trade receivables 6 13,500
Tax expense 7 34,000
 chapter 6  Purpose of the statement of cash flows 125

worked e x amp le   6.5 continued

Payables 8 (1,800)
Tax paid 7 (16,600)
Net cash flows from operating activities 144,800
Cash flows from investment activities
Purchase of property, plant and equipment 4 (96,000)
Disposal of property, plant and equipment Note 2 21,500
Net cash flows from investment activities (74,500)
Cash flows from financing activities
Share issue Note 4 42,000
Dividends paid Note 3 (50,000)
Repayment of long-term loan 9 (10,000)
Net cash flows from financing activities (18,000)
Net increase/(decrease) in cash and cash equivalents 52,300
Opening cash and cash equivalents 10 (8,800)
Closing cash and cash equivalents 10 43,500

Notes 2, 3 and 4 are from the question.

Calculation of cash flow items:

Item 1: Depreciation write-back

Depreciation charge £
Opening depreciation 154,000
Less: Depreciation on sale of asset (84,000)
Adjusted opening depreciation 70,000
Closing depreciation 110,000
Less: Adjusted opening depreciation 70,000
To operating activities 40,000

Item 2: Gain/(Loss) on disposal of assets write-back

Gain/(loss) on disposal £
Cost of disposed assets 90,000
Less: Accumulated depreciation (84,000)
NBV of disposed assets 6,000
Cash received on disposal 21,500
Less: NBV of disposed assets 6,000
Gain on disposal of assets 15,500

Item 3: Gain/(Loss) on revaluation of assets write-back

Gain/(loss) on revaluation £
Opening revaluation reserve 10,000
Gain on revaluation of assets 10,000
Closing revaluation reserve 20,000
126 Part two  The preparation and presentation of financial statements

worked e x amp le   6.5 continued

Item 4: Asset purchased for cash

Purchase of non-current assets £
Opening PPE 334,000
Disposal of PPE (90,000)
PPE cost before revaluation 244,000
Gain on revaluation of PPE 10,000
Cost of PPE after revaluation 254,000
Closing PPE 350,000
Less cost of assets after revaluation 254,000
To operating activities 96,000

Item 5: Inventory adjustment

Inventory £
Closing inventory 82,000
Opening inventory 83,900
Change in inventory (1,900)

Item 6: Trade receivables adjustment

Trade receivables £
Closing trade receivables 54,500
Opening trade receivables 68,000
Change in trade receivables (13,500)

Item 7: Tax expense and paid adjustments

Tax expense and tax paid £
Opening tax balance 7,000
Tax charge for the year 34,000
41,000
Closing tax balance 24,400
Tax paid in the year 16,600

Item 8: Payables adjustment

Payables £
Closing payables 38,200
Opening payables 40,000
Change in payables (1,800)

Item 9: Long-term loan adjustment

Long-term loan £
Closing long-term loan 90,000
Opening long-term loan 100,000
Change in long-term loan (10,000)
 chapter 6  Purpose of the statement of cash flows 127

worked e x amp le   6.5 continued

Item 10: Cash and cash equivalents

Cash Bank overdraft Total
Cash and cash equivalents £ £ £
Closing cash and cash equivalents 43,500 0 43,500
Opening cash and cash equivalents 10,000 (18,800) (8,800)
Change in short-term balance 33,500 18,800 52,300

6 Further guidance on statement cash flows

IAS 7 gives additional advice on the preparation of items disclosed on the face of the statement
of cash flows. The additional guidance relates to specific treatment items and the way they
should be presented:

The exchange rate used for translation of transactions denominated in a foreign currency
should be the rate in effect at the date of the cash flows (IAS 7.25).
Cash flows of foreign subsidiaries should be translated at the exchange rates prevailing
when the cash flows took place (IAS 7.26).
Aggregate cash flows relating to acquisitions and disposals of subsidiaries and other busi-
ness units should be presented separately and classified as investing activities, with specified
additional disclosures (IAS 7.39). The aggregate cash paid or received as consideration should
be reported net of cash and cash equivalents acquired or disposed of (IAS 7.42).
Cash flows from investing and financing activities should be reported gross by major class
of cash receipts and major class of cash payments except for the following cases, which may
be reported on a net basis: (IAS 7.22–24).
Cash receipts and payments on behalf of customers (e.g. receipt and repayment of demand
deposits by banks, and receipts collected on behalf of and paid over to the owner of a property).
Cash receipts and payments for items in which the turnover is quick, the amounts are
large and the maturities are short, generally less than three months (e.g. charges and collec-
tions from credit card customers, and purchase and sale of investments).
Cash receipts and payments relating to deposits by financial institutions.
Cash advances and loans made to customers and repayments thereof.
Investing and financing transactions which do not require the use of cash should be
excluded from the statement of cash flows, but they should be separately disclosed elsewhere
in the financial statements (IAS 7.43).
The components of cash and cash equivalents should be disclosed, and a reconciliation
presented to amounts reported in the statement of financial position (IAS 7.45).
The amount of cash and cash equivalents held by the entity that is not available for use
by the group should be disclosed, together with a commentary by management (IAS 7.48).
Source: Deloitte IAS Plus

7 Interpretation of cash flow information and

disclosures
A company’s cash flow can provide useful information on its ability to meet current and future
commitments. The cash flow of some companies move much faster than others, mainly due
to the nature of their business and their business sector. Broadly speaking, companies whose
customers are the general public (e.g. Tesco, Sainsbury, Mothercare) tend to deal primarily in
cash transactions, hence they have a faster cash cycle. If we were to compare the cash flow state-
ments of these companies, we would find trends in the cash cycle.
128 Part two  The preparation and presentation of financial statements

Analysis of cash flow trends and cycles allows managers to plan for difficult times and situ-
ations to ensure they can meet the company’s short- and long-term commitments. Cash flow
analysis can highlight when shortfalls in funding should be met with assistance from lenders
and allow decision-makers to plan for either short-term or long-term borrowing.
Cash flow analysis can further help in cash flow management related to trade receivables and
trade payables. In times of financial difficulty, management may need to review credit policy.
When a company has a strong reputation, it can negotiate shorter credit terms with its suppli-
ers. By the same token, a strong company can negotiate longer credit periods for payment of
debt, enabling the company to hold on to cash for longer periods.

T E S T YO UR K N OW L E D G E   6.3

Explain the potential information a user would be looking for in a statement of cash flows together
with the other financial statements.

7.1 Cash flows from discontinued operations

Cash flows arising out of discontinued operations require separate disclosure in the financial
statements. Additional information must be made similar to the requirement for the statement
of profit or loss and other comprehensive income either on the cash flow statement or the nar-
ratives. An example taken from a discontinued operation by Vodafone is shown below.
Cash flows from discontinued operations:

2007 2006
£m £m
Net cash flows from operating activities 135 1,651
Net cash flows from investing activities (266) (939)
Net cash flows from financing activities (29) (536)
Net increase in cash and cash equivalents (160) 176
Cash and cash equivalents at the beginning of the financial year 161 4
Exchange loss on cash and cash equivalents (1) (19)
Cash and cash equivalents at the end of the financial year – 161

8 Limitations of the statement of cash flows

One problem often stated in relation to IAS 7 is that the classifications used are too broad. It
could be argued that if a company’s expenditure were explained in more detail, it would give
users of financial information much greater insight in to the underlying economic reality. Items
such as research and development, mining and exploration costs and marketing expenditure
should be disclosed in the cash flow statement. However, the issue arises as to where such
expenditure should be disclosed (i.e. under operating or investing activities).
The indirect method causes confusion for some users as it is based on the statement of
financial position movements and reconciliation. For this reason it has been argued that IAS
7 should only permit the direct method. However, companies could counter-argue that new
accounting procedures would need to be adopted to keep track of cash movements.
Another argument in favour of the indirect method is that a reconciliation of cash flows from
operating activities from net profit allows users to see if profit figures are being manipulated;
this would facilitate a greater degree of analysis and would allow users to make better informed
economic decisions. Similarly, cash raised through financing instruments such as loans should
not form part of cash flows from operating activities, but should be shown separately from cash
flows generated through business activity.
 chapter 6  Purpose of the statement of cash flows 129

TEST YO UR K N OW LE DG E   6.4

a) Discuss the potential limitations of the statement of cash flows.

b) What other information could usefully be included?

stop and t hink  6.1

Do you think we should simply revert to accounting on a cash basis?

? END OF CHAPTER QUESTIONS

6.1 In a statement of cash flows, which of the following items will NOT appear in the cash flow from the investing
activities section when using the indirect method?
a) Purchase of non-current assets
b) Taxation paid
c) Purchase of investments;
d) Disposal proceeds of non-current assets
6.2 In accordance with IAS 7 ‘Statement of Cash Flows’, which of the following categories is NOT used to classify
cash flows in a statement of cash flows?
a) Managing activities
b) Financing activities
c) Investing activities
d) Operating activities
6.3 Why is reported profit different to a company’s cash flow for a particular accounting period?
6.4 Explain how the following events will impact cash flow movements:
a) Increase in inventory from one period to the next
b) Decrease in payables
c) Decrease in receivables
d) Increase in the market value of a company’s share price
e) Gains made on disposal of a non-current asset
f) Issue of new shares at market price
6.5 If credit sales for the year were £75 million, and trade receivables at the start of the year were £20 million
and at the end of the year were £12 million, state how much cash was received from trade customers.
6.6 A company has made purchases of materials on credit totalling £36 million during the year. At the beginning
of the year, the payables balance was £12 million. The closing payables balance was £18 million. State how
much money was paid to suppliers during the year.
6.7 Give three examples of statement of profit or loss and other comprehensive income items that do not involve
cash payment, and explain why.
6.8 The proceeds of cash sale of an item of plant amounted to £120,000. The item was originally purchased for
£500,000 and had accumulated depreciation of £400,000. How will this information affect the cash flow
statement?
6.9 Capri Ltd has net profits of £20 million, which includes a charge of £500,000 for depreciation. During the
year, the inventory decreased by £800,000 and receivables increased by £200,000. Payables decreased by
£400,000. Prepare a calculation of cash flows from operations.
6.10 Sarah Ltd is a manufacturer of a line of children’s clothing with a 31 December financial year end. The results
for last year are shown on the next page.
130 Part two  The preparation and presentation of financial statements

? END OF CHAPTER QUESTIONS continued

Statement of profit or loss and other comprehensive income for the year ended 31 December 20X4:
£
Revenue 949,000
Cost of sales (442,000)
Gross profit 507,000
Administration expenses (47,000)
Distribution costs (82,000)
Operating profit 378,000
Finance costs (26,000)
Profit before taxation 352,000
Taxation (36,000)
Profit for the period 316,000
Extract from statement of changes to equity
Dividends 274,000

Statement of financial position as at 31 December 20X4:

20X4 20X3
£ £
Assets
Non-current assets
Property, plant and equipment at cost 470,000 470,000
Accumulated depreciation 230,000 180,000
240,000 290,000
Current assets
Inventory 75,000 45,000
Trade receivables 144,000 120,000
219,000 165,000
Total assets 459,000 455,000
Equity and liabilities
Equity
Ordinary share capital (£1 ord. shares) 140,000 100,000
Share premium 8,000 –
Retained earnings 121,000 79,000
Total equity 269,000 179,000
Non-current liabilities
Long-term loans 66,000 84,800
Current liabilities
Trade payables 87,000 170,000
Taxation 30,000 18,000
Bank overdraft 7,000 3,200
124,000 191,200
Total liabilities 190,000 276,000
Total equity and liabilities 459,000 455,000
 chapter 6  Purpose of the statement of cash flows 131

? END OF CHAPTER QUESTIONS continued

Notes:
1. Dividends relating to 20X4 £274,000 were paid in cash by the year end.
2. A total of 40,000 ordinary £1.00 shares were issued at the market price of £1.20.
3. There were no purchases of property, plant and equipment in the year.
4. Interest costs for 20X4 (£26,000) have not been paid.

Required
Prepare a statement of cash flows for Sarah Ltd for the year ending 31 December 20X4.
6.11 Plumbus Ltd is a small engineering firm that manufactures various types of piping for industrial clients. The
information below relates to 30 September 20X4:

Statement of profit or loss and other comprehensive income for the year ended 30 September 20X4:

£
Revenue 1,200,000
Cost of sales (810,000)
Gross profit 390,000
Administration expenses (105,000)
Distribution costs (87,000)
Operating profit 198,000
Finance costs (8,000)
Profit before taxation 190,000
Taxation (54,000)
Profit for the period 136,000

Statement of financial position as at 30 September 20X4:

20X4 20X3
£ £
Assets
Non-current assets
Property, plant and equipment at cost 520,000 418,000
Accumulated depreciation (260,000) (188,000)
260,000 230,000
Current assets
Inventory 64,000 68,000
Trade receivables 38,000 45,000
Cash and cash equivalents 144,000 54,000
246,000 167,000
Total assets 506,000 397,000
Equity and liabilities
Equity
Ordinary share capital (£1 ord. shares) 150,000 120,000
Share premium 24,000 –
Revaluation reserve 18,000 8,000
Retained earnings 56,000 33,000
Total equity 248,000 161,000
132 Part two  The preparation and presentation of financial statements

? END OF CHAPTER QUESTIONS continued

Non-current liabilities
Long-term loans 224,000 165,000
Current liabilities
Trade payables 12,000 60,000
Taxation 22,000 11,000
34,000 71,000
Total liabilities 258,000 236,000
Total equity and liabilities 506,000 397,000

Notes:
1. During the year a depreciation charge of £70,000 charge was made to cost of sales and £32,000 to
administration expenses in the statement of profit or loss and other comprehensive income.
2. Plant and equipment (PPE) disposed of during the year had an original cost of £40,000 and accumulated
depreciation of £30,000. Cash received on disposal was £8,000.
3. Additions to PPE were purchased for cash.
4. A cash issue of 30,000 ordinary £1 shares were made during the year for £1.80 per share.
5. Finance costs were not paid during the year.
6. All dividends were paid in cash during the year.

Required
a) Prepare a statement of cash flows for Plumbus Ltd for the year ending 30 September 20X4 using the
indirect method under IAS 7.
b) Comment on your findings on the statement of cash flows and propose any remedial action that is
required by the company.
 part three

The preparation and

presentation of financial
statements for groups
■■ List of chapters
7. Group accounting
Part 3 covers the syllabus section entitled ‘Group accounting’.

■■ Overview
The dismantling of international trade barriers and the ability of large corporations to be cross-
listed in other countries facilitated the need for reporting that conveyed the economic reality of a
business as an economic unit, rather than just a legal entity within business combinations.
The ability of large corporations to unite several entities into one economic entity necessitated the
need for changes to the way financial reports are prepared and presented in light of the relevant
IFRS and IAS. Part 3 addresses the issues specific to this process. It looks at the different ways in
which companies combine and consolidate, and how this is reflected in accounts prepared for
groups of companies.
The chapter ends with practice questions that require application of the knowledge gained.
7 Group accounting

■■ Contents
1. Introduction
2. Combinations based on assets or shares
3. The group
4. Consolidation
5. Other consolidation adjustments
6. Consolidated statement of financial position
7. Consolidated statement of profit or loss and other comprehensive income
8. Investment in associates
9. Interest in joint ventures

■■ Learning outcomes
This chapter deals with the part of the syllabus section entitled ‘The preparation and presenta-
tion of financial statements for groups in compliance with legal and regulatory requirements,
including the relevant International Accounting Standards ’. After reading and understanding
the contents of the chapter, working through all the worked examples and practice questions,
you should be able to:
■■ understand the group and consolidation process;
■■ identify the existence of a group of companies;
■■ explain why parent companies are required to publish consolidated accounts and the circum-
stance in which this obligation does not apply;
■■ prepare a consolidated statement of comprehensive income and a consolidated statement of
financial position that takes account of adjustments required for: goodwill; post-acquisition
profits and minority interest;
■■ demonstrate and apply an understanding of the nature and significance of other consolida-
tion adjustments;
■■ appreciate the value added to the accounting package available to external users by the exist-
ence of requirements to publish consolidated accounts;
■■ identify and account for associated companies and joint ventures in accordance with stand-
ard accounting requirements;
■■ show familiarity with the content of a consolidated cash flow statement; and
■■ explain the purposes and limitations of group accounts.

1 Introduction
This chapter discusses issues related to group accounting and the provisions of the IFRSs and
IASs that give guidance on how to disclose items in the financial statements. We start with
a definition of a ‘group’ and explain the need for consolidated accounts and benefits to users
of consolidated accounting information. The objective of IFRS 10 ‘Consolidated Financial
Statements’ is ‘to establish principles for the presentation and preparation of consolidated
financial statements when an entity controls one or more other entities’.
We will discuss various terminology used in a group accounting context and give an expla-
nation as to their meaning and application. While IFRS 10 gives guidance on preparation and
presentation of consolidated accounts, IFRS 12 ‘Disclosure of Interests in Other Entities’ sets
out disclosure requirements for reporting entities that have an interest in a subsidiary, joint
arrangement, associate or unconsolidated structured entity.
 chapter 7  Group accounting 135

The need to develop an IFRS to deal specifically with issues of consolidated accounts arose
due to inherent weaknesses in IAS 27. While recognising that the basic model for consolidated
accounts was fine in IAS 27, inconsistency in applying the provisions of IAS 27 necessitated the
need for a single combined model that met the needs of both those preparing accounts and end
users of financial information in a consistent manner.

Table 7.1 Summary of relevant International Financial Reporting Standards

IFRS 10 (2011) Consolidated financial statements

IAS 27 (2011) Separate financial statements
IFRS 3 (2008) Business combinations
IAS 28 (2011) Investments in associates

1.1 Definition of key terms

The terms that underpin the consolidation of financial statements are set out in IFRS 10 and
set out in Table 7.2.

Table 7.2 Terms relating to the consolidation of financial statements in IFRS 10

Consolidated The financial statements of a group in which the assets, liabilities, equity, income,
financial expenses and cash flows of the parent and its subsidiaries are presented as those
statements of a single economic entity.
Control of an An investor controls an investee when the investor is exposed, or has rights, to
investee variable returns from its involvement with the investee and has the ability to affect
those returns through its power over the investee.
Investment An entity that:
entity ■■ obtains funds from one or more investors for the purpose of providing those
investor(s) with investment management services;
■■ commits to its investor(s) that its business purpose is to invest funds solely for
returns from capital appreciation, investment income, or both; and
■■ measures and evaluates the performance of substantially all of its investments
on a fair value basis.
Parent An entity that controls one or more entities.
Power Existing rights that give the current ability to direct the relevant activities.
Protective rights Rights designed to protect the interest of the party holding those rights without
giving that party power over the entity to which those rights relate.
Relevant Activities of the investee that significantly affect the investee’s returns.
activities

According to IFRS 10, an investor controls an investee if and only if the investor has all of the
following elements (IFRS 10:7):
■■ power over the investee (i.e. the investor has existing rights that gives it the ability to direct
the relevant activities – the activities that significantly affect the investee’s returns);
■■ exposure, or rights, to variable returns from its involvement with the investee; and
■■ the ability to use its power over the investee to affect the amount of the investor’s returns.

1.2 Definition of a group

A business entity can exist in mutual relationship with other business entities in many ways.
These relationships can be in the form of subsidiaries, associates and joint ventures.
136 Part three  The preparation and presentation of financial statements for groups

In the context of a group, IFRS 3 ‘Business Combinations’ describes a group as a

transaction or event in which an acquirer obtains control of one or more businesses. A busi-
ness is defined as an integrated set of activities and assets that is capable of being conducted
and managed for the purpose of providing a return directly to investors or other owners,
members or participants.

IFRS 10 gives a more definitive description of a group suggesting that a group exists where one
enterprise (the parent) controls, either directly or indirectly, another enterprise (subsidiary). It
follows that a group consists of a parent (owner) and subsidiary.
Additionally, an entity can have control over another entity or entities either directly or indi-
rectly. Figures 7.1 and 7.2 demonstrate how direct or indirect control is achieved by a parent
company:

ALPHA

70%

BETA

Figure 7.1 Direct control by a parent company

In Figure 7.1, the parent company (Alpha) has direct control of the subsidiary company (Beta)
due to its controlling rights. This is manifested through a majority shareholding in the subsidi-
ary company of 70% of the ordinary shares.

ALPHA

70% 40%

BETA DELTA
20%

Figure 7.2 Indirect control by a parent company

In Figure 7.2, the parent company (Alpha) has an indirect control over Delta. Since Alpha has
majority control over Beta (70%) and also has a 40% stake in Delta (due to the fact that Beta
also has a 20% stake in Delta) Alpha has control over Delta (40% + 20%). Hence, both Beta and
Delta will be regarded as subsidiaries of Alpha.
Linking together the various definitions, we can say that consolidated financial statements
must be prepared where one company – the parent – controls the activities of another company
– the subsidiary. So, how does one decide whether one entity is able to control another, giving
rise to the obligation to prepare consolidated accounts? The basic rule, as we have seen above,
is that a parent/subsidiary relationship exists where the first company owns a majority of the
voting share capital of the latter company.
In a simple and straightforward world this would be enough, but the business world is nei-
ther simple nor straightforward. Over the years, various schemes were devised by managers, in
conjunction with their professional advisers, with the objective of conducting a part of a com-
pany’s business operations through another organisation that, although in reality a subsidiary,
was not in law a subsidiary (e.g. the Special Purpose Entity or SPE). It therefore became neces-
sary to define the parent/subsidiary relationship more closely in order to prevent these abuses.
Today, control is presumed to exist (and consolidated financial statements must, therefore,
be prepared) when the parent acquires more than half the voting rights of the enterprise. In the
absence of a majority of voting rights, a subsidiary should be consolidated where the parent has
power:
 chapter 7  Group accounting 137

■■ over more than one half of the voting rights by virtue of an agreement with other investors; or
■■ to govern the financial and operating policies of the other enterprise under a contractual
agreement; or
■■ to appoint or remove the majority of the members of the board of directors; or
■■ to cast the majority of votes at a meeting of the board of directors.
Often two or more of these tests produce the same result. For example, it is usually necessary to
acquire more than half the voting shares to control the composition of the board of directors. In
certain circumstances, a parent company/subsidiary company relationship may exist by applying
one test but not the other. Only one of the above points needs to apply for a subsidiary to exist.

worked e x amp le   7.1

Alpha Ltd purchased 102,000 ordinary shares in Beta Ltd on 1 January 20X4. The issued share capital
of Beta Ltd consists of 200,000 ordinary shares of £1 each, which carry equal voting rights. Alpha
Ltd is, therefore, the parent company of Beta Ltd, as from 1 January 20X4, because:
■■ it holds more than half the voting power and is therefore able to control the composition of the
board of directors; and
■■ it owns more than half the equity share capital, and the relationship between the two companies
can be presented as follows:
– 51% Alpha Ltd (Parent) Beta Ltd (Subsidiary)

2 Combinations based on assets or shares

The combination of two or more businesses may be based on the purchase of assets or shares.

2.1 Combinations based on the purchase of assets

These occur where one company, A, acquires the assets of another company, B, and ownership
of B’s assets is transferred to A. B then goes into liquidation and A carries on the activities for-
merly undertaken by two companies. Alternatively, company C may be formed to acquire the
assets of both A and B.
Companies A and B may then be wound up and a single legal entity, C, emerges to carry on
the activities previously undertaken by the two companies. In both cases it is necessary to value
the assets transferred for inclusion in the acquiring company’s books. Once this has been done,
the assets are accounted for in the normal way and the reporting problems that arise when the
combination is based on shares (see below) are avoided.

2.2 Combinations based on the purchase of shares

This is achieved by one company acquiring enough shares of another to give it control (e.g.
company A acquires the entire share capital of company B). You should note that agreement is
reached between A and the shareholders of B. The transaction does not affect B directly and it
remains in existence as a separate legal entity. A combination based on shares may alternatively
involve the formation of a new company, C, to acquire the shares of A and B. Again, A and B
remain in existence as separate legal entities.
The reasons for basing a combination on an acquisition of shares rather than assets are as
follows:
■■ Economy – It is not necessary to purchase all the target company’s shares; it is enough to
ensure effective control over its activities.
■■ Continuity – Where the acquired company maintains a separate identity, its goodwill is more
likely to survive unimpaired.
■■ Decentralisation – For both managerial and decision-making processes, decentralisation is
facilitated where companies retain their own identity.
138 Part three  The preparation and presentation of financial statements for groups

T E S T YO UR K N OW L E D G E   7.1

Identify three reasons for basing a business combination on the purchase of shares rather than the
purchase of assets.

3 The group
3.1 Legal and economic forms
The external reporting requirements imposed by the Companies Acts, until 1948, applied only
to separate legal entities. In Figure 7.1, for instance, Alpha and Beta each had to publish sepa-
rate accounts, but these accounts were confined to the transactions directly affecting them as
separate legal entities.
The accounts published by Alpha, therefore, included cash actually received from Beta in the
form of dividends, but any profits earned and retained by the subsidiary were not reported by
the parent company. This gave management an enormous amount of scope to publish mislead-
ing financial information if it was inclined to do so. For instance, when the parent company’s
profits were low, management was often able to conceal this by making large, undisclosed trans-
fers of dividends from profitable subsidiaries.
In different circumstances, management allowed subsidiaries to retain all their profits and
even made generous provisions for actual or potential losses of subsidiaries to depress a highly
favourable profit figure that might otherwise have become the basis for unwelcome wage
demands or dividend claims. Admittedly, these are extreme examples, but they indicate the
scope for potential abuse where accounting reports are confined to the legal entity.
Where such abuses occurred, the parent company’s accounts were of little use for assessment
purposes or as a basis for resource allocation decisions. The legislature’s response, in 1948,
was to require parent companies to supplement their legal entity-based accounts with financial
statements based on the affairs of the entire economic entity.
In Figure 7.3, Alpha (parent) and Beta (subsidiary) are separate legal entities which continue
to publish legal entity-based accounts. In addition, Alpha is required to publish group accounts
dealing with the affairs of the overall economic entity formed by Alpha and Beta.

Legal entity
ALPHA

Economic entity 70% BETA

Figure 7.3 Separate legal entities

T E S T YO UR K N OW L E D G E   7.2

Discuss the difference between a legal entity and an economic entity.

 chapter 7  Group accounting 139

4 Consolidation
The concept underlying the preparation of consolidated accounts is extremely simple. The
objective is to provide the shareholders and other stakeholders of the parent company with full
information concerning the activities of the entire economic unit. This is achieved by combin-
ing all the assets and liabilities of the parent company and its subsidiary into a single statement
of financial position to disclose the overall financial position of the group.
We will first consider the effect of a share purchase on the statement of financial position of
the separate legal entities. Later, we turn our attention to the preparation of the consolidated
statement of financial position.

4.1 General rule and exceptions

All parent entities are required to prepare consolidated financial statements (comprising the
parent entity’s accounts combined with the subsidiary). A parent is exempted from the require-
ment to prepare consolidated accounts if all the following conditions are met:
■■ it is a wholly or partially owned subsidiary of another entity whose owners have been informed
about the decision not to consolidate and they do not have any objection to the decision;
■■ the intermediate parent entity that has decided not to consolidate does not have any debt or
equity instruments that are publicly traded; and
■■ its ultimate or intermediate parent prepares consolidated financial statements for public use
that comply with IFRS.

4.2 Determining the cost of a business combination

The consideration given by the parent entity to acquire control in the investee firm must be
measured at fair value.
In general, the consideration given by the parent entity can be split in to four categories:
1. cash;
2. shares in the parent company;
3. deferred consideration; and
4. contingent consideration.

4.2.1 Components of the purchase consideration

Direct costs of the acquisition, such as legal and other consultancy fees, are not treated as part
of the purchase consideration. They are expensed!
■■ Cash: This is the most straightforward form of acquisition. The parent company acquires the
control of a subsidiary through a cash settlement.
■■ Shares in the parent company: The part of the purchase consideration settled in shares is
valued at the market value of the parent entity’s shares at the date of acquisition.
■■ Deferred consideration: This refers to the part of the purchase consideration that is payable
at a future date. The present value of the amount payable should be recorded as part of the
consideration transferred at the date of acquisition. At the end of the financial year, debit the
consolidated retained earnings and credit the deferred consideration account with the inter-
est that has accrued on the deferred consideration.
■■ Contingent consideration: This is payable in the future if, say, a target is met. Under revised
IFRS 3, contingent consideration must be included at its fair value, even if it is deemed
unlikely to be paid.

4.2.2 Parent company’s statement of financial position

A parent company may acquire the shares of a subsidiary for cash or in exchange for its own
shares or loan stock. You should note that where consideration is entirely in the form of cash,
former shareholders of the subsidiary no longer retain any financial involvement with the
group. Where consideration is entirely in the form of shares, the former shareholders of the
subsidiary combine with the shareholders of the parent company and have a joint interest in
the activities of the group.
140 Part three  The preparation and presentation of financial statements for groups

In the parent company’s statement of financial position, the investment in the subsidiary
is shown at the ‘fair value’ of the purchase consideration. Where the purchase consideration is
entirely in the form of cash, the investment is valued at the amount of cash paid. Where part
of the consideration is shares or loan stock issued by the parent company, these securities are
included at market price to arrive at the value of the investment. Worked example 7.2 demon-
strates the parent company’s statement of financial position on acquiring a subsidiary.

worked e x amp le   7.2

The summarised statements of financial position of Alpha Ltd and Beta Ltd as at 31 December 20X4
are as follows.

Alpha Ltd Beta Ltd

£ £
Assets
Non-current assets at carrying value 36,000 27,000
Current assets
Inventories 20,000 7,000
Trade receivables 18,000 8,000
Bank 37,000 1,000
Total assets 111,000 43,000
Equity and liabilities
Share capital (£1 ordinary shares) 60,000 25,000
Retained profits 36,000 10,000
Equity 96,000 35,000
Liabilities 15,000 8,000
Total equity and liabilities 111,000 43,000

Alpha Ltd purchased the entire share capital of Beta Ltd for £35,000 on 31 December 20X4.

Required
Prepare revised statement of financial position for Alpha Ltd on the following alternative
assumptions:
a) The purchase consideration is paid entirely in cash.
b) The purchase consideration consists of two elements: cash of £20,000; 10,000 shares in Alpha
Ltd valued at £1.50 each.

Answer

a) b)
£ £
Assets
Non-current assets at carrying value 36,000 36,000
Investment in Beta Ltd 35,000 35,000
Current assets
Inventories 20,000 20,000
Trade receivables 18,000 18,000
Bank 2,000 17,000
Total assets 111,000 126,000
 chapter 7  Group accounting 141

worked e x amp le   7.2 continued

Equity and liabilities

Share capital (£1 ordinary shares) 60,000 70,000
Share premium account 5,000
Retained profits 36,000 36,000
Equity 96,000 111,000
Liabilities 15,000 15,000
Total equity and liabilities 111,000 126,000

The investment in Beta Ltd is shown in each case at the fair value of the purchase consideration,
namely £35,000. Under (a), the only change is a redistribution of Alpha Ltd’s assets; £35,000 is
transferred from ‘Bank’ to ‘Investment in Beta Ltd’. Under (b), ‘Bank’ is reduced by £20,000; the
remainder of the consideration is shares valued at £15,000. This gives rise to an increase in ‘Share
capital’ of £10,000 and a balance on ‘Share premium account’ of £5,000. The statement of financial
position of Beta remains unchanged in either case; the transaction is with shareholders of Beta Ltd
and no resources transfer into or out of the subsidiary company as a result of the share purchase.

TEST YO UR K N OW LE DG E   7.3

a) Prepare a diagram showing the relationship between a parent company and a subsidiary
company.
b) Outline the conditions that must be met for one company to be considered, for financial
reporting purposes, the subsidiary of another company.

5 Other consolidation adjustments

The preparation of consolidated accounts requires certain further adjustments to be made. On
consolidation, there is a need to ensure that inter-company balances agree before they are elimi-
nated. Differences in balances may be due to:
■■ inventory in transit;
■■ cash in transit; and
■■ management fees not recorded by subsidiary entity.

5.1 Inter-company loans and transfers of goods

Quite often, transfers of cash and goods are made between the members of a group of com-
panies. Indeed, an important reason for takeovers and mergers is that they provide scope for
achieving a more effective utilisation of available resources. Where, for instance, a public com-
pany with significant and readily available sources of finance acquires a controlling interest in
a small family concern, which has good potential for expansion but finds it difficult to raise
funds, a transfer of cash (via inter-company loan accounts) may follow almost immediately.
The loan is, of course, reported respectively as an asset and liability in the separate accounts
published for the parent company and subsidiary. Group accounts, however, regard these sepa-
rate legal entities as a single undertaking and inter-company balances must be cancelled out on
consolidation.
142 Part three  The preparation and presentation of financial statements for groups

5.2 Inter-company unrealised earnings

The accounting convention that a transfer at arm’s length must occur before profit is recognised
must be applied on a group basis when preparing consolidated accounts. Intra-group transfers of
inventories are quite common, particularly where the share purchase has resulted in an element
of vertical integration designed to safeguard either sources of raw materials or consumer outlets.
These transfers of inventories are often made at a figure that approximates market price, both
to enable the performance of individual companies to be fairly assessed and to avoid unneces-
sary complications where minority shareholdings exist. Provided that the recipient company
has resold the item transferred, either in its original form or incorporated in a different product,
it is perfectly legitimate to recognise both elements of profit in the consolidated accounts (i.e.
the profit arising on the intra-group transfer and the profit arising on the sale of the product to
an external party). Where, however, the item transferred remains unsold by the transferee com-
pany at the end of the accounting period, consolidation adjustments must be made to reduce
the value of the inventories to a figure which represents its original cost to the group and in
order to eliminate the unrealised profit.

worked e x amp le   7.3

Small Ltd is a wholly owned subsidiary of Large Ltd. During 20X1, Small Ltd transferred inventories
to Large Ltd, for £36,000. The transfer price was arrived at by adding 50% to the cost to Small Ltd
of the inventories. At the year end, 31 December 20X1, Large Ltd had resold three-quarters of the
inventories for £31,000.

Required
Calculate the amount of unrealised profit and explain how it must be treated in the consolidated
accounts.

Answer
The inventories which remain unsold by Large Ltd at the statement of financial position date have
not left the economic entity and must be restated at cost to that entity.

Unsold inventories – £36,000 × 1/4 = £9,000

Cost of unsold inventories = £9,000 × (100% / 150%) = £6,000
Unrealised profit £3,000
The unrealised profit must be deducted from both profit and the value of inventories

Journal entry to record the adjustment: Debit Credit

Statement of profit or loss and other comprehensive income £3,000
Inventories £3,000

Note: Even if Large Ltd did not hold all the shares in Small Ltd, the entire unrealised profit should be
removed as part of the consolidation exercise. The justification for this treatment is that the minority
shareholders are outside the group and, so far as they are concerned, the profit has been realised
and they should not therefore be affected by an adjustment designed to ensure that inventories are
reported at cost.

5.3 Dividends out of pre-acquisition earnings

A controlling interest may be acquired after a new subsidiary has proposed a dividend payment
but before it has been paid. The source of the dividend is therefore profits earned by the sub-
sidiary before the combination took place. The dividend therefore represents a partial return of
the capital cost and must be accounted for as a reduction in the value of the investment. The
journal entry required to account for a dividend paid out of pre-acquisition profit is:
Journal entry to record the adjustment: Debit Credit
Cash £xxxx
Investment in subsidiary £xxxx
 chapter 7  Group accounting 143

Worked example 7.4 illustrates the calculations needed to give effect to the three secondary
adjustments discussed above as well as the three principal calculations already considered.

worked e x amp le   7.4

The summarised statement of financial position of Quick plc and Silver Ltd at 31 December 20X2
contained the following information.

Quick Silver
£m £m
Non-current assets
Property, plant and machinery at carrying value 172 27
30 million shares in Silver Ltd 43
Loan to Silver 7
222 27
Current assets
Inventories 20 17
Receivables 39 18
Cash and cash equivalents 30 10
89 45
Total assets 311 72
Equity and liabilities
Share capital (£1 ordinary shares) 200 40
Retained earnings 75 20
275 60
Non-current liabilities
Loan from Quick plc 0 5
0 5
Current liabilities
Trade and other payables 36 7
36 7
Total equity and liabilities 311 72

The shares in Silver Ltd were purchased on 31 December 20X1, when the statement of financial
position of that company included retained earnings amounting to £12 million. Silver Ltd paid a final
dividend for 20X1 of £4 million on 31 March 20X2. Quick plc’s share of the dividend is included in its
retained earnings of £75 million in the above summarised statement of financial position.

At 31 December 20X2, the inventories of Silver Ltd include goods transferred from Quick plc, at cost
plus a 50% mark-up, amounting to £3 million. On 29 December 20X2, Silver despatched a cheque
for £2 million to Quick plc, in part repayment of the loan, which was received by the latter company
on 3 January 20X3.

Required
Set out the consolidated statement of financial position of Quick plc and its subsidiary company, on
the basis of IFRS, at 31 December 20X2.

Note: There were no differences between the carrying value and fair value of Silver’s assets and
liabilities at 31 December 20X1.
144 Part three  The preparation and presentation of financial statements for groups

worked e x amp le   7.4 continued

Answer
The following journal entries give the appropriate treatment, for consolidation purposes, of the items
covered in section 5 above:
Debit Credit
Dividends out of pre-acquisition earnings £m £m
Retained earnings 3
Investment in Silver 3
Debit Credit
Inter-company unrealised profit (see calculation below) £m £m
Reserves 1
Inventories 1

%
Cost 100
Mark-up 50
Selling price 150
Mark-up 50%
Selling price 150% × £3m = £1m

Debit Credit
Inter-company loan £m £m
Cash-in-transit 2
Loan to Silver 2

Total At Since Minority

equity acquisition acquisition interest
£m £m £m £m
Share capital (see calculations below) 40 30 10
Retained earnings:
At acquisition 12 9 3
Since acquisition 8   6 2
60 39 6 15
Price paid (£43m – £3m [pre-acquisition]) 40
Goodwill 1
Retained earnings of parent company
(£75m - £3m [pre-acquisition]) – £1m
[unrealised profit on inventories]) 71
Gross retained earnings 77

Percentage of shares purchased – calculation:

Total share capital in Silver Ltd: £40 million
Shares purchased by Quick plc: £30 million
% of shares purchased by Quick plc:
30 million /40 million × 100% = 75%
(Hence NCI = 25%)
Statement of financial position as at 31 December 20X2:
 chapter 7  Group accounting 145

worked e x amp le   7.4 continued

Non-current assets £m
Property, plant and equipment 199
Goodwill 1
(On consolidation inter-company loan is eliminated and does not
appear on SOFP) 200
Current assets
Inventories (£37m – £1m [unrealised profit on inventories]) 36
Trade receivables 57
Cash and cash equivalents (£40m + £2m [cash-in-transit]) 42
Total assets 335
Equity and liabilities
Parent company shareholders’ equity
Share capital 200
Retained earnings 77
277
NCI 15
Total equity 292
Current liabilities
Trade and other payables 43
Total equity and liabilities 335

TEST YO UR K N OW LE DG E   7.4

What adjustments need to be made to take account of inter-company unrealised earnings?

5.4 Interpreting consolidated statement of financial position

We have already drawn attention to the fact that the basic objective of consolidated accounts
is to provide the shareholders of the parent company with detailed information concerning the
activities of the entire economic unit in which they have invested.
We have examined the various procedures followed when preparing a consolidated statement
of financial position and it is now possible to consider more fully what this statement means.
The parent company’s legal entity-based accounts deal with the results of a single organisa-
tion, whereas group accounts set out the combined results of at least two (and perhaps a much
larger number of) legally separate businesses. Therefore, it is not surprising that there are often
significant differences between the two sets of accounts. Some important differences may well
be clearly visible from a simple comparison of the totals appearing in the statement of financial
position. For instance, the parent company’s statement of financial position may contain a
large overdraft, whereas the consolidated statement of financial position shows a healthy cash
surplus indicating that the subsidiaries are in possession of substantial amounts of cash.
A more searching comparison can be made of the information contained in economic entity-
based and legal entity-based accounts by using techniques such as ratio analysis and cash flow
analysis.
146 Part three  The preparation and presentation of financial statements for groups

For illustrative purposes, a comparison is made below of the information contained in Clubs
Ltd’s own statement of financial position (see practice question 7.3) and the statement of finan-
cial position of the group given in the solution to that question. The main points of interest are
as follows:
1 Revenue reserves:
Clubs Ltd £43,000
Group £38,850

This shows that the two subsidiaries are not improving the overall profitability of the group;
the post-acquisition profits of Diamonds Ltd are more than cancelled out by the post-acqui-
sition losses of Hearts Ltd.
2 Fixed assets:
Clubs Ltd £59,000
Group £488,200

This shows that most of the group’s non-current assets are owned by the subsidiary compa-
nies. This information would be of particular interest to prospective creditors of the parent
company, who might be keen to ensure that their advance is adequately secured. One option
open to them would be to require subsidiaries to guarantee repayment of the loan.
3 Solvency:
The working capital ratio relates to the ability of a company to meets its day-to-day cash
requirements. The ratio gives an indication of the liquidity of a company to meet its short-
term cash requirements and it will be discussed in chapter 8. Therefore it may be useful to
return to this section once you have read that chapter.
Current assets
Working capital ratio =
Current liabilities
For Clubs Ltd:
£79,000
Working capital ratio = = 1.2 : 1
£65,000

For the Group:

(79,000 + 62,500 + 29,500)
Working capital ratio = = 0.96 : 1
(65,000 + 37,400 + 75,600)
The working capital position of Clubs Ltd is significantly better than that of the group as
a whole. This would suggest that there are underlying financial difficulties which are not
evident from examining the content of Clubs Ltd’s own statement of financial position. An
examination of the subsidiary companies’ statement of financial position shows that the
problem is at Hearts Ltd, where current liabilities significantly exceed current assets, which
shareholders of the group would not see.
4 Gearing:
Gearing is a comparison between the amounts of borrowing a company has to its share-
holders’ funds. The gearing ratio indicates the proportion of capital available within the
company in relation to that owed to sources outside the company and it will be discussed
in chapter 9. Therefore it may be useful to return to this section once you have read that
chapter.
Debt/equity ratio Clubs Ltd Zero (no loans)
Group 105%
Inter-company shareholdings cancel out on consolidation, whereas all the debentures held out-
side the group must be aggregated. Consequently, the consolidated statement reveals a much
higher level of gearing than is evident from an examination of the individual statement of finan-
cial position of Clubs Ltd and the other companies within the group. The group pays annual
interest to debenture holders totalling £37,500 (£250,000 × 15%). Annual profit figures are not
given, but the interest charge is almost equal to the total retained profits. This would suggest
that the group will find it difficult to meet its interest payments unless trading results improve.
 chapter 7  Group accounting 147

The group accounts point to the existence of significant financial difficulties that are not
evident from Clubs Ltd’s own statement of financial position.

6 Consolidated statement of financial position

The reason for producing consolidated accounts is that the group of companies is in substance,
though not in law, a single undertaking. It therefore follows that the essence of consolidation
procedures is the cancellation of inter-company balances and the aggregation of any remaining
balances. Following the acquisition, Alpha Ltd’s revised statement of financial position contains
an asset entitled ‘Investment in Beta Ltd, £35,000’, whereas Beta Ltd’s statement of financial
position shows a similar amount ‘owing’ to its shareholders (i.e. the total of share capital and
reserves and equity (assets minus liabilities) of Alpha Ltd). When preparing a consolidated
statement of financial position, these inter-company balances cancel out (signified by ¢) and the
remaining assets and liabilities are combined to produce total figures for the group.

worked e x amp le   7.5

Prepare the consolidated statement of financial position of Alpha Ltd and its subsidiary, Beta Ltd, for
the year ended 31 December 20X4, from the summarised statements of financial position shown
below.

Alpha Ltd Beta Ltd

£ £
Assets
Non-current assets at carrying value 36,000 27,000
Current assets
Inventories 20,000 7,000
Trade receivables 18,000 8,000
Bank 37,000 1,000
Total assets 111,000 43,000
Equity and liabilities
Share capital (£1 ordinary shares) 60,000 25,000
Retained profits 36,000 10,000
Equity 96,000 35,000
Liabilities 15,000 8,000
Total equity and liabilities 111,000 43,000

Alpha Ltd purchased the entire share capital of Beta Ltd for £35,000 on 31 December 20X4.The
purchase consideration was entirely in the form of cash.

Answer
Consolidated statement of financial position and subsidiary workings:

Alpha Ltd Beta Ltd Group

£ £ £
Assets
Non-current assets at carrying value 36,000 27,000 63,000
Investment in Beta Ltd 35,000
148 Part three  The preparation and presentation of financial statements for groups

worked e x amp le   7.5 continued

Current assets
Inventories 20,000 7,000 27,000
Trade receivables 18,000 8,000 26,000
Bank 2,000 1,000 3,000
Total assets 111,000 43,000 119,000
Equity and liabilities
Share capital (£1 ordinary shares) 60,000 25,000 60,000
Retained profits 36,000 10,000 36,000
Equity 96,000 35,000 35,000
Liabilities 15,000 8,000 23,000
Total equity and liabilities 111,000 43,000 58,000

This illustrates the essence of consolidation procedures, but it is an oversimplification. It is very

unlikely that the price paid on acquisition will exactly equal the figure for shareholders’ equity
in the subsidiary company’s statement of financial position. Furthermore, a period of time usu-
ally elapses between the date when the shares are acquired and the consolidation date. Finally,
the investing company may well take the opportunity, which this form of business combination
permits, to achieve control while purchasing less than the entire share capital. Consequently,
the preparation of consolidated accounts under the purchase method (the only method now
allowed under IFRS, as the Merger Method is no longer used) involves the following three prin-
cipal calculations:
1. goodwill
2. post-acquisition profits
3. minority interest.
The calculation of these balances will now be examined.

6.1 Goodwill
Often, the price paid for the shares in a subsidiary significantly exceeds the carrying value of
the underlying net assets. Part of this surplus is attributable to the favourable trading connec-
tions, or goodwill, built up by the subsidiary company over the years. The residual difference is
a consequence of the fact that a disparity exists between the carrying value and the fair value
of the assets and liabilities of the subsidiary at the takeover date. Standard accounting practice,
therefore, requires goodwill to be computed in two stages:
1. Restate the subsidiary company’s assets and liabilities at their ‘fair value’. Fair value is
intended to reflect conditions at the time of acquisition, which refers to the time of the com-
pany takeover and not the date of the acquisition of the assets by the subsidiary. They need
not be written into the books of the subsidiary company and used for the purpose of its legal
entity-based accounts, but they must be used for consolidation purposes. IAS 32, ‘Financial
Instruments: Disclosure and Presentation’, provides guidance for the identification of fair
value through the following definition: ‘Fair value is the amount for which an asset can be
exchanged, or a liability settled, between knowledgeable, willing parties in an arm’s length
transaction.’
2. Compute goodwill, in accordance with IFRS 3, as the excess of the price paid for the shares
in the subsidiary over and above the net fair value of the identifiable assets, liabilities and
contingent liabilities acquired. However, IFRS 3 prohibits the amortisation of goodwill.
Instead, goodwill must be tested for impairment at least annually in accordance with IAS
36 ‘Impairment of assets’.
 chapter 7  Group accounting 149

If the parent’s interest in the fair value of the acquired identifiable net assets exceeds the cost
of the business combination, that excess (sometimes referred to as negative goodwill) must be
recognised immediately in the consolidated statement of profit or loss and other comprehensive
income as a gain. Negative goodwill is, of course, a very unusual occurrence. It reveals that the
business has been sold as a going concern for less than might have been produced by selling
assets off individually at their fair value. Before concluding that ‘negative goodwill’ has in fact
arisen, IFRS 3 requires that the parent reassess the identification and measurement of the sub-
sidiary’s identifiable assets, liabilities and contingent liabilities, and the measurement of the
cost of the combination.

TEST YO UR K N OW LE DG E   7.5

Explain the effect on the legal entity-based statement of financial position of a holding company of
acquiring the entire share capital of a new subsidiary for £350,000 in cash.

worked e x amp le   7.6

The summarised statements of financial position of Tom Ltd and Jones Ltd at 31 December 20X1 are
as follows.

Tom Ltd Jones Ltd

£ £
Assets
Non-current assets at carrying value 60,000 46,000
Investment in Jones Ltd 75,000
Current assets
Inventories 32,000 13,000
Trade receivables 27,000 17,000
Bank 1,000 2,000
Total assets 195,000 78,000
Equity and liabilities
Share capital (£1 ordinary shares) 100,000 50,000
Retained profits 70,000 12,000
Equity 170,000 62,000
Liabilities 25,000 16,000
Total equity and liabilities 195,000 78,000

Tom Ltd purchased the entire share capital of Jones Ltd on 31 December 20X1. The non-current
assets of Jones Ltd are considered to possess a fair value of £54,000, but there are no material
differences between the carrying values and fair values of the remaining assets.

Required
a) Calculate the goodwill arising on consolidation.
b) Prepare the consolidated statement of financial position of Tom Ltd and its subsidiary at 31
December 20X1.
150 Part three  The preparation and presentation of financial statements for groups

worked e x amp le   7.6 continued

Answer
Calculation of goodwill arising on consolidation (net asset approach):

£ £
Price paid 75,000
Less: value of business acquired:
Non-current assets at fair value 54,000
Inventories 13,000
Trade receivables 17,000
Bank 2,000
Liabilities (16,000) 70,000
Goodwill 5,000

Note
When solving examination questions, it is generally necessary to calculate the ‘value of business
acquired’ using the equity components rather than the net asset approach above. The result is the
same, but the former procedure is followed because, in most group accounting questions, a period
of time will have elapsed between the dates of takeover and consolidation. Consequently, the figures
for assets and liabilities may not be available, but sufficient information will be given to enable
examinees to build up the figure for the shareholders’ equity interest at that date. The calculation of
goodwill applying the shareholders’ equity approach is as follows.

a) Calculation of goodwill arising on consolidation (shareholders’ equity approach):

£ £
Price paid 75,000
Less: value of business acquired:
Share capital 50,000
Revaluation surplus (W1) 8,000
Retained profits 12,000 70,000

Goodwill 5,000

Workings
W1 £54,000 (fair value of Jones’ non-current assets) – £46,000 (book value)

b) Consolidated statement of financial position of Tom Ltd at 31 December 20X1:

£ £
Non-current assets
Goodwill arising on consolidation 5,000
No current assets (W2) 114,000 119,000
Current assets
Inventories 45,000
Trade receivables 44,000
Bank 3,000 92,000
Total assets 211,000
 chapter 7  Group accounting 151

worked e x amp le   7.6 continued

Equity and liabilities

Share capital (£1 ordinary shares) 100,000
Retained profits 70,000 170,000
Equity 170,000
Non-current liabilities 41,000 41,000
Total equity and liabilities 211,000

W2 balance includes the non-current assets of Jones Ltd at their fair value.

The consolidated profit figure consists only of the retained profits of the parent company and
includes no part of the retained profits of the subsidiary at the takeover date. Profits earned prior
to the date of acquisition (pre-acquisition profits) accrue to the former shareholders of Jones Ltd
and are paid for in the purchase price. They are, therefore, unavailable for distribution to the
shareholders of Tom Ltd and are instead treated as part of the capitalised value of the business
at the takeover date.
This is clearly demonstrated in the calculation of goodwill that uses the shareholders’ equity
approach. The retained profits at acquisition and revaluation surplus, which are also pre-acqui-
sition, are added to share capital to produce a figure of £70,000 for shareholders’ equity. This
is offset against the price paid (£75,000) and results in a balance of £5,000 that is described as
‘goodwill arising on consolidation’ in the consolidated statement of financial position. Profits
earned after the date of acquisition accrue to the parent company’s shareholders, and their
accounting treatment will be examined in the next section.

6.2 Post-acquisition profits

A period of time usually elapses between the acquisition of a controlling interest in a subsidiary
company and the date of the consolidated accounts. The subsidiary company may have gener-
ated profits during the interim period. These profits accrue to the shareholders of the parent
company and, when transferred, are available for distribution. Their accounting treatment is
dealt with in Worked example 7.7.

worked e x amp le   7.7

The summarised statement of financial position of Tom Ltd and Jones Ltd at 31 December 20X11,
Tom Ltd had purchased the entire share capital of Jones Ltd on 31 December 20X0, at which time
the retained profits of Jones Ltd amounted to £9,500.
Tom Ltd Jones Ltd
£ £
Assets
Non-current assets at carrying value 60,000 46,000
Investment in Jones Ltd 75,000
Current assets
Inventories 32,000 13,000
Trade receivables 27,000 17,000
Bank 1,000 2,000
Total assets 195,000 78,000
152 Part three  The preparation and presentation of financial statements for groups

worked e x amp le   7.7 continued

Equity and liabilities

Share capital (£1 ordinary shares) 100,000 50,000
Retained profits 70,000 12,000
Equity 170,000 62,000
Liabilities 25,000 16,000
Total equity and liabilities 195,000 78,000

Required
a) Calculate:
(i) goodwill; and
(ii) post-acquisition profits of Jones Ltd.
b) Prepare the consolidated statement of financial position of the group at 31 December 20X1.

Note
Goodwill arising on consolidation is to be included in the accounts at 31 December 20X1 at £6,000
based on an impairment at review date. Ignore depreciation of other non-current assets.

Answer

a) Calculations
(i) Goodwill:
£ £
Price paid 75,000
Less: value of business acquired:
Share capital 50,000
Revaluation surplus 8,000
Retained profits 9,500 67,500
Goodwill 7,500

(ii) Post-acquisition profits:

£
Retained profits at 31 December 20X1 12,000
Less: Retained profits at 31 December 20X0 9,500
2,500

The retained profit of the group therefore consists of the retained profit of Tom Ltd, £70,000,
plus the post-acquisition profit of Jones Ltd, £2,500, minus goodwill impaired £1,500 (£7,500
– £6,000) = £71,000.
b) Consolidated statement of financial position of Tom Ltd as at 31 December 20X1:

£ £
Non-current assets
Goodwill arising on consolidation 6,000
No current assets (W2) 114,000 120,000
Current assets
Inventories 45,000
 chapter 7  Group accounting 153

worked e x amp le   7.7 continued

Trade receivables 44,000

Bank 3,000 92,000
Total assets 212,000
Equity and liabilities
Share capital (£1 ordinary shares) 100,000
Retained profits 71,000 171,000
Equity 171,000
Non-current liabilities 41,000 41,000
Total equity and liabilities 212,000

There are three further matters that require emphasis concerning the calculation of reported
profits for inclusion in the consolidated statement of financial position:
1. Losses suffered by a subsidiary company since the acquisition date are attributable to the
shareholders of the parent company in the same way as profit earned. Any post-acquisition
losses must, therefore, be deducted from the parent company’s balance of retained profits
to compute the reported profit of the group.
2. We have seen that a subsidiary company’s non-current assets must be stated at fair value in
the consolidated accounts. Where the subsidiary chooses to retain non-current assets at his-
torical cost for the purpose of its own accounts, a consolidation adjustment must be made
equal to the difference between the historical cost-based charge for depreciation, already
made, and an appropriate charge based on the re-valued amount.
3. To the extent that post-acquisition profits earned by a subsidiary are transferred to the
parent company by way of dividends, the amount to be aggregated when consolidation takes
place is correspondingly reduced. For instance, in Worked example 7.5, assume Jones Ltd
had paid an interim dividend of £800 during July 20X1. Tom Ltd’s retained profits increase
to £70,800, the retained profit of Jones Ltd falls to £11,200 and the post-acquisition retained
profits of Jones Ltd become £1,700 (£11,200 – £9,500).
The consolidated balance of reported profit remains unchanged at £71,000 (£70,800 + £1,700
– £1,500 [goodwill impaired]).

TEST YO UR K N OW LE DG E   7.6

a) Explain the calculation of goodwill when shares are acquired in a subsidiary company.
b) Why is it that only the post-acquisition profits of a subsidiary are consolidated under the
purchase method?

6.3 Non-controlling interest

In many cases, the parent company may choose a controlling interest of less than 100% either
in the interests of economy, or because of the obstinacy of certain shareholders. In these cir-
cumstances, the investment confers an interest in the subsidiary company’s net assets based
on the proportion which the number of equity shares acquired bears to the total number of
equity shares then in issue. This must be taken into account when preparing the consolidated
statement of financial position. The appropriate procedure is to include the full amount of the
subsidiary’s assets and liabilities in the consolidated statement of financial position, with the
proportion financed by outside investors represented by a credit balance described as ‘minority
154 Part three  The preparation and presentation of financial statements for groups

interest’. This is shown as a separate item, normally immediately following shareholders’

equity. The non-controlling interest (NCI) consists of an appropriate proportion of the share
capital plus reserves and any other credit balances that accrue to the equity shareholders at the
consolidation date.

worked e x amp le   7.8

The summarised statements of financial position of Zen Ltd and Duff Ltd at 31 December 20X1 are
as follows:
Zen Ltd Duff Ltd
£ £
Non-current assets at carrying value 94,000 58,000
Investment in Duff Ltd 90,000 –
184,000 58,000
Current assets
Inventories 103,000 52,000
Trade receivables 79,000 25,000
Cash and cash equivalents (West Bank) 35,000 –
217,000 77,000
Total assets 401,000 135,000
Equity and liabilities
Share capital (£1 ordinary shares) 200,000 80,000
Retained profits at 1 January 20X1 77,000 7,000
Add: Profit for 20X1 18,000 6,000
Equity 295,000 93,000
Current liabilities
Trade payables 106,000 25,000
Cash and cash equivalents (East Bank) – 17,000
Liabilities 106,000 42,000
Total equity and liabilities 401,000 135,000

Notes
1. The investment in Duff Ltd consists of 60,000 ordinary shares purchased on 1 January 20X1.
2. It may be assumed that there are no significant differences between the carrying value and fair
value of Duff Ltd’s assets.
3. Goodwill arising on consolidation remains unimpaired at 31 December 20X1.

Required
a) Calculate
(i) goodwill;
(ii) retained profits of the group; and
(iii) minority interest.
b) Prepare the consolidated statement of financial position at 31 December 20X1.

Answer
When answering a question involving the preparation of consolidated accounts, the starting point is
to determine the exact relationship between the members of the group.
 chapter 7  Group accounting 155

worked e x amp le   7.8 continued

The relationship may be presented in the form of a diagram (below):

Zen Ltd

75% shareholding (see W1 below)

Duff Ltd (pre-acquisition profit £6,000)

(i) Goodwill:
£ £
Price paid 90,000
Less: value of business acquired:
Share capital 80,000
Retained profits 7,000 65,250 W1
Goodwill 24,750

W1. Proportion of shares acquired 60,000/80,000 × 100% = 75%

Retained profits: Zen Ltd:

£
Retained profits Zen Ltd 95,000
Duff Ltd, 6,000 (post-acquisition profit) × 75% 4,500
Group retained profits 99,500

(iii) NCI:

£
Total equity of Duff Ltd at the consolidation date 80,000
Share capital 13,000
Retained profits 93,000

Proportion attributable to minority shareholders:

20,000/80,000 × 100% = 25%* × 93,000

= 23,250
*Since Zen purchased 75% of the shares in Duff, the NCI will hold the other 25% of the shares.

Note
The figures for goodwill, post-acquisition profit and NCI may be calculated in a convenient manner
by constructing a table (see below), where:
1. the subsidiary’s balance of total equity (including any revaluation reserve and consequential
depreciation adjustment) is distributed between the parent company, distinguishing between the
positions ‘at’ and ‘since’ acquisition, and the minority interest;
2. goodwill is calculated by comparing the value of the subsidiary ‘at acquisition’ with the price paid;
3. the parent company’s retained profits are added to the subsidiary’s profits arising ‘since
acquisition’ to arrive at group retained profits;
4. goodwill may be subject of impairment, though not so in this case; and
5. the balances for goodwill, if any, reported profit and minority interest are transferred to the
consolidated statement of financial position.
156 Part three  The preparation and presentation of financial statements for groups

worked e x amp le   7.8 continued

Duff Ltd
Total At Since Minority
equity acquisition acquisition interest
£ £ £ £
Share capital (see calculations below) 80,000 60,000 20,000
Retained earnings:
At acquisition 7,000 5,250 1,750
Since acquisition 6,000   4,500 1,500
93,000 65,250 4,500 23,250
Price paid 90,000
Goodwill on acquisition 24,750
Retained earnings Zen Ltd 95,000
Gross retained earnings 24,750 99,500

An advantage of this presentation is that it is easy to check whether total equity has been fully
allocated for the purpose of calculating goodwill, retained profits and minority interest. Also,
provided the additions and cross-casts are checked, the possibility of arithmetical error is reduced.

£ £
Non-current assets
Goodwill at carrying value 24,750
Non-current assets at carrying value 152,000 176,750
Current assets
Inventories 155,000
Trade receivables 104,000
Cash and cash equivalents (E1) 35,000 294,000
Total assets 470,750
Equity and liabilities
Share capital (£1 ordinary shares) 200,000
Retained earnings 99,500 299,500
NCI 23,250
Total equity
Current liabilities
Trade and other payables 131,000
Cash and cash equivalents (E1) 17,000
Total equity and liabilities 470,750

E1. The bank overdraft and bank balance are at different banks. Best accounting practice, therefore,
requires these items to be shown separately and not offset against one another. If they were offset,
current assets and current liabilities would both be understated. In large companies holding many
bank accounts, a practical step might be to amalgamate and show all bank balances which are
overdrawn and show as one overdrawn figure and amalgamate all bank balances that are not
overdrawn, to overcome the difficulty of reporting each individual bank balance(s).
 chapter 7  Group accounting 157

7 Consolidated statement of profit or loss and other

comprehensive income
We have seen above that, for the purpose of preparing the consolidated statement of financial
position, the investment in a subsidiary is replaced by the subsidiary’s underlying net assets (and
the minority interest, if any). The same logic applies for the purpose of preparing the consolidated
statement of profit or loss and other comprehensive income where the dividend income from the
subsidiary, if any, is replaced by the underlying income and expenditure of the subsidiary (less
the minority interest, if any). This method of consolidation is often described as line-by-line con-
solidation, or sometimes full consolidation. This name is derived from the fact that, on each line
of the statement of financial position and the consolidated statement of profit or loss and other
comprehensive income, the figures of the subsidiary are aggregated with those of the parent. We
have seen above that inter-company transactions must be eliminated on consolidation. Most of
the possibilities relevant to financial reporting and analysis examination have already been con-
sidered. We only need to draw attention here to the need to eliminate inter-company sales when
preparing the consolidated statement of profit or loss and other comprehensive income.

worked e x amp le   7.9

The individual statements of profit or loss and other comprehensive income of Fast plc and Loose plc
contain the following information for the year ended 31 December 20X1.

Fast plc Loose plc

£,000 £,000
Revenue 6,000 5,000
Cost of sales (4,100) (3,200)
Gross profit 1,900 1,800
Dividends received 75
Distribution expenses (250) (500)
Administration expenses (900) (700)
Profit before taxation 825 600
Taxation (200) (160)
Profit for the year 625 440
Note
Dividends paid 0 (100)
Retained earnings 20X1 625 340

The retained earnings of Fast and Loose at 1 January 20X1 amounted to £500,000 and £1.1 million,
respectively.

Fast acquired 150,000 shares (out of a total of 200,000 shares) of £1 each in Loose on 1 January
20X1. During the year, goods that cost Fast £50,000 were sold to Loose for £68,000; however, none
of these were in inventory at the end of the period. An interim dividend of £100,000 for 20X1 was
paid by Loose on 31 July 20X1.

Required
Provide:
a) the consolidated statement of profit or loss and other comprehensive income of Fast plc and its
subsidiary Loose plc for the year ended 31 December 20X1; and
b) an explanation of how the retained earnings of Loose plc at 1 January 20X1 would be treated in
the consolidated accounts.
158 Part three  The preparation and presentation of financial statements for groups

worked e x amp le   7.9 continued

Answer
a) Consolidated statement of profit or loss and other comprehensive income for the year ended 31
December 20X1:

Fast plc Loose plc Adj Group

£,000 £,000 £,000 £,000
Revenue 6,000 5,000 (68) 10,932
Cost of sales (4,100) (3,200) 50 (7,250)
Gross profit 1,900 1,800 (18) 3,682
Dividends received 75 0 (75) 0
Distribution expenses (250) (500) (750)
Administration expenses (900) (700) (1,600)
Profit before taxation 1,332
Taxation (200) (160) (360)
Profit for the year 972
Attributable
Equity holders of the parent 862
NCI 110
972

b) The retained earnings of Loose plc at 1 January 20X1 have accrued during the period prior to
acquisition and are treated as part of the shareholders’ equity in the subsidiary for the purpose of
computing goodwill arising on consolidation.

7.1 Summary of consolidation procedures

Consolidated statement of profit or loss and other comprehensive income.
Adjustment to profits:
1. Eliminate intra-group sales on consolidation.
2. Eliminate unrealised profit on intra-group sales of unsold goods still in closing inventory.
3. Aggregate the adjusted sales and cost of sales figures.
4. Aggregate expenses.
5. Deduct impairment loss.
6. Adjustment to intra-group dividends and interest:
(i) eliminate dividends paid to parent by subsidiary; and
(iii) eliminate intra-group interest paid.
7. Aggregate the taxation figures (parent and subsidiary).
8. Allocate net profit to parent’s shareholders and NCI.

T E S T YO UR K N OW L E D G E   7.7

Discuss the accounting treatment of dividends and interest on consolidation.

 chapter 7  Group accounting 159

8 Investment in associates
During the 1960s, companies increasingly began to conduct part of their activities through
other companies in which they had acquired a less than 50% equity interest and which, conse-
quently, escaped the group accounting provisions introduced in the Companies Act 1948 (now
incorporated in the Companies Act 2006). Significant influence was exercised, however, either
through the existence of some form of partnership agreement, or because of a wide dispersal of
shares. Consequently, the directors of the investing company were able to influence both the
commercial and financial policies of the company in which shares were held.
The growing demand for fuller disclosure was therefore fully justified:
a) to remove obvious opportunities for the managers of investing companies to manipulate
their company’s reported results, for instance, by building up undisclosed profits in the
accounts of the investee company which could, when required, be transferred to the invest-
ing company in the form of a dividend; and
b) to provide more meaningful performance data concerning the activities of the entire eco-
nomic unit over which some influence was exercised. In this context, the growing popular-
ity of the price/earnings ratio emphasised the increasing significance attached to reported
earnings as a performance indicator. It was therefore important to take steps to ensure that
the investing company’s published earnings fairly represented their actual performance.
The matter was referred to the Accounting Standards Committee (as it then was), which con-
cluded that where management assumes a measure of direct responsibility for the performance
of its investment by actively participating in the commercial and policy-making decisions of an
associated company, it must present a full account to its members.
Accordingly, it was decided that group accounts, prepared in accordance with the Companies
Act, should be extended to incorporate additional information concerning the activities of these
associated companies.
This decision obliged the regulators to draft requirements covering:
■■ the identification of an associated company; and
■■ the additional information to be published.

8.1 Definition of an associate

IAS 28 defines an associate as ‘an entity over which the investor has significant influence and
that is neither a subsidiary nor an interest in a joint venture’. Significant influence is defined
as ‘the power to participate in the financial and operating policy decisions of the investee but is
not control or joint control over those policies’. Holding 20% or more of the voting power leads
to the presumption of significant influence. (Note, however, that the carrying amount of the
investment in the associate is tested for impairment.)

8.2 Indicators of significant influence

On the basis of IAS 28, and for the purposes of financial reporting, the following items will be
indicators of significant influence by the investor company which may give rise to reporting for
associates:
■■ representation on the board;
■■ participation in decisions about profit distribution and retention;
■■ material transactions between the investor and investee; and
■■ exchange of managerial staff.

8.3 Accounting for associates

IFRS 12 ‘Disclosure of Interests in Other Entities’ gives guidance on reporting in relation to
associate entities. The standard suggests that interests in unconsolidated structured entities
shall be disclosed taking into account the following. IFRS 12:24 states that an entity shall dis-
close information that enables users of its financial statements to:
160 Part three  The preparation and presentation of financial statements for groups

■■ understand the nature and extent of its interests in unconsolidated structured entities; and
■■ evaluate the nature of, and changes in, the risks associated with its interests in unconsoli-
dated structured entities.
Associates are accounted for using the equity method-single line consolidation. The amount
reported in the statement of financial position is arrived at as follows:
- Initial investment in associate x
+/- share of associates post x
- Impairment of goodwill x
Acquisition profits
+/- Share of post-acquisition x
Reserves, e.g. revaluation reserves x
Carrying amount of investment in associate x
The accounting treatment for associates is not the same as for subsidiaries. Consideration must
be given to the following issues:
■■ Transactions between investor and associate – the investor’s share of any unrealised profit
must be adjusted against the share of associates profit for the period.
■■ How do we account for unrealised profit on goods sold by associate to the parent company?
■■ How do we account for unrealised profit on goods sold by parent to the associate company?
■■ Intercompany balances are not eliminated.

8.4 Applying the equity method of accounting

The following are the key issues that require attention where an investment is accounted for in
accordance with the equity method.
1. The investment must be recorded initially at cost of acquisition. Any difference (whether
positive or negative) between cost and the investor’s share of the fair values of the net iden-
tifiable assets of the associate is attributed to goodwill and accounted for in accordance with
IFRS 3 ‘Business Combinations’.
2. At subsequent accounting dates, the investing company’s share of the post-tax profits less
losses of associated companies must be computed. This amount is then brought into the
investing company’s accounts as an addition:
a) to profit in the consolidated statement of profit or loss and other comprehensive income
(credit entry); and
b) to the value of the investment in the associated company reported in the statement of
financial position (debit entry). The carrying value of the investment must of course be
reduced to the extent that the profits of the associate have been transferred to the inves-
tor in the form of dividends.
3. Any goodwill shown as part of the carrying amount of the investment in an associate must
be checked annually as normal for impairment, in accordance with the provisions of IFRS 3.
4. Unrealised profits and losses resulting from upstream (associate to investor) and down-
stream (investor to associate) transactions should be eliminated to the extent of the inves-
tor’s interest in the associate.
5. If the associate uses accounting policies that differ from those of the investor, the associate’s
financial statements should be adjusted to reflect the investor’s accounting policies for the
purpose of applying the equity method.
Investments accounted for in accordance with the equity method must be classified as non-
current assets in the statement of financial position.
 chapter 7  Group accounting 161

worked e x amp le   7.10

On 31 December 20X7, Investment plc purchased 25% of the equity share capital of Associated plc
for £1 million. At the acquisition date, Associated plc possessed identifiable assets, net of liabilities,
with a fair value of £3.6 million.

In 20X8, Associated plc earns a profit of £300,000, of which £140,000 is paid out as a dividend
during 20X8 (ignore taxation).

Required
a) Allocate the price paid for the shares in Associated plc between fair value and goodwill.
b) For 20X8, show the amounts which must be recognised in the accounts of Investment plc in
respect of its shares in Associate plc.

Answer
a) £,000
Price paid 1,000
Fair value of net assets acquired £3.6m ÷ 4 900
Goodwill 100

b) Statement of financial position – non-current assets £,000

Investment in associate 1,000
Share of undistributed profits ([300,000 -140,000] ÷ 4) 40
1,040
Consolidated statement of profit or loss and other
comprehensive income £300,000 ÷ 4 75

worked e x amp le   7.11

The results of L plc and its subsidiaries for 20X8 have already been consolidated. The results of K plc,
an associated company, must now be incorporated by applying the requirements contained in IAS
28. The following information is provided.

Consolidated statement of profit or loss and other comprehensive income for year ended 31
December 20X8:

L Group K plc
£m £m
Revenue 51 290
All operating costs (36) (170)
Profit before tax 15 120
Taxation (4) (20)
162 Part three  The preparation and presentation of financial statements for groups

worked e x amp le   7.11 continued

Profit for the year 11 100

Statement of financial position at 31 December 20X8:

L Group K plc
£m £m
Non-current assets
Property, plant and equipment 54 178
Investment in K plc at cost 80  
134 178
Current assets 95 364
Total assets 229 542
Equity and liabilities
Share capital 137 170
Retained earnings 21 192
158 362
NCI 16  
174 362
Current liabilities 55 180
Total equity and liabilities 229 542

L plc acquired 25% of the share capital of K plc on 31 December 20X6, at which date the reserves
of K plc stood at £40 million. At 31 December 2006, the statement of financial position of K plc
contained net assets whose fair value and carrying value were identical at £260 million.

The goodwill attributable to the shareholding of the L Group in K plc was the subject of an
impairment review after the above accounts were prepared. The impairment review revealed that a
write-off of £6 million was required. The amount of tax payable remains unaffected.

Required
Provide the consolidated statement of profit or loss and other comprehensive income of the L group
of companies for 20X8 and the consolidated statement of financial position as at 31 December 20X8
incorporating the results of the associated company K plc.

Answer
Consolidated statement of profit or loss and other comprehensive income for the year ended 31
December 20X8:

L Group
£m £m
Revenue 51
All operating costs (36)
Profit for the period 15
Share of profit of associate (120 ÷ 4) - 6 (impairment review) 24
Profit before taxation 39
Taxation – L Group (4)
 chapter 7  Group accounting 163

worked e x amp le   7.11 continued

Associate (5) (9)

Profit for the year 30

Consolidated statement of financial position at 31 December 20X8:

L Group
£m £m
Non-current assets
Property, plant and equipment 54
Investment in K plc at cost 80
Add: post acquisition retained profit
([192 - 40] ÷ 4) - 6 32 112
Current assets 95
Total assets 261
261
Equity and liabilities
Share capital 137
Retained earnings (21 + 32) 53
190
NCI 16
Total equity 206
Current liabilities 55
Total equity and liabilities 261

Table 7.3 indicates the likely categorisation of an equity investment, based on the level of share-
holding, as an investment, an associate or a subsidiary. Remember that the level of sharehold-
ing is not the definitive test.

Table 7.3 Accounting for equity investments

Accounting for equity investment  

% of shares held Classification Accounting method

< 20% Investment Cash basis
> 20% < 50% Associate Equity method
> 50% Subsidiary Purchase method

9 Interest in joint ventures

A joint venture involves the pooling of resources and expertise by two or more businesses to
achieve a particular goal. The risks and rewards of the enterprise are also shared. The reasons
behind the formation of a joint venture often include business expansion, development of new
products or moving into new markets, particularly overseas. Collaborating with another com-
pany for this purpose may be useful because, for example, it provides access to:
■■ more resources
■■ greater capacity
■■ increased technical expertise
■■ established distribution channels.
164 Part three  The preparation and presentation of financial statements for groups

Joint ventures are particularly popular where cooperation between businesses in different coun-
tries is an advantage (e.g. in the areas of transport, tourism and hotels).

9.1 Relevant IFRS and IAS to joint ventures

IAS 28 ‘Investments in Associates and Joint Ventures’ (effective since 1 January 2013 and
superseding IAS 28 (2003) ‘Investments in Associates’) describes a joint venture as ‘A joint
arrangement whereby the parties that have joint control of the arrangement have rights to the
net assets of the arrangement’. The objective of IAS 28 is to prescribe the accounting treatment
for joint ventures. Where a joint venture clearly exists, management shall report on the same
conditions under IAS 28.
IFRS 11 ‘Joint Arrangement’ (effective since January 2013) requires parties to a joint arrange-
ment to determine the type of joint arrangement in which they are involved by assessing its
rights and obligations, and account for those rights and obligations in accordance with that type
of joint arrangement.
IFRS 12 ‘Disclosure of Interests in Other Entities’ prescribes the disclosure of information
that enables users of financial statements to evaluate:
■■ the nature of, and risks associated with, its interests in other entities; and
■■ the effects of those interests on its financial position, financial performance and cash flows.

9.2 Disclosure requirements

There are no disclosures specified in IAS 28. Instead, IFRS 12 ‘Disclosure of Interests in Other
Entities’ outlines the disclosures required for entities with joint control of, or significant influ-
ence over, an investee.

9.3 Identifying a joint venture

IAS 28 describes three types of joint ventures:
1. Joint arrangement – An arrangement of which two or more parties have joint control.
2. Joint control – The contractually agreed sharing of control of an arrangement, which exists
only when decisions about the relevant activities require the unanimous consent of the par-
ties sharing control.
3. Joint venture – A joint arrangement whereby the parties that have joint control of the
arrangement have rights to the net assets of the arrangement.

9.4 Accounting for a joint venture

IAS 28 (effective from 1 January 2013) only allows accounting for joint ventures under the
equity method and defines various aspects of accounting treatment as follows.
1. Basic principle: Under the equity method, on initial recognition the investment in an asso-
ciate, investment is above 20% but less than 50%, or a joint venture, a contractually agreed
sharing of control, is recognised at cost and the carrying amount is increased or decreased to
recognise the investor’s share of the profit or loss of the investee after the date of acquisition.
2. Distributions and other adjustments to carrying amount: The investor’s share of the inves-
tee’s profit or loss is recognised in the investor’s profit or loss. Distributions received from
an investee reduce the carrying amount of the investment. Adjustments to the carrying
amount may also be necessary for changes in the investor’s proportionate interest in the
investee arising from changes in the investee’s other comprehensive income (e.g. to account
for changes arising from revaluations of property, plant and equipment and foreign currency
translations).
3. Potential voting rights: An entity’s interest in an associate or a joint venture is determined
solely on the basis of existing ownership interests, and generally does not reflect the pos-
sible exercise or conversion of potential voting rights and other derivative instruments.
 chapter 7  Group accounting 165

4. Interaction with IFRS 9: IFRS 9 ‘Financial Instruments’ does not apply to interests in asso-
ciates and joint ventures that are accounted for using the equity method. Instruments
containing potential voting rights in an associate or a joint venture are accounted for in
accordance with IFRS 9, unless they currently give access to the returns associated with an
ownership interest in an associate or a joint venture.
5. Classification as non-current asset: An investment in an associate or a joint venture is gen-
erally classified as a non-current asset, unless it is classified as held for sale in accordance
with IFRS 5 ‘Non-current Assets Held for Sale and Discontinued Operations’.

worked e x amp le   7.12

Grumpy plc and Sleepy plc jointly established Dopey Ltd to operate a holiday business. Grumpy and
Sleepy have equal shares in Dopey and share profits equally. The results of Grumpy plc and Dopey
Ltd are set out below.

Statement of profit or loss and other comprehensive income for the year ended 31 December 20X1:

Grumpy plc Dopey Ltd

£m £m
Revenue 300 170
All operating costs (229) (86)
Profit before tax 71 84
Taxation (15) (18)
Profit for the year 56 66

Statement of financial position at 31 December 20X1:

£m £m
Non-current assets
Property, plant and equipment 111 100
Investment in Dopey Ltd at cost 60  
171 100
Current assets 49 134
Total assets 220 234
Equity and liabilities
Share capital 50 120
Retained earnings 140 90
190 210
Current liabilities 30 24
Total equity and liabilities 220 234

Required
Provide the consolidated statement of profit or loss and other comprehensive income of financial
position and notes showing movement on reserves of Grumpy plc for 20X1 incorporating the results
of Dopey on the equity method on the basis of IAS 28.
166 Part three  The preparation and presentation of financial statements for groups

worked e x amp le   7.12 continued

Answer
Consolidated statement of profit or loss and other comprehensive income for the year ended 31
December 20X1:

Grumpy plc
£m
Revenue 300
All operating costs (229)
Profit before tax 71
Share of profit of joint venture (84 ÷ 2) 42
113
Grumpy plc (15)
Joint venture (9)
Profit for the year 89

Consolidated statement of financial position at 31 December 20X1:

Grumpy plc
£m
Non-current assets
Property, plant and equipment 111
Investment in Dopey Ltd at cost 60
ADD: Post acquisition retained profit (90 ÷ 2) 45
216
Current assets 49
Total assets 265
Equity and liabilities
Share capital 50
Retained earnings 185
235
Current liabilities 30
Total equity and liabilities 265

Statement of change in equity:

Grumpy plc
£m
Balance at 1 January 20X1: 140 - 56 = 84 + 50% of (90 – 66) 96
Earnings for the period 89
Balance at 31 December 20X1 185

T E S T YO UR KN OW L E D G E   7.8

Why do companies enter into joint ventures?

 chapter 7  Group accounting 167

? END OF CHAPTER QUESTIONS

7.1 The summarised statements of financial position of Halesworth Ltd and Haverhill Ltd as at 31 October 20X0
were as follows:

Halesworth Haverhill
£,000 £,000
Assets
Investment in Haverhill 6,000
Other net assets at book Value 7,200 3,700
13,200 3,700
Financed by:
Ordinary share capital (£1 shares) 10,000 1,000
Retained profit at 1 October 20X9 2,940 1,720
Net profit for 20X9-X0 260 980
13,200 3,700

Halesworth purchased the entire share capital of Haverhill on 1 November 20X9 for £6 million. The fair value
of the net assets of Haverhill at that date was £1.2 million in excess of book value.

Required
Prepare the consolidated statement of financial position of Halesworth and its subsidiary, as at 31 October
20X0, based on the information provided. You should use the purchase method and comply, as far as the
information permits, with standard accounting practice.
7.2 The following summarised statement of financial position is provided for Twickenham Ltd as at 30 September
20X1.

£,000
Non-current assets at carrying value 2,000
Net current assets 1,600
Total assets 3,600
Share capital (£1 ordinary shares) 2,700
Retained profit at 1 October 20X0 600
Profit for year to 30 September 20X1 300
Total equity and liabilities 3,600

Wembley Ltd purchased 1.8 million shares in Twickenham Ltd on 1 October 20X0 for £2.5 million. There
were no differences between the carrying values and fair values of the Twickenham’s assets and liabilities at
that date, and the company has paid no dividends for some years.

Required
Based on the above information, calculate the balances to be included in the accounts of the Wembley Ltd
group of companies for the year to 30 September 20X1 in respect of:
1. goodwill
2. NCI
3. post-acquisition profits.
168 Part three  The preparation and presentation of financial statements for groups

? END OF CHAPTER QUESTIONS continued

7.3 The summarised statement of financial position of Clubs Ltd and its subsidiary companies Diamonds Ltd and
Hearts Ltd at 31 December 20X6 were as follows:

Clubs Ltd Diamonds Ltd Heart Ltd

£ £ £
Non-current assets at carrying value 59,000 299,500 129,700
80,000 shares in Diamonds Ltd 126,000 – –
30,000 shares in Hearts Ltd 44,000 – –
229,000 299,500 129,700
Current assets 79,000 62,500 29,500
Total assets 308,000 362,000 159,200
Equity and liabilities
Share capital (£1 shares) 200,000 80,000 40,000
Retained earnings at 31 December 20X5 36,000 33,200 7,200
Profit/(loss) for 20X6 7,000 11,400 (13,600)
243,000 124,600 33,600
Non-current liabilities
15% debentures   200,000 50,000
243,000 324,600 83,600
Current liabilities 65,000 37,400 75,600
Total equity and liabilities 308,000 362,000 159,200

Clubs Ltd acquired the shares in both subsidiaries on 31 December 20X5. Neither subsidiary paid a dividend
during the year.

Required
Provide the consolidated statement of financial position for the group at 31 December 20X6 presented in
vertical format so as to disclose the balance for net current assets.

Notes
1 Ignore taxation.
2. Assume no differences between the carrying values and fair values of the assets and liabilities of
Diamonds Ltd and Hearts Ltd.
3. You should assume that any goodwill arising on consolidation suffers impairment equal to one-quarter
of its initial value at the end of 20X6.
4. Interest on debentures has been charged in arriving at the profit or loss for the year.
7.4 During the year ended 30 September 20X7, Company A (the parent company) sells goods to Company B (the
subsidiary) at cost plus a mark-up of 25%.
Explain the appropriate accounting treatment, for consolidation purposes, of the profit arising in the books
of Company A on transfers of stock to Company B.
Also explain the logic behind the treatment.
7.5 Alpha paid £265,000 to acquire 70% of the equity shares of Beta on 1 January 20X7. Beta’s retained
earnings at the date of acquisition were £50,000. The market price of Alpha’s shares on 1 April 20X6 was
£4 each. The market price of Beta’s shares was £2.50 each. The statements of financial position for the two
companies at the close of business on 31 December 20X7 were as follows.
 chapter 7  Group accounting 169

? END OF CHAPTER QUESTIONS continued

Alpha Beta
£ £
Non-current assets
Intangible non-current assets – 30,000
Tangible non-current assets 500,000 70,000
Investments 290,000 60,000
790,000 160,000
Current assets
Inventory 100,000 50,000
Trade receivables 150,000 100,000
Cash and cash equivalents 30,000 20,000
280,000 170,000
Total assets 1,070,000 330,000
Equity and liabilities
Ordinary shares of £1 each 700,000 100,000
Share premium 140,000 50,000
Retained earnings 100,000 100,000
940,000 250,000
Current liabilities
Trade payable 90,000 60,000
Accruals 40,000 20,000
130,000 80,000
Total equity and liabilities 1,070,000 330,000

Additional information
1. At the date of acquisition, 1 January 20X7, Beta owned a piece of land that had a fair value of £20,000
in excess of its book value. The fair value adjustments have not been reflected in the individual financial
statements of Beta.
2. One-half of goodwill arising on acquisition of Beta is impaired.
3. During the year to 31 December 20X7, Alpha sold goods to Beta for £20,000 (at a mark-up on cost of
20%). Beta had one-half of these goods in its inventory at 31 December 20X7.
4. Intangible assets of Beta are all of a type whose recognition would not be permitted under IAS 38. This
is to be followed in preparing the consolidated financial statements. When Alpha made its investment
in Beta on 1 January 20X7, the intangible assets of Beta included £10,000 that would not qualify for
recognition under IAS 38.
5. Creditors reported by Beta include £10,000 owed to Alpha, whereas the corresponding amount in
Alpha books is £15,000. The difference in inter-company balances is due to cash in transit.
6. It is group policy to value the non-controlling interest at the date of acquisition at its proportionate
share of the fair value of the subsidiary’s net assets. The non-controlling interest in Beta is to be valued
at its (full) fair value. For this purpose, Beta’s share price at that date of acquisition can be taken to be
indicative of the fair value of the shareholding of the non-controlling interest at the date of acquisition.

Required
Prepare a consolidated statement of financial position for Alpha at 31 December 20X7.
7.6 Explain what is meant by the parent entity concept and how the choice of this concept affects the
preparation of consolidated financial statements.
170 Part three  The preparation and presentation of financial statements for groups

? END OF CHAPTER QUESTIONS continued

7.7 The following information is provided in respect of Ronson plc.
£m
Operating profit for 20X7 26
Inventories:
1 January 20X7 107
31 December 20X7 101
Receivables
1 January 20X7 86
31 December 20X7 99
Payables
1 January 20X7 54
31 December 20X7 72
Taxation charge, 20X7 12
Depreciation charge, 20X7 33
Purchase of non-current assets 111

Required
Calculate the ‘Net cash generated from (or used in) operating activities’ for Ronson plc for 20X7 in accordance
with the provisions of IAS 7 ‘Statement of Cash Flows’ using the Indirect Method.
 part four

Analysis and
interpretation of
accounts
■■ List of chapters
  8. Trend analysis and introduction to ratio analysis
  9. Analysis and interpretation of accounts 1
10. Analysis and interpretation of accounts 2
11. Limitations of published accounts
12. Financial reporting within the business environment

Part 4 covers the syllabus section entitled ‘Analysis and interpretation of accounts’.

■■ Overview
Part 4 looks at and discusses, with relevant examples, the analysis and interpretation of financial
reports. This allows users to make informed economic decisions and to evaluate emerging trends.
8 Trend analysis and introduction
to ratio analysis

■■ Contents
1. Introduction
2. Stewardship and the role of managers
3. Horizontal and vertical analysis of accounts
4. Trend analysis to a time series
5. Principles of ratio analysis
6. Primary ratios

■■ Learning outcomes
This chapter deals with the part of the syllabus section entitled ‘Analysis and interpretation of
accounts’. After reading and understanding the contents of the chapter, working through all the
worked examples and practice questions, you should be able to:
■■ undertake horizontal analysis of accounts between two periods based on percentage changes;
■■ take account of the effect of exceptional items on comparability;
■■ apply trend analysis to the results of a series of accounting periods;
■■ undertake vertical analysis based on common size statements; and
■■ understand the nature of accounting ratios and the use that can be made of them.

1 Introduction
Stakeholders, current and potential investors, creditors, customers and employees all have a
vested interest in the financial performance and other aspects of a company. Financiers and
credit providers need to gauge the creditworthiness of a company prior to any commitment of
finances. This need for stakeholder servicing by companies is mostly enshrined in law, as well
as in national and international guidelines.
Published financial reports provide stakeholders with financial information. Each stakeholder
having a different vested interest in a business entity requires access to financial information
that serves their purposes. The information may be accessible in different forms, allowing users
of financial information to determine the current state of affairs of a company and to anticipate
its future prospects.
Changes to company and related law and the development of, and considerable amendments
to, International Financial Reporting Standards (IFRSs) has placed a greater burden on compa-
nies to deliver additional and more detailed information, thereby facilitating a greater depth and
quality of transparency, particularly after the ‘credit crunch’ that began in 2007–08.
This chapter will primarily evaluate company financial performance on the basis of pub-
lished financial reports of listed companies. The nature of the modern corporation, being a
limited liability entity, gives it a legal personality distinct from its owners. However, the nature
of limited liability ensures that the liability of owners is limited to the extent of their ownership
stake.

2 Stewardship and the role of managers

Stewardship refers to a situation under which one party is responsible for taking good care of
resources entrusted to them. The owners of a business (for example, the shareholders) trust
others to manage the business on their behalf. Shareholders entrust the board of directors of a
 chapter 8  Trend analysis and introduction to ratio analysis 173

company with the responsibility for managing the affairs of the company by giving it direction,
providing control and strategy, and ensuring continuance.
The board of directors consists of non-executive and executive directors. Executive directors
are ‘hands-on’; they are involved in the day-to-day operations and management of the company.
Non-executive directors are not involved in the day-to-day operation of the business. These
directors provide a wider perspective.
The board employs managers to implement their strategic vision and to help ensure the
investments of owners are maximised. To ensure this happens effectively, owners put mech-
anisms in place to monitor managerial behaviour. The UK Code on Corporate Governance
(2010) provides guidelines for board conduct, behaviour, duties and obligations. The UK Code
is principle-based and requires directors to conduct business with integrity, responsibility and
accountability. Corporate governance and ethical issues are covered in chapter 12. The remain-
der of this chapter discusses and analyses financial reports using various analysis techniques.

TEST YO UR K N OW LE DG E   8.1

What is meant by stewardship?

3 Horizontal and vertical analysis of accounts

3.1 Performing a horizontal analysis
The main point of performing a horizontal analysis on the financial statements is to see how
things have changed from one period to the next. A horizontal analysis of the accounts is a
comparison of two or more years’ financial data. Horizontal analysis is facilitated by showing
changes between years in both pound and percentage form (see Worked example 8.1). Showing
changes in pound form helps the analyst to focus on key factors that have affected profitability
or financial position.
A horizontal analysis allows the user to compare the financial numbers from one period to
the next, using financial statements from at least two distinct periods. Each line item has an
entry in a current period column and a prior period column. Those two entries are compared to
show both the pound difference and the percentage change between the two periods.
In Worked example 8.1, although sales increased in 20X1 by £4 million, the comparative
increase in the cost of sales of £4.5 million contributed to a decrease in gross profit in 20X1.

worked e x amp le   8.1

The comparative financial statements of Jane plc as at 31 December 20X1 and 20X0 are shown
below.

Statement of financial position as 31 December:

20X1 20X0
£,000 £,000
Non-current assets
Property and equipment:
Land 4,000 4,000
Building 12,000 8,500
Total non-current assets 16,000 12,500
174 Part four  Analysis and interpretation of accounts

worked e x amp le   8.1 continued

Current assets
Cash 1,200 2,350
Accounts receivable 6,000 4,000
Inventory 8,000 10,000
Prepaid expenses 300 120
Total current assets 15,500 16,470
Total assets 31,500 28,970
Equity and liabilities
Share capital (£12 shares) 6,000 6,000
Share premium 1,000 1,000
6% preferred shares
(£100 nominal value) 2,000 2,000
Retained earnings 8,000 6,970
17,000 15,970
Long-term liabilities:
Bonds payable 8% 7,500 8,000
Total long-term liabilities 7,500 8,000
Current liabilities
Accounts payables 5,800 4,000
Accrued payables 900 400
Notes payables 300 600
Total current liabilities 7,000 5,000
Total liabilities 14,500 13,000
Total equity and liabilities 31,500 28,970

Consolidated statement of profit or loss and other comprehensive income for the year ended
31 December:

20X1 20X0
£,000 £,000
Sales 52,000 48,000
Cost of goods sold 36,000 31,500
Gross profit 16,000 16,500
Operating expenses
Selling expenses 7,000 6,500
Administrative expense 5,860 6,100
Total operating expenses 12,860 12,600
Operating profit before interest and taxation (PBIT) 3,140 3,900
Interest expense 640 700
Profit before tax 2,500 3,200
Income taxes (30%) 750 960
Profit for the period 1,750 2,240
 chapter 8  Trend analysis and introduction to ratio analysis 175

worked e x amp le   8.1 continued

Required
Provide a horizontal analysis for Jane plc for the two years.

Answer
Horizontal analysis of the statement of financial position for the financial years ended 31 December
20X1 and 20X0:

Increase/
20X1 20X0 (decrease) Change
£,000 £,000 £,000 %
Non-current assets
Property and equipment:
Land 4,000 4,000 0 0.00%
Building 12,000 8,500 3,500 41.18%
Total non-current assets 16,000 12,500 3,500 28.00%
Current assets
Cash 1,200 2,350 (1,150) –48.94%
Accounts receivable 6,000 4,000 2,000 50.00%
Inventory 8,000 10,000 (2,000) –20.00%
Prepaid expenses 300 120 180 150.00%
Total current assets 15,500 16,470 (970) –5.89%
Total assets 31,500 28,970 2,530 8.73%
Equity and liabilities
Share capital (£12 shares) 6,000 6,000 0 0.00%
Share premium 1,000 1,000 0 0.00%
6% preferred shares
(£100 nominal value) 2,000 2,000 0 0.00%
Retained earnings 8,000 6,970 1,030 14.78%
17,000 15,970 1,030 6.45%
Long-term liabilities
Bonds payable 8% 7,500 8,000 (500) –6.25%
Total long-term liabilities 7,500 8,000 (500) –6.25%
Current liabilities
Accounts payables 5,800 4,000 1,800 45.00%
Accrued payables 900 400 500 125.00%
Notes payables 300 600 (300) –50.00%
Total current liabilities 7,000 5,000 2,000 40.00%
Total liabilities 14,500 13,000 1,500 11.54%
Total equity and liabilities 31,500 28,970 2,530 8.73%
176 Part four  Analysis and interpretation of accounts

worked e x amp le   8.1 continued

Horizontal analysis of the consolidated statement of profit or loss and other comprehensive income
for the financial years ended 31 December 20X1 and 20X0:

Increase/
20X1 20X0 (decrease) Change
£,000 £,000 £,000 %
Sales 52,000 48,000 4,000 8.33%
Cost of goods sold 36,000 31,500 4,500 14.29%
Gross profit 16,000 16,500 (500) –3.03%
Operating expenses
Selling expenses 7,000 6,500 500 7.69%
Administrative expense 5,860 6,100 (240) –3.93%
Total operating expenses 12,860 12,600 260 2.06%
Operating profit before
interest and taxation 3,140 3,900 (760) –19.49%
Interest expense 640 700 (60) –8.57%
Profit before tax 2,500 3,200 (700) –21.88%
Income taxes (30%) 750 960 (210) –21.88%
Profit for the period 1,750 2,240 (490) –21.88%

The expression of the comparative annual changes in absolute monetary terms does not pro-
vide the analyst with a true scale of the periodic change. An increase in sales of £4 million may
seem very significant or material, but the significance cannot be determined by relying simply
on the monetary value of the change. To ascertain the scale of periodic changes between two or
more accounting periods, the annual changes are expressed in percentage terms. The expres-
sion in percentage terms provides the analyst and readers of financial statements with informa-
tion relating to the scale of the change, as the expression of the percentage is based upon the
movement in the item from the original position. Analysts and readers are able to see that the
£4m increase in sales during the period represented an increase of 8.3%. The proportionate
change of 8.3% is more useful than knowing the sales increased by £4 million.

T E S T YO UR K N OW L E D G E   8.2

a) What is horizontal analysis is and how is it carried out?

b) What useful information can the user extract by performing horizontal analysis?

3.2 Performing a vertical analysis

Vertical analysis is often referred to by financial analysts as ‘common size’ analysis. Vertical
analysis provides a business with a greater understanding of how its sales revenue is being
consumed within the business. A vertical analysis of the statement of profit or loss and other
comprehensive income restates every expenditure item as a proportion of the sales revenue.
Knowledge of where the sales revenue is being consumed or applied enables management to
undertake further investigation and/or any necessary action if the level of activity is deemed to
be adverse for the business.
 chapter 8  Trend analysis and introduction to ratio analysis 177

Similarly, a vertical analysis of the statement of financial position restates each asset as a
percentage of the total assets, and each liability is restated as a percentage of total equity and
liabilities. This provides the analyst with an understanding of the significance of each asset and
liability within the business.
Worked example 8.2 demonstrates what a vertical analysis looks like for both a statement of
profit and loss and a statement of financial position.

worked e x amp le   8.2

Comparative vertical analysis of the consolidated statement of profit or loss and other comprehensive
income for Jane plc for the years ended 31 December:

20X1 20X1 20X0 20X0

£,000 % £,000 %
Sales 52,000 100.00 48,000 100.00
Cost of goods sold 36,000 69.23 31,500 65.63
Gross profit 16,000 30.77 16,500 34.38
Operating expenses
Selling expenses 7,000 13.46 6,500 13.54
Administrative expenses 5,860 11.27 6,100 12.71
Total operating expenses 12,860 24.73 12,600 26.25
Operating profit before interest and taxation 3,140 6.04 3,900 8.13
Interest expenses 640 1.23 700 1.46
Profit before income tax 2,500 4.81 3,200 6.67
Less income taxes (30%) 750 1.44 960 2.00
Post tax profit 1,750 3.37 2,240 4.67

It can readily be seen that, although actual sales increased were up in 20X1, the gross profit had
fallen by 3.61% due to the increased cost of goods sold in 20X1. This needs to be investigated and
reasons sought as to why this has happened. It could be that material was more expensive in 20X1
than in 20X0. Even though the rest of the expenses were comparatively higher in 20X0 to sales, net
profits were lower in 20X1 due to the increased cost of sales.

Comparative vertical analysis of the statement of financial position for Jane plc for the comparative
the years ended 31 December:

20X1 20X1 20X0 20X0

£,000 % £,000 %
Non-current assets
Property and equipment:
Land 4,000 12.70 4,000 13.81
Building 12,000 38.10 8,500 29.34
Total non-current assets 16,000 50.79 12,500 43.15
Current assets
Cash 1,200 3.81 2,350 8.11
Accounts receivable 6,000 19.05 4,000 13.81
Inventory 8,000 25.40 10,000 34.52
178 Part four  Analysis and interpretation of accounts

worked e x amp le   8.2 continued

Prepaid expenses 300 0.95 120 0.41

Total current assets 15,500 49.21 16,470 56.85
Total assets 31,500 100.00 28,970 100.00
Equity and liabilities
Share capital (£12 shares) 6,000 19.05 6,000 20.71
Share premium 1,000 3.17 1,000 3.45
6% preferred shares
(£100 nominal value) 2,000 6.35 2,000 6.90
Retained earnings 8,000 25.40 6,970 24.06
17,000 53.97 15,970 55.13
Long-term liabilities:
Bonds payable 8% 7,500 23.81 8,000 27.61
Total long-term liabilities 7,500 23.81 8,000 27.61
Current liabilities
Accounts payables 5,800 18.41 4,000 13.81
Accrued payables 900 2.86 400 1.38
Notes payables 300 0.95 600 2.07
Total current liabilities 7,000 22.22 5,000 17.26
Total liabilities 14,500 46.03 13,000 44.87
Total equity and liabilities 31,500 100.00 28,970 100.00

The vertical analysis of the statement of financial position reveals that during the year, the company
has increased its non-current assets as a proportion of its total assets. In addition, the liabilities share
of the equity and liabilities has increased. The expression of the changes in proportionate terms are
more useful to analysts and other readers of the financial statements.

T E S T YO UR K N OW L E D G E   8.3

a) Explain vertical analysis. How is it carried out?

b) What useful information can the user extract by performing a vertical analysis?

3.2.1 Dealing with exceptional items

Exceptional items are those items that occur during the ordinary course of the business but
need to be disclosed due to their size or incidence. A customer may go bankrupt and this may
materially increase the bad debt of an entity for the period. The actual size of the debt owing to
the entity, not the bankruptcy, is what gives rise to the item being exceptional.
An operational definition of exceptional items is used by ITV plc in their Annual Report and
Accounts for the year ended 31 December 2012:

exceptional items are material and non-recurring items excluded from management’s assess-
ment of profit because by their nature they could distort the Group’s underlying quality of
earnings. These are excluded to reflect performance in a consistent manner and are in line
with how the business is managed and measured on a day-to-day basis.
 chapter 8  Trend analysis and introduction to ratio analysis 179

These exceptional items should be identified and isolated for consideration before any analysis
is undertaken. Readers of financial statements are concerned about the financial performance
arising from the ordinary trading activities; hence, any exceptional items should be isolated
prior to any analysis. The separation of exceptional items from any analysis allows the analyst
to determine any trends or patterns in the company performance arising from its ordinary trad-
ing activities.

4 Trend analysis to a time series

Horizontal analysis of financial statements can also be carried out by computing trend percent-
ages. Trend percentage restates multiple years’ financial performance results in terms of a base
year. The base year equals 100%, with all other years expressed relative to this to this base.

worked e x amp le   8.3

Consider a corporation that runs a multinational chain of fast-food outlets and restaurants, with thousands
of outlets and restaurants worldwide. The corporation enjoyed tremendous growth in the years 2000–10, as
evidenced by the following data.

£,000 2010 2009 2008 2007 2006 2005 2004 2003 2002 2001 2000
Sales 14,200 13,300 12,400 11,400 10,700 9,800 8,300 7,400 7,100 6,700 6,380
Operating 1,980 1,950 1,550 1,640 1,570 1,430 1,220 1,080 960 860 796
income

An observation of the data reveals an annual increase in sales every year, and an increase in operating income
every year except 2008. It is difficult to determine the rate of annual change from the data presented. It is also
difficult to determine whether the sales and operating profit have exhibited any direct or indirect relationship over
the ten-year period.

It is easier to judge the significance of annual changes in the sales and operating income when they are restated
in terms of the first year (the base year). The restatement is as follows.

£,000 2010 2009 2008 2007 2006 2005 2004 2003 2002 2001 2000
Sales 223% 208% 194% 179% 168% 154% 130% 116% 111% 105% 100%
Operating 249% 245% 195% 206% 197% 180% 153% 136% 121% 108% 100%
income

This trend analysis, if plotted on a graph, would reveal almost parallel growth in both sales, apart from a dip in
operating income in 2008. A review of the company’s statement of profit or loss and other comprehensive income
and the statement of financial position would be required to ascertain the contributory factors to the decline in
operating income growth in 2008. One possible explanation may be a temporary increase in costs – for example,
due to a food scare affecting the price of beef. If the expenditure in 2008 was found to be exceptional, it would
be prudent for the purposes of analysis to write-back the expense to profits in determining the trend over the ten-
year period.

5 Principles of ratio analysis

Ratios, as a tool of financial analysis, provide evidence that enables judgments to be made con-
cerning the financial health of a business. As previously mentioned, different groups of people
are interested in different aspects of a business. The significance of ratio analysis differs for dif-
ferent groups. This will be explained below.
180 Part four  Analysis and interpretation of accounts

5.1 Usefulness to management

5.1.1 Decision-making
The management of a company will generally have quicker and easier access to financial infor-
mation than other stakeholder groups. However, they may suffer from ‘information overload’
as the mass of information contained in internal reports and financial statements may be unin-
telligible and confusing. Ratios help to highlight areas requiring attention and any corrective
action needed, facilitating rapid decision-making.

5.1.2 Financial forecasting and planning

Ratios collated over a period of time help management to understand the history of the busi-
ness. They also provide useful data on the existing strengths and weaknesses of the business.
This knowledge is vital, as it allows management to plan and forecast for the future.

5.1.3 Communication
Ratios can help to communicate information to interested parties in a way that makes the
significance of figures easier to understand. This enables groups to make better-informed eco-
nomic decisions – for example, by enabling the current situation to be understood better and
enabling judgments to be made about prospects for the future.

5.1.4 Facilitate coordination

By being precise, brief and highlighting specific areas, ratios are likely to improve coordination
between internal management: for example, the management teams responsible for different
business functions and business units.

5.1.5 Control is more effective

Planning and forecasting systems establish budgets, develop forecast statements and lay down
standards. The use of rations enables meaningful comparison to be made between forecasts,
standards and actual results. Variances can be computed and analysed by managers, thereby
administering an effective system of control.

5.1.6 Owners/shareholders
Existing, as well as prospective owners or shareholders, are fundamentally interested in the
long-term solvency and profitability of the business. Ratio analysis enables these key indicators
to be understood better and enables judgments to be made about prospects for the future.

5.1.7 Creditors
Creditors are owed money by the business. Their primary interest is ensuring the business is
able to pay them. Short-term, trade creditors are interested in the immediate and short-term
liquidity of the business.
Long-term creditors, such as financial institutions (mortgage holders) and debenture holders
are interested in the capacity of the business to repay its loans and interest over the term of the
loan.
Ratio analysis enables both types of creditors to judge better the financial position of the busi-
ness and the risk attached to the repayment of what they are owed.

5.1.8 Employees
Employees are interested in fair wages and salaries, acceptable fringe benefits and bonuses
linked with productivity and profitability. Ratio analysis can provide them with information
regarding the efficiency and profitability of the business. This allows them to bargain more
effectively for improved wages, bonuses and other aspects of their employment contracts.
 chapter 8  Trend analysis and introduction to ratio analysis 181

5.1.9 The government

The government is interested in obtaining financial information from businesses for a variety of
reasons and uses. Financial information from businesses regarding production, sales and profit
provides central government with useful information to assess their prospective taxation rev-
enue. However, on a wider level, government requires such information both to assess current
policy and to assist in the determination of future policies. In addition, the financial informa-
tion provides a valuable source of information for statistical analysis of the business sector as a
whole and/or subsectors.
Group information from industry is required to formulate national policies and planning. In
the absence of dependable information, government plans and policies may not achieve their
desired results.
The accounts published annually by companies constitute an important source of informa-
tion for external users, and their form and content are regulated with the intention of ensuring
that they are a helpful and reliable guide to corporate progress. The amount of useful informa-
tion that can be obtained from the statement of profit or loss and other comprehensive income
for the period and statement of financial position may be severely limited, even when a detailed
breakdown of trading results is provided. For example, the consolidated statement of profit or
loss and other comprehensive income might show sales amounting to £500 million and the
statement of financial position might disclose trade receivables totalling £21 million (sales to
trade receivables ratio), but, taken in isolation, it is impossible to assess whether these amounts
are satisfactory or unreasonable.

5.2 Nature of ratio analysis

Ratios, by themselves, are one of the means of understanding the financial health of a business
entity. Ratio analysis is a technique for establishing and identifying relationships between items
within the financial statements and interpreting the relationships to form a judgment regarding
the financial affairs of a business.
Ratio analysis has been developed to help translate the information contained in the accounts
into a form more helpful and readily understandable to users of financial reports. The ratios do
not appear in the accounts, however, and users must calculate and interpret them themselves
or employ someone with the necessary skills to do the job.
Accounting ratios are calculated by expressing one or more items in the financial statements
as a ratio or percentage of another item or items. The objective is to identify and disclose rela-
tionships and trends that may not be immediately evident from the examination of the indi-
vidual financial statements. The ratio that results from a comparison of two figures possesses
real significance only if an identifiable commercial relationship exists between the numerator
and the denominator. For example, one may expect there to be a positive relationship between
operating profit and the level of sales. Assuming that each item sold produces a profit, one
would expect a higher sales figure to produce more profit. So, mere observation of the fact that
profit is £5 million is not particularly illuminating. What may be of greater interest is operating
profit expressed as a percentage of sales.
The significance of an accounting ratio is enhanced by comparison with some yardstick of
corporate performance. There are three main options available, namely comparison with:
■■ results achieved during previous accounting periods by the same company (trend analysis);
■■ results achieved by other companies (inter-firm comparisons); and
■■ predetermined standards or budgets.
The advantage of making comparisons is that it enables users to judge a company’s perfor-
mance in context. For example, by comparing a ratio against other similar businesses or against
past performance of the same business, a judgment may be made that classifies performance
as good, average or poor. Sifting through the large volume of information contained in annual
reports is cumbersome; reducing such information to a handful of important and very useful
ratios enables the user to answer key questions on the economic reality of a company:
1. Does the profit being earned reflect good progress?
2. Is the company sufficiently cash-enabled?
3. Is there sufficient amount of capital on a long-term basis?
4. Are the resources of the company being used efficiently?
5. Are trade receivables and payables being managed efficiently?
182 Part four  Analysis and interpretation of accounts

Ratios are regarded as a highly efficient way of determining the answers to the above questions,
particularly if they are used on a time-series basis.

6 Primary ratios
The primary ratios are a combination of profitability and liquidity ratios to allow analysts (and
users of financial statements) to ascertain an initial assessment of the financial strength of an
entity.

6.1 Primary operative ratios (GPM and OPM)

Two primary operative ratios exist to enable the analyst and reader gain a better understanding
of the financial performance of a business. These ratios are the gross profit margin (GPM) and
the operating profit (OPM). These ratios are calculated as follows:
Gross profit
Gross profit margin = × 100
Sales

Operating profit
Operating profit margin = × 100
Sales
The GPM and OPM are measures of the returns generated from each monetary unit of sales
revenue.

worked e x amp le   8.4

Jane plc has provided you with their consolidated statement of profit or loss and other
comprehensive income below for the years ended 31 December in 20X0 and 20X1.
20X1 20X0
£,000 £,000
Sales 52,000 48,000
Cost of goods sold 36,000 31,500
Gross profit 16,000 16,500
Operating expenses:
Selling expenses 7,000 6,500
Administrative expense 5,860 6,100
Total operating expenses 12,860 12,600
Operating profit before interest and taxation 3,140 3,900
Interest expense 640 700
Profit before tax 2,500 3,200
Income taxes (30%) 750 960
Profit for the period 1,750 2,240

Required
Calculate the primary operative ratios for 20X0 and 20X1.
 chapter 8  Trend analysis and introduction to ratio analysis 183

worked e x amp le   8.4 continued

Answer
The comparative primary operative ratios are as follows.

Gross profit margin Operating profit margin

Gross profit Operating profit

= × 100 × 100
Sales Sales
16,000 3,140
20X1 = × 100 × 100
52,000 52,000

= 30.77% 6.04%
16,500 3,900
20X0 = × 100 × 100
48,000 48,000

= 34.38% 8.13%

The gross profit margin (GPM) shows the profit generated per monetary unit of sales. In 20X0, Jane
plc generated £34 gross profit per £100 sales revenue, whereas in 20X1, the company generated
a lower return per £100 of sales revenue. This decline in GPM would need to be investigated.
However, from the consolidated statement of profit or loss and other comprehensive income and our
previous horizontal analysis, the decline in the GPM can be attributed to an increase in cost of sales
greater than the increase in sales revenue. The rate of increase in the cost of sales is often outside
the control of the company, and perhaps a solution may be to source alternative and lower-priced
cost of sales. However, the management should be mindful that lower cost of inputs may have an
adverse impact on the quality of output.
The operating profit margin (OPM) shows the operating profit generated per monetary unit of
sales. In 20X0, Jane plc generated £8 operating profit per £100 sales revenue, whereas in 20X1, the
company generated a lower return: £6, per £100 of sales revenue. This decline in OPM would need
investigation. However from the consolidated statement of profit or loss and other comprehensive
income and our previous horizontal analysis, the decline in the OPM can be attributed to an increase
in cost of sales and operating expenses greater than the increase in sales revenue.
Despite the decline in both the GPM and OPM in 20X1, it is not all bad news. The company
exercised greater control over its operating expenses in 20X1, as the GPM less OPM declined from
26.25% to 24.73% between 20X0 and 20X1. The difference between the GPM and OPM is a
general measure on the operating expenses consumption of the sales revenue.

TEST YO UR K N OW LE DG E   8.4

a) Why would you expect the operating profit margin to increase when sales increase?
b) Outline three possible reasons for an increase in the gross profit margin.

6.2 Primary liquidity ratio

Businesses require working capital to function in their day-to-day operations. Any pressure on
working capital could lead to a business either defaulting on its current obligations (e.g. to trade
payables and employees) or, in the worst-case scenario, lead to total business failure. Liquidity
ratios measure the working capital employed in a business and changes in the working capital
over time provide an indication of the financial strains the business is experiencing in the short
term.
184 Part four  Analysis and interpretation of accounts

There are two standard ratios that are used for the purpose of assessing and measuring the
primary liquidity of a business. These ratios are the current ratio and the acid test, and are
examined below.

6.2.1 Working capital (current) ratio

The working capital (current ratio) is defined as the excess of current assets over current liabili-
ties, and a surplus is normally interpreted as a reliable indication of the fact that a company is
solvent. The current ratio is calculated as follows:
Current assets
Current ratio = Working capital ratio = :1
Current liabilities
The purpose of the current ratio is to assess and measure the ability of a company to pay its cur-
rent debts as they fall due. A question often asked by readers of financial statements is: ‘What is
a correct working capital ratio?’ A general benchmark for the current ratio is 2:1. However, this
should not be interpreted as a set standard for all companies. Any deviation from 2:1 should not
be interpreted as indicating a better or worse company.
Analysts must familiarise themselves with the rate at which current assets are converted
into cash and how quickly current liabilities must be paid. This very much depends on what
the generally accepted or agreed practice is within the particular sector. For example, a retailer
who sells goods for cash would generally operate with a much lower current ratio than a manu-
facturer who sells goods on credit. In the retail industry, resources are converted directly from
inventories into cash, whereas in manufacturing, goods sold are probably tied up as debts out-
standing for six to eight weeks before cash becomes available. The period for which inventories
are held varies from one industry to another. A manufacturer of small metal products is likely to
convert raw materials into finished goods and sell them much more quickly than a construction
company where inventories are likely to comprise a much higher proportion of current assets to
reflect the relatively slow rate of turnover.
For these and other reasons, one should guard against always accepting accounting ratios at
face value, and should assess their significance after carefully considering the economic facts
that lie behind them.
The current ratio as a measure of solvency suffers from one limitation, namely its inclusion
of inventory. To be solvent, a company needs to be able to convert its current assets into cash at
short notice and minimal cost. Unfortunately, inventories are not readily convertible into cash.
This renders the current ratio as an ineffective and unreliable measure of solvency.

6.2.2 Acid test (quick ratio)

The acid test or quick ratio is used to examine solvency to overcome the limitation of the
current ratio. It is calculated in a similar manner to the working capital ratio, but with one
important difference: the exclusion of inventory from the current assets and the liquidity ratio
concentrates attention more on a company’s prospect of paying its debts as they fall due. It
is for this reason that the calculation is often described as the ‘quick ratio’ or ‘acid test of sol-
vency’. The acid test is derived as follows:
Current assets – inventory
Acid test = :1
Current liabilities

A liquidity ratio of 1:1 is desirable as it affords a company the comfort of knowing it can meet
its short-term debts. However, 1:1 is not a good or bad ratio in isolation from other non-finan-
cial factors, such as the operating sector, the company, its reputation, the economy etc.
 chapter 8  Trend analysis and introduction to ratio analysis 185

worked e x amp le   8.5

Jane plc has provided you with its statement of financial position for the years ended 31 December
in 20X0 and 20X1.

20X1 20X0
£,000 £,000
Non-current assets
Property and equipment:
Land 4,000 4,000
Building 12,000 8,500
Total non-current assets 16,000 12,500
Current assets
Cash 1,200 2,350
Accounts receivable 6,000 4,000
Inventory 8,000 10,000
Prepaid expenses 300 120
Total current assets 15,500 16,470
Total assets 31,500 28,970
Equity and liabilities
Share capital (£12 shares) 6,000 6,000
Share premium 1,000 1,000
6% preferred shares
(£100 nominal value) 2,000 2,000
Retained earnings 8,000 6,970
17,000 15,970
Long-term liabilities:
Bonds payable 8% 7,500 8,000
Total long-term liabilities 7,500 8,000
Current liabilities
Accounts payables 5,800 4,000
Accrued payables 900 400
Notes payables 300 600
Total current liabilities 7,000 5,000
Total liabilities 14,500 13,000
Total equity and liabilities 31,500 28,970

Required
Calculate the primary liquidity ratios for the years ended 31 December 20X0 and 20X1.

Answer
The primary liquidity ratios for Jane plc for the years ended 31 December 20X0 and 20X1 are as
follows.
186 Part four  Analysis and interpretation of accounts

worked e x amp le   8.5 continued

Current ratio Quick ratio

Current assets Current assets – Inventories

= :1 :1
Current liabilities Current liabilities
15,500 15,500–8,000
20X1 = :1 :1
7,000 7,000

= 2.21 : 1 1.07 : 1
16,470 16,470–10,000
20X0 = :1 :1
5,000 5,000

= 3.29 : 1 1.29 : 1

T E S T YO UR K N OW L E D G E   8.5

a) Why is it important to have an adequate level of working capital?

b) Explain how the liquidity ratio is calculated.

6.3 Return on Capital Employed (ROCE)

The Return on Capital Employed (ROCE) ratio is a measure of efficiency and profitability. It
measures how well capital has been utilised. The ratio is derived from the earnings (profit)
before interest and taxation (from the statement of profit or loss and other comprehensive
income for the period) expressed over the total capital employed in the business. The total capi-
tal employed is the total assets less the current liabilities. It is important to state at this point
that, in practice, there are multiple variations on both the denominator and numerator used
for the ROCE and other ratios that seek to measure a return. It is therefore important, when
conducting financial analysis or reviewing financial analysis, to ensure one knows the basis for
the computations before advancing to conclusions or any comments on performance. ROCE is
calculated as follows:
Profit before interest and taxation
× 100
Total assets – Current liabilities
The earnings before interest and taxation are used because this figure represents the actual
returns before any distortion by interest rates or taxation, especially when conducting compara-
tive analysis. Purists within the business and financial analyst community may go further and
use EBITDA (Earnings Before Interest Taxation Depreciation and Amortisation) as the numera-
tor, because EBITDA is regarded as the pure return unaffected by distorters such as deprecia-
tion, interest charges and taxation.
ROCE is used to indicate the value the business has obtained from its capital (expressed as
assets less liabilities). The ratio is used to show how efficiently a business is using its resources.
However, the main drawback of ROCE is that it measures return against the book value of
assets in the business. As these depreciate, the ROCE will increase even if the cash generated
remained the same. Thus older businesses, with depreciated assets, will tend to have higher
ROCE than newer, possibly more profitable businesses. In addition, while cash flow is affected
by inflation, the book value of assets is not. Consequently, revenue increases with inflation,
while capital employed generally does not (as the book value of assets is not affected by inflation).
 chapter 8  Trend analysis and introduction to ratio analysis 187

6.4 Return on Equity (ROE)

Return on Equity (ROE) is a primary investment ratio used in financial analysis. The ratio
measures the profitability of the business and how effective management have been in generat-
ing a return for shareholders. In general terms, investors are seeking a high ROE. Therefore,
when conducting comparative analysis, a higher ROE would be preferable to a lower ROE. The
ratio is expressed as follows:
Profit before interest and taxation
× 100
Total equity
The earnings (profit) before interest and taxation (from the statement of profit or loss and other
comprehensive income for the period) is expressed over the total equity of the company. The
total equity is extracted from the statement of financial position.
Because the ratio is based upon the operating profit from the business activity of the com-
pany before deductions for interest charges and taxation, ROE provides an insight to the income
generating ability of an entity.
Despite the merits of ROE, as with all ratios it should be interpreted with caution and assessed
in the context of other indicators. A company with a low equity base – for example, a knowl-
edge-driven business – is likely to have a much lower equity base than a business that requires
significant investment in production machinery. As a result, the knowledge-based business will
exhibit a higher ROE. Conversely, companies that require larger amounts of investment may
be prone to a lower ROE.

worked e x amp le   8.6

The comparative financial statements for Jane plc for the years ended 31 December 20X0 and 20X1
are as follows.

Statement of financial position as 31 December:

20X1 20X0
£,000 £,000
Non-current assets
Property and equipment:
Land 4,000 4,000
Building 12,000 8,500
Total non-current assets 16,000 12,500
Current assets
Cash 1,200 2,350
Accounts receivable 6,000 4,000
Inventory 8,000 10,000
Prepaid expenses 300 120
Total current assets 15,500 16,470
Total assets 31,500 28,970
Equity and liabilities
Share capital (£12 shares) 6,000 6,000
Share premium 1,000 1,000
6% preferred shares
(£100 nominal value) 2,000 2,000
Retained earnings 8,000 6,970
17,000 15,970
188 Part four  Analysis and interpretation of accounts

worked e x amp le   8.6 continued

Long-term liabilities:
Bonds payable 8% 7,500 8,000
Total long-term liabilities 7,500 8,000
Current liabilities
Accounts payables 5,800 4,000
Accrued payables 900 400
Notes payables 300 600
Total current liabilities 7,000 5,000
Total liabilities 14,500 13,000
Total equity and liabilities 31,500 28,970

Consolidated statement of profit or loss and other comprehensive income for the year ended 31
December:
20X1 20X0
£,000 £,000
Sales 52,000 48,000
Cost of goods sold 36,000 31,500
Gross profit 16,000 16,500
Operating expenses:
Selling expenses 7,000 6,500
Administrative expense 5,860 6,100
Total operating expenses 12,860 12,600
Operating profit before interest and taxation 3,140 3,900
Interest expense 640 700
Profit before tax 2,500 3,200
Income taxes (30%) 750 960
Profit for the period 1,750 2,240

Required
Calculate the ROCE and ROE for Jane plc for each of the two years.

Answer
Return on Capital Employed (ROCE) Return on Equity (ROE)
Profit before interest and taxation Profit before interest and taxation
= × 100 × 100
 Total assets – Current liabilities       Total equity
3,140 × 100 3,140 × 100
20X1 = 24,500 17,000
= 12.82% 18.47%
3,900 × 100 3,900 × 100
20X0 =
23,970 15,970
= 16.27% 24.42%

Both ratios declined in 20X1, which initially indicates a reduced return on the capital employed and
return for shareholders. However, closer examination reveals the decline can be further explained
as result of the decline in PBIT and increases in the capital employed and total equity. The increases
in capital employed and equity did not generate a greater level of profitability. This may give rise to
further investigation by the management of Jane plc.
 chapter 8  Trend analysis and introduction to ratio analysis 189

stop and t hink  8.1

The real value in financial ratios lies in cash-flow-based ratios – accounting ratios do not show
much.
Do you agree or disagree with this?

? END OF CHAPTER QUESTIONS

8.1 Explain the role of stewardship in managing a company’s financial affairs.
8.2 Explain the principal features of ratio analysis.
8.3 State the primary accounting ratios and explain their purpose and usefulness in assessing a firm’s
performance.
8.4 An extract of balances for current assets and liabilities in respect of Roadster Ltd are presented below:

20X2 20X1
  £,000 £,000
Current assets    
Inventory 180 240
Trade receivables 520 400
Cash and cash equivalents 60 55
  760 695
Current liabilities    
Account payables 320 425
Accrued expenses 40 80
  360 505

Required
a) Calculate the liquidity ratios for the two years 20X1 and 20X2 respectively.
b) Comment on the movements of the liquidity ratios and any issues of concern arising.
8.5 The following information relates to Brent Limited for the two years to 31 December 20X1 and 20X2.

Brent Ltd – statement of profit or loss and other comprehensive income for the years to 31 December:

20X2 20X1
£,000 £,000 £,000 £,000
Sales (all credit) 1,900 1,500
Opening inventory 100 80
Purchases 1,400 995
1,500 1,075
Closing inventory 200 100
Cost of goods sold 1,300 975
Gross profit 600 525
Less: Expenses 350 250
250 275
190 Part four  Analysis and interpretation of accounts

? END OF CHAPTER QUESTIONS continued

Brent Ltd – Statement of financial position at 31 December
20X2 20X1
£,000 £,000 £,000 £,000
Non-current assets (NBV) 460 580
Current assets
Inventory 200 100
Trade receivables 800 375
Cash and cash equivalents 0 25
1,000 500
Total assets 1,460 1,080
Equity and liabilities
Ordinary shareholders fund 500 500
Retained earnings 550 300
Total equity 1,050 800
Non-current liabilities
Debentures 200 200
Current liabilities
Bank overdraft 10 0
Trade payables 200 210 80 80
Total liabilities 410 280
Total equity and liabilities 1,460 1,080

Note: Ignore taxation.

Required
a) Calculate the following accounting ratios for 20X1 and 20X2 respectively:
(i) gross profit margin
(ii) current ratio; operating profit margin
(iii) acid test
(iv) return on capital employed
(v) return on equity.
b) Comment on the company’s performance for the year to 31 December 20X2.
8.6 Using the information from Brent Ltd in Question 8.5, carry out vertical and horizontal analysis for the
company, and comment on your findings.
Analysis and interpretation 9
of accounts 1

■■ Contents
1. Introduction
2. Subsidiary ratios
3. Liquidity ratios
4. Asset turnover ratios
5. The cash operating cycle
6. Pyramid of ratios

■■ Learning outcomes
This chapter continues with the part of the syllabus section entitled ‘Analysis and interpretation
of accounts’. After reading and understanding the contents of the chapter, working through all
the worked examples and practice questions, you should understand:
■■ the purpose of and explanations for gearing ratios;
■■ the purpose of and explanations for company performance ratios;
■■ the impact of debt on company profitability;
■■ the link between gearing and profitability;
■■ the impact of gearing on shareholders return;
■■ the impact of working capital on cash flow and company profit;
■■ company efficiency and asset usage ratios; and
■■ the pyramid of ratios.

1 Introduction
This chapter delves more deeply into ratio analysis, examining company performance from
the perspectives of profitability, asset usage and efficiency. We discuss the specific ratios used
to evaluate company financial performance and those that measure levels of financial commit-
ment in relation to resources employed.

2 Subsidiary ratios
2.1 Gearing ratio
The capital employed in a company comes from two sources: equity or debt. Gearing is the
term used to explain the proportion of debt a company has in its capital structure. One way of
measuring gearing is through ratios. The debt: equity ratio is the most common ratio used to
measure the level of gearing. A number of different approaches are used to measure gearing.
However, for our purposes, gearing refers to the relationship between long-term debt and total
equity. As such, the gearing ratio is as follows:
Long-term debt
× 100
Total equity

The gearing ratio is a key ratio in financial analysis. The ratio measures the proportion of
long-term debt carried by a company, which can be a key indicator of financial health. In gen-
eral terms, an entity is deemed to be highly geared if the gearing ratio exceeds 50%. However,
the determination of high or low gearing will be dependent upon the industry and sector. A
192 Part four  Analysis and interpretation of accounts

company with a ratio of over 50% has more debt than equity in its capital structure. This
renders the company vulnerable to external takeover and adverse changes in interest charges.
Increasing levels of gearing increases a company’s exposure to interest rate movements. This
can have a critical impact on the survival of the company, especially in periods of declining sales
and profitability. Despite this concern about gearing, in some circumstances it may be argued
that increasing gearing is the correct course of action.
Gearing may be measured in either of two ways:
a) Debt defined as long-term loans:
Long-term loans*
Debt : Equity ratio = : 1 Shareholders’ equity
Shareholders’ equity
*This could include any preference shares outstanding.
b) Debt defined as total borrowing:
Lenders, when assessing risk, want to examine a business’s full financial exposure. For this
reason, they often find it useful to extend the definition of debt, used for the purpose of
calculating the debt:equity ratio, in the following manner:
Total financial debt*
Total debt : Equity ratio × : 1
Shareholders’ equity
*Includes loans from directors and bank overdrafts that, although technically for the short
term, are a permanent source of financing for many businesses.
The use of debt capital has direct implications for the profit accruing to the ordinary sharehold-
ers, and expansion is often financed in this manner with the objective of increasing, or ‘gear-
ing up’, the shareholders’ rate of return. This objective is achieved, however, only if the rate of
return earned on the additional funds raised exceeds that payable to the providers of the loan.

worked e x amp le   9.1

Ludlow plc has presented its statement of financial position for the year ended 31 December as
follows.

20X1 20X0
£ £ £ £
Non-current assets
Cost 900,000 700,000
Accumulated depreciation 185,000 150,000
715,000 550,000
Current assets
Inventories 1,500,000 1,360,000
Trade receivables 1,560,000 960,000
Cash and cash equivalents 120,000 20,000
3,180,000 2,340,000

Less: Current liabilities

Trade payables 567,500 467,500
Taxation 177,500 172,500
745,000 640,000
Working capital 2,435,000 1,700,000
2,250,000
 chapter 9  Analysis and interpretation of accounts 1 193

worked e x amp le   9.1 continued

Non-current liabilities:
10% debenture loan 800,000  
Net assets 2,350,000 2,250,000
Equity
Share capital 1,500,000 1,500,000
Reserves 850,000 750,000
Shareholders’ funds 2,350,000 2,250,000

Required
a) Calculate the gearing for Ludlow plc for both years.
b) Comment on your findings.

Answer
a) The comparative years gearing is as follows:

Gearing 20X1  20X0

Long-term debt  800,000      0    
× 100 ×100 × 100
Total equity 2,350,000 2,250,000
34.04% 0.00%

b) In 20X0, the company did not have any long-term debt, therefore its gearing was 0%. In 20X1,
the company raised £800,000 via a 10% debenture, which led to the company having a gearing
level of 34%. As the gearing level is less than 50%, this may be regarded as a low level of
gearing. However, this 34% level of gearing must be viewed within the context of the industry
and sector before one can be satisfied that Ludlow plc is lowly geared. Furthermore, the company
should be mindful of further increases in gearing, as this can begin to put pressure on the
operating profit, especially if sales and operating profit begin to decline.

worked e x amp le   9.2

Ponty Ltd and Pop Ltd are established companies engaged in similar lines of business. Trading
conditions change significantly from year to year. An analysis of past results achieved by companies
in the same line of business as Ponty and Pop shows that operating profit before deducting interest
charges can fluctuate by up to 50% up or down from year to year. The forecast results for the next
financial year are shown below.

Ponty Pop
  £,000 £,000
Ordinary share capital (£1 shares) at 1 June 2010 1,500 3,200
Revaluation surplus at 1 June 2010 500 1,000
Capital redemption reserve at 1 June 2010 0 800
14% debentures at 1 June 2010 4,000 1,000
Operating profit before interest 2010–11 840 840

It is the policy of each company to pay out its entire profits in the form of dividends.
194 Part four  Analysis and interpretation of accounts

worked e x amp le   9.2 continued

Required
a) For each company, calculate:
(i) the estimated rate of return on shareholders’ equity;
(ii) the gearing (debt: equity) ratio.
b) Set out a discussion of the relative merits of the capital structures of each of the two companies
from the shareholders’ point of view. The discussion should include calculations of maximum
possible variations in the return on shareholders’ equity.

Note: Ignore taxation.

a) Ponty Pop
£,000   £,000
Operating profit before interest 840 0
× 100 × 100 × 100
Total Equity 1,500 1,500
56.00% 0.00%
Long-term debt 4,000 1,000
× 100 × 100 × 100
Total Equity 2,000 5,000
200.00% 20.00%
Answer: 2:1 or 200% 1:5 or 20%

b) Ponty Pop
50% –50% 50% –50%
£,000 £,000 £,000 £,000
Operating profit 1,260 420 1,260 420
Interest 560 560 140 140
700 (140) 1,120 280
Ordinary share capital 1,500 3,200
Revaluation surplus 500 1,000
Capital redemption reserve 0 800
Equity 2,000 2,000 5,000 5,000
Return on shareholders’ equity 63% 21% 25.20% 8.40%

The following relevant comments might be made:

1. The capital structure of Ponty Ltd is highly geared, which means that there is a high ratio of
debt to equity finance.
2. The main advantage of gearing is that any return in excess of the cost of borrowing is returned
to shareholders.
3. This can be seen above, with an increase in profits of 50% resulting in the return on
shareholders’ equity increasing from 12.5% to 63%.
4. Conversely, when profits decline, the return on equity falls quickly due to the fact that the fixed
interest charges, in the case of Ponty £560,000, must still be paid.
5. A fall in operating profit of 50% would result in a level of operating profit that is insufficient to
cover interest charges, and a reduction in shareholders’ equity to £140,000.
6. The capital structure of Pop, in contrast, has a relatively low level of gearing with a debt:equity
ratio of 1:5 or 20%.
7. A 50% rise in profits results in an increase in the return on shareholders’ equity, but the rise is
more modest, to 25.2%.
 chapter 9  Analysis and interpretation of accounts 1 195

worked e x amp le   9.2 continued

8. Conversely, a fall in profits is not so detrimental to the equity shareholders, who continue to
receive a return of 8.4% on their investment.
9. A further drawback of a high level of gearing is that the company may face acute financial
difficulties if there is a significant fall in profits. Whereas dividends can be reduced when
profits are low (if necessary, to zero), interest charges are a legal obligation, and must be paid
irrespective of profit levels.

TEST YO UR K N OW LE DG E   9.1

Explain the purpose of the gearing ratio in the analysis of financial statements.

2.2 Proprietorship ratio – a brief discussion

Before discussing other ratios related to liquidity, it may be helpful to touch upon a longer-term
financial ratio related to how a company is financed.
The total assets belonging to a company are financed by a combination of resources provided
by shareholders and lenders. The proportion of business assets financed by the shareholders
is measured by the proprietorship ratio, which is conventionally calculated by expressing the
shareholders’ investment, or equity, in the company as a percentage of total sources of finance.
Shareholder’s equity
Proprietorship ratio = × 100
Total sources of finance*
*Total sources of finance include both non-current and current liabilities.

This ratio is a measure of financial stability, since the larger the proportion of business activity
financed by shareholders, the smaller the creditors’ claims against the company. This produces
two advantages:
1. Equity finance is normally repaid only when the company is wound up. Even then, repay-
ment occurs only if sufficient cash remains after all other providers of finance have been
refunded the amounts due to them. Where an excessive proportion of total finance is pro-
vided by short-term creditors, management is likely to be under continuous pressure to
finance repayments falling due. In these circumstances, any withdrawal/reduction of a
source of finance causes the company acute financial embarrassment.
2. Dividends are payable at the discretion of management, whereas interest payable on loan
capital is a legally enforceable debt. A company with a large proportion of equity finance is
therefore more able to survive a lean period of trading than a highly geared company that is
legally obliged to make interest payments irrespective of profit levels.
It is difficult to specify an appropriate percentage, as this depends a great deal upon trading
conditions within the industry. In general, a higher percentage is expected in those industries
where there are large fluctuations in profitability, because reliance on overdraft and loan finance
gives rise to heavy interest charges that a company may find it difficult to pay when results
are poor. In any event, one normally expects shareholders to provide at least half the finance,
and the implications of significant changes from one year to the next should receive careful
investigation.
The proprietorship ratio, viewed from the creditor’s standpoint, provides a useful indication
of the extent to which a company can stand a fall in the value of its assets before the credi-
tor’s position is prejudiced. Carrying values are not the same as current values, of course, but
196 Part four  Analysis and interpretation of accounts

a proprietorship ratio of, say, 75% would indicate that a significant cushion for creditors exists,
and the resale value of assets would have to fall to less than one-quarter of their carrying value
before the creditors’ position on liquidation would be jeopardised.

3 Liquidity ratios
The primary liquidity ratios, current and quick ratios, were demonstrated in Chapter 8, section
6.2. We will now discuss subsidiary ratios related to working capital.

3.1 Interest cover

The fact that a company is legally obliged to meet its interest charges was referred to when
examining the proprietorship ratio (see section 2 above). There is no legal restriction on sources
of cash that may be employed by management to meet its interest payments; management may
even make an additional share issue with the intention that part of the proceeds should be used
for that purpose. Nevertheless, interest payments are a business expense and, in the long run,
all such costs must be met out of sales revenue if the company is to remain viable. Interest
cover stresses the importance of a company meeting its interest charges out of revenue, and it
does this by expressing net profit before interest charges (operating profits) as a multiple of the
interest charged.
Profit before interest
Interest cover = × 100
Interest charges
The interest cover ratio measures the ability of a company to meet its fixed interest obligations
out of profit. The lower the level of interest cover, the greater the burden of the interest charges
on the company and the greater is its likelihood of financial failure. For example, debentures
may be raised with two to three years’ capital requirements in mind, but a full utilisation of the
additional resources made available is unlikely to be achieved straight away. In this situation,
current earnings have to bear the full weight of the additional charges, but the extra revenue,
which is expected to result from an expansion programme, takes longer to materialise.
Interest cover is a ratio that receives a significant amount of attention from analysts in
general and lenders in particular. Traditional measures of asset utilisation and asset cover for
advances are of little relevance in service-based industries where tangible assets are at a low
level. In these circumstances, it is particularly important to measure a company’s ability to
generate enough revenue to cover finance charges and leave a sufficient balance for dividends
and to finance eventual loan repayments. The ratio of earnings to finance charges helps a great
deal in this situation.

T E S T YO UR K N OW L E D G E   9.2

a) What is the advantage of a high proprietorship ratio?

b) What is the reason for the growing importance of the interest cover calculation?

4 Asset turnover ratios

The ratios examined in this section are designed to measure management’s effective utilisation
of its resources. These ratios help to explain the upward and downward movement in the sol-
vency of a business. They also provide clues to underlying changes in profitability.

4.1 Rate of inventory turnover

The rate of inventory turnover measures the number of times per year that a company turns
over its inventory. The calculation is made as follows.
 chapter 9  Analysis and interpretation of accounts 1 197

Cost of goods sold

Inventory turnover =
Average inventory held
Two typical queries asked about the above formula are:
1. Why use the cost of goods sold rather than sales?
2. Why use the average inventory level rather than closing inventory?
The reason is the same in both cases – to ensure that both the numerator and the denominator
are computed on a comparable basis. However, it must be emphasised that in practice, the cost
of sales is not used. Inventory, which makes up the denominator, is valued at cost for account-
ing purposes and the numerator must be computed on a similar basis. The sales figure can
be used to produce a ratio that enables users to make helpful inter-period comparisons, when
cost-of-sales figures are not available. However, there is a risk that incorrect conclusions may
be drawn if there are changes in the gross profit margin from one accounting period to another.
Turning to the reason for using average inventory levels, the numerator measures the cost of
goods dispatched to customers during an accounting period, and the denominator must there-
fore represent the investment in inventory during the same time period. In practice, inventory
levels are likely to fluctuate a great deal; they are often built up during relatively quiet times and
subsequently run down when the level of activity increases.
For this reason, it is important to calculate the average investment in inventory rather than
use the inventory level at a particular point in time. The average is usually based on the opening
and closing figures. A more precise calculation makes use of inventory levels at various dates
during the year, perhaps at the end of each month (for similar reasons, average figures are used
in the calculation of a number of other ratios considered below).
Many analysts prefer to present this ratio in terms of the number of days that have elapsed
between the date that goods are delivered by suppliers and the date they are dispatched to cus-
tomers (i.e. the stockholding period). This is done by modifying the formula so as to achieve the
desired result in the following single step.
Average inventory held
Inventory days = × 365
Cost of goods sold
Companies strive to keep the stockholding period as low as possible to minimise associated
costs. An increase in the stockholding period from, say, 30 to 60 days causes the investment in
inventory to double. Extra finance then has to be raised, handling costs increase, and the poten-
tial loss from damage to inventory and obsolescence is much greater. But although management
aims to keep inventory to a minimum, it must at the same time ensure that there are sufficient
raw materials available to meet production requirements (in the case of a manufacturer) and
enough finished goods available to meet consumer demand. It is, therefore, management’s job
to maintain a balance between conflicting objectives.
For example, a company with an average inventory level of £120,500 and cost of goods sold
of £900,000 will have an inventory turnover of 7.47 times per year, and hold its inventory for
48.87 days.
The calculations are as follows.
Cost of goods sold
Inventory turnover =
Average inventory held

900,000
120,500
= 7.47 times, commonly expressed as 7.47x
Average inventory held
Inventory days = × 365
Cost of goods sold

120,500
× 365
900,000
= 48.87 days
There is a clear relationship between both ratios. If the inventory turnover is divided into 365,
the number of inventory days is found.
198 Part four  Analysis and interpretation of accounts

T E S T YO UR K N OW L E D G E   9.3

Why is it usual to use cost of goods sold rather than sales for the purpose of computing the rate of
inventory turnover?

4.2 Rate of collection of trade receivables

The period of credit taken by customers varies between industries, but as a general rule, compa-
nies extract the maximum amount of credit from suppliers, since (in the absence of discounts
for prompt payment) accounts unpaid represent a free source of finance. At the same time,
undue delays should be avoided, as these have a harmful long-term effect on the company’s
credit rating. In practice, it is quite usual for customers to take six to eight weeks to pay their
bills. The rate of collection of trade receivables is calculated in days, as follows:
Average trade receivables
Trade receivable days = × 365
Sales
It should be noted that the denominator is sales and not credit sales, because credit sales are
never extractable from published financial statements.
The ability of a company to collect its trade receivables on time has a direct impact upon
its solvency and its solvency and liquidity ratios. As a benchmark, the trade receivables of a
company should be its average length of credit days. Changes in the collection of trade receiva-
bles may arise from changes in general economic conditions, changes in credit management
policies, changes in discounts granted and taken, or from the fear of penalties for late payment.
These changes may be responsible for an improvement or deterioration in the collection of
trade receivables.

4.3 Rate of payment of trade payables

The rate of payment of trade payables measures the time taken by companies to pay their sup-
pliers. The result must be interpreted with particular care, as not all suppliers grant similar
terms of credit, but provided there are no significant changes in the mix of trade creditors, the
average payments period should remain stable.
Average trade payables
Trade payable days = × 365
Cost of sales
A change in the rate of payment of suppliers may well reflect an improvement or decline in
the solvency position of a company. For instance, if a company is short of cash, it is likely that
suppliers will have to wait longer for the payment of amounts due to them. This may be an
acceptable short-term strategy.
Changes in payment of trade payables is similar to collection of trade receivables, and has
a direct relationship with the solvency of a company. A delay in the payment to creditors may
be a policy to improve cash holdings or result from a worsening in cash balances. Conversely,
early payment of creditors may arise from surplus cash balances or a desire to maintain a good
credit rating.

T E S T YO UR K N OW L E D G E   9.4

a) What are the possible reasons for an increase in the rate of collection of trade receivables?
b) Is an increase in the rate of payment of trade payables a good or a bad thing?
 chapter 9  Analysis and interpretation of accounts 1 199

5 The cash operating cycle

A period of time elapses between the payment for goods or raw materials received into inventory
and the collection of cash from customers in respect of their sale. The gap is known as the cash
operating cycle. During this period of time, the goods acquired, together with the value added
in the case of a manufacturer, must be financed by the company. The shorter the length of time
between the initial outlay and ultimate collection of cash, the smaller the amount of working
capital that needs to be financed.
To estimate the length of the cash operating cycle, it is necessary to:
1. calculate the time that the product spends in each stage of its progression from acquisition
to sale and subsequent cash receipt; and
2. deduct, from the length of time found in step 1, the period of credit received from suppliers.
The combination of the previously identified asset turnover ratios are the elements of the cash
operating cycle.
Average inventory held
Inventory days = × 365
Cost of goods sold
Plus
Average trade receivables
Trade receivable days = × 365
Sales
Less
Average trade payables
Trade payable days = × 365
Cost of sales
However, in a manufacturing sector that involves the holding of raw materials, semi-finished
and finished goods, a more detailed examination of the cash operating cycle will be involved.
This will be illustrated in the upcoming Worked example 9.3, which shows that Wing Ltd’s cash
operating cycle has 145 days in 2010 and 192 days in 2011.

5.1 Inventory
Items are purchased or produced, held for a period of time and then used or sold. We have previ-
ously seen that estimates of the length of time for which various categories of inventory that are
held must be based on a comparison of the average inventory levels with the issues of inventory
during the period under consideration. In the case of a manufacturing company, separate calcu-
lations must be made for each of the following three categories of inventory.
1. Raw materials – These are acquired, held in stock and then transferred to production.
Stocks of raw materials are related to raw materials consumed to find the average length of
time for which they are held.
2. Work in progress – Raw materials are taken from stock and processed, which involves addi-
tional manufacturing costs. The average production time is found by relating the value of
work in progress to the cost of goods manufactured.
3. Finished goods – When production is complete, the finished goods are transferred from the
factory to the warehouse. (In the case of a trader, finished goods, stored in the warehouse, are
purchased from outside.) The average length of time for which items are held can be found
by relating the stock of finished goods to the cost of goods sold during the accounting period.

5.2 Trade receivables

The average age of debts is found from the values of trade receivables and sales (see section 4.2).

5.3 Trade payables

Trade payables finance the production and selling cycle from the time raw materials or goods are
received into stock until they are paid for. The period of credit is found from the values of trade
payables and purchases (see section 4.3).
200 Part four  Analysis and interpretation of accounts

The length of the cash operating cycle is obtained by aggregating the periods of time calcu-
lated for each of the above items.

worked e x amp le   9.3

The cash balance of Wing Ltd. has declined significantly over the last 12 months. The following
financial information is provided.

20X2 20X1
Year to 31 December £ £
Sales 573,000 643,000
Purchases of raw materials 215,000 264,000
Raw materials consumed 210,000 256,400
Cost of goods manufactured 435,000 515,000
Cost of goods sold 420,000 460,000
Balances at 31 December 20X2 20X1
Trade receivables 97,100 121,500
Trade payables 23,900 32,500
Inventory:    
Raw materials 22,400 30,000
Work in progress 29,000 34,300
Finished goods 70,000 125,000

All purchases and sales were made on credit.

Required
a) Provide an analysis of the above information which should include calculations of the cash
operating cycle (i.e. the time lag between making payment to suppliers and collecting cash from
customers) for 20X1 and 20X2.
b) Create a brief report on the implications of the changes that have occurred between 2010 and
2011.

Notes
1. Assume a 365-day year for the purpose of your calculations and that all transactions take place at
an even rate.
2. All calculations are to be made to the nearest day.

Answer

a) 20X2 20X1
      days     days
22,400 30,000
Raw materials × 365 39 × 365 43 
210,000 256,400
Less          
23,900 32,500
Credit from suppliers × 365 41 × 365 45
215,000 264,000
Plus          
29,000 34,300
Production period × 365 24 × 365 24
435,000 515,000
 chapter 9  Analysis and interpretation of accounts 1 201

worked e x amp le   9.3 continued

Plus          
70,000 125,000
Finished goods × 365 61 × 365 99 
420,000 460,000
Plus          
97,100 121,500
Credit to customers × 365 62 × 365 69
573,000 643,000
Cash operating cycle     145     190

b) The cash operating cycle has decreased by 45 days or 31%. The increased investment in working
capital may be calculated as follows.

  £ £
Inventory 121,400 189,300
Receivables 97,100 121,500
  218,500 310,800
Less    
Payables 23,900 32,500
  194,600 278,300

The decreased period for which raw materials are held has been balanced by an equivalent
decrease in the period of credit taken from suppliers. Furthermore, the production period has
remained constant at 24 days, suggesting no change in the efficiency with which resources are
moved through the factory. There are no areas of concern, as there are significant decreases in the
period of credit taken by customers and decreases in the holding of finished goods – the latter
has fallen from the equivalent of three months’ sales at the end of 20X1 to two months’ sales at
the end of 20X2.
The company has experienced a significant decline in its gross profit percentage. More
information is needed to assess the likely consequences of decrease in profit on the business.

5.4 Non-current asset turnover ratio

The non-current asset turnover ratio measures the effectiveness of non-current assets in gener-
ating sales. This is particularly pertinent to manufacturing companies where there is a concern
to assess whether the investment in non-current assets has generated the desired impact on
sales.
Sales
Non-current asset turnover ratio = :1
Average non-current assets
The ratio is likely to reveal excess capacity from time to time during the life of a business, and
it may be unavoidable. Possible reasons include:
■■ temporary inconveniences, such as a strike or a fire that destroys essential equipment;
■■ the collapse in demand for a product line, unless steps are promptly taken to dispose of the
equipment or transfer it to an alternative use;
■■ the acquisition of additional non-current assets. The point is eventually reached where exist-
ing non-current assets are used to their full capacity and any further increase in business
activity first requires the acquisition of additional plant. It is some while before demand
increases sufficiently to absorb the extra capacity, however, and meanwhile non-current asset
turnover declines.
202 Part four  Analysis and interpretation of accounts

Note: as non-current assets (NCAs) depreciate and sales are constant, NCA turnover rises.
Also, when sales increase with inflation and NCAs do not, NCA turnover rises.

worked e x amp le   9.4

During 20X4, Rhyl Ltd operated at full capacity and 1,000 units of output were produced and sold
for £50 each using plant that cost £20,000. On 1 January 20X5, management purchased additional
plant for £20,000, with a capacity to produce a further 1,000 units. Output for the years 20X5–X7 is
as follows.

20X5 1,200 units

20X6 1,500 units
20X7 2,000 units

The selling price remained unchanged at £50 per unit.

Required
Calculate the non-current asset turnover ratio for each year, ignoring depreciation.

Answer
50,000
20X4 : = 2.5:1
20,000
60,000
20X5 : = 1.5:1
40,000
75,000
20X6 : = 1.9:1
40,000
100,000
20X7 : = 2.5:1
40,000
The new plant is working at only one-fifth of its capacity during 20X5, and the result is that non-
current asset turnover declines to 1.5:1. Only when both new and old plant are working at full
capacity in 20X7 is the ratio restored to 2.5:1.

T E S T YO UR K N OW L E D G E   9.5

Give three possible reasons for a decline in the non-current asset turnover ratio.

5.5 Total asset turnover ratio

Management is responsible for making the most effective use of a company’s available resources
to achieve their corporate goals, whether these are maximisation of profit, shareholder value or
any other agreed goal. The total asset turnover ratio seeks to measure management’s ability to
make effective use of its asset base to generate sales. This is important, as the ability to generate
sales is key to business survival and success. The total asset turnover ratio is derived as follows.
Sales
Total asset turnover = :1
Average total assets
The ratio indicates the monetary unit of sales generated per monetary unit of average total
assets. Generally, a higher ratio is preferred, as the higher the ratio, the better the return on
total assets. A decline in the ratio suggests that assets are under-utilised and may indicate they
 chapter 9  Analysis and interpretation of accounts 1 203

should either be used more effectively or sold. One drawback of the calculation is that it pro-
duces a more favourable ratio for companies using older assets. Older assets are likely to have a
relatively low book or carrying value, as they will have been depreciated over time.
Consider the following results that were extracted from Louisa plc for the year ended 30 June.

20X2 20X1
£,000 £,000
Sales 7,000 6,000
Assets 3,895 2,890

On 1 July 20X0, Louisa plc’s total assets were £2,710,000.

The comparative total asset turnover ratios would be as follows.

20X2 20X1
7,000 6,000
(3,895+2,890) × 0.5 (2,890+2,710) × 0.5
2.06 : 1 2.14 : 1

The ratio may be expressed either in the above form or as an amount of sales per £1 invested
(i.e. sales were £2.14 per £1 invested in 20X1 and £2.06 per £1 invested in 20X2). It is therefore
apparent that a 3.7% reduction in asset utilisation has occurred from 20X1 to 20X2.

5.6 Profit ratios

The profit ratios were introduced in chapter 8, section 6.1. As a reminder, the primary profit
ratios are as follows.
Gross profit
Gross profit margin = × 100
Sales

Operating profit
Operating profit margin = × 100
Sales
The expectation that the gross profit margin should remain relatively stable, irrespective of the
level of production and sales, is based on the assumption that all costs deducted when comput-
ing gross profit are directly variable with sales. This is explored further in Worked example 9.5
and throughout the rest of this section.

worked e x amp le   9.5

Chester is a trader who purchases frame tents for £40 each and sells them, through a mail order
catalogue, at a price of £50 each. During 20X0 and 20X1, sales amounted to 1,000 tents and 2,000
tents, respectively. There is no opening or closing stock.

Required
Prepare Chester’s trading account for 20X0 and 20X1, and calculate the gross profit margin for each
year.

Answer

20X1 20X0
Trading account £ £
Sales 100,000 50,000
Less: Cost of goods sold 80,000 40,000
Gross profit 20,000 10,000
Gross profit margin 20% 20%
204 Part four  Analysis and interpretation of accounts

worked e x amp le   9.5 continued

Sales have doubled in 20X1. Because the cost of goods sold are directly variable with sales, they have
also doubled. This has resulted in gross profit twice the 20X0 level. Although the actual gross profit
has doubled, the gross profit margin remains unchanged at 20%.

A stable gross profit margin may be usual for a retail trader like Chester, but is less likely for
a manufacturer. This is because the cost of goods sold figure for a manufacturing company is
likely to fluctuate, due to the impact of variable costs on the profit margin. However, any large
variation in the gross profit margin would require careful investigation. Possible causes include
the following.

5.6.1 Price cuts (selling price)

A company may need to reduce its selling price to achieve the desired increase in sales. For
example, let’s assume that Chester had to reduce the selling price from £50 to £48 to sell 4,000
tents in 20X1. The revised trading account would be as follows.

20X1
Trading account £
Sales 192,000
Less: Cost of goods sold 160,000
Gross profit 32,000
Gross profit margin 16.67%

5.6.2 Cost increases

The cost of goods purchased from suppliers, during a period of inflation, is likely to rise. If these
costs rise but the selling price remains the same, a company will experience a reduction in its
gross profit margin. Let’s assume Chester had to pay an additional £4 for each of its tents in
20X1 such that the unit price rose to £44 per tent and the original selling price of £50 remains
unchanged.

20X1
Trading account £
Sales 100,000
Less: Cost of goods sold 88,000
Gross profit 12,000
Gross profit margin 12.00%

5.6.3 Changes in mix

A change in the range or mix of products sold results in an overall change in the gross profit
margin, assuming individual product lines earn different gross profit percentages.

5.6.4 Undervaluation or overvaluation of inventory

If closing inventory is undervalued, this results in the cost of goods sold being overstated and
profit understated. An incorrect valuation might be the result of an error during the stocktaking
process, or the result of a more serious misdemeanour, such as fraud. For example, a business
might intentionally undervalue inventory to reduce the amount of tax payable (lower profit
means lower tax). It must, of course, be remembered that the closing inventory of one period is
the opening inventory of the next, so the effect of errors may be reversed in the following period.
 chapter 9  Analysis and interpretation of accounts 1 205

5.6.5 Rate of return on gross assets

The rate of return on gross assets is often alternatively described as the rate of return on capital
employed.
The problem with the latter description is that the term ‘capital employed’ is used, in
accounting, to signify at least two different financial totals:
■■ shareholders’ equity
■■ gross or net assets.
This section focuses on the rate of return on gross assets, which is calculated as follows.
Profit before interest
Rate of return on gross assets = × 100
Average gross assets

6 Pyramid of ratios
6.1 Relationship between accounting ratios
A common weakness when analysing company reports with ratios is the failure to examine the
relationship between the various ratios that have been calculated. One particularly important
relationship is expressed in what is known as the du-Pont formula, a three part method used
to assess a company’s Return on Equity (ROE). This is separated into primary and secondary
ratios below.

Secondary ratios Primary ratios

Total asset turnover × Operating profit margin = Rate of return on gross assets

Management endeavours to maximise the return earned on gross assets, and it can accomplish
this objective in two ways. Firstly, management can aim to increase the net profit percentage.
Secondly, management can endeavour to achieve a higher rate of asset utilisation. It may be
the case that that greater asset utilisation – for instance, more sales – can only be achieved by
lowering prices. Management has to decide whether the increased volume of activity is suffi-
cient to justify the lower gross and net margins that result from implementing a policy of price
reduction.

worked e x amp le   9.6

Holly and Head run separate businesses in different geographical areas, marketing a similar product
for which there exists a ready market. They meet at a conference and are interested to discover that,
whereas Holly keeps prices low in order to keep the business operating at full capacity, Head supplies
goods only at ‘normal prices for the industry’. They decide to compare their results and extract the
following information from recently published accounts.

Holly Head
  £ £
Operating profit 50,000 100,000
Sales 600,000 750,000
Average total assets 200,000 500,000
Profit before interest (i.e. operating profit) 50,000 100,000
Sales 600,000 750,000
Average gross assets 200,000 500,000

Required
Calculate the ‘primary’ and ‘secondary’ ratios (per the du-Pont formula) of Holly and Head.
206 Part four  Analysis and interpretation of accounts

worked e x amp le   9.6 continued

Answer
Applying the formula:

Secondary ratios Primary ratios

Total asset turnover × Operating profit margin × 100 = Return on gross assets
Sales Profit before interest Profit before interest
Holly = × × 100 =
Average total assets Sales Average total assets
600,000 50,000 50,000
× × 100 = × 100
200,000 600,000 200,000
3 × 8.33% = 25.00%
750,000 100,000 100,000
Head = × × 100 = × 100
500,000 750,000 500,000
1.5 × 13.33% = 20.00%

The above calculations show that Holly achieves a greater asset utilisation (£3 of sales per £1
invested, as compared with the £1.50 achieved by Head), but its operating profit percentage
is lower (8.3% compared with Head’s 13.3%). Overall, Holly’s policies seem to be more
successful (i.e. the greater asset utilisation more than compensates for the lower margins,
and achieves a rate of return on gross assets of 25%).

T E S T YO UR K N OW L E D G E   9.6

Explain the nature and purpose of the du-Pont formula.

sto p and t hink  9.1

Do you think companies should publish financial ratios rather than leaving the user to calculate them?

? END OF CHAPTER QUESTIONS

9.1 The minority-shareholding in Merino Ltd is 20%. mark-up is usually 100% on cost in this type
The company manufactures kitchen implements of business, of which about two-thirds goes in
that are sold to retail chains and through a cash overheads. The minority shareholders have also
sales outlet from the company’s factory premises. discovered that external liabilities are normally
The minority shareholders are unsure whether this about one-quarter of equity and that interest
company is being well managed and have asked normally comprises about 20% of operating
for your help in studying the accounts. profit. The following financial information is
The minority shareholders tell you that the available for Merino Ltd.
 chapter 9  Analysis and interpretation of accounts 1 207

? END OF CHAPTER QUESTIONS continued

Consolidated statement of profit or loss and (iii) two ratios based on the above accounts
other comprehensive income for the year to 31 which examine the capital structure of
December 20X2: the company.
Wherever possible, the ratios calculated
  £,000
should be those in respect of which
Sales 5,500 comparative data is available.
Cost of sales 2,700 b) Set out a discussion of the financial position
Gross profit 2,800 and performance of Merino Ltd based
on the results of your calculations under
Administration expenses 375
(a) and the information provided in the
Distribution costs 1,175 question.
Operating profit 1,250 9.2 The following information is provided for Tanner
Interest costs 300 Ltd and Spanner Ltd, which supply a similar
range of products but are located in different
Profit before tax 950
geographical areas and are not in competition
Tax 220 with one another.
Profit for the year 730
Tanner Spanner
  £,000 £,000
Statement of financial position at 31 December
Operating profit 1,000 1,200
20X2:
Turnover 7,200 9,000
  £,000 £,000 Average investment in total
Non-current assets   6,000 assets 2,400 6,000
Current assets    
Inventory 235   The following accounting ratios are provided by
the trade association to which they each belong.
Trade receivables 235  
The ratios are averages for members of the
Cash and cash equivalents 230 700 association.
Total assets   6,700
Gross asset turnover 2
Equity and liabilities    
Operating profit percentage 14%
Share capital   1,835
Operating profit on total assets 21%
Retained earnings   1,230
    3,065
Required
Non-current liabilities    
a) Provide separate calculations for Tanner Ltd
Debentures   3,000 and Spanner Ltd of the accounting ratios
Current liabilities     equivalent to those provided by the trade
Trade payables 405   association.
b) An explanation of the relationship between
Taxation 230 635
the three ratios and advice about how the
Total liabilities   3,635 relationship might be explored in greater
Total equity and liabilities   6,700 depth.
c) An analysis of the performance of Tanner
Ltd and Spanner Ltd by comparison with
Required
members of the trade association and with
a) Calculate:
each other.
(i) three ratios based on the above
accounts which examine the Note
management of working capital; Calculations should be to one decimal place.
(ii) three ratios based on the above
accounts which examine the profitability
of the company; and
208 Part four  Analysis and interpretation of accounts

? END OF CHAPTER QUESTIONS continued

9.3 You are given the following financial information for XYZ Ltd in the following table.

£,000 20X7 20X6 20X5 20X4

Sales 290 190 160 90
Net assets 420 340 280 190
Total assets 1140 950 880 680

Using the net asset turnover ratio and the total asset turnover ratio, calculate the ratios and comment on the
efficiency of asset usage of the company.
9.4 A company has 90 days’ inventory outstanding, 60 days’ sales outstanding and 70 days’ payable
outstanding.

Required
Calculate the cash operating cycle of the business.
Analysis and interpretation 10
of accounts 2

■■ Contents
1. Introduction
2. Segmental accounting and analysis
3. Rate of return on shareholders’ equity
4. Inter-company comparison
5. Cash flow-based accounting ratios
6. Earnings per share

■■ Learning outcomes
This chapter discusses further topics related to the analysis and interpretation of accounts.
After reading and understanding the contents of the chapter, working through all the worked
examples and practice questions, you should be able to:
■■ understand the purpose and explanations for segmental and cash flow ratios;
■■ understand how to analyse and interpret cash flow ratios;
■■ analyse using various investor ratios;
■■ carry out inter-company comparison; and
■■ discuss and calculate various measures of earnings per share (EPS).

1 Introduction
As discussed in chapters 8 and 9, accounting ratios enable users and analysts to assess company
financial performance. In this chapter we discuss further uses of ratios by looking at segmental
analysis of ratios, and investor ratios that cast light on shareholder returns and the efficiency of
company finances by looking at various measures of cash flow ratios.

2 Segmental accounting and analysis

The primary purpose of all profit-making businesses is to make profit. The continued success
of a business is dependent upon sustained and satisfactory levels of income. This requires good
decision-making and performance evaluation. The statement of profit or loss and other com-
prehensive income, while serving many purposes, is primarily a tool for performance evaluation
by the varied stakeholders.
Businesses make financial disclosures on a number of items in the financial reports. While
financial results can be reported in a number of ways, IFRS 8 and IAS 14 provide the basis for
financial disclosure of activities of different business segments (segmental activity). IFRS 8
defines reportable and operating segments, while IAS 14 defines the requirements for financial
disclosure.
The purpose of segmental accounting and segmental analysis is to account for, and analyse,
the performance of an identifiable part or segment of a business. IAS 14 defines reportable seg-
ments on the basis of geographical segments and product segments.
Two primary ways of analysing segments are the full cost approach and marginal contribu-
tion approach. These two management accounting techniques are used to help analyse the
performance of a business segment.
210 Part four  Analysis and interpretation of accounts

2.1 Full cost approach

From a segmental perspective, there are two types of expenses incurred by a business: direct
and indirect.
Direct expenses are those expenses of a segment that are directly traceable to a business seg-
ment. The closure of a segment would mean those costs would then not be incurred. Indirect
expenses are expenses common to the overall business entity. These expenses are not directly
caused by any one particular segment, but arise due to the overall functioning of a business
entity.
The key characteristic of indirect expenses from a segmental viewpoint is that they must
be allocated in order to measure the net income of a segment. Examples of indirect expenses
include:
■■ salaries of senior management (e.g. the CEO);
■■ head office operating expenses;
■■ insurance on head office and head office equipment; and
■■ salaries of head office staff.
The underlying theoretical consideration for the full cost approach is that all expenses, regard-
less of where and why they have been incurred, must be charged to the segments that benefit
directly and indirectly. As such, these types of expenses must be allocated using some basis.
Because various methods of allocation are available and because different methods result in
different allocation percentages, the allocated cost may be perceived to be somewhat arbitrary.
Some of the methods used to allocate indirect expenses include:
■■ sales by value
■■ number of employees
■■ assets employed
■■ floor space occupied.
The method(s) used should be based on a logical apportionment on an equitable basis.
Inappropriate use of methods would tend to give the wrong impression of financial performance
of segments of a business.
The basic principles of the full cost approach are summarised as follows:
a) The objective is to measure net income of each operating segment.
b) Overall net income of the business is the sum of the segmental net income.
c) All indirect expenses must be allocated across each segment.
d) Allocation of indirect expenses involves selecting bases of allocation.
The segmental net income approach may be defined mathematically as follows:
Segmental net income = segmental sales – direct expenses – allocated indirect expenses
Or:
SNI = S – DE – AIE
Direct expenses are those expenses that can be traced directly to the business segment. Variable
expenses are activity-based expenses and are directly traceable to a segment. Fixed expenses
may be direct or indirect, and can also be allocated or not to a segment depending on their
nature. This is examined in the next section. The contractual nature of fixed expenses must be
examined carefully to determine whether or not the expense is direct.

2.2 Segmental contribution approach

A problem with the full cost approach when applied to a segment is that it is technically pos-
sible for a segment to show an operating loss, yet at the same time be making a positive con-
tribution to net income. In other words, if the seemingly unprofitable segment is closed, it is
possible that the overall net income of the business will decrease. To avoid this shortcoming of
the full cost approach, many businesses prefer to use the contribution approach to measuring
segmental profitability.
The segmental contribution approach, as indicated by its name, measures segmental contri-
bution. This contribution may simply be defined as sales less direct expenses. Note that seg-
mental contribution differs from contribution margin, which is sales less variable expenses. As
 chapter 10  Analysis and interpretation of accounts 2 211

some fixed expenses can be direct expenses, segmental contribution and contribution margin
are not the same.
The principles of the segmental contribution approach are as follows.
a) Only the contribution of each segment is computed. No attempt is made to compute the
net income of the segment.
b) Indirect expenses of each segment are not allocated.
c) Indirect expenses, however, are usually deducted from total segmental contribution in order
to arrive at overall business net income.
d) A segment is considered profitable if sales of the segment exceed the direct expenses of the
segment.
The segmental contribution approach may be presented mathematically as follows:
Segmental contribution (SC) = Segmental sales (SS) – Direct expenses (DE)
This may be expressed as:
1. SC = SS – DE
2. DE = V(Q) + F D
3. S = P(Q)
Where:
■■ DE = direct expenses
■■ P = price of the product in the segment
■■ V = variable cost rate for the segment
■■ Q = units of sales in a specific segment
■■ FD = direct fixed expenses of the segment.
Therefore, the equation above may be restated as follows:
SC = P(Q) – V(Q) – FD
It is apparent from this second equation that the principles of cost–volume–profit analysis apply
to segmental decision-making. Variable costs are always direct costs. When activity ceases, vari-
able costs cease. When activity increases, variable costs by definition increase. Indirect expenses
are almost always fixed expenses.
The indirect expenses allocated to a segment will continue to be incurred, regardless of
whether the segment is continued or discontinued. Therefore, as long as the segment is making
a contribution towards indirect fixed expenses, continuing operations at least in the short run
makes the business better off.

worked e x amp le   10.1

The following example illustrates the basic principles of the full cost and segmental contribution
approaches.

Full cost approach

Alpha Beta Total
£ £ £
Sales 40,000 30,000 70,000
Expenses
Cost of goods sold 24,000 18,000 42,000
Sales salaries 6,000 9,000 15,000
Executive salaries 6,000 5,000 11,000
Total expenses 36,000 32,000 68,000
Net income/loss 4,000 (2,000) 2,000
212 Part four  Analysis and interpretation of accounts

worked e x amp le   10.1 continued

Segmental contribution approach

Alpha Beta Total
£ £ £
Sales 40,000 30,000 70,000
Direct expenses
Cost of goods sold 24,000 18,000 42,000
Sales salaries 6,000 9,000 15,000
Total direct expenses 30,000 27,000 57,000
Segmental contribution 10,000 3,000 13,000
Indirect expenses
Executive salaries 11,000
Net income/loss     2,000

In the above example, cost of goods sold and sales salaries are direct expenses of each segment.
Executive salaries are an indirect expense. This expense needs to be charged to the segments
by being allocated on some (ideally logical) basis. However, under the segmental contribution
approach, indirect expenses are not allocated.
Let’s consider, from the above example, how allocations were made under the full cost
approach. Under this approach, segment Alpha was allocated £6,000 of the executive salaries
cost and segment Beta £5,000. As a consequence, segment Beta is operating at a net loss of
£2,000. It may seem logical to close down segment B, as the business would be better off by
£2,000. However, the segmental contribution approach shows that segment B is making a con-
tribution of £3,000. Secondly, it can be seen that executive salaries were allocated in the ratio
of 57:43. The allocation percentages were determined by dividing segmental sales by total sales.
Segmental analysis provides management with the tools to isolate and analyse the perfor-
mance of each sector (whether the sector is based on a geographical basis or product basis). By
examining trends and results carefully in each segment, management is able to understand the
value of each sector better, and make better-informed decisions.

3 Rate of return on shareholders’ equity

The factor that motivates shareholders to invest in a company is the expectation of an adequate
return on their funds. Shareholders will periodically assess the rate of return earned in order to
decide whether to continue with their investment. The rate of return on shareholders’ equity is
generally referred to as ROSE (Return on Shareholders’ Equity), and is derived as follows:
*Earnings for equity shareholders
Return on shareholders’ equity = × 100
Average shareholders’ equity
*The ROSE ratio may be based on a pre- or post-tax basis but, whichever basis is used, any
preference dividends payable must be deducted, since they reduce profits available for ordinary
shareholders. An argument for using the pre-tax basis is that the resulting ratio can be related
more meaningfully to the other calculations demonstrated in this chapter. On the other hand,
corporation tax must be deducted to arrive at the balance available for distribution to sharehold-
ers and the post-tax basis implies full recognition of this fact.
 chapter 10  Analysis and interpretation of accounts 2 213

worked e x amp le   10.2

The following information was extracted from the financial statements of Ludlow plc for the year
ended 31 December:

20X2 20X1
£,000 £,000
Pre-tax earnings 355 345
Post-tax earnings 177 173
Shareholders’ equity 2,350 2,250

The shareholders’ equity on 1 January 20X1 was £2,155,000.

Required
Calculate the return on shareholders’ equity for each year (for both pre-tax and post-tax earnings).

Answer

ROSE – Pre-tax earnings basis ROSE – Post-tax earnings basis

345 173
20X1 × 100 15.66% 20X1 × 100 7.85%
(2,155 + 2,250) 0.5 (2,155 + 2,250) 0.5

355 177
20X2 × 100 15.43% 20X2 × 100 7.70%
(2,250 + 2,350) 0.5 (2,250 + 2,350) 0.5

There has been a modest decline in the return earned for shareholders. The return earned for
shareholders is dependent on three key factors:

1. profit margins
2. asset utilisation
3. capital structure.

In the previous chapter, we explained that the rate of return on gross assets is a function of profit
margins and asset utilisation. However, this measure takes no account of the company’s capital
structure (this can be confirmed by observing the fact that the numerator comprises net profit
before deducting any interest charges). We explain the significance for the equity shareholders of
financing a part of a company’s activities with loan capital later, in the section covering gearing.

4 Inter-company comparison
Ratio analysis facilitates inter-company comparison by providing data from different companies
that enables differences and similarities between firms and between sectors to be measured. An
inter-company comparison provides the relevant data for the comparison of the performance
of different firms and/or sectors. The comparison enables judgments to be made using relative
performance.
Inter-firm comparisons enable variances and trends to be identified and tracked over time.
If a company’s performance ratios are inferior to other companies in the same sector, the com-
parison will show this, and enable management to investigate and take action to remedy the
situation.
The analysis of ratios from different companies enables relative comparison of overall finan-
cial health, profitability and operational efficiency, depending upon the ratios included in the
comparison. This helps ensure management has the information required to manage the com-
pany effectively, including optimum utilisation of a company’s assets.
214 Part four  Analysis and interpretation of accounts

Table 10.1 offers some comparisons of the food retail sector and indicates the top retailers
with their respective results in the form of return on assets (ROA) and after-tax profit margins.

Table 10.1 Ratios for Tesco and Sainsbury’s – 2011

Company Business sector ROA Profit margin EPS ROCE

Tesco Retailer clothing, food and financial 4.00% 5.72% 33.3p 12.90%
services
J. Sainsbury Retailer clothing, food and financial 5.90% 3.61% 34.4p 8.00%
services

Note:
■■ ROA = Return on assets
■■ EPS = Earnings per share
■■ ROCE = Return on capital employed
Table 10.1 provides some level of inter-company comparison for two UK retail giants. The two
companies have similar ratios but overall, based on these ratios, Tesco has performed better
than J Sainsbury.
The ROA is lower for Tesco than J Sainsbury. Investigation of this may reveal that the ROA
reflects a higher level of investment in fixed assets made by Tesco.
Tesco’s higher profit margin could be interpreted to mean that Tesco has been more efficient
with costs and has negotiated lower prices with suppliers than J Sainsbury.
J Sainsbury has achieved a higher EPS (discussed later in this chapter), and Tesco achieved a
higher ROCE.
This snapshot of ratios would require more detailed analysis and investigation before any
definite conclusions could be drawn. Management could use the comparison as a starting point
for investigation. For example, J Sainsbury management may want to investigate why their
profit margin is lower than Tesco and take remedial action. Similarly, J Sainsbury’s ROCE is
also much lower than Tesco’s and this will also warrant further examination.

5 Cash flow-based accounting ratios

The usefulness of financial statements is enhanced by an examination of the relationship
between them, and also by comparison with previous time periods, other entities and expected
performance. We have seen that value can be further added through the calculation and inter-
pretation of accounting ratios. An examination of accounting textbooks and the pages of
accounting periodicals reveals an enthusiasm for rehearsing the potential of ‘accounting ratios’,
demonstrated through calculations of the net profit margin, return on capital employed, cur-
rent ratio and a host of other ‘traditional’ measures based on the contents of the consolidated
statement of profit or loss and other comprehensive income and statement of financial position.
None of these focuses on cash flow.
Traditional ratios suffer from the same defect as the financial statements (the statement of
profit or loss and other comprehensive income and statement of financial position) on which
they are based. Such ratios are the result of comparing figures that have been computed using
accounting conventions which include the use of estimates and judgment. Given the difficulty
of deciding the length of the period over which non-current assets should be written off, whether
the tests which justify the capitalisation of development expenditure have been satisfied or the
amount of the provision to be made for claims under a manufacturer’s 12-month guarantee (to
give just a few examples), ratios based on such figures won’t always provide an accurate picture.
This is not to suggest that the traditional ratios are irrelevant. Clearly this is not so, as they
reveal important relationships and trends that are not apparent from the examination of indi-
vidual figures appearing in the accounts. However, given the fact that cash flow ratios contain
at least one element that is factual (the numerator, the denominator or both), their historic lack
of prominence in accounting literature and their limited use in the business world is puzzling.
 chapter 10  Analysis and interpretation of accounts 2 215

TEST YO UR K N OW LE DG E   10.1

In what way might cash-based accounting ratios be considered superior to traditional accounting
ratios?

The principal focus for informed investment decisions is cash flows, whether the capital project
appraisal method is ‘pay-back’ or one of the more sophisticated discounted cash flow-based tech-
niques, namely ‘net present value’ and ‘internal rate of return’. Turning to performance evalu-
ation, however, the emphasis usually shifts to techniques such as return on capital employed.
The inconsistency between the two approaches is highlighted by the use of depreciation cost
allocation procedures for the purpose of computing the ROCE, a calculation that has no place
whatsoever in the above project appraisal methods.
Below are presented:
1. ratios that link the cash flow statement with the consolidated statement of profit or loss and
other comprehensive income and statement of financial position; and
2. ratios based entirely on the contents of the cash flow statement.
To illustrate these calculations, the results of XYZ plc for 20X1 and 20X2 are shown in Figure
10.1. For each ratio, both the calculation and a discussion of its significance are presented.
Inevitably, there will be some overlap in the messages conveyed by the various ratios presented.
This may be due to similarities in the nature of the calculations or to the fact that the results
of just one company are used for illustration purposes. The application of the same ratios to
different financial facts might well yield additional valuable insights.
The following information is provided as at 31 December 20X0:
■■ property, plant and equipment at cost, £2,700,000;
■■ current assets, £1,802,000;
■■ payables and taxation, £838,000; and
■■ called-up share capital, £1,400,000.
Note: XYZ raised a loan of £1 million during 20X2. This, together with the already existing
loan, is repayable by ten equal instalments commencing in 20X3.

5.1 Ratios linking the cash flow statement with the two other
principal financial statements
Cash generated from operations to current liabilities:
Cash generated from operations
Cash generated from operations to current liabilities = × 100
Average current liabilities
Where:
■■ cash generated from operations is taken directly from the cash flow statement published to
comply with IAS 7; and
■■ average current liabilities are computed from the opening and closing statement of financial
position.
This ratio examines the liquidity of the company by providing a measure of the extent to which
current liabilities are covered by cash flowing into the business from normal operating activi-
ties. The ratio is thought by some to be superior to the statement of financial position-based
ratios, such as the liquidity ratio, as a measure of short-term solvency. This is because state-
ment of financial position ratios are based on a static positional statement (the ‘instantaneous
financial photograph’) and are therefore subject to manipulation by, for example, running down
inventory immediately prior to the year-end and not replacing them until the next account-
ing period. Ratios based on statements of financial position may alternatively be affected by
unusual events that cause particular items to be abnormally large or small. In either case, the
resulting ratios will not reflect normal conditions.
216 Part four  Analysis and interpretation of accounts

Cash flow statement (using indirect method)

20X2 20X1
£,000 £,000
Cash flows from operating activities
Operating profit 501 420
Depreciation charges 660 600
Increase/decrease in inventory (305) 250
Increase/decrease in receivables (184) 220
Increase in payables 420 120
Cash generated from operations 1,092 1,610
Interest paid (150) (50)
Dividends paid (160) (60)
Taxation paid (130) (210)
Net cash generated from operating activities 652 1,290

Cash flows from investing activities

Purchase of property, plant and equipment (1,620) (900)

Cash flows from financing activities

Proceeds from issue of loan 1,000 100
Net increase in cash 32 490

Statement of profit or loss and other comprehensive income extracts

Operating profit 501 420
Interest paid (150) (50)
Profit before tax 351 370
Taxation (125) (115)
Profit for the year 226 225
Extracts from statements of changes to equity
Dividends paid (175) (145)
Retained profit for the year 51 80

Statement of financial position at 31 December

20X2 20X1
£,000 £,000
Assets
Property, plant and equipment at cost 5,220 3,600
Less: accumulated depreciation (2,360) (1,700)
2,860 1,900
Current assets (including cash) 1,893 1,372
Total assets 4,753 3,272
Equity and liabilities
Called up share capital (£1 ordinary shares) 1,400 1,400
Share premium account 250 250
Retained earnings 333 282
1,983 1,932
Non-current liabilities
10% loan repayable 20X3–X2 1,350 500
Current liabilities
Loan repayment due 150 –
Tax 125 115
Payables 1,145 725
Total liabilities 1,420 840
Total equities and liabilities 4,753 3,272

Figure 10.1 Draft accounts of XYZ plc for 20X2 and 20X1
 chapter 10  Analysis and interpretation of accounts 2 217

Calculations for XYZ plc

Cash generated from operations to current liabilities:

20X2
1,092
× 100
(1,420 + 840) 0.5
96.64%

20X1
1,610
× 100
(840 + 838) 0.5
191.90%

There has been a significant decrease in this ratio between 20X1 and 20X2, falling to half of
the previous level. The decrease reflects a reduction in the operating cash flow plus a rise in the
average current liabilities. Nevertheless, the current liabilities (which include taxation which
may not be payable until the next financial year) remain adequately covered by cash flow on the
assumption that this aspect of XYZ’s financial affairs is repeated in the year 20X0.

5.2 Cash recovery rate

The cash recovery rate (CRR) is a measure of the rate at which a company recovers its invest-
ment in non-current assets. The quicker the recovery period,, the lower the risk. The CRR
is effectively the reciprocal of the pay-back period used for capital project appraisal purposes,
assuming projects have equal (or roughly equal) annual cash flows. The CRR is derived as
follows:
Cash flow from operations
Cash recovery rate = × 100
Average gross assets
Where:
■■ cash flow from operations is made up of ‘cash generated from operations’ together with any
proceeds from the disposal of non-current assets; and
■■ gross assets (current and non-current assets) is the average gross value (before deducting
accumulated depreciation) of the entity’s assets over an accounting period.
However, the statement of financial position usually shows the carrying value of non-current
assets. A search of the notes is needed to find the gross value. Assets are required to generate a
return that is ultimately, if not immediately, in the form of cash.
The CRR for XYZ plc is as follows:

20X2 20X1
1,092 1,610
× 100 × 100
(7,113 + 4,972) 0.5 (4,972 + 4,502) 0.5
18.07% 33.99%

The CRR has also fallen by almost half over the period. The implication is that the company
is now taking almost twice as long in 20X2 to recover its investment in business assets than
in 20X1.

5.3 Cash flow per share

Cash flow per share represents the net operating cash a company generates per share. As it
is the actual cash generated it is deemed less likely to be manipulated as the earnings in the
earnings per share ratio. Consequently, some analysts find it to be a more reliable measure of a
company’s financial situation than the earnings per share metric.
218 Part four  Analysis and interpretation of accounts

Net cash flow from operating activities

Cash flow per share =
Weighted average number of shares
This ratio provides a general indication of a company’s ability to fund long-term investment
out of resources generated internally. A higher cash flow per share is preferred, as it is often
deemed to be a measure of good performance. However, this may not always accurately reflect
a company’s overall financial position or strength.
The number of shares used as the denominator should be the weighted average of the number
in issue during the year. However, the average needs to be weighted only if there is an issue of
shares involving an inflow of resources; in the case of a bonus issue (where no extra resources
are generated), the number of shares post-bonus issue should be used without weighting and
the number in issue the previous year made comparable.
The comparative cash flow per share for XYZ plc is as follows.

20X2 20X1
652 1,290
1,400 1,400
0.47 0.92
47p 92p

The significant decline in the cash flow per share reflects the significant disinvestment in work-
ing capital that occurred in 20X1.

5.4 Capital expenditure per share

The capital expenditure per share measures the amount of capital expenditure which the com-
pany incurs in order to maintain its operating assets. Capital expenditure is the cash flows from
investing activities.
This ratio, in conjunction with cash flow per share, can be used in order to provide a general
indication of whether a business is a net generator of cash or whether it is cash-hungry. The
ratio is derived as follows.
Cash flow from investing activities
Cash expenditure per share =
Weighted average number of shares
The comparative capital expenditure per share for XYZ plc is as follows:

20X2 20X1
1,620 900
1,400 1,400
1.16 0.64
116p 64p

The capital expenditure per share has risen dramatically, by 80%, and indicates the cash hunger
and consumption of the business has caused a need to seek alternative sources to fund invest-
ments made during 20X2.

5.5 Debt service coverage ratio

The debt service coverage ratio (DSCR) seeks to measure the ability of a company to meet its
debt and interest commitments from pure earnings. EBITDA (earnings before interest, tax,
depreciation and amortisation) is taken as a pure non distorted measure of earnings. The DSCR
is determined as follows.
EBITDA
Annual debt repayment and interest charges
The greater the DSCR, the less exposed a company is likely to be to external changes in interest
rate changes and other external risks. One limitation of DSCR, particularly when comparing
 chapter 10  Analysis and interpretation of accounts 2 219

different years, is that it does not take into account variations in the level of capital repayments
– these can vary considerably, depending on the period of the loan repayment and the capital
project.
The comparative DSCR for XYZ plc is as follows.

20X2 20X1
501 + 660 420 + 600
150 + 150 50 +150
3.87x 5.1x

The DSCR for 20X1 is strong, with EBITDA providing 5.1x coverage of the prospective interest
charges. For 20X2, the ratio declines to 3.9x, but still shows debt commitments to be com-
fortably covered out of internally generated cash flow. The multiple also suggests that there is
surplus cash available to meet working capital requirements and for tax and dividend payments
and capital expenditure. Note that repayment of the capital of the loan does not start until
2013.

5.6 Ratios based entirely on the contents of the cash flow statement
It is possible to add to the interpretative value of the cash flow statement by expressing some of
the financial totals contained in the cash flow statement as ratios of one another. As is always
the case with ratio analysis, the usefulness of a ratio depends on the existence of an expected
relationship between the financial magnitudes being compared. A number of valid ratios could
be computed, and two are presented below to illustrate the possibilities available. We will now
calculate some key ratios from the cash flow statement of XYZ plc presented in Figure 10.1.

5.7 The internal: external finance ratio

The relationship between internal finance and external debt finance may be examined by
expressing net cash generated from operations as a ratio of external financing (cash flows from
financing activities). A low ratio indicates the company is reliant on external funding. A ratio
that falls indicates increased reliance on external finance, perhaps for the purpose of further
investment.
The comparative internal:external finance ratio for XYZ plc is as follows.

20X2 20X1
internal:external finance ratio 652 : 1,000 1,290 : 100
0.65 : 1 12.9 : 1

It is evident that the sources of finance XYZ plc used changed significantly. XYZ plc increased
their dependence upon external finance in 20X2. This is reflected in the statement of financial
position by a revision of the long-term capital structure of the company, which could be further
examined by computing leverage ratios.

5.8 The shareholder funding ratio

The shareholder funding ratio measures the extent to which capital investment has been funded
internally by the shareholders. This ratio is determined as follows:
Shareholder funding ratio = Net cash generated from operating activities : expenditure on
non-current assets
The comparative results for XYZ plc are as follows:

20X2 20X1
652 : 1,620 1,290 : 900
0.40 : 1 1.4 : 1
220 Part four  Analysis and interpretation of accounts

The shareholders of XYZ plc comfortably funded the entire business investment in 20X1, leav-
ing a significant surplus to improve the company’s liquidity position. However, in 20X2, only
40% of expenditure on non-current assets was funded internally. XYZ plc relied primarily upon
debt to fund the investment programme undertaken during 20X2.

5.9 Review
The purpose of the cash flow statement is to improve the informative value of published finan-
cial reports. The sections above have demonstrated the contribution of two types of calculation:
a) ratios that link the cash flow statement with key related items appearing in the statement
of financial position; and
b) ratios that explore the inter-relationship between items within the cash flow statement.
As usual, it should be noted that different ratios are expressed in different ways, as percentages,
as multiples or in pence, as well as in the classic form. The interpretative value of individual
ratios will depend upon the nature of the financial developments at a particular business. It
is also the case that the messages conveyed by certain ratios may be similar for a particular
company covering a particular year, but in a different time and place the same ratios may yield
different insights.
Finally, one must remember the importance of not attaching too much weight to any single
ratio but to use a representative range of ratios that combine cash flow ratios with traditional
ratios to build up a meaningful business profile.

T E S T YO UR K N OW L E D G E   10.2

Explain how ratios can be used to improve the informational value of the cash flow statement.

6 Earnings per share

The earnings per share (EPS) calculation reveals the amount of profit accruing to the holder of
one share in a company.
EPS is widely used as a measure of company performance, due to:
■■ the belief that earnings are an important determinant of share price. They set an upper limit
for dividends, and, by comparing earnings with dividends, a measure of likely future growth
from retained earnings can be obtained;
■■ the popularity of the price/earnings ratio as an indicator of financial performance and also a
method of business valuation; and
■■ the determination of financial commentators to reduce the complexities of corporate activity
to a single figure.

6.1 Definition of EPS

The nature, purpose and calculation of EPS are dealt with in IAS 33 ‘Earnings Per Share’. EPS
may be defined as the earnings, in pence (for UK companies), attributable to each equity share,
and is calculated using the following formula:
EPS =
Earnings
No of equity shares in issue
 chapter 10  Analysis and interpretation of accounts 2 221

Where:
■■ earnings = the profit (or in the case of a group the consolidated profit) of the period after
tax, minority interests and extraordinary items and after deducting preference dividends and
other appropriations in respect of preference shares; and
■■ shares = the number of equity shares in issue and ranking for dividend in respect of the
period
Further points to note:
■■ IAS 33 applies only to listed companies.
■■ When a loss is suffered, the EPS is a negative figure.
■■ The importance attached to EPS is reflected by the requirement for the current year’s figure,
together with the comparative for the previous year, to be displayed on the face of the con-
solidated statement of profit or loss and other comprehensive income. It cannot be ‘tucked
away’ in the notes.
A company is permitted to disclose, in addition to basic earnings per share, a second calcula-
tion, the fully diluted EPS, based on a different figure for earnings. This further disclosure is
likely to occur where the directors consider that earnings have been affected by a non-recurrent
transaction, so that exclusion of its effect produces a more useful indication of the projected
performance of the enterprise. The revised figure is often referred to as the underlying earnings
per share. The accounts should disclose how the revised earnings figure has been computed and
the ‘underlying’ EPS must be given no greater prominence than the basic EPS.
An illustration of how the two figures might be reported is given in Figure 10.2 and is taken
from the accounts of Tesco plc.

Full year 26 Feb 20X1 20X0

52 weeks 52 weeks
Revenue 67,573 62,537
Underlying profit from operations 3,754 3,424
Underlying operating margin 6.00% 5.90%
Joint ventures and associates 57   33
Profit from operations 3,811 3,457
Underlying profit before tax * 3,813 3,395
Profit before tax 3,535   3,176
Underlying EPS * 27.10p 29.31p
Basic EPS 27.14p 29.33p

Figure 10.2 Extract from financial statement of Tesco plc 20X0–X1

* Underlying profit excludes the impact of non-cash elements of IAS 17, 19, 32 and 39 (principally the
impact of annual uplifts in rents and rent free period, pension cost, and the mark-to-market of financial
instruments), the amortisation charge on intangible assets arising on acquisition, acquisition costs and the
non-cash impact of IFRIC 13. It also excludes costs relating to restructuring (US and Japan), closure costs
(Vin Plus) and the impairment of goodwill in Japan.
Source: www.tescoplc.com/investors/financials/five-year-summary; http://ar2011.tescoplc.com/pdfs/tesco_
annual_report_2011.pdf.
222 Part four  Analysis and interpretation of accounts

6.2 Calculation of EPS

We start with the basic calculation where no shares have been issued during the year.

worked e x amp le   10.3

The following information is provided for A plc in respect of 20X1:

£,000 £,000
Profit before taxation 300
Taxation (30%) 90
Profit for the year 210
Dividends paid during the year:
Ordinary shares 100
Preference shares 35 135
75

The company has in issue £1 million ordinary shares of 50p each and £500,000 7% convertible
preference shares.

Required
Calculate the EPS for 20X1.

Answer
(210,000 – 35,000*) 100
EPS =
1,000,000 ord shares ÷ 50p

17,500,000
2,000,000

(210,000 – 35,000*) 100

2,000,000 
8.75p
* £500,000 × 7% = £35,000

6.3 Share issues during the year

We now introduce the complication of a share issue being made during the current year. There
are three possibilities:
1. an issue at full market price;
2. a bonus issue during the year; and
3. a rights issue during the year.

6.3.1 Issue at full market price

This increases both the number of shares in issue and the earnings capacity of the company.
The earnings for the period must, therefore, be spread over the increased number of shares in
issue. However, where the issue takes place partway through the year, it is necessary to calculate
the average number of shares in issue during the year, on a weighted time basis, as the extra
shares only increase earnings capacity after they have been issued.
 chapter 10  Analysis and interpretation of accounts 2 223

worked e x amp le   10.4

A plc (see Worked example 10.3) issues a further 600,000 ordinary shares on 1 May 20X2. The profit
for the year for the year ended 31 December 20X2 is £280,000.

Required
Calculate the EPS for 20X2.

Answer
(280,000 – 35,000) 100
EPS =
(1,000,000 × 2) + (600,000 × 2/3)
24,500,000
2,400,000
10.21p

6.3.2 Bonus issue

A bonus issue of shares to current shareholders of a company produces no cash and so will not
increase the available resources nor affect earnings capacity. The effect of the issue, therefore,
is to spread the earnings over a greater number of shares. Because the bonus issue does not
increase earnings capacity, there is no need to calculate a weighted average for the shares in
issue during the year. Therefore, the date of the bonus issue, if given in a question, is irrelevant
and can be ignored. However, it is necessary to restate the comparative EPS figure, for the previ-
ous year, in order to place it on a ‘like for like’ basis.

worked e x amp le   10.5

The results of A plc for 20X1 are shown below. During 20X2, A plc makes a bonus issue of one
additional ordinary share for every two shares presently held. Profits for the year for 20X2 are £280,000.
£,000 £,000
Profit before taxation 300
Taxation (30%) 90
Profit for the year 210
Dividends paid during the year:
Ordinary shares 100
Preference shares 35 135
75
Required
a) Calculate the EPS for 20X2.
b) Calculate the revised EPS for 20X1.
Answers
Calculation for 20X2:

EPS = (280,000 – 35,000) 100

(1,000,000 × 2) 3/2
24,500,000
3,000,000
8.17p
Revised calculation for 20X1: EPS = 8.75 × 2m/3m = 5.8p. This adjusts for the fact that there are
50% more shares in issue in 20X2 compared with 20X1.
224 Part four  Analysis and interpretation of accounts

6.3.3 Rights issue

A rights issue occurs when new shares are issued to existing shareholders, usually at below the
existing market price. This increases the number of shares in issue, but does not increase the
earning capacity of the company proportionally. After a rights issue, the market price should
therefore fall. The dilution in the value of pre-rights issue share capital, in such circumstances,
can be demonstrated as follows.

worked e x amp le   10.6

£
Four shares in circulation before rights issue at a market price of £2 each: 8.00
Rights issue of, say, one for two at an artificially low price of 50p each for
illustrative purposes: 1.00
Six shares then in issue will have theoretical post-rights issue worth of: 9.00
Theoretical ex-rights price will be £9 ÷ 6 shares 1.50
Diluted post-rights equivalent of pre-rights issue shares:
Four shares worth £2 each (pre-issue) = 4 × (£2 ÷ £1.5) = 5.3 shares post issue

Proof:
£
Four shares at pre-issue market price of £2: 8.00
5.3 shares at theoretical ex-rights price of £1.5: 8.00

The above adjustments are incorporated in the calculation of EPS in the following manner:

1. Calculate total value of equity before rights issue: market price × number of shares.
2. Calculate proceeds of new issue.
3. Calculate theoretical price after issue:

1+2
Number of shares after rights issue

4. Calculate the post-issue equivalent of the number of shares outstanding pre-issue:

Actual pre-issue price
Number of shares ×
Theoretical post-issue price

5. Calculate the number of shares in issue during the year on the weighted average basis.
6. Compute EPS.
7 Obtain corresponding comparative figure for previous year:
Theoretical post-issue price
Last year’s EPS ×
Actual pre-issue price

The following information is provided for B Ltd:

■■ B plc has earnings of £16,640 for 20X2.
■■ There were 120,000 ordinary shares in issue at the start of the year.
■■ A total of 40,000 further shares were issued on 31 August 20X2 at £1.50 each.
■■ The market price of each share immediately before the rights issue was £2.

Required
Calculate the EPS for 20X2.
 chapter 10  Analysis and interpretation of accounts 2 225

worked e x amp le   10.6 continued

Answer
Procedure to calculate EPS:
1. Calculate total value of equity before issue: market price × number of shares:
£2 × 120,000 = £240,000
2. Calculate proceeds of new issue:
£1.50 × 40,000 = £60,000
3. Calculate theoretical price after issue:

(240,000 + 60,000)
120,000 + 40,000
300,000
160,000
£1.875

4. Calculate the post-issue equivalent of the number of shares outstanding pre-issue:

2
120,000 × = 128,000
1.875

5. Calculate the number of shares in issue during the year on the weighted average basis:
(128,000 × 2/3) + (160,000 × 1/3) = 138,667
6. Compute EPS:

16,640
× 100 = 12p
138,667

TEST YO UR K N OW LE DG E   10.3

a) Define earnings per share.

b) What is meant by a weighted average EPS?

6.3.4 Diluted earnings per share (DEPS)

IAS 33 describes diluted earnings per share as follows:

Dilution: A reduction in earnings per share or an increase in loss per share resulting from the
assumption that convertible instruments are converted, that options or warrants are exer-
cised, or that ordinary shares are issued upon the satisfaction of specified conditions.

On occasions, a company, whose shares are traded on a stock exchange, can issue shares that
in effect are below the market price of those shares had they been available to interested parties
ordinarily. The impact of offering shares at less than market price is the same as offering all or
a portion of shares for free. Consequently this has a diluting effect on EPS.
226 Part four  Analysis and interpretation of accounts

worked e x amp le   10.7

The results of A Ltd for 20X1 are as in Worked example 10.3. During 20X2, the entire 7%
convertible preference shares of £1 each totalling £500,000 are converted at four ordinary shares for
one convertible preference share. Profits for the year for 20X2 are £280,000.

Required
Calculate the diluted EPS for 20X2.

Answer

No of shares Earnings Price

£,000 £,000 p
Basic EPS (W1) 2,000 280–35 12.25
Convertible preference shares (W2) 2,000 35
Diluted EPS 4,000 280 7.00
Diluted EPS 7.00p per share

The net effect of the preference shares converting to ordinary shares is that basic EPS has reduced
from 12.25 pence per share to 7.00 pence per share.

(W1)
For basic EPS purposes, profits available would have been:
(£280,000 - £35,000) / 2,000 shares = 12.25p per share

(W2)
Preference share conversion:
2 ordinary shares × 1 (£1 preference share)
2 × 500,000 = 2 million ordinary shares.

T E S T YO UR K N OW L E D G E   10.4

Explain the difference between basic and diluted EPS.

? END OF CHAPTER QUESTIONS

10.1 Gamma plc makes up its accounts on the calendar year basis. The profit for the year to 30 September
20X1, attributable to the ordinary shareholders, is £20 million after deducting interest on £40 million 12%
debenture stock. The ordinary share capital presently amounts to 100 million shares of £1 each, but the
debenture holders have the right to convert their holding into ordinary shares at any date after 1 January
20X5. The terms of the conversion are 120 ordinary shares for every £100 of debenture stock.
Assume a tax rate of 30%.

Required
Calculate the basic and fully diluted earnings per share.
 chapter 10  Analysis and interpretation of accounts 2 227

? END OF CHAPTER QUESTIONS

10.2 The following information is provided in respect of Roxon plc:
a) Statement of profit or loss and other comprehensive income extracts, year to 31 December

20X2 20X1
£m £m
Operating profit 132 108
Interest payable 36 36
Profit before tax 96 72
Taxation (33%) 32 24
Profit for the period 64 48
Extract from statement of changes in equity
Dividends: ordinary shares (32) (16)
8% preference shares (8) (8)

(i) The ordinary share capital consisted of 30 million shares of £1 each in 20X1 and through to
30 April 20X2, when a bonus issue was made of one new ordinary share for every five shares
presently held.
(ii) The 8% preference share capital amounted to £100 million throughout 20X1 and 20X2.
(iii) The interest payable is in respect of 12% debenture stock. The debenture holders have the right
to convert their stock into ordinary shares at any time after 1 January 20X2. The terms of the
conversion are 20 ordinary shares of £1 each for every £300 of debenture stock.

Required
a) Define earnings per share in accordance with standard accounting practice.
b) Explain what is meant by a bonus issue of shares, and indicate its likely effect on the market price of
the shares.
c) Compute the figures for EPS, including re-stated EPS for 20X1, to be disclosed in the accounts of Roxon
for 20X2.
d) Outline the circumstances in which the obligation to compute the fully diluted earnings per share
arises.
e) Compute the figures for fully diluted earnings per share to be disclosed in the accounts of Roxon for
20X2.
10.3 The du-Pont Analysis is a technique for analysing the three components of return on equity (ROE):
a) Net margin = Net income / Sales. How much profit a company makes for every £1 it generates in
revenue. The higher a company’s profit margin, the better.
b) Asset turnover = Sales / Total assets. The amount of sales generated for every pound of assets. This
measures the firm’s efficiency at using assets. The higher the number, the better.
c) Leverage factor = Net income / Shareholder’s equity. The higher the number, the more debt the
company has.
The du-Pont analysis uses the following formula:

Net income Sales Assets Net income

× × =
Sales Assets Equity Equity

Given the following information, in £,000, calculate firm efficiency for Alpha plc:
■■ Net income = 3,300
■■ Sales = 19,600
■■ Assets = 135,000
■■ Equity = 9,500
228 Part four  Analysis and interpretation of accounts

? END OF CHAPTER QUESTIONS

10.4 The following information appeared under equity in the statement of financial position of Anfield Ltd at 31
December 20X4:

Equity

20X4 20X3
£,000 £,000
Issued share capital (£1 ordinary shares) 45,000 25,000
Share premium account 13,500 6,000
Retained earnings 16,200 19,000
74,700 50,000

You discover that the directors of Anfield arranged a bonus issue of one new ordinary share of £1 each for
every five shares held on 31 March 20X4. This was followed by a rights issue at £1.50 per share on 1 May
20X4. The directors of Anfield paid an interim dividend for 20X4 of 15p per share on 31 July 20X4.

Required
Compute the following items for inclusion in the cash flow statement and related notes of Anfield for 20X4,
so far as the information permits:
■■ proceeds from rights issue; and
■■ profit for the period (20X4).

Notes:
1. Ignore taxation.
2. Anfield neither received nor paid any interest during 20X4.
Limitations of published 11
accounts

■■ Contents
1. Introduction
2. Limitations of accounting ratios
3. Subjectivity and earnings management – impact on reported figures
4. Creative accounting or earnings management
5. Substance over form
6. The role of audit in mitigating creative accounting
7. Auditors and non-audit services

■■ Learning outcomes
Chapter 11 covers the syllabus section entitled ‘Limitations of Published Accounts’. After read-
ing and understanding the contents of the chapter, working through all the worked examples
and practice questions, you should be able to:
■■ understand and explain subjectivity and earnings management and how managers can take
opportunity to meet their own aims;
■■ appreciate and demonstrate how creative accounting occurs and the various means by which
managers manipulate accounting numbers such as debt factoring, consignments, sale and
repurchase agreements;
■■ discuss and apply the principal of substance over form; and
■■ discuss the role of the external audit and the implications of audit and non-audit services for
corporate governance.

1 Introduction
The IFRSs provide guidance to those who prepare financial statements; they also provide dis-
cussion and reflection on the presentation of financial statements. IFRSs and IASs cover the
general format of financial reporting. When an accounting issue arises, those involved in the
preparation of accounts can consult the framework for guidance on how to report. The general
aim is to ensure matters are reported in a manner that is transparent and useful to users.
However, financial reporting standards cannot ensure financial statements always provide a
completely accurate and full picture to all users of accounting information. Some of the main
limitations of financial statements are discussed below:
1. The financial position of a business is affected by several factors: economic, social and
financial, but only financial factors are presented in the financial statements. Economic
and social factors are excluded. Thus, the financial position disclosed by these statements
is incomplete. However, a trend towards reporting on social and environmental impact by
businesses is becoming common practice, particularly with large listed UK companies. This
wider approach is known as ‘integrated reporting’.
2. The financial statements only cover a specific period of time. They are essentially interim
reports presented on an annual basis. Past performance may not be an accurate indicator of
future performance.
3. Facts that have not been recorded in the accounts are not depicted in the financial statement.
Only quantitative factors are taken into account. Qualitative factors, such as reputation and
the prestige of the business with the public, the efficiency and loyalty of its employees, and
the integrity and skill-set of management do not appear in the financial statements.
230 Part four  Analysis and interpretation of accounts

4. The past ‘buying power’ of a national currency may not reflect current buying power. Historic
cost accounting is based on the assumption that the value of the monetary unit remains
constant. Assets are recorded by the business at the price at which they are acquired, and
liabilities are recorded at the amounts at which they are contracted. However, a monetary
unit is never completely stable, especially under inflationary conditions. In times of infla-
tion, this results in significant distortions in financial statements.
5. Many items included in financial statements have a significant impact on reported profit,
but depend on the personal judgment of management (e.g. provision for depreciation, inven-
tory valuation, bad debts provision).
6. The convention of accounting conservatism: the consolidated statement of profit or loss
and other comprehensive income may not disclose the true income of a business entity as
probable losses are considered, while probable income is not reported.
7. The non-current (fixed) assets are shown at cost less depreciation. But the market value of
non-current assets may not be the same on disposal. The disposal of a non-current asset
may give rise to a significant loss or gain that distorts the financial statements.
8. Management’s judgment is always involved in the preparation of financial statements, leav-
ing the statements open to manipulation. Financial data must be analysed and evaluated
in some way to give some sort of indication of the future prospects of a business. It is the
analyst or user who gives meaning to financial information.

2 Limitations of accounting ratios

The various calculations illustrated in this and the last two chapters suffer from a number of
limitations that should be borne in mind by anyone attempting to interpret their significance.
The main limitations are as follows.
Accounting ratios can be used to assess whether performance is satisfactory, by means of
inter-company comparison, and also whether results have improved, worsened or remained
stable, by comparing this year’s results with those achieved last year. The ratios do not provide
explanations for observed changes, however, and the external user’s ability to obtain further
information varies considerably. The shareholder may ask questions at the annual general meet-
ing, while a financial institution may demand extra information when an advance is requested,
but only management has direct access to the information needed to provide the right answer.
Deterioration in an accounting ratio cannot necessarily be interpreted as poor management.
For example, a decline in the rate of inventory turnover initially appears undesirable, but further
investigation might reveal the accumulation of scarce raw materials that enable the plant to
continue working when competitors are forced to suspend production.
Too much significance should not be attached to individual ratios (e.g. a rate of return on
gross assets of 30% might indicate that all is well, but this conclusion might be unjustified if
further analysis revealed a liquidity ratio of 0.4:1).
Changes in many ratios are closely associated with one another and produce similar conclu-
sions (e.g. the ratio of total debt to total assets (not illustrated in this chapter) and the debt:
equity ratio). Care should therefore be taken when selecting ratios to be used as the basis for the
analysis; a representative selection should be made and duplication avoided.
Company financial statements are usually based on historical cost and, therefore, accounting
ratios based on these figures would be expected to improve, irrespective of efficiency during a
period of rising prices (e.g. total asset turnover of £3 per £1 invested might be computed from
historical cost accounts, whereas a figure of £1.80 per £1 invested might be obtained if assets
were restated at current values).
Differences in accounting policies may detract from the value of inter-company comparisons
(e.g. the valuation of inventory on the LIFO (last-in, first-out) basis (now banned) rather than
the FIFO (first-in, first-out) basis would probably produce a much lower working capital ratio).
Financial statements and accounting ratios can be distorted as the result of one-off large
transactions such as the credit purchase of plant, which will significantly increase current lia-
bilities until payment is made, or a profit on the sale of a non-current. Analysts should similarly
be on their guard for evidence of window-dressing, perhaps designed to conceal a deteriorating
financial position.
 chapter 11  Limitations of published accounts 231

Where a company undertakes a mix of activities, it is important to calculate separate ratios

for each section wherever possible.
Particular care must be taken when interpreting accounting ratios calculated for a seasonal
business. Where sales are high at a particular time during the year (e.g. at Christmas), stock
might be expected to increase and cash to decline in the months leading up to the busy period.
In these circumstances, deteriorations in both the liquidity ratio and the rate of inventory
turnover, compared with the previous month, are not necessarily causes for concern.
Consideration must be given to variations in commercial trading patterns when assessing the
significance of accounting ratios computed for particular companies. For example, a retail chain
of supermarkets would be expected to have a much lower liquidity ratio and a much higher rate
of inventory turnover than a constructional engineering firm. In this context, accepted ‘norms’
such as a working capital ratio of 2:1 must be used with care.

TEST YO UR K N OW LE DG E   11.1

Outline three limitations of accounting ratios.

3 Subjectivity and earnings management – impact on

reported figures
Modern accounting methods are based on the accruals (or matching) concept in which revenues
and expenses are reported in the period they are incurred, irrespective of when physical cash
transactions take place. IAS 1 requires business entities to prepare accounts on an accruals
basis.
There are many reasons why those preparing financial information may not present a com-
pletely accurate picture. This was discussed earlier with regard to agency theory. Managers,
typically, use accounting techniques that either enhance actual earnings or defer earnings to
future periods. One reason why managers may enhance earnings figures is self-interest (e.g.
meeting bonus and remuneration targets).
Earnings have two components: cash and accruals. In an accruals-based accounting system,
revenues and expenses are matched in the period they are incurred. Accruals, however, are
a subjective measure of revenue and expenses. Nevertheless, the non-discretionary accruals
(NDAC) element of total ‘accruals’ can be shown to be accurate – for instance, sales at the end
of the year. In certain cases, managers will use their judgment to accrue revenues and expenses
that are not clearly definable. They use their inside knowledge to communicate this informa-
tion to the outside world. For example, a contract for services straddles more than one financial
year. The value of the contract is £10 million and the contract runs for five years. Management
may decide that the bulk of the contractual income (say 60%) will be in the first two years.
They will thus reflect 60% of the contractual income in the first two years in reported finan-
cial figures. This is acceptable if managers follow the relevant accounting standards and can
explain their reasoning to the external auditors.
Conversely, managers may sometimes manage earnings for their own purposes to meet cer-
tain targets. This is known as managerial opportunism. As mentioned earlier, the main mecha-
nism for managing reported earnings is through accruals manipulation. The nature of accruals
is such that they reverse in the next accounting period. This has repercussions on reported fig-
ures. Any unassigned accruals will not be matched by the eventual receipt or payment of cash.
This has an impact on current and future reported earnings.
Apart from meeting earnings expectations to achieve bonus targets, managers may increase
(by various means) reported earnings to meet market expectations (e.g. by reducing gearing
levels or increasing earnings per share (EPS)), hence strengthening the statement of financial
position.
232 Part four  Analysis and interpretation of accounts

worked e x amp le   11.1

The following are the financial figures of Raymond Ltd. In exercising judgment, management has
been over-optimistic about the amount of revenue it believes should be reported.
The pre-accruals column shows the actual figures as they should be reported. The post-accruals
column shows the figure after managers have accrued an extra £8 million revenue. The impact of
this is demonstrated below:

Pre-accruals Post-accruals
£,000 £,000
20X1 20X1
Sales 52,000 60,000
Cost of goods sold 36,000 36,000
Gross profit 16,000 24,000
Operating expenses
Selling expenses 7,000 7,000
Administrative expenses 5,860 5,860
Total operating expenses 12,860 12,860
Net operating income 3,140 11,140
Interest expenses 640 640
Profit before tax 2,500 10,500
Income taxes (30%) 750 3,150
Profit for the year 1,750 7,350

Pre-accruals Post-accruals
£,000 £,000
20X1 20X1
Non-current assets
Property, plant and equipment 16,000 16,000
Current assets
Inventory 8,000 8,000
Receivables 6,000 14,000
Prepaid expenses 300 300
Cash and cash equivalents 3,700 3,700
Total current assets 18,000 26,000
Total assets 34,000 42,000
Equity and liabilities
Share capital (£1 shares) 6,000 6,000
Share premium 1,000 1,000
6% Preferred shares 2,000 2,000
Retained earnings 8,000 15,400
17,000 24,400
 chapter 11  Limitations of published accounts 233

worked e x amp le   11.1 continued

Non-current liabilities
8% loan 10,000 10,000
Current liabilities:
Accounts payable 5,800 5,800
Accrued payable 900 900
Taxation 300 900
Total current liabilities 7,000 7,600
Total liabilities 17,000 17,600
Total equity and liabilities 34,000 42,000

Required
Raymond Ltd is a manufacturer of machine parts. To assist in the cash management and expansion
of the business, Raymond secured a £10 million long-term loan from its bankers. The terms and
conditions of the loan stipulated that Raymond should not exceed a 50% debt:equity ratio (see
formula given above). However, at the end of 20X1, the debt covenant with the lender appears to
have been breached. Managers at Raymond Ltd decided to increase revenue sales figures by an extra
£8 million. The premise for this increase is based on over-optimistic expectation of revenues from
contracts with certain customers.

Required
Calculate the gearing ratio pre- and post-accruals for Raymond Ltd, and make relevant comments on
the change in gearing.

Answer
Pre-accruals Post-accruals
£,000 £,000
20X1 20X1
Sales 52,000 60,000
Earnings 1,750 7,350
Long-term finance 10,000 10,000
Shareholders’ funds 17,000 24,400
10,000 10,000
Gearing ratio 17,000 24,400
= 59% 41%

worked e x amp le   11.2

Given the above information, the consequence of actions taken by Raymond Ltd would have
repercussions on other aspects of the company’s financial figures.

Required
Calculate the change in earnings per share and any expectations by shareholders and potential
investors.
234 Part four  Analysis and interpretation of accounts

worked e x amp le   11.2 continued

Answer

Pre-accruals Post-accruals
£,000 £,000
20X1 20X1
Sales 52,000 60,000
Earnings 1,750 7,350
Shares in issue 6 million 6 million
1,750 7,350
EPS 6,000 6,000
= 0.29 1.23

It would appear that based on pre-accruals figures, Raymond Ltd would have defaulted on the debt
covenant agreed with the lender. The pre-accruals gearing ratio is 59%, way above the agreed level.
Managers at Raymond Ltd have accrued an extra £8 million in revenue, which has increased total
shareholders’ funds by about 44%. This appears to indicate that drastic action has been taken by
Raymond’s managers to ensure they remain within the terms of the debt covenant in the current
year. However, the impact of this £8 million extra accrual will have consequences for the following
financial year, as revenue will be reduced by £8 million in 20X1. Unless Raymond Ltd increases its
actual revenue by an equal amount in 20X1, the company will face the same difficulties (i.e. default
on the debt covenant).
The action taken by Raymond Ltd has meant an increase in earnings from the pre-accruals
position to the post-accruals position of 320%. Similarly, the EPS has also risen by over 320% from
pre-accrual EPS of 29p per share to £1.23 per share. This may cause difficulties for the company, as
shareholders are likely to expect a dramatic rise in dividends to be announced. When this does not
materialise, this may give cause for concern, not just to the shareholders and lenders of Raymond,
but also to other stakeholders.
Taking the example from Raymond Ltd (above), discuss any further impact the action of
management will have on the statement of financial position for Raymond.

worked e x amp le   11.3

The table below indicates the impact of change in ratio measuring company performance.

Pre-accruals Post-accruals % change

£,000 £,000 post-accruals
20X1 20X1 20X1
Current ratio 2.57 3.42 33.07%
Acid test 1.43 2.37 65.73%
Total asset turnover 1.53 1.43 –6.54%
ROE (W1) 11% 32% 190.91%
ROCE (W2) 6% 21% 250.00%
 chapter 11  Limitations of published accounts 235

worked e x amp le   11.3 continued

Pre- Post-
accruals accruals
£,000 £,000
W1 20X1 20X1
Return on equity (ROE)
Equity (excluding preference shares)
Share capital 6,000 6,000
Share premium 1,000 1,000
Retained earnings 8,000 15,400
15,000 22,400
Net income 1,750 7,350
Dividends to preferred shareholders (120) (120)
Income attributable to shareholders 1,630 7,230

ROE 1,630 7,230

15,000 22,400
ROE 10.87% 32.28%
W2
Return on capital employed (ROCE)
Capital employed 27,000 35,000

ROCE 1,750 7,350

27,000 35,000
ROCE 6.48% 21.00%

As would be expected, as a result of accruing significant additional income. the post-accruals

figures indicate substantial strengthening of the statement of financial position for Raymond
Ltd.

■■ Current ratio: This suggests that the liquidity position of the company has improved sub-
stantially. However, this is mainly due to the increase in receivables following the increase in
revenue brought about through inappropriate accruals management.
■■ Acid test: The acid test ratio, a more stringent version of the current ratio that excludes
inventory in its calculation, again suggests that the liquidity of the company has strength-
ened. Again, though, this is due to the increase in revenue brought about through inappropri-
ate accruals management.
■■ Total asset turnover ratio: This suggests that company efficiency has fallen, even though rev-
enues have increased substantially. This is due to the corresponding increase in total asset
increase, since the accruals effect has also increased receivables.
■■ Return on equity: The figures indicate that an increase of 191% has taken place due to the
effects of increase in revenues and hence earnings. The increase in earnings is not, however,
matched by any level of increase in shareholders’ equity. Hence, a sharp rise in the ROE ratio
is indicated.
■■ Return on capital employed: This ratio takes into account the total shareholders’ fund that
includes reserves and retained earnings. The figures suggest an increase in ROCE by 250%
due to increased earnings and increased total shareholders’ fund.
236 Part four  Analysis and interpretation of accounts

It would be interesting to see how the company manages its revenues in 20X2. An actual rise
in revenue, without accruals management, would cancel out the effects of the use of accruals in
20X1. However, if no action is taken and no accruals management occurs in 20X2, we would
expect a sharp and substantial fall in the ratios indicated. This would have repercussions for
stakeholders, and confidence in company performance may fall.

T E S T YO UR K N OW L E D G E   11.2

Outline the reasons why managers may engage in earnings management.

4 Creative accounting or earnings management

Creative accounting can be defined in a number of ways. However, a working definition is: ‘a
process by which managers use their knowledge of accounting choices available to them to
manipulate the figures reported in the accounts of a business.’
Creative accounting, or (to use the more modern phraseology) earnings management, can
occur in a number of ways, both intentional and unintentional. Some basic reasons why crea-
tive accounting occurs and the role of audit in mitigating such practices are as follows:
■■ Accounting system – the weaknesses inherent in the accepted accounting methods render
the system susceptible to manipulation by opportunistic managers.
■■ Accounting choices – Accounting rules allow companies to choose between relevant account-
ing methods. In many countries, a company can choose between a policy of writing off
development expenditure as it occurs, or amortising it over the life of the related project. A
company can, therefore, choose the accounting policy that suits its purpose. In the UK, and
under IFRS development, expenditure must be written off to the consolidated statement of
profit or loss and other comprehensive income.
■■ Accounting judgment – By and large, the manner in which accounting rules and regula-
tions are drafted demand management to deliver some level of estimates. Currently, the
IFRSs require management to provide some level of estimate where exact or accurate figures
are either unavailable or inaccessible (e.g. pension costs). The defined benefits (DB) scheme
is notorious for estimating pension costs to companies. In some circumstances, relevant
experts are engaged to make estimates; for instance, an actuary would normally be employed
to assess the prospective pension liability. In this case, the creative accountant can manipu-
late the valuation both by the way in which the expert is briefed and by engaging an expert
known to take either a pessimistic or an optimistic view. In either case, management may
select the most favourable expert.
■■ Accounting transactions – Certain entries in the accounts involve an unavoidable degree of
estimation, judgment and prediction. In some cases, such as the estimation of an asset’s
useful life made to calculate depreciation, these estimates are normally made inside the
business and the creative accountant has the opportunity to err on the side of caution or
optimism in making the estimate.
Artificial transactions can be entered into both to manipulate the statement of financial posi-
tion balances and to move profits between accounting periods. This is achieved by entering
into two or more related transactions with an obliging third party, normally a bank. Suppose
an arrangement is made to sell an asset to a bank, then lease that asset back for the rest of
its useful life. The sale price under such a ‘sale and leaseback’ can be pitched above or below
the current value of the asset, because the difference can be compensated for by increased or
reduced rentals.
Genuine transactions can also be timed so as to give the desired impression in the accounts.
As an example, suppose a business has an investment of £1 million at historic cost which can
easily be sold for £3 million, being the current value. The managers of the business are free to
choose in which year they sell the investment and so increase the profit in the accounts at a
desired time.
 chapter 11  Limitations of published accounts 237

5 Substance over form

The principle of ‘substance over form’ allows a company to ensure that its financial reports offer
a true and fair view of the economic realities of the business. In this way, the economic substance
rather than the legal form is reported. The IASB (International Accounting Standards Board)
has, in recent years, diverted its attention on the statement of financial position approach.
Standards have been developed and either enhanced or amended to allow the substance of a
transaction, rather than its legal form, to convey economic reality.
Some transactions present a window of opportunistic behaviour for managers. The ‘sub-
stance over form’ concept has addressed some of the mechanisms that were used (or in some
cases that may still be used, perhaps in smaller companies) to hide the true nature of a transac-
tion. Some of these mechanisms are discussed below.

5.1 Sale and leaseback arrangement

A company that needs cash can enter into a financial arrangement with a willing third party,
such as a bank. The company sells its machinery to the bank and gets it back via a lease. This
is called a ‘sale and leaseback’ arrangement, as mentioned above. Under this arrangement,
although the legal ownership has transferred, the underlying economics remain the same.
Under the ‘substance over form’ principle, the sale and subsequent leaseback are considered to
be one transaction. If two companies swap their inventories, they will not be allowed to record
a sale, because no sale has occurred, even if they have entered into a valid enforceable contract.

5.2 Consignment stock

Consignment sales are arrangement between two parties: the principal and the agent. In this
arrangement, the agent holds the goods on behalf of the principal with a view to selling on the
good on behalf of the principal, thereby earning a fee or a commission.
In a consignment arrangement, the consignor (seller) ships goods to the consignee (buyer),
which acts as the agent of the consignor in trying to sell the goods. There are many forms of
consignment arrangements; however, the two main methods are:
■■ where the consignee receives a commission; or
■■ where the consignee ‘purchases’ the goods simultaneously with the sale of goods to the final
customer.
Goods out on consignment are properly included in the inventory of the consignor and excluded
from the inventory of the consignee. Disclosure may be required of the consignee, however,
since common financial analytical inferences (such as days’ sales in inventory or inventory
turnover) may appear distorted unless the financial statement users are informed. However, the
IFRSs do not explicitly address this.

5.3 Debt factoring

A factoring arrangement involves the factor, which is perhaps a financial institution or special-
ist factoring company, buying some or all of an entity’s accounts receivable or debt outright.
The factor then administers the sales ledger, taking responsibility for sending out statements
to customers and chasing up outstanding payments. The specific arrangements made (e.g. the
amount advanced and responsibility for bad debts) can vary significantly. For example, the
arrangement may involve an advance of 90% of the value of receivables with the remaining
amount paid over, when collected, less a commission plus interest on the advance. The Scottish
Enterprise website states that factoring is particularly attractive to businesses whose growth
is sales-based and who need regular injections of working capital to buy materials, to increase
production and to fund inventories purchase as sales rise. They continue:

Late payment is the bane of most small businesses. Factoring substantially reduces the aver-
age payment period on invoices, something that can do wonders for the financial perfor-
mance of a rapidly growing business. In particular, factoring can help avoid ‘over-trading’ and
with a more predictable cash flow, your business can plan more effectively.
238 Part four  Analysis and interpretation of accounts

According to statistics released by the Factors & Discounters Association, factoring or invoice
discounting in the UK was, as of 2012, being used by almost 42,000 companies, generating a
combined turnover in excess of £212 billion.
The accounting treatment of a factoring arrangement naturally depends on who has the risks
and rewards of ownership. If the total receivables are the subject of an outright sale, risks and
rewards are transferred to the factor, and the asset should be derecognised in the vendor’s state-
ment of financial position. If, at the other extreme, there are full rights of recourse in respect of
bad debts, then the risks and rewards are not transferred, and the receivables should continue
to be reported in the entity’s statement of financial position.

T E S T YO UR K N OW L E D G E   11.3

a) Explain debt factoring.

b) Describe how debt factoring can be useful for small companies.

5.4 Sale and repurchase arrangement

In effect, a sale and repurchase agreement is a loan. In this arrangement, the sale of an asset
takes place between two parties with a view to the asset’s subsequent repurchase at a higher
price. The difference between the sale price and the repurchase price represents interest, which
is at times referred to as the ‘repo’ rate. The party that originally buys the securities effectively
acts as a lender. The original seller is effectively acting as a borrower, using their security as col-
lateral for a secured cash loan at a fixed rate of interest.
A sale and repurchase agreement is another arrangement that can be exploited to produce
off-statement of financial position finance. Its essential feature is that the company purports to
have sold an asset, but has not relinquished all the risks and rewards associated with that asset
in a manner which one would expect in the case of a normal sale. Fundamentally, therefore, it
is a form of secured borrowing.

worked e x amp le   11.4

A whisky blending company contracts to sell part of its stock of whisky to a bank for £10 million on
1 January 20X2. The agreement makes provision for the whisky company to buy back the whisky
two years later, for £12.1 million. The whisky remains at the blending company’s premises.
The market rate of interest for an advance to a whisky blending company is known to be 10%.

Required
Explain the substance of this transaction and how it should be accounted for in the books and
accounts of the whisky company in 20X2–X3.

Answer
If the transaction were accounted for as a normal sale, inventory would be reduced by £10 million
and cash would be increased by £10 million in the company’s statement of financial position. In such
a case, the financing arrangement would remain off-statement of financial position and the assets of
the company would also be understated.
However, this is a financing arrangement rather than a normal sale. The company has transferred
no risks and rewards of ownership to the bank, and has merely borrowed money on the security of
an appreciating asset.
The inventories should remain in the statement of financial position of the whisky blending
company, at the date of the initial advance (1 January 20X2), at £10 million, with the cash received
from the bank shown as a liability.
 chapter 11  Limitations of published accounts 239

worked e x amp le   11.4 continued

20X2 accounts of whisky blending company £m

Consolidated statement of profit or loss and other comprehensive income – finance charge  
Statement of financial position – ‘loan’ 11

20X1 accounts of whisky blending company

Consolidated statement of profit or loss and other comprehensive income – finance charge 1.1
Statement of financial position – ‘loan’ 12.1

On 1 January 20X4, the whisky blending company pays £12.1 million to the bank and the loan is
removed from its statement of financial position.

This is a straightforward financing arrangement, but additional provisions may be included that make
it less easy to determine the substance of the transaction. Examples include the following:

■■ The nature of the asset – It is perhaps unlikely that a bank would want to retain ownership of
a stock of whisky, but the position might be different in the case of property; the appropriate
accounting treatment would then be different.
■■ The nature of the repurchase provision – Is there an unconditional commitment by both parties,
or do either (or both) possess options concerning repurchase arrangements?
■■ The initial sale price and the repurchase price – Do these look like artificial prices designed to
operationalise a financing arrangement, or are they the actual market prices at one or both dates?
If the figures used at each date are market prices, the arrangement begins to look more like a
normal sale in which risks and rewards are transferred, particularly if either or both parties enjoy
appropriate options (e.g. the ‘purchaser’ has the option to retain the asset rather than resell it to
the initial vendor).
■■ The location of the asset and the right of the seller to use the asset while it is owned by the buyer
– Where the asset remains on the vendor’s premises or the vendor retains a right of access to the
asset, the transaction would appear not to possess the characteristics of a normal sale.

A sale and repurchase agreement often involves securities rather than tangible goods. See the
arrangement disclosure in the following service offered by Arck Marketing Limited.

c a se E XAMPLE   11.1

ARCK LLP is a management company with a number of business and controlling interests in a variety
of companies.
This is a ‘contracted’ sale and repurchase agreement involving three parties. The first party is
ARCK Estrela Limited/ARCK LLP (The owner). The second party is the SARP Client – Individual,
Company, Self-Directed Pension, etc (SARP). The third party is the Fund – e.g. Integrity Alternative
Asset Fund Protected Cell Company, and the associated Protected Cell Number (the fund).
The fund enters into a Promissory Contract of Purchase with the owner to purchase a completed
property – as an example, £150,000. The fund has, prior to Notarisation of the completed property,
to on-sell this Promissory Contract to any third party, but may only do so once they have undertaken
their liabilities on the contract – i.e. full payment to the owner.
The owner always retains the Freehold of the Land and Property under development until final
Notarisation. The fund allows the owner to sell and repurchase (SARP) this contract to a third party,
provided the third party never has any beneficial ownership, title or use to the land/property.
The fund purchases individual units at a time depending on the inflows of money to that
fund. Once it has sufficient invested funds, including any gearing it might take, the fund issues a
Promissory Contract on a Specific Plot.
240 Part four  Analysis and interpretation of accounts

c ase E XAMPLE   11.1 continued

On doing so, the fund will also sign a SARP contract on that specific plot, thus guaranteeing the
purchase for a specific amount at a specific fixed value.
The owner will then also sign the same contract allowing the sale to a specific SARP client selling
it to them for a fixed price (£25,000 as an example) and also guaranteeing to purchase it back on
the same day The fund purchases the plot from the owner. The purchase price to the SARP is listed
on the contract.
Source: http://arckllp.com/uploads/Updated%20FAQ%20No.7.pdf<

6 The role of audit in mitigating creative accounting

The external auditor is increasingly viewed as a way to hold managers to account through an
appropriate application of accounting policies and sound judgment when preparing financial
reports. To this end, an external auditor could help in mitigating creative accounting practices.
This requires two fundamental perspectives:
1. expertise in determining errors and misstatements in reported financial figures; and
2. the independence to report such errors or misstatements.
These are discussed below.
The audit process, being a mechanism of corporate governance, is supposed to provide a
measure of reassurance to users of accounts. In providing such assurance, the auditor must
convey two primary characteristics:
■■ Auditor expertise – In being able to mitigate errors or misstatements (creative accounting),
the auditor must have expertise both in their profession and, in some cases, in the industry
in which they specialise. Faced with a new customer, or perhaps a new industry, smaller audi-
tors may not have the acumen to conduct effective audits, and therefore offer reassurance to
end users who may rely on their opinion.
■■ Auditor independence – Auditors depend on audit fees, in large part, to sustain their busi-
ness. If an auditor has a small client base that makes up the bulk of their income, this
may compromise auditor independence. However, in the UK, no more than 10–15% of fees
income can arise from one client. Auditor independence is measured by the auditor’s ability
to demand correction to errors or misstatements made by management in financial accounts.
Auditor expertise and independence together constitute what is called audit quality. This is the
joint probability that an auditor will detect and report an error or a misstatement. The detec-
tion of an error or misstatement relates to auditor expertise. The auditor’s ability to report this
relates to their independence.

6.1 External auditor – principles and practices

The external audit is a mechanism of corporate governance. Corporate governance has risen
to prominence, particularly in the last 25 years, due mainly to high-profile corporate failures,
some of which are listed below.
The company Enron, as an example, became synonymous with all that is bad in accounting
and managerial opportunism. Lawsuits and criminal proceedings were instituted against the
top management of the company, with losses running into billions of dollars.
At the time, Arthur Andersen (once one of the ‘big four’) was Enron’s auditor and was paid
audit fees indicated to be around $23 million. The scandal led to the dissolution of Arthur
Andersen and the company had to surrender its licence to practise.
The Powers Committee (appointed by Enron’s board to look into the firm’s accounting in
October 2001) made the following assessment:
 chapter 11  Limitations of published accounts 241

The evidence available to us suggests that Andersen did not fulfil its professional responsi-
bilities in connection with its audits of Enron’s financial statements, or its obligation to bring
to the attention of Enron’s Board (or the Audit and Compliance Committee) concerns about
Enron’s internal contracts over the related-party transactions.

Some of the principal qualities expected of auditors are as follows.

1. Independence from related parties who have an interest in the financial affairs of a company.
In this respect, auditors must not be swayed from their principal duty of being independent.
Independence of mind is an additional pre-requisite. It is essential that the auditor not only
acts independently, but also appears to be independent. If an auditor is in fact independent,
but one or more factors suggest otherwise, this could lead to stakeholders concluding that
the audit report does not give a ‘true and fair view’. The two types of independence threat
can be summarised as:
a) independence of mind: freedom from the effects of threats to auditor independence that
would be sufficient to compromise an auditor’s objectivity; and
b) independence in appearance: no activities, relationships, or other circumstances that
could lead well-informed investors and other users reasonably to conclude that there is
an unacceptably high risk that an auditor lacks independence of mind (source: The CPA
Journal).
2. Client–auditor relationship – This refers to the level of professionalism in an audit engage-
ment. The client is a source of income for the auditor. This could lead to a compromise on
standards if the client puts pressure on the auditor to act in a specific manner.
3. The size of the audit fee – This can be a mitigating factor on independence and profes-
sionalism in practice. The larger the fee, the greater the probability that an auditor will
relinquish their responsibilities and perform the audit without due diligence. If auditor fees
are concentrated around a limited number of clients, this could have an impact on auditor
professionalism and independence.
4. Repeat business – An auditor needs to secure regular income and foster long-term client
relationships. This may lead to lower fee quotations, so the auditor may reduce their level
of substantive and due diligence work to cover costs.
5. Familiarity – Auditors are required to be sceptical of information and representations made
by their clients. Over-reliance on the client’s word can compromise both independence and
professionalism. For example, an auditor may become overly familiar with a client if they
have a particularly close or long-standing personal or professional relationship with them.
6. Non-audit services – The long-standing debate on non-audit services has particular reper-
cussions on auditor professionalism and independence. Many studies have suggested that
to secure the more lucrative non-audit services contracts, auditors have tended to low-ball
or undercut the audit price. Again, this practice may entice auditors to perform to a low
standard by cutting corners in audit work.
The role of the auditor and corporate governance were introduced in chapter 1.

7 Auditors and non-audit services

Non-audit services provided by auditors to client companies have been a contentious issue in
recent years. The issue mainly relates to auditors auditing their own work and the compromise
to the quality of audit this presents. The Code on Audit Committee and Auditors provides a
basis for the auditor–audit committee relationship:

The board should establish formal and transparent arrangements for considering how they
should apply the corporate reporting and risk management and internal control principles
and for maintaining an appropriate relationship with the company’s auditor.

In implanting the above principal of corporate governance practice, the code further suggests
that the task of the audit committee is:

to review and monitor the external auditor’s independence and objectivity and the effective-
ness of the audit process, taking into consideration relevant UK professional and regulatory
requirements.
242 Part four  Analysis and interpretation of accounts

There is currently no bar on auditors providing non-audit services for the same client; however,
the code suggests that audit committees need:

to develop and implement policy on the engagement of the external auditor to supply non-
audit services, taking into account relevant ethical guidance regarding the provision of non-
audit services by the external audit firm, and to report to the board, identifying any matters
in respect of which it considers that action or improvement is needed and making recom-
mendations as to the steps to be taken.

In this regard, the code requires the audit committee to explain to shareholders, in the annual
report, how auditor objectivity and independence is maintained if the auditor provides audit
and non-audit services, and the amount of payment for the non-audit services has to be dis-
closed in the published accounts.
The audit committee deliberates on auditor remit in relation to audit and non-audit services,
to ensure these do not impair the auditor’s independence and that they comply with legislation.
Under the code’s guiding principles, the auditor’s independence will be deemed to be impaired
if the auditor provides a service where they:
■■ have a management role in the company; or
■■ audit their own work; or
■■ serve in an advocacy role for the company.
The three compromising actions above are not exhaustive, but are the main reasons for auditor
compromise in due diligence. There needs to be a balance between the level of auditor involve-
ment in a company’s affairs and their independence and professionalism.

? END OF CHAPTER QUESTIONS

11.1 Explain the term ‘creative accounting’. At 31 December 20X4, Luboil’s financial
11.2 How does creative accounting arise in financial statements included the total £10 million in
reporting systems? revenue invoiced to Seeder. However, only £1
11.3 Luboil Ltd supplies a special type of machine million of inventory was disclosed in the cost of
oils to the manufacturing industry. On 1 January sales.
20X4, Luboil entered in to a contract with
Required
Seeder Ltd to supply £10 million worth of oil
a) As auditor of Luboil Ltd, explain to the
over five-year period. The contract stipulated
management the accounting treatment that
price variation subject to market forces agreed in
should have been disclosed.
advance between the two parties.
b) Discuss the impact on the ratios for Luboil
As part of the contract, Seeder agreed to
after the necessary accounting changes.
pay Luboil £10 million in advance subject to the
price review. The supply of oil would be in equal
instalments.
Financial reporting within 12
the business environment

■■ Contents
1. Introduction
2. Subscription databases and company accounts
3. XBRL – business reporting language and business application
4. CSR reports and the triple bottom line (TBL)
5. Nature of business ethics
6. The role of ethics in modern business
7. Ethics and accountants in practice
8. Professional ethics – regulations

■■ Learning outcomes
Chapter 12 addresses the developing role of financial reporting and the accountant within
organisations. After reading and understanding the contents of the chapter, working through all
the worked examples and practice questions, you should be able to:
■■ explain the nature and purpose of subscription-based databases and their relationship to
company accounts;
■■ discuss and demonstrate how XBRL business language fits in with, and applies to, account-
ing and financial reporting;
■■ understand and appreciate the role of the accountant in a capitalist society and the implica-
tions of the role for reporting;
■■ understand and explain what stand-alone environmental reports are;
■■ demonstrate the purpose and application of the Eco-Management and Audit Scheme, and its
importance for business strategy;
■■ understand and explain the main features of social accounting in Britain;
■■ understand the purpose of corporate social responsibility reporting and the triple bottom line;
■■ relate to the positivist and normative approaches to business ethics;
■■ understand the relevance and importance of emerging role of ethics in business; and
■■ understand the implications for accountants and the ethical dimension.

1 Introduction
This chapter discusses current issues relevant to the role of chartered secretaries in the modern
business environment. The role of the chartered secretary is very demanding and requires a
person to be knowledgeable generally, but particularly in the changing and diverse business
setting.
Companies regularly share information with a number of organisations such as the stock
markets on which they are listed. Companies also need to provide financial and related infor-
mation to government agencies. The cost of information distribution can be high and, in some
cases, is enormous. Developments such as the IT platform eXtensible Business Reporting
Language (XBRL) facilitate business efficiency, allowing companies to develop cost-effective data
storage and retrieval systems that allow flexibility in data analysis and data transformation.
Environmental concerns have become more prominent in recent years, and companies are
now expected to operate responsibly and proactively in relation to environmental and social
issues. Many organisations such as Greenpeace lobby governments to pass legislation that
makes companies responsible for their actions.
244 Part four  Analysis and interpretation of accounts

Companies are now expected to report social aspects of their business activities, the impact
their activities have on the environment, and how they contribute to the environment and soci-
ety in which they operate. Reporting on corporate social responsibility is increasingly becoming
common in the annual reports of listed companies, and is part of a movement towards ‘inte-
grated reporting’.

2 Subscription databases and company accounts

The ever-increasing demand for information efficiency and cost-effective information systems
has led to the widespread development and use of database systems. Databases are software
systems designed to store and retrieve data in the format an entity requires in the most cost-
effective manner. As with any system, in order to be cost-effective and add value, the benefits
that the system brings (such as better informed decision-making) must outweigh the costs of
development and implementation. Several subscription databases exist that process and pre-
sent financial information in a standardised format. These databases take financial data and
information from companies, and process this data into a standardised form that facilitates
comparability, analysis and usage. Some of these databases are described below.

2.1 Amadeus
Amadeus contains financial information on over 400,000 European public and private com-
panies (the Amadeus website states it holds information on over 19 million companies, but
the information held on the majority of these companies would be relatively basic). For some
companies, Amadeus holds up to ten years of detailed information in a standardised financial
format comprising 22 statements of financial position items, 24 statement of comprehensive
income account items and 25 ratios.
The database provides descriptive information that includes:
■■ official national identification number, address, telephone, email address, fax, website and
legal form;
■■ year of incorporation;
■■ senior managers;
■■ auditors’ details;
■■ number of employees;
■■ quoted/unquoted indicator;
■■ industry and activity codes; and
■■ a trade description in the local language and English.
It offers company peer group analysis and ranked and formatted output.

2.2 Bloomberg
Bloomberg’s database covers international companies and markets. The database system pro-
vides real time and historical financial market data and economic data, covering all sectors
worldwide. It also features analytics, company financials, news and customisable charting.
Bloomberg provides company descriptions, five to ten years of financials, interest rates, time
series of statistics, and company and industrial news.

2.3 Datastream
Datastream is a Thomson Reuters database that stores financial information on international
companies, markets and economic statistics. It includes company accounts and ratios, equity
and capital market data, interest and exchange rates, economic and industrial statistics, long
time series for all data and downloads easily.

2.4 FAME
FAME (Financial Analysis Made Easy) covers companies registered in the UK and Ireland. It
offers up to ten years of detailed information for 1.6 million companies, plus summarised
 chapter 12  Financial reporting within the business environment 245

information for a further 1 million companies, including those that have recently formed and
have yet to file their first set of accounts. The detailed information includes:
■■ company profile;
■■ consolidated statement of profit or loss and other comprehensive income;
■■ statement of financial position;
■■ statement of cash flows; ratios and trends;
■■ County Court Judgments and mortgage data;
■■ credit score and rating;
■■ complete lists of holding companies, subsidiaries, directors and shareholders (including
enhanced shareholders’ option); and
■■ all ‘site/trading’ addresses and activity information, including brand names and miscellane-
ous information.
The demand from the user community to have access to web-based applications such as XBRL
and online XBRL or iXBRL-based databases is increasing at an alarming rate. XBRL and iXBRL
is explained in section 3. Developers are constantly trying to keep pace with this ever-increasing
demand. With the advancement of computer and wireless technology, users can access informa-
tion on the go.
A survey conducted by Thomson Reuters and published in Accountingweb online magazine
reported the following on 1 February 2012:

Accountants are hungry for applications that allow on-the-go access to the data they need
to make decisions and run their practices, according to new research by Thomson Reuters
Digita, a leading provider of accountancy practice software.

Digita, part of the Tax and Accounting business of Thomson Reuters, conducted the ‘12 Digita
Days in December’ poll to gauge attitudes and opinions on a wide range of technology-related
issues. The survey comprised 12 questions on various topics including integration, iXBRL, time
saving and how software adds value to the contemporary practice.
The survey attracted 432 responses from a cross-section of firms:
■■ 55% sole practitioners;
■■ 30% from mid-tier firms with between two and five partners; and
■■ 15% from large firms with six or more partners.
Many of the responses focused on the integration of practice software with mobile tools – con-
firming the view that tax and accounting professionals are increasingly adopting web-based and
mobile applications in a drive towards greater efficiency and productivity.
Representative answers included:
■■ ability to use practice application software on an iPad;
■■ links with Outlook and BlackBerry;
■■ integration with Windows Messenger;
■■ integrated document capture;
■■ voice recognition capability; and
■■ easier recording of clients’ phone calls.
The world of accounting practice is undergoing a transformation in terms of integration and
online software as cloud operation increases. The referral to the cloud is really the use of remote
hosted servers which are accessible via the internet to enable access from any desktop computer.
Despite the explosion of the use of hosted remote networks, it may be regarded as a return to
desktops being ‘dumb terminals’.
‘Our results suggest that accountants are increasingly looking for added integration with
their day-to-day mobile applications to maximise efficiency,’ said Andrew Flanagan, managing
director, Digita for the Tax & Accounting business of Thomson Reuters. ‘It is crucial to under-
stand the changing needs of the profession and this survey is just part of an ongoing dialogue
to ensure that Digita applications deliver the innovative functionality the profession demands.’
Business entities that wish to integrate their business processes are increasingly under pres-
sure to formalise web-based applications both in-house (i.e. within the company to integrate
sharing of information on work practices and financial information) and externally, to integrate
with other applications such as subscription-based databases such as Bloomberg, or government
246 Part four  Analysis and interpretation of accounts

departments such as HMRC for tax and related matters. Increasingly XML-based web languages
are used to accommodate the switch to common web-based platforms for cost-effective data
transfer and migration. The following is an example of a common data transfer requirement:

worked e x amp le   12.1

An individual who is preparing financial reports has the following query:

As a practice we only produce one set of accounts in Excel spreadsheet format, so we are looking
for a way of converting them into iXBRL without having to spend a fortune on software and
without having to spend hours tagging everything ourselves. Some kind of Excel spreadsheet add-
on would be the perfect solution. I’m sure there must be other practices facing the same problem,
so I would appreciate any recommendations you could pass on to us.

Answer

Scenario 1 – by respondent 1
You can indeed buy a ‘tagging tool’, which can be used to convert files from Word or Excel into
XBRL. These are cheaper than a full software package, but, as I understand it, are inevitably slightly
more limited, so some manual tagging is necessary. Software developer, IRIS plc, provides such a
tagging tool. I’m sure all of the big software companies do, as there are undoubtedly numerous
firms that still use Excel and Word for preparing accounts. Alternatively, you could consider
outsourcing the tagging function to a third party – which again is a solution offered by IRIS – but this
can be fairly costly.

Scenario 2 – by respondent 2
You can use the VT3 add-in to produce an iXBRL file from any set of accounts or tax computation in
any Excel workbook. Views differ on how easy it is to self-tag a set of accounts. If you have to select
tags from the full list (called taxonomy), then it is not easy at all. However, VT includes a special
tagging dialog in which all the tags for a small company are laid out in the form of a sample set of
accounts. It’s easy to find the tag you want. It is possible, with experience, to self-tag a small set of
accounts in 15 minutes. All the tagging data is saved in your own workbook (but is only accessible
via the VT add-in).
Once your workbook is tagged, you just have to click on the Generate iXBRL File button on the
toolbar created by the add-in. VT will check your tagging and tell you if there are any problems. If
there are critical problems, it will not generate an iXBRL file. In theory, it is not possible to generate
an iXBRL file using VT that will be rejected by HMRC, but things can go wrong further down the line.
Since April 2011, HMRC has required company accounts to be submitted in the form of an iXBRL
file. Paper and pdf files are no longer accepted. An iXBRL file has the same format as a page on a
website and the accounts it contains can be viewed in any web browser simply by opening the file.
In addition, much of the data is specially tagged so that it can also be machine read.

T E S T YO UR K N OW L E D G E   12.1

a) Explain the purpose and use of a subscription database.

b) How can subscription databases help in communicating with relevant company stakeholders?
 chapter 12  Financial reporting within the business environment 247

3 XBRL – business reporting language and business

application
The common language of the internet is Hyper-Text Markup Language (HTML), which enabled
users to disseminate and share data and information on the internet in various ways and for-
mats. Soon after the advent of the internet, many types of hypertext languages were developed
specialising in the facilitation of various applications such as moving pictures, interactivity and
sound, and real-time communication.
The business world, too, made headway in the development of hypertext languages that ena-
bled users of financial information to exchange and store data in a reusable format at minimal
cost.
The development of XBRL (eXtensible Business Reporting Language) enabled the business
community electronically to communicate economic and financial information in a manner
that cut down costs, provides a greater level of efficiency of use and improved reliability to users
and suppliers of information.
XBRL uses the XML (eXtensible Markup Language) syntax and related XML technologies,
which are the standard tools used to communicate information between businesses and the
internet. Data can be converted to XBRL by appropriate mapping tools designed to convert
electronic data to XBRL format, or data can be written directly in XBRL by suitable software.
XBRL works on a system of tags. Instead of treating financial information as a block of text,
as in a standard internet page or a printed document, XBRL provides an identifying tag for each
individual item of data. This is computer readable. For example, company revenues and items
of expenses and net profit have their own unique tag. This enables manipulation by users,
through query forms, to generate data and information in the required format.
The introduction of XBRL tags enables automated processing of business information by
computer software, facilitating efficient re-use of data for comparison. Computers can treat
XBRL data ‘intelligently’, enabling the following:
■■ Storage of data and information in XBRL enables selection, analysis, exchange and presenta-
tion in a variety of ways, dependent on the end-users’ requirements.
■■ Speed – XBRL greatly increases the speed of handling of financial data, reduces the chance of
error and permits automatic checking of information.
■■ Costs – Companies can use XBRL to save costs and streamline their processes for collecting
and reporting financial information.
■■ Retrieval – Consumers of financial data, including investors, analysts, financial institutions
and regulators, and researchers, can locate, manipulate, compare and analyse data much
more rapidly and efficiently in XBRL than by other online facilities.
■■ Data handling – XBRL can handle data in different languages and accounting standards. It
can easily be adapted to meet different requirements and uses.

worked e x amp le   12.2

What file format is used by iXBRL files?

Answer
iXBRL files are written in HTML, the language used by web pages. An iXBRL file can be displayed in
your web browser by double clicking on it. XBRL tags are also buried within the HTML, but are not
visible in a standard web browser. These tags can only be seen in specialist software such as VT Fact
Viewer or Corefiling’s Magnify (Corefiling are HMRC’s consultants).
HMRC’s computer system only ‘sees’ the tagged items that are shown with a yellow background
in VT Fact Viewer. However, if your accounts or tax computation are ever reviewed by a human
being at HMRC, they will see all the text that you normally expect to see in a set of accounts or
computation (as shown on the Document tab of VT Fact Viewer or in a web browser).
248 Part four  Analysis and interpretation of accounts

T E S T YO UR K N OW L E D G E   12.2

a) What is XBRL?
b) How can companies make use of XBRL in financial reporting and information sharing within the
company and with outsiders?

3.1 XBRL metadata

Metadata terminology is fundamental to understanding the way in which XBRL works. Put
simply, metadata is data about data. In XBRL, financial data is tagged so that it can be under-
stood and processed by computers.
For example, the word Asset together with brackets < and > would be called a tag: <Asset>.
If XBRL included <Asset>900</Asset>, the computer would use the tags and the value to
ascertain there is an Asset with a value of 900.
Elsewhere, other tags would help ensure assets are categorised and treated appropriately, in
line with accounting rules.
Any aspect of the business process can be transferred to XBRL using the system of tags in the
taxonomy dictionary. As is indicated from the answer in scenario 2 in Worked example 12.1,
many UK governmental returns are now submitted using XBRL formula-based technology.

3.2 XBRL taxonomy

XBRL taxonomies are the repositories that act as dictionaries containing assigned tags for spe-
cific individual items of financial data (e.g. profit). This enables the development of country-
or company-specific taxonomies facilitating the application of accounting rules, regulations,
standards and laws. From a user’s perspective, there is no need to understand the technicalities
of the language. It is a user-defined spectrum allowing for data migration, transferability, use
and analysis.
XBRL supports an open standard of financial reporting. This means that it is flexible enough
to support all the current ways of reporting in different countries and industries. The XBRL
system is free; there are no licence fees either to supply or to access the information. It is
a non-profit venture primarily supported by XBRL International, which is a collaboration of
around 550 major international companies, organisations and government agencies. XBRL has
already been implemented and is regularly used in a growing number of countries and indus-
tries around the world.
The IFRS Foundation now publishes an annual taxonomy that is in effect a translation of
IFRSs (International Financial Reporting Standards) into XBRL (eXtensible Business Reporting
Language).

3.3 IFRS and XBRL developments

The purpose of IFRSs in the business community are to pave the way for global reporting pro-
cesses that are common across countries. To facilitate and strengthen this process, the IASB
and XBRL entities are working together to develop a set of XBRL taxonomies that will enable
the creation and use of common set of internet-enabled reporting formats throughout the world.
The IFRS Foundation now publishes an annual taxonomy that is in effect a translation of
IFRSs (International Financial Reporting Standards) into XBRL (eXtensible Business Reporting
Language).
The following passages are from the IASB website:

Both IFRSs and XBRL are intended to standardise financial reporting in order to promote
transparency and to improve the quality and comparability of business information, there-
fore, the two entities form a perfect partnership.
The IASB XBRL Team is responsible for developing and maintaining the XBRL representa-
tion of the IFRSs, known as the IFRS Taxonomy. The IFRS Taxonomy is used around the
 chapter 12  Financial reporting within the business environment 249

world to facilitate the electronic use and exchange of financial data prepared in accordance
with IFRSs.
The IASB’s XBRL activities include:
■■ Taxonomy development – for companies reporting in IFRS, the Foundation publishes
tags for each IFRS disclosure. These tags are organised and contained within the IFRS
Taxonomy.
■■ Support materials – the Foundation produces support materials to facilitate use and under-
standing of the IFRS Taxonomy.
■■ Translations – translations of the IFRS Taxonomy into key languages are provided to sup-
port users of both IFRS and the IFRS Taxonomy whose primary language is not English.
■■ Global outreach – the Foundation makes a concerted effort to promote the use of XBRL in
conjunction with IFRSs around the world. The Foundation also encourages co-operation
and communication with users of the IFRS Taxonomy.
The collaboration between IASB and XBRL is an important move towards harmonisation
of financial reporting processes. This will have tremendous implication for the capital mar-
kets around the world enabling information capture, analysis and decision-making at greater
speed than at any other time in history.

The accountant is no longer the isolated bean-counter in the back room. The role and practice
of the accountant is now very much at the forefront, driving and steering the business through
unchartered waters, some of which are shark infested!
The accountant is now a key player in the strategy development of an entity and no longer
reports solely on financial performance to a narrow audience. Accountants today play a central,
direct role in the process of business. They communicate a wide range of accounting and finan-
cial information to internal and external stakeholders.

4 CSR reports and the triple bottom line (TBL)

Corporate social responsibility (CSR) reporting is concerned with being a ‘good corporate citi-
zen’. While CSR reporting includes social accounting, it is a broader aspect of corporate report-
ing, integrating financial reporting with social and environmental perspectives.
Powerful multinational corporations touch people’s lives in more ways now than at any time
in the past. This necessitated a change in corporate attitude towards the environment and society
in which they operate. CSR reporting is a corporate tool that engages companies’ self-assessment
and self-regulation by integrating business functions with social needs, thereby taking account of
ethical considerations as well as various stakeholder interests. Guiding principles and practices
have developed from a number of perspectives, including the three we discuss below.

4.1 ISO 26000

ISO 26000 (International Organization for Standards) is international standard, principle-based
guidance on CSR practices and is designed to assist companies in implementing and integrating
business practices with social awareness. This is not a certifiable standard and hence cannot
be used as part of a social audit. The ISO website presents the following components of ISO
26000:

ISO 26000 will help all types of organisations – regardless of their size, activity or location –
to operate in a socially responsible manner by providing guidance on:
■■ concepts, terms and definitions related to social responsibility;
■■ background, trends and characteristics of social responsibility;
■■ principles and practices relating to social responsibility;
■■ core subjects and issues related to social responsibility;
■■ integrating, implementing and promoting socially responsible behaviour throughout the
organisation and, through its policies and practices, within its sphere of influence;
■■ identifying and engaging with stakeholders; and
■■ communicating commitments, performance and other information related to social
responsibility.
250 Part four  Analysis and interpretation of accounts

ISO 26000 is developed on the basis of best practice from around the world and is seen as an
important initiative in helping and guiding companies to integrate best practices in their busi-
ness activity.

4.2 Triple bottom line framework

Initially developed for the public sector, this approach has become a dominant feature in pro-
viding the basis for reporting beyond profit figures. There are three components to the triple
bottom line (TBL) framework approach:
1. economic
2. ecological
3. social.
However, TBL has not taken off significantly, although CSR has become an important issue
in modern business practices. Freer Spreckley (1981) argued for an extended version of the
‘bottom’ line in company financial reports. His idea of the TBL was developed in ‘Social audit:
a management tool for co-operative working’.
The concept of the TBL encapsulates all stakeholders who are impacted by corporate behav-
iour, and advocates an integrated approach to business activity that takes account of environ-
mental, ecological and sustainability issues.
As an example, the Kjaer group (Denmark) deals in automotive parts in North Africa. In its
2012 Annual Report, the group made the following statement:

The Kjaer Group Way of Management

The Kjaer Group Way of Management consists of the Group’s mission, vision, key processes,
policies and adoption of the ‘Triple Bottom Line’ principle, which ensures that decisions
are made with equal balance between financial results as well as social and environmental
responsibility.

As the bulk of the group’s business is with North African countries, it maintains the highest
of standards in dealing fairly with its customer base and links economic progress with social
progress in a number of ways (e.g. it is involved in and contributes to NGOs’ work with people
living in poverty in North Africa).

4.3 Global Reporting Initiative (GRI)

This is a not-for-profit organisation that promotes both economic and sustainability issues.
The GRI initiative is an important development and encompasses a number of issues for cor-
porations and entities to take into account in both their business and non-business activities.
These include ecological footprint reporting, TBL reporting, environmental social governance
(ESG) reporting and corporate governance reporting. The idea behind GRI is to promote equal
importance to social, environmental and governance matters with regard to economics.

4.4 Social, ethical and environment issues – a summary

All the initiatives discussed above demonstrate the relevance and global need for a greater qual-
ity of reporting above and beyond simple economic performance. The continuing integration
of national processes within the greater global community now demands fairness for all. The
developed world has to work hand-in-hand with the developing world, with a fair return for
all. The Fair Trade initiative seeks to promote a better quality of life for workers in developing
economies. Increasingly, retailers of consumer goods are disclosing how they source their raw
material and finished and semi-finished goods from countries such as India, Pakistan and some
African states.
 chapter 12  Financial reporting within the business environment 251

Tesco plc is the largest food and retail chain in the UK with a turnover in 2011 of almost £61
billion and reported net profit of £2.7 billion. Tesco discloses its CSR policy very clearly on its
dedicated corporate website. It specifically states its corporate dedication to fair-trade policies
and publishes a separate stand-alone CSR policy. Tesco’s 2011 CSR report indicated that the
company:
■■ donated £64.3 million to various charities;
■■ provided employment for 4.2 million people in Thailand;
■■ created eight new regeneration pacts across the UK;
■■ procured £1 billion of locally sourced products in the UK; and
■■ was proactive in both carbon disclosure projects and in environmental, climate change and
waste issues.
The CSR policies pursued by Tesco enhance its corporate image with its worldwide customers.
By integrating its economic aims with the social agenda, Tesco is at the forefront of CSR.

TEST YO UR K N OW LE DG E   12.3

Explain the purpose of the TBL concept and its usefulness to companies’ corporate reporting.

5 Nature of business ethics

Ethics is concerned with the concept of right and wrong. Ethics can mean different things to
different people. At its core, ethics subscribes to human behaviour that provides a basis for fair-
ness and socially acceptable conduct that does not allow one group of people to infringe on the
rights of another. Some definitions of ethics are provided below:
■■ Ethics is fundamental to human behaviour and is related to good or bad practices in society.
■■ Moral conduct can be described as either being right or wrong, acceptable or unacceptable.
■■ Business ethics substantially relates to good or bad behaviour.
Business ethics examine the ethical principles and moral or ethical problems that arise in a
business environment. It is a field of ethics that deals with moral and ethical dilemmas in many
areas of human endeavour such as medicine, technology and the law.
In an ever-changing corporate landscape, business ethics has gained ground. Capitalism can
no longer be seen as a simple case of making a profit. However, since capitalism requires people
to make it work, societies and individuals demand fairness in their lives. Business ethics can
provide benefits for companies through the efficient adoption of ethical practices that impact
upon:
■■ the common good of society;
■■ a sense of ethical motivation and sustainability;
■■ a balanced approach to the needs of stakeholder groups;
■■ social and economic reputation;
■■ security from legal implications; and
■■ enhanced employee commitment and retention.
Ethical implications relate to all areas of a business including finance, marketing and oper-
ational, and management activity. By giving due regard to business ethics, companies can
enhance their reputational capital and thus retain customer loyalty.

5.1 Ethical motivation

This protects a company’s reputation by creating an efficient and productive working environ-
ment. In the current economic climate, promoting ethical principles gives employees greater
sense of security.
252 Part four  Analysis and interpretation of accounts

5.2 Needs of stakeholders

This is a primary issue in business ethics. Stakeholder interest has a greater connotation in
terms of societal pressures placed upon companies to be seen to be ethical. Company values and
reputation are built not only on adopting ethical behaviour but also by applying, demonstrating
and communicating that behaviour and its measurable impact on the environment and society.

5.3 Employee commitment and retention

Even in constrained times, businesses lose employees due to changes that are perceived as being
unfair. This could prove to be a costly exercise when employees with good skills lose confidence
in their employment. An ethical programme of employee engagement could prove to be a worth-
while exercise in which making the right decisions provides perceived benefits and rewards.

5.4 Legal implications of unethical behaviour

Legal implications can arise both from within a company and from external litigation. Employees
who feel aggrieved by their company’s policies should have an avenue open to them, within the
business, that enables them to air their concerns without fear. Employee concerns should be
dealt with systematically and fairly.
Additionally, legal implications may arise if companies do not have robust detection and pre-
vention measures in place to check and deal with legal issues that may cause reputational risk.
For instance, if a company is fully compliant with legal requirements for health and safety, the
possibility of legal liability would be greatly reduced.
Selected issues have been discussed above to demonstrate the nature of business ethics. Prior
research has shown that unethical practices cost industry many millions in lost revenue. For
example, work-related stress means employees are off work for many days or weeks, resulting in
lost revenue and production and the higher costs of employing temporary replacements.

T E S T YO UR K N OW L E D G E   12.4

Explain business ethics and the role it plays in modern corporations.

sto p and t hink  12.1

Consider the policies a petrochemical company based in North Scotland should consider in its ethical
approach to business.

6 The role of ethics in modern business

Much of what comprises business ethics already been discussed. Increasingly the business com-
munity can no longer function efficiently unless it can demonstrate a commitment to ethical
practices. To understand this concept further, let’s look at some comments made by Charles
Harrington of Parsons Inc (USA), a mid-size company employing 11,200 workers:

Our strong commitment to our six Core Values – Safety, Quality, Integrity, Diversity,
Innovation and Sustainability – governs everything we do at Parsons. Our Core Values are the
very beliefs that form the culture of our organization, that make us who we are, that form the
basis for all of our decisions. We strive hard to create an atmosphere where the question of
deviating from those Core Values, from doing what is right, whether for perceived individual
or corporate gain, never even gets raised.
 chapter 12  Financial reporting within the business environment 253

In the above commentary, important words and phrases used are:

■■ core values ■■ innovation
■■ commitment ■■ sustainability
■■ safety ■■ beliefs
■■ quality ■■ organisational culture
■■ integrity ■■ doing what is right.
■■ diversity
Some very important terminologies are used here, demonstrating that CSR and ethics are
embedded in the business management processes of Parsons Inc. Similarly, in the UK, Tesco
plc has embedded the ethical approach to its business processes as part of its business strategy,
thereby enhancing company image, value and reputation. It is critical that the values, mis-
sion, and identity of the company come from the leaders and are implemented throughout the
organisation so that it becomes second nature to the employees of the company.
In formulating participatory business ethics, applied ethics can assist companies to deter-
mine policies and processes that are developed from a shared perspective, offering stakeholders
the opportunity to participate in the decision-making process. For example:
■■ Tesco plc has a consultation process where the company’s suppliers are involved in its pro-
curement policies. This gives some level of assurance to suppliers where Tesco may be their
only, or main, customer.
■■ The Body Shop has a comprehensive procurements policy for the sourcing of its products
and is a member of the ‘Fair Trade’ initiative. The company tries to ensure that its overseas
suppliers get a fair deal for their products and is also proactive in the context of illegal or
socially unacceptable sourcing of its products (e.g. the use of child labour in the production
of products).
Companies that attempt to create a balance between value maximisation and non-financial
issues generally are trying to manage their businesses on a sustainable basis. The fact is that
national and international accounting standards exist to regulate financial reporting, yet huge
corporate collapses still occur (e.g. Satyam in India in 2009). This demonstrates that ethical
malpractices abound in both developed and developing countries. However, many corporate
collapses are simply down to economic factors or fail due to business strategy (e.g. Woolworths,
Peacocks and Game).
Many examples, such as Tesco, have been provided in this section on business ethics.
However, a recent development to hit the news relates to intellectual property rights (IPR).
An intellectual property right is the ownership of an idea, thought, code or information. For
instance, protection of a particular drug developed over years of research ensures that the devel-
oping company has the right to any revenues that transpire. However, recent events indicate
that patents are a company’s way of monopolising a certain market. This suggests the stifling
of competition in a capitalist market where competition is seen as good for the economy and
protection for consumers. Competition forces companies to develop their business strategy to
meet and manage competing forces.
Companies view IPR from a utilitarian perspective. However, a moral perspective has a
counter-argument in that utility is developed from societal needs and that a product that has
universal application and provides relief for vast numbers of human beings cannot, by nature,
be protected from value-maximising economic constraints; hence it must be shared universally.
Some 39 pharmaceutical companies filed a lawsuit against South Africa’s 1997 Medicines and
Related Substances Control Amendment Act, as its provisions aimed to provide affordable HIV
medicines. This has been cited as a harmful effect of patents-based monopolisation by a hand-
ful of corporations.
British companies are seen as very proactive in ethical matters. Larger corporations have an
integrated and embedded ethical approach to managing their business processes. Some com-
panies have appointed ethics officers to manage the company’s ethical affairs. Much ethical
concern developed between 1980 and 2010, due to highly publicised corporate collapses mainly
in the USA. With the enactment of the Sarbanes-Oxley Act 2002, ethics-related development
formed a backdrop to unethical American business practices. Ethics is about setting boundaries
beyond which it would be considered wrong to engage in activity that would damage a com-
pany’s reputation.
254 Part four  Analysis and interpretation of accounts

7 Ethics and accountants in practice

Accountants have a fiduciary duty towards their employers as well as to their investors and to
the larger world. This duty is based on both legal and ethical considerations. The past decades
have seen some remarkable corporate collapses, mainly in the USA, with Enron, Worldcom,
Tyco, etc. Methods of accounting, such as off-statement of financial position finance and special
purposes entities, were one of the main causes of financial irregularities coupled with (in some
cases) unprofessional conduct by management and external auditors. These events have drawn
attention to the professionalism of practising accountants and levels of ethical standards.
The ‘crisis’ in the accounting profession that followed and the criticism it faced led to a
stream of regulations emanating from both accounting bodies and governments to prevent
further damage to the profession and bring a sense of stability and confidence to stakeholders.
In an article published in 2007 in the Managerial Auditing Journal, mitigating factors were
identified that contributed to ethical weaknesses for accountants. The article surveyed 66 mem-
bers of the International Federation of Accountants (IFAC). The main factors that were identi-
fied included:
■■ self-interest;
■■ failure to maintain objectivity and independence;
■■ inappropriate professional judgment;
■■ lack of ethical sensitivity;
■■ improper leadership and ill-culture;
■■ failure to withstand advocacy threats;
■■ lack of competence;
■■ lack of organisational and peer support; and
■■ lack of professional body support.
Above all, the main threat to an accountant’s ethical behaviour is the self-interest that places
personal consideration above ethical and professional judgment. For example, if an auditor
questions the appropriateness of a particular accounting entry in an audit, the financial con-
sideration in terms of fees being charged to the client may allow the auditor to act unethically
and ignore the issue. In such circumstances, the accountant is faced with making professional
decisions that include:
■■ reporting a particular matter or set of issues to an immediate superior both formally and
informally; such issues could be related to lack of clarity on cash flows in and out of a
company;
■■ whistle-blowing to an external and relevant agency – this would require careful consideration
on the part of the accountant as it may involve exposure to possible litigation (e.g. illegal
sourcing of products or trading with banned organisations or even countries);
■■ ignoring the issue and letting the system catch up with it (an unethical alternative and not
recommended). However, there may be legal implications for ‘not doing nothing’, and in cer-
tain circumstances the law may require an individual to have deemed to have known certain
facts and thereby taken some sort of an action to disclose a relevant issue; and
■■ considering resigning from their post on ethical grounds.

8 Professional ethics – regulations

After the notoriety of corporate scandals since the 1980s, new and enhanced regulations
have emerged, putting the onus on accountants to take ethical actions in circumstances that
demand it.

8.1 Money laundering regulations

Money laundering has become a sophisticated venture for some organisations and persons.
HMRC provides some guidance on this issue:

The Money Laundering Regulations 2007 came into force in December 2007. All businesses
that are covered by the regulations have to put suitable anti-money laundering controls in
 chapter 12  Financial reporting within the business environment 255

place. If the regulations apply to your business you must put these controls in place as soon
as possible.
As part of the anti-money laundering controls that you have to put in place, you need to
appoint a nominated officer (sometimes called the money laundering reporting officer).

Changes to the Money Laundering Regulations in 2007 recognised the same client–accountant
privilege as exists with lawyers. This means that, since 2007, accountants are no longer required
to report suspicious transactions to the National Criminal Intelligence Service. However, pro-
fessional accounting bodies still retain an ethical dimension in their guidelines.
All UK professional accounting bodies publish a code of conduct for their members, in both
industry and practice, based upon the International Federation of Accountant’s (IFAC) ethical
standards. The ethical standards that shape the codes of the professional accountancy bodies
are:
■■ integrity
■■ objectivity
■■ professional competence and due care
■■ confidentiality
■■ professional behaviour.

TEST YO UR K N OW LE DG E   12.5

Identify and explain the implications for the accountant with regard to business ethics.

Accountants, both in practice and in business, are seeing emerging trends for accountability and
the requirement for ethical behaviour. The accountant in business comes under the scrutiny
of the auditor. A conflict of loyalty may arise between the requirement to be transparent and
management pressure to comply with its agenda. In such situations, ethical judgment needs to
be exercised by accountants that may have professional and career implications.

? END OF CHAPTER QUESTIONS

12.1 Abbey Group plc is a manufacturer of specialised and, in some cases, this information reaches the
machine parts and has a presence in most major HQ in the form of e-mail attachments.
growing economies such as China, India, Pakistan The Chief Finance Officer (CFO) of Abbey plc is
and Brazil, as well as the European Union. Abbey unhappy about the length of time taken to collect
maintains a divisionalised group structure where and process financial and accounting data into a
each country is a division. The group maintains usable format for group purposes. The group is
a decentralised structure with divisions able to listed on the London and New York stock markets
make decisions on a local basis; however, strategy and has been previously warned by the listing
is developed by Abbey HQ. regulators about the delay in submitting the
Each division maintains its own IT policy with group financial report.
heterogeneous systems employed across the The CFO calls a meeting of a working group to
various divisions. Up to now, the data sharing investigate the solutions to Abbey’s IT problems.
between divisions has been minimal as each The Chief Systems Officer (CSO) suggests that
division specialises in its own area of expertise the group could develop a common information
and manufactures totally different machine sharing platform based on XBRL technology.
parts. However, collecting the financial data a) From the information the case of Abbey plc,
is a laborious exercise and the annual group explain XBRL.
financial reports are badly affected. Financial and b) How can Abbey plc use XBRL to share
accounting data is collected in different formats financial information?
256 Part four  Analysis and interpretation of accounts

? END OF CHAPTER QUESTIONS continued

c) What would be the level of cost involved a) Consider the ethical concerns that James is
in setting up the new technology without dealing with.
going into the amounts in detail? b) What action should the company take in
d) What platform would XBRL require? assessing its environmental impact?
e) Comment on the benefits of using XBRL to c) How should the company report such an
Abbey plc. impact?
12.2 James is the environmental compliance officer 12.3 Stakeholders are increasingly looking to the
for a medium-sized car parts manufacturing quality and quantity of corporate social reporting.
company. James has to decide whether or not In assisting users of corporate social reports,
the company should invest in new technology disclosures in the annual financial reports play an
that would reduce toxic emissions from current important role.
technology being released into the atmosphere. a) Apart from a company’s business
The company’s emission levels are within performance, how can users of annual
legal guidelines; however, James knows that financial reports assess corporate social
environmental regulations for this particular toxin behaviour and a company’s attitude
are lagging behind scientific evidence. A recent towards its environment?
academic research paper suggests that if toxins of b) What other sources of information are
this type are not legislated for, it would impact on available to ascertain corporate social
the health of people living near the company. behaviour?
Answers to end-of-chapter
questions

Chapter 1 – The regulatory framework for the preparation and

presentation of financial statements
1.1 n 
To develop, in the public interest, a single set of high-quality, understandable and
enforceable global accounting standards that require high-quality, transparent and com-
parable information in financial statements and other financial reporting to help par-
ticipants in the world’s capital markets and other users make economic decisions.
■■ To promote the use and rigorous application of those standards.
■■ To bring about convergence of national accounting standards and IFRS.

1.2 Accounting standards:

■■ oblige companies to disclose the accounting policies they have used to prepare their
published financial reports. This should make the financial information easier to under-
stand and allow both shareholders and investors to make informed economic decisions;
■■ require companies to disclose information in the financial statements that they might
not disclose if the standards did not exist;
■■ reduce the risk of creative accounting. This means that financial statements can be used
to compare either the financial performance of different entities or the same entity over
time; and
■■ provide a focal point for discussion about accounting practice. They should increase the
credibility of financial statements by improving the uniformity of accounting treatment
between companies.

1.3 The external audit provides an independent opinion on the true and fair representation
of financial statements that a company has produced. The audit provides the users of the
financial statements with an assurance of increased confidence and reduced risks in the
use of the financial statements for their own economic decisions. In addition, the external
audit serves as a part of the corporate governance process in that the auditor is reporting
on the effectiveness and reliability of the systems installed by management as part of the
financial reporting process.

1.4 Corporate governance concerns the systems by which a company is directed and serves
as the overall framework within which financial reports are generated. The effectiveness
and reliability of the internal controls put in place by management are the operational
framework that enable the production of financial statements for the multiple user groups.
Corporate governance is designed to ensure that the output of the financial reporting
system, the financial statements, are reliable and may be used by the various user groups.

1.5 Social accounting is the formal process by which an entity reports on the wider social
impact of its economic activity to stakeholders. The range of social reporting may include:
■■ recycling of waste;
■■ education;
■■ environment/pollution emission/chemicals;
■■ regeneration, social inclusion and community investment;
■■ workforce issues;
■■ responsible behaviour in developing countries;
■■ agriculture;
■■ pharmaceuticals/animal testing/drug development; and
■■ regeneration issues.
258 Answers to end-of-chapter questions

Chapter 2 – The conceptual framework for the preparation and

presentation of financial statements
2.1 The general purpose of financial reports is to provide information about the financial posi-
tion of a reporting entity, which is information about the entity’s economic resources and
the claims against the reporting entity. Financial reports also provide information about
the effects of transactions and other events that change a reporting entity’s economic
resources and claims. Both types of information provide useful input for decisions about
providing resources to an entity.

2.2 a) False
b) False
c) True
d) False
e) True
f) False

2.3 The four enhanced characteristics that make financial reporting information useful for its
readers are as follows.
Comparability
Comparability is the qualitative characteristic that enables users to identify and under-
stand the similarities in, and differences among, items in their comparative analysis.
Comparability does not relate to a single item. Consistency, although related to compara-
bility, is not the same. Comparability is not uniformity.
Verifiability
Verifiability is the quality that helps to assure users that the reported financial informa-
tion faithfully represents the economic phenomena it purports to represent. Verifiability
would permit two or more different knowledgeable and independent observers to reach
consensus that a particular depiction is a faithful representation. Verification can be direct
or indirect. Direct verification may arise from the process of direct observation, such as the
end-of-year stock count. Indirect verification is the process of checking using a calculation
model or technique to verify the financial information.
Timeliness
Timeliness is the provision of the information to decision-makers with sufficient time to
allow the information to influence their decisions.
Understandability
Information should be classified, characterised and presented clearly and concisely to
facilitate understanding by users. The users of financial information are deemed to have
a reasonable knowledge of business and economic activities such that the exclusion of a
complex phenomenon should not occur to ease understanding.

2.4 The going concern concept is the underlying assumption identified in the conceptual
framework. ‘Going concern’ means that the financial statements of an entity are normally
prepared on the assumption that the entity will continue in operation for the foreseeable
future. Hence, it is assumed that the entity has neither the intention nor the need to liq-
uidate or curtail materially the scale of its operations; if such an intention or need exists,
the financial statements may have to be prepared on a different basis and, if so, the basis
used should be disclosed.

2.5 Own answers.

2.6 The two concepts of capital maintenance are as follows.

Financial capital maintenance
Profit is earned only if the financial (or monetary) amount of the net assets at the end of
the period exceeds the financial (or monetary) amount of net assets at the beginning of
the period, after excluding any distributions to, and contributions from, owners during the
 Answers to end-of-chapter questions 259

period. Financial capital maintenance can be measured in either nominal monetary units
or units of constant purchasing power.
Physical capital maintenance
Profit is earned only if the physical productive capacity (or operating capability) of the
entity (or the resources or funds needed to achieve that capacity) at the end of the period
exceeds the physical productive capacity at the beginning of the period, after excluding any
distributions to, and contributions from, owners during the period.

Chapter 3 – Financial accounting and the preparation of financial

reports
3.1 The four principal statements that a company is required to publish and include are:
■■ a statement of financial position (balance sheet) at the end of the period;
■■ a statement of profit or loss and other comprehensive income for the period (presented
as a single statement, or by presenting the profit or loss section in a separate statement
of profit or loss, immediately followed by a statement presenting comprehensive income
beginning with profit or loss);
■■ a statement of changes in equity for the period; and
■■ a statement of cash flows for the period.
The statement of financial position demonstrates to the user the assets and liabilities and
equity of a company at any particular moment in time, usually the year end.
The purpose of the statement of profit or loss and other comprehensive income for the
period is to show the financial performance of the company based on inputs and outputs
and the profits that transpire.
The statement of cash flows for the period shows the cash flow in and out of the com-
pany through three main headings: cash flow from operating activities; cash flow from
investing activities; and cash flow from financing activities.
The statement of changes in equity for the period shows all changes in an owner’s
equity for a period of time.

3.2 Answer: (c) best reflects the statement of changes in equity.

3.3 Sigma plc

Statement of financial position as at 31 December 20X1
Assets £,000
Non-current assets
Property, plant and equipment 900
Brand 100
Capitalised development expenditure 200
Investments in subsidiaries 200
Other receivables (due to be received 20X4) 300
Goodwill 400
2,100
Current assets
Inventory 300
Trade and other receivables  950
Derivative financial assets (short-term) 100
Cash and cash equivalents 200
1,550
Total assets 3,650
260 Answers to end-of-chapter questions

Equity and liabilities

Equity
Ordinary share capital (£1 ord. shares) (see W1) 2,390
Capital redemption reserve 80
Revaluation reserve 150
Retained earnings 300
Total equity 2,920
Non-current liabilities
10% bonds – 20X5 60
Deferred tax 100
Provision for decommissioning of nuclear plant in 20X5 50
Retirement benefit obligations 120
330
Current liabilities
Trade payables 300
Taxation 100
400
Total equity and liabilities 3,650
(W1)
Total assets 3,650
Non-current liabilities 330
Current liabilities 400
Total liabilities 730
Equity items:
Capital redemption reserve 80
Revaluation reserve 150
Retained earnings 300
Total equities 530
Total equity and liabilities (excluding share capital) 1,260
Share capital – £1 ordinary shares: £3,650 – £1,260 2,390

3.4 1. Opal Ltd

Statement of profit or loss and other comprehensive income for the year ended 31
December 20X2

£,000
Revenue 5,100
Cost of sales (2,480)
Gross profit 2,620
Distribution costs 545
Administrative expenses 971 W1 = 924 + 60 – 13
Profit from operations 1,104
Interest payable 12 W2 = 200 × 6%
Profit before tax 1,092
Tax 300 Note 9
Profit for the year 792
 Answers to end-of-chapter questions 261

2. Opal Ltd
Statement of changes in equity for the year ended 31 December 20X2

Share capital Share premium Retained earnings Total

£,000 £,000 £,000 £,000
Balance 01/01/20X2 1,750 250 850 2,850
SOCI 792 792
Dividends (35) (35)
New issue of shares 250 200 450
2,000 450 1,607 4,057

3. Opal Ltd
Statement of financial position at 31 December 20X2

£,000 £,000
Non-current assets
Equipment 4,490 W2 = 3,890+600
Current assets
Inventory 270 Note 6
Trade receivables 208
Prepayments 13 491 Note 3 (W4 = 26,000 / 2 = 13,000)
4,981
Equity and liabilities
Share capital 2,000 Note 7 & 8 (W5 = 2,200 – 200)
Share premium 450
Retained earnings 1,607 4,057
Non-current liabilities
6% debenture loan 200 200
Current liabilities
Trade and other payables 229 W8 = 212 + 12+5
Income tax 300 544 Note 9
4,801

4. a) IFRS 3 defines fair value as ‘the amount for which an asset could be exchanged, or a
liability settled, between knowledgeable, willing parties in an arm’s length agreement’.
b) Measurement and recognition of revenues – IAS 18 prescribes the measure and rec-
ognition of revenue. The measurement of revenue is provided in IAS 18 as follows:
Revenue should be measured at the fair value of the consideration received or receiv-
able. An exchange for goods or services of a similar nature and value is not regarded
as a transaction that generates revenue. However, exchanges for dissimilar items are
regarded as generating revenue.
Recognition of revenues – IAS 18 provides an explanation of revenue as follows:
Recognition, as defined in the IASB Framework, means incorporating an item that
meets the definition of revenue (above) in the income statement when it meets the
following criteria:
■■ it is probable that any future economic benefit associated with the item of revenue
will flow to the entity, and
■■ the amount of revenue can be measured with reliability.
262 Answers to end-of-chapter questions

c) Other comprehensive income is defined as gains or losses on non-current assets that

have yet to be realised. These items may include:
■■ gains or losses on foreign currency translations;
■■ changes in the fair value of available-for-sale financial assets;
■■ actuarial gains and losses arising on a defined benefit pension plan;
■■ revaluations of property, plant and equipment; and
■■ changes in the fair value of a financial instrument in a cash-flow hedge.
d) Reporting entities: An entity that carries on business and conducts financial transac-
tion is classified as a reporting entity and is required to file accounts with at least the
tax authority (HMRC). These include: sole traders, partnerships, clubs and societies,
and limited companies. In the latter case there may be other requirements, such as
publication of annual reports (for listed companies) and the submission of accounts
to Companies House.

Chapter 4 – Accounting policies 1

4.1 c) Recognise the reduction as an impairment indicator and carry out an impairment
test.

4.2 Lease Payments

Year Loan Repay Capital Interest Loan O/S

£ £ £ £ £
0 38,211 0 38,211 0 761,789
1 761,789 230,010 169,067 60,943 592,722
2 592,722 230,010 182,592 47,418 410,130
4 212,972 230,010 212,972 17,038 0

Depreciation charge

Year Opening value Depn charge Closing value

£ £ £
1 804,000 201,000 603,000
2 603,000 201,000 402,000
3 402,000 201,000 201,000
4 201,000 201,000 0

The opening balance of lease charges are: £800,000 - £38,211 = £761,789.

In each year of the lease, the company will make a depreciation charge of £201,000; how-
ever, in the first year, the procurement cost of £4,000 will be capitalised, hence the total
cost of purchase of the lease will show a balance of £761,789.

4.3 a) The initial cost of tangible non-current assets should be measured according to the
provisions of IAS 16:
An item of property, plant and equipment should initially be recorded at cost. Cost
includes all costs necessary to bring the asset to working condition for its intended
use. This would include not only its original purchase price, but also costs of site
preparation, delivery and handling, installation, related professional fees for archi-
tects and engineers.
b) The circumstances in which subsequent expenditure on those assets should be capi-
talised are:
■■ that expenditure provides an enhancement of the economic benefits of the tangible
non-current asset in excess of its previously assessed standard of performance;
■■ a component of an asset that has been treated separately for depreciation purposes
is replaced or restored; or
 Answers to end-of-chapter questions 263

subsequent expenditure relates to a major inspection or overhaul that restores the

■■
economic benefits that have already been consumed and reflected in depreciation.
IAS 16’s requirements regarding the revaluation of non-current assets and the
accounting treatment of surpluses and deficits on revaluation and gains and losses
on disposal provide the following:
■■ Depreciation should be on a systematic basis over the useful economic life of the
asset. However, a periodic review of the fair value of an asset must be carried out
by the directors and disclosed in the financial reports.
■■ If on fair value inspection an asset appreciates in value, the difference between the
fair value and the carrying value must be credited to reserve and debited to prop-
erty, plant and equipment or another class of non-current assets.
■■ Any subsequent loss in value should first debit against the revaluation reserve. If
the whole amount can be charged to the revaluation reserve, no entry is needed in
the statement of income.
■■ If the revaluation reserve is less than the impaired value, the revaluation reserve is
depleted first, then any difference is charged to the income statement.
■■ On disposal of an asset, any gains or losses on disposal are charged to the income
statement.

4.4 Year Loan Repay Capital Interest Loan O/S

1 1,500,000 160,000 85,000 75,000 1,415,000
2 1,415,000 160,000 89,250 70,750 1,325,750
3 1,325,750 160,000 93,712 66,288 1,232,038
4 1,232,038 160,000 98,398 61,602 1,133,640
5 1,133,639 160,000 103,318 56,682 1,030,321
6 1,030,321 160,000 108,484 51,516 921,837
7 921,837 160,000 113,908 46,092 807,929
8 807,929 160,000 119,604 40,396 688,326
9 688,326 160,000 125,584 34,416 562,742
10 562,742 160,000 131,863 28,137 430,879
11 430,879 160,000 138,456 21,544 292,423
12 292,423 160,000 145,379 14,621 147,044
13 147,044 154,396 147,044 7,352 0

The final instalment payment is reduced to £154,396 as per the question.

4.5 An adjusting event is an event that arises after the reporting period but its condition was
known to exist at the end of the reporting period. This includes any event that may render
the going concern assumption to be breached. The discovery that the inventories had been
overstated or understated during the end-of-period stock-checking process would be an
example of an adjusting event.
A non-adjusting event is any event that arises after the reporting period and its condi-
tion was not in existence at the end of the reporting period. Although such an event does
not give rise to an adjustment in the financial statements, a disclosure is made in the
financial statements if the event is material. The damage to inventory through a fire or
flood following after the reporting period is an example of a non-adjusting event as the
damage occurred after the reporting period. The materiality of the damage would deter-
mine whether a disclosure was required in the notes to the financial statements.
In conclusion, the determining factor in the classification of adjusting or non-adjusting
is whether the condition was known to exist at the reporting date.
264 Answers to end-of-chapter questions

4.6
Restated
20X3 20X2
£,000 £,000
Turnover 800 600
Cost of goods sold 410 255
Gross profit 390 345
Operating expenses 320 240
Profit before taxation 70 105
Taxation at 20% 14 21
Post tax profit 56 84

b)
Retained earnings
£,000
31 Dec 20X1 85
31 Dec 20X2 (Revised) 84
169
31 Dec 20X3 Post tax profit 56
31 Dec 20X3 225

Chapter 5 – Accounting policies 2

5.1 Due to quantity or value, not all operating segments need to be separately reported.
Operating segments only need to be reported if they exceed quantitative thresholds.
Quantitative thresholds (IFRS 8 para 13)
Information on an operating segment should be reported separately if:
■■ reported revenue (external and inter-segment) is 10% or more of the combined revenue
of all operating segments;
■■ the absolute amount of the segment’s reported profit or loss is 10% or more of the
greater of: the combined reported profit of all operating segments that did not report a
loss; and the combined loss of all operating segments that reported a loss; or
■■ the segment’s assets are 10% or more of the combined assets of all operating segments.
Two or more operating segments may be combined (aggregated) and reported as one if
certain conditions are satisfied. The objective of this standard is to establish principles for
reporting financial information by segment to help users of financial statements:
■■ better understand the enterprise’s past performance;
■■ better assess the enterprise’s risks and returns; and
■■ make more informed judgments about the enterprise as a whole.

5.2 Statement of profit or loss and other comprehensive income of Buffalo Ltd as at 31
December 20X4
Copiers Paper Printing HO Total
£,000 £,000 £,000 £,000 £,000
Revenue 611 395 104 0 1,110
Less: Cost of sales 384 146 44 0 574
Administration expenses 47 9 18 22 96
Distribution 101 17 24 0 142
Finance costs 6 1 1 2 10
Net profit 73 222 17 (24) 288
 Answers to end-of-chapter questions 265

Statement of financial position of Buffalo Ltd as at 31 December 20X4

Assets Copiers Paper Printing HO Total
£,000 £,000 £,000 £,000 £,000
Non-current assets at book value 1,012 767 432 232 2,443
Current assets
Inventories 31 14 12 – 57
Receivables 23 12 9 – 44
Bank 148 46 31 – 225
Total assets 1,214 839 484 232 2,769
Equity and liabilities
Share capital 1,000 1,000
Retained earnings 1,449 1,449
Non-current liabilities
Long-term borrowing 210 – – – 210
Current liabilities
Payables 32 20 16 10 78
Short-term borrowing 13 7 4 8 32
Total equity and liabilities 255 27 20 2,467 2,769

5.3 An entity must change its accounting policy only if the change is:
■■ required by standard accounting practice; or
■■ results in the financial statements providing more relevant and reliable information
about the entity’s financial position, financial performance or cash flows.
Usually, a change in accounting policy is applied retrospectively to all periods presented
in the financial statements, as if the new accounting policy has always been applied. This
means that the brought-forward carrying value of the asset or liability and retained profits
must both be appropriately adjusted.

5.4 a) IAS 8 defines an item as material in the following circumstances. Omissions or mis-
statements of items are material if they could, by their size or nature, individually
or collectively influence the economic decisions of users taken on the basis of the
financial statements. Materiality depends on the size and nature of the omission or
misstatement judged in the surrounding circumstances. The size or nature of the
item, or a combination of both, could be a determining factor.
b) Statement of profit or loss and other comprehensive income of Hawkestone Ltd as at
31 December 20X4
£,000
Revenue 74,400
Cost of sales (Note 1) (50,240)
Gross profit 24,160
Distribution costs (7,200)
Administrative expenses (12,400)
Profit from continuing operations 4,560
Closure of manufacturing division (Note2) (14,600)
Loss for period (10,040)
266 Answers to end-of-chapter questions

Statement of changes in equity of Hawkestone Ltd for year to 30 June 20X2

Share Share premium Retained

capital account earnings Total
£,000 £,000 £,000 £,000
Balance at 1 July 20X1 20,000 25,200 45,200
Prior period error (note 3) (4,280) (4,280)
Changes in equity during the year 0
Loss for the period (10,040) (10,040)
Issues share capital 0
Balance 30 June 20X2 10,000 18,000 28,000
30,000   10,880 40,880

5.5 A non-recurring item is a gain or loss found on a company’s income statement that is not
expected to occur regularly (e.g. litigation costs, write-offs of bad debt or worthless assets,
employee litigation costs, and repair costs for damage caused by natural disasters).
Analysts seeking to measure the sustainable profitability of a company typically disre-
gard non-recurring items, as these items are not expected to affect the company’s future
net income. If non-recurring items have a significant effect on the company’s finances,
they should be listed, net of tax, on a separate line below operating profit from continuing
operations. Additionally, narratives to the accounts should provide further analysis and
explanation as to the nature of the non-recurring items.

5.6 IFRS 5 determines the basis for classification for an asset held for sale and suggests that,
in general, the following conditions must be met for an asset (or ‘disposal group’) to be
classified as held for sale:
■■ management is committed to a plan to sell;
■■ the asset is available for immediate sale;
■■ an active programme to locate a buyer is initiated;
■■ the sale is highly probable, within 12 months of classification as held for sale (subject
to limited exceptions);
■■ the asset is being actively marketed for sale at a sales price reasonable in relation to its
fair value; and
■■ actions required to complete the plan indicate that it is unlikely that plan will be signifi-
cantly changed or withdrawn.
In essence, once an asset has been declared as held for sale, it must be transferred to cur-
rent assets and disposed of during the next 12 months.

5.7 Discontinued operations represent divisions within a business that have either ceased
operations due to a lack of profitability or have been sold. This may be due to the fact that
the operation is unprofitable, or a change of business direction. IFRS 5 requires listed com-
panies to report earnings per share of all divisions in its business, including discontinued
operations.
IFRS 5 indicates the definition of discontinued operations as:
 discontinued operation is a component of an entity that either has been disposed of
A
or is classified as held for sale, and:
■■ represents either a separate major line of business or a geographical area of opera-
tions, and is part of a single co-ordinated plan to dispose of a separate major line of
business or geographical area of operations, or
■■ is a subsidiary acquired exclusively with a view to resale and the disposal involves
loss of control.

5.8 IFRS 8 defines an operating segment as a component of an entity:

■■ that engages in business activities from which it may earn revenues and incur expenses
(including revenues and expenses relating to transactions with other components of the
same entity);
 Answers to end-of-chapter questions 267

■■ whose operating results are reviewed regularly by the entity’s chief operating decision-
maker to make decisions about resources to be allocated to the segment and assess its
performance; and
■■ for which discrete financial information is available.

Chapter 6 – Purpose of the statement of cash flows

6.1 b) Taxation paid.

6.2 a) Managing activities.

6.3 Cash flows are not a measure of a company’s profit, but represent the cash flow in and out
of a company due to its revenues and expenses and cash flow from investing and financing
activities. Company profit takes into account all goods and services received but not paid
for. These are recorded under the accruals concept thus facilitating a profit.
Cash flow indicates a company’s ability to meet its financial obligations. Positive cash
flow enables a company to meet payroll, pay suppliers, meet debt repayments and make
distributions to owners. Cash can be generated by operations, or provided by lenders or
owners.
Profits provide the basis for a company to measure firm performance against set 
criteria
and expectation and plan investment activity or rationalise operations to meet economic
environment.

6.4 a) Increase in inventory leads to a cash outflow since payment has been made for the
increase in inventory.
b) Decrease in payables also leads to a cash outflow since the creditors have been paid.
c) Decrease in receivables means an inflow of cash, as debtors have been reduced.
d) The increase in market value of a company’s shares directly does not have any effect
on in/outflow of cash unless new shares are issued by the company.
e) A gain is an accounting entry and does not have an impact on the cash flow per se;
however, cash inflow will be realised on disposal of assets.
f) When shares are issued, these represent financing activity; hence cash inflow will be
recorded under this activity.

6.5 £m
Opening receivables 20
Credit sales for the year 75
95
Cash received from debtors 83 Balancing figure
Closing receivables 12

Cash received from trade receivables is: £83 million during the year.

6.6 £m
Opening payables 12
Credit purchases for the year 36
48
Cash paid from debtors 30 Balancing figure
Closing Payables 18

Cash paid to creditors: £30 million during the year.

6.7 a) Depreciation – this is a calculated charge over the useful life of an asset.
b) Impairment charge – this is a non-cash charge to the income statement and does not
have a cash flow impact.
268 Answers to end-of-chapter questions

c) Gains and losses – these are also non-cash movements as they are computed profit or
loss on disposal of an asset.

6.8 Irrespective of the gains or losses incurred on disposal of the asset, the only item that will
be recorded in the cash flow statement under investing activity is the £120,000 received
on disposal of the asset.
However, the statement of comprehensive income will record the following profit or
loss:
£,000
Cost of purchase 500
Accumulated depreciation 400
100
Cash on disposal 120

Profit made on disposal 20

The profit made on disposal of the asset is £20,000.

6.9 £,000
Profit 20,000
Add: depreciation 500
20,500
Decrease in inventory 800
Increase in receivables (200)
Decrease in payables (400)
Cash from operating activities 20,700

6.10 Sarah Ltd – statement of cash flow to 31 December 20X4

Operating activities Item £ £
Profit from operations 352,000
Adjustments
Depreciation 1 50,000
402,000
Changes in working capital
Inventories 2 (30,000)
Receivables 3 (24,000)
Payables 4 (83,000)
(137,000)
Cash generated from operations 265,000
Tax paid 5 (24,000)
Net cash from operations 241,000
Financing activities £
Issued share capital 6 48,000
Long-term borrowing 7 (18,800)
Payment of finance lease 0
Dividends paid (274,000)
Net cash applied in financing activities (244,800)
 Answers to end-of-chapter questions 269

Net cash increase/decrease in cash and cash equivalents (3,800)

Cash and cash equivalents at the start of period (3,200)
Cash and cash equivalents at the end of period (7,000)
Check (3,800)

Calculations:

Item £
1 Depreciation:
Opening depreciation 180,000
Balancing charge 50,000
Closing depreciation 230,000
2 Inventory:
Opening inventory 45,000
Balancing movement 30,000
Closing inventory 75,000
3 Trade receivables:
Opening trade receivables 120,000
Balancing movement 24,000
Closing trade receivables 144,000
4 Payables:
Opening payables 170,000
Balancing movement (83,000)
Closing payables 87,000
5 Tax paid:
Opening tax 18,000
Tax charge to income statement 36,000
54,000
Less closing tax 30,000
Tax paid in the year 24,000
6 Share issue:
Shares issue: £1.20 × 40,000 48,000
7 Loan:
Closing loan balance 66,000
Opening loan balance 84,800
Loan movement during the year (18,800)

6.11 a) Plumbus Ltd – statement of cash flow to 30 September 20X4

Operating activities Item £ £
Profit before tax 190,000
Adjustments
Depreciation 1 102,000
292,000 292,000
Changes in working capital
Inventories 4,000
270 Answers to end-of-chapter questions

Receivables 7,000
Payables (48,000)
Loss on disposal 2 2,000
(35,000) (35,000)
Cash generated from operations 257,000 257,000
Tax paid 3 (43,000) 214,000
Net cash from operations 214,000
Investing activities
Purchase of NCA 4 (132,000)
Proceeds from sale of NCA 8,000
Net cash applied in investing activities (124,000)
Financing activities
Issued share capital 54,000
Long-term borrowing 59,000
Dividends paid 5 (113,000)
Net cash applied in financing activities 0
Net cash increase/decrease in cash and cash equivalents 90,000
Cash and cash equivalents at the start of period 54,000
Cash and cash equivalents at the end of period 144,000
Check 90,000

1. Depreciation
Opening 188,000
Disposal (30,000)
Depreciation for the year 102,000
260,000
2. PPE disposal
Book value 40,000
Depreciation (30,000)
Net Book Value 10,000
Sold 8,000
Loss on disposal 2,000
3. Taxation
Opening 11,000
Taxation for the year 54,000
65,000
Closing tax balance 22,000
Paid 43,000
4. Property, plant and equipment (PPE)
Opening PPE 418,000
Additions 132,000
Disposal (40,000)
Revaluation reserves 10,000
Closing PPE 520,000
 Answers to end-of-chapter questions 271

5. Dividends
Opening retained profit 33,000
Profit for the year 136,000
Dividends paid in cash 113,000
Closing retained profit 56,000

b) The company appears to be in a stable financial condition.

The company appears to be managing its payables and receivables well. However,
it seems this company may be an SME in its growth stage, so it should review its sup-
plier and customer policy on credit received and allowed, to increase working capital
and liquidity in the company.
The company could also consider raising both its shareholding and further long-
term capital through a new share issue to private investors. Plumbus is a small lim-
ited company and may not be able to offer its shares to the general investor.

Chapter 7 – Group accounting

7.1 £,000
Goodwill on acquisition 6,000 – [1,000 + 1,720 + 1,200] 2,080

Other net assets at book value 7,200 + 3,700 + 1,200 12,100

14,180
Financed by:
Ordinary share capital (£1 shares) 10,000
Retained profit at 31 October 20X0 2,940
Net profit for 20X8–9 260 + 980 1,240

7.2 Goodwill
£,000 £,000
Consideration 2,500
Share capital 1,800
Pre-acquisition profits 1 Oct 20X0: 600 × 2/3 400
Goodwill 300
Minority interest: 3,600 × 1/3 1,200
Post-acquisition profits: 300 × 2/3 200

7.3
Total equity At acquisition Since acquisition Minority interest
£ £ £ £
Diamonds
Share capital 80,000 80,000
Retained profits:
At acquisition date 33,200 33,200
Since acquisition 11,400 11,400
124,600 113,200 11,400  
272 Answers to end-of-chapter questions

Total equity At acquisition Since acquisition Minority interest

£ £ £ £
Hearts
Share capital 40,000 30,000 10,000
At acquisition date 7,200 5,400 1,800
Since acquisition (13,600) (10,200) (3,400)
33,600 35,400 (10,200) 8,400

Total equity At acquisition Since acquisition Minority interest

£ £ £ £
Totals (Diamond and
Hearts) 158,200 148,600 1,200 8,400
Total price paid, £126,000
+ £44,000 170,000
Goodwill on acquisition 21,400
43,000
Retained profits, Clubs Ltd
Goodwill impairment
(21,400/4) (5,350) (5,350)
158,200 16,050 38,850 8,400

Consolidated statement of financial position for Clubs Ltd and Subsidiaries at 31 December 20X6

£
Goodwill 16,050
Non-current at carrying value 488,200
Current assets 171,000
Less: Current liabilities 178,000
Net current assets (7,000)
Total assets less current liabilities 497,250
Less: 15% debentures 250,000
247,250
Financed by:
Share capital (£1 shares) 200,000
Retained profits 38,850
Minority interest 8,400
247,250

7.4 In the process of preparing consolidated financial statements, it is necessary to eliminate

intra-group balances and transactions such as plant and machinery, purchase and sales of
inventories and other assets between parent and subsidiary. In many cases, the separate
financial statements of a parent company and a subsidiary include amounts of inter-com-
pany items that should be offset or eliminated. Before preparing the consolidated financial
statements, accounting entries should be prepared to bring the balances up to date and to
eliminate the inter-company balances.
 Answers to end-of-chapter questions 273

Company A will have to adjust its profits figure by following the accounting treatment
for unrealised profits:
■■ Reduce the retained earnings of Company A by 25% (the mark-up) or 20% of the selling
price.
■■ Reduce the inventory of Company B by 25% (the mark-up) or 20% of the price.
The above adjustments only apply to unsold inventory.

7.5 Step 1: Group structure: 70% Parent, 30% NCI

Step 2: Calculate the consideration transferred
Given in the question 265,000
Step 3: Calculate fair value of net assets at the date of acquisition and at the
reporting date
Fair value of
net assets
£ £
39,814 40,178
Share capital 100,000 100,000
Share premium 50,000 50,000
Retained earnings 50,000 100,000
Fair value adjustment 20,000 20,000
Intangible non-current assets written off (10,000) (30,000)
210,000 240,000
Step 4: Calculate the post-acquisition profit of Beta
Fair value of NCI assets at the reporting date 240,000
Less fair value of NCI assets at the date of acquisition 210,000
Post-acquisition profit 30,000
Group (70% × 30,000) 21,000
NCI (30% × 30,000) 9,000
Step 5: Calculate the goodwill at the date of acquisition and at
the reporting date
Consideration transferred 265,000
Fair value of NCI (30% × 100,000 × 2.5) 75,000
340,000
Less fair value of net assets at acquisition date (from step 3) 210,000
Goodwill arising on acquisition 130,000
Less goodwill impairment 65,000
Goodwill at 31 December 2009 65,000
Goodwill impairment will be split between the group and the
NCI as follows:
Group (70% × 65,000) 45,500
NCI (30% × 65,000) 19,500
Step 6: Calculate the NCI at the reporting date
Fair value of NCI at the date of acquisition 75,000
Add NCI’s share of the post-acquisition profit of Beta (step 4) 9,000
Less NCI’s share of goodwill impairment (19,500)
NCI at the reporting date 64,500
274 Answers to end-of-chapter questions

Step 7: Calculate the consolidated retained earnings

Alpha’s retained earnings 100,000
Add group’s share of the post-acquisition profit of Beta (step 4) 21,000
Less unrealised profit on inventory (20/120 × 20,000 × 1/2) (1,667)
Less group’s share of goodwill impairment (step 5) (45,500)
Alpha Group
Consolidated statement of financial position at 31 December
20X7 73,833
Non-current assets £ £
Goodwill 65,000
Property plant and equipment (500,000 + 70,000 + 20,000) 590,000
Investments (290,000 + 60,000 – 265,000) 85,000
740,000
Current assets
Inventory (100,000 + 50,000 - 1,667) 148,333
Trade receivable (150,000 + 100,000 - 15,000) 235,000
Bank (30,000 + 20,000 + 5,000) 55,000
438,333
Total assets 1,178,333
Equity and liabilities
Share capital 700,000
Share premium 140,000
Consolidated retained earnings 73,833
913,833
Non-controlling interest 64,500
978,333
Current liabilities
Trade payables (90,000 + 60,000 - 10,000) 140,000
Accruals 60,000 200,000
1,178,333

7.6 The parent entity concept considers the group to consist of the net assets of the parent and
all its subsidiaries with the non-controlling interest being a liability of the group.
The effects of the preparation of consolidated financial statements are:
a) the non-controlling is classified as liability; and
b) the effects of intra-group transactions are proportionally adjusted.
According to IFRS 10: ‘Control of an investee arises when an investor is exposed, or has
rights, to variable returns from its involvement with the investee and has the ability to
affect those returns through its power over the investee.’
An investor controls an investee if, and only if, the investor has all of the following ele-
ments (IFRS 10:7):
■■ power over the investee (i.e. the investor has existing rights that gives it the ability to
direct the relevant activities – those that significantly affect the investee’s returns);
■■ exposure or rights to variable returns from its involvement with the investee; and
■■ the ability to use its power over the investee to affect the amount of the investor’s
returns.
 Answers to end-of-chapter questions 275

7.7 Profit 26
Add:
Depreciation 33
Taxation 12
71
Working capital movement:
Inventories: 107 – 101 6
Receivables: 86 – 99 (13)
Payables: 72 – 52 20
Tax paid during the year (5)
8
Cash flow from operating activities 79

The item of purchase of non-current asset will come under ‘investing activities’ and will
not be disclosed in cash flow from operating activities.

Chapter 8 – Trend analysis and introduction to ratio analysis

8.1 Alternative theories exist that attempt to explain the nature and characteristics of the
modern corporation. However, in contrast to the agency theory, stewardship theory sug-
gests that, left to their own devices, managers will act responsibly to maximise shareholder
wealth.
Stewardship, therefore, has a pivotal role in managing the affairs of a company.
Management will select the best strategies given the limited resources of the firm and,
within the context of those limited resources, managers will attempt to increase the value
of the firm. This basically means managers have custody of the firm’s assets and in the
presence of competing demands will select the options that maximise returns.

8.2 Ratio analysis is a form of financial statement analysis that is used to obtain a quick indi-
cation of a firm’s financial performance in several key areas. The ratios are categorised
as short-term solvency, debt management, asset management, profitability and market
value.
As a tool, ratio analysis possesses several important features. The data, provided by
financial statements, is readily available. The computation of ratios facilitates the com-
parison of firms that differ in size. Ratios can be used to compare a firm’s financial per-
formance with the industry average. They can also be used as a form of trend analysis to
identify areas where performance has improved or deteriorated over time.
Because ratio analysis is based on accounting information, its effectiveness is limited
by the distortions that arise in financial statements (e.g. historical cost accounting and
inflation). Therefore, it should only be used as a first step in financial analysis, to obtain
a quick indication of a firm’s performance and to identify areas which need to be investi-
gated further.

8.3 There are three main ratios that can be used to measure the profitability of a business:
1. gross profit margin
2. net profit margin
3. Return on Capital Employed (ROCE).
The gross profit margin
This measures the gross profit of the business as a proportion of the sales revenue.
The net profit margin
This measures the net profit of the business as a proportion of the sales revenue.
276 Answers to end-of-chapter questions

Return on Capital Employed (ROCE)

This is often referred to as the ‘primary accounting ratio’ and it expresses the annual per-
centage return that an investor would receive on their capital.

8.4 The liquidity ratios are measured using the current ratio and the quick ratio. The current
ratio is current assets divided by current liabilities. The quick ratio measures liquidity in
a company by excluding inventory (stock) from the current ratio:

a) 20X2 20X1
760 695
Current ratio 360 505
Current ratio 2.1 1.4
760 – 180 695 – 240
Quick ratio
360 505
Quick ratio 1.6 0.9

b) The two ratios suggest that Roadster Ltd has improved its liquidity position over the
two-year period from 20X1 to 20X2. The current ratio has gone up from 1.4 to 2.1
suggesting the company has been efficient in its use of current assets.
The quick ratio has also gone up from 0.9 to 1.6, an increase of 78%, suggesting that
the company has been highly efficient in current asset management.

8.5 a) 20X2 20X1

Gross profit margin 32% 35%
Operating profit margin 13% 18%
Current ratio 4.8 6.3
Acid test 3.8 5

b) Comments on company performance – Brent Ltd:

The highlights from the profit margins and liquidity ratio analysis suggest the com-
pany has not performed as well in 20X2 as it did in 20X1.
The gross profit and operating profit ratios indicate a decline in profitability. This
argument is strengthened by the fact that ROCE has declined from 34% in 20X1 to
24% in 20X2.
The liquidity ratios have also deteriorated during the year, though the general
liquidity levels do not suggest the company is at risk of corporate failure. However,
the cash position of Brent Ltd has moved from positive cash and cash equivalents
balance in 20X1 to a £10,000 overdraft at the end of 20X2.
The cash movement may warrant closer monitoring by the management, even if
it is linked to a strategic development plan.

8.6 Vertical analysis – Brent Ltd

Brent Ltd – income statement for the years to 31 December
20X2 20X1
£,000 % £,000 %
Sales (all credit) 1,500 100 1,900 100
Opening inventory 80 100
Purchases 995 66% 1,400 74%
Closing inventory 100 200
Cost of goods sold 975 65% 1,300 68%
Gross profit 525 35% 600 32%
Less: Expenses 250 17% 350 18%
275 18% 250 13%
 Answers to end-of-chapter questions 277

The company appears to be making reasonable operating profits in both years.

However, profitability has declined in 20X2. This appears to be due to purchases and
expenses.

Horizontal analysis – Brent Ltd

Year Sales CoGS Gross profit Expenses Op. profit
20X1 1,500 975 525 250 275
20X2 1,900 1,300 600 350 250

Sales CoGS Gross profit Expenses Op. profit

20X1 100% 100% 100% 100% 100%
20X2 127% 133% 114% 140% 91%
CoGS = Cost of goods sold

The horizontal analysis clearly shows where problems have occurred during 20X2.
The CoGS and expenses during 20X2 have contributed to the decline in 20X2 profits.
Management may wish to consider the above analysis and investigate why this has
happened.

Chapter 9 – Analysis and interpretation of accounts 1

9.1 a) Working capital management
CA 700
Current ratio = = 1.1:1
CL 635

CA – Inventory 700 – 235

Acid test ratio = = 0.73:1
CL 635

Turnover 5,500
Asset turnover ratio = = 0.8
Total assets 6,700

Stock 235
Stock turnover ratio × 365 × 365 = 32 days
Cost of sales 2,700

Profitability
Gross profit 2,800
Gross profit margin = = = 51%
Turnover 5,500

Net profit 1,250

Operating profit margin = = = 23%
Turnover 5,500

Net profit 1,250

Return on assets = = = 19%
Total assets 6,700

Capital structure
Long-term liabilities 3,000
Gearing 1 = = = 98%
Total equity fund 3,065

Operating profit 1,250

Interest cover = = = 4.2:1
Interest expense 300
278 Answers to end-of-chapter questions

b) Working Capital Management

This ratio shows that the company is its working capital reasonably well. With the
current ratio at 1.1 and the acid test ratio at 0.73, and the nature of the business
being in retail, the level of liquidity is acceptable. However, this situation can change
quickly and management must have sound plans to keep the current and acid test
ratios at the same or higher levels.
Profitability
All three profitability ratios show a healthy return to the investor. The gross margin
ratio shows a 51% turnover which is due to the usual sector return. The net profit
margin and return on asset ratios also seem to be in line with expectation. Nevertheless,
the kitchen appliance business is very susceptible to economic downturn; people will
delay home improvements in austere times, so, while returns appear to be acceptable,
there could be severe impact on the business in tough economic conditions.
Capital structure
The gearing ratios can be estimated in two ways: debt/equity or debt/(equity + debt).
Lenders will usually set a debt covenant based on gearing levels. Some lenders may
stipulate that a company’s gearing may not go over, say, 50% based on debt/debt +
equity estimation. However, the interest cover ratio (4:1) suggests the company can
meet its interest payments.
The ratio suggests the company is highly geared and any further increase in debt
will risk a default on the debt covenant. The company needs to lower its debt and/or
increase its profits and profitability to stay within agreed bounds.

9.2 a) Tanner Spanner Trade

£,000 £,000
Operating profit 1,000 1,200
Turnover 7,200 9,000
Average investment in gross assets 2,400 2,600
Gross asset turnover 3 times 1.5 times 2 times
Operating profit percentage 13.89% 13.33% 14%
Operating profit to gross assets 41.67% 20.00% 21%

b) The three ratios are intrinsically linked to each other, as they are all a different meas-
ure of company performance. The gross asset turnover and the operating profit ratios
compare company performance in relation to sales. As gross asset turnover moves
up or down, this is reflected in the movement respectively in the operating profit
percentage ratio. Again, the rate of return on gross assets is linked to gross asset
turnover. As the gross asset turnover moves up or down, the rate of return on gross
assets moves likewise.
c) Both Tanner and Spanner seem to be in line with the trade association performance.
However, Tanner has gross asset turnover of three times as compared with the trade
association and Spanner, who have two times and 1.5 times gross asset turnover
respectively. Tanner seems to be more efficient in its costs and expenses, and has
superior operating profits and operating profit to gross assets. This suggests Tanner is
more profitable than Spanner.

9.3 Net asset turnover ratio = Sales / Net assets

Total asset turnover ratio = Sales / Total assets

20X7 20X6 20X5 20X4

Sales £,000 290 190 160 90
Net assets £,000 420 340 280 190
Total assets £,000 1140 950 880 680
Net asset turnover % 69 56 57 47
Total asset turnover % 25 20 18 13
 Answers to end-of-chapter questions 279

Asset usage efficiency:

The ratios indicate that the company has progressively become highly efficient in the use
of its assets. By 20X7 the company had increased sales by 222%, while having increased its
asset base by 68%. It will be useful to consider why such efficiency has transpired due to
the increase in the company asset base. This exercise will continue to enable the company
to maintain and improve its operations and processes.

9.4 Cash operating cycle

= Days sales outstanding + Inventory days outstanding - Payable days outstanding
Cash operating cycle
= 60 + 90 - 70
= 80 days
Using the cash operating formula, the company has an 80-day cash operating cycle. This
result by itself is of limited use. It is not possible to make a judgment on the cash operat-
ing cycle for this or any company without knowledge of the operating business sector or
any comparative benchmarks for the sector or previous year’s results for the company.
Management would be advised to assess this result against any comparative benchmark
for the sector for the current year, or against the company’s past performances or against
the budgeted cash operating cycle. The results of these comparisons will enable manage-
ment to take the appropriate course of action.

Chapter 10 – Analysis and interpretation of accounts 2

10.1 £
Basic earnings per share (EPS)
Earnings 20,000,000
Shares issued 100,000,000
Basic EPS 20p/share
Diluted earnings per share (DEPS)
Earnings 20,000,000
Savings on interest (£40m × 12%) 4,800,000
24,800,000
Reduced tax savings on foregone interest* (1,440,000)
Adjusted net earnings 23,360,000
(*£4,800,000 × 30% = £1,440,000)
Number of shares on conversion:
Shares issued 100,000,000
Conversion: £40m/100 × 12 = 48,000,000
Total shares: 148,000,000
DEPS after adjusted net earnings:
£23,360,000 / 148,000,000 16p/share

The debenture conversion has diluted the current shareholder wealth. The impact of the
conversion would decrease current basic EPS from 20p per share to 16p per share.

10.2 a) Earnings per share (EPS) represent the profit attributable to ordinary shareholders
divided by the weighted average number of shares in issue during the year.
280 Answers to end-of-chapter questions

b) A bonus share is essentially a free share given to current shareholders in a company,

based on the number of shares that the shareholder already owns. While the issue
of bonus shares increases the total number of shares issued and owned, it does not
increase the value of the company.
Although the total number of issued shares increases, the ratio of number of shares
held by each shareholder remains constant. An issue of bonus shares is referred to as
a bonus issue. Depending upon the constitutional documents of the company, only
certain classes of shares may be entitled to bonus issues, or may be entitled to bonus
issues in preference to other classes.
c) 20X2 20X1
£,000 £,000
Basic earnings per share (EPS)
Profit for the year 64,000 48,000
8% preference share (£100m × 8% = £8m) (8,000) (8,000)
Profit attributable to ordinary shareholders 56,000 40,000
Shares in issue 30,000 30,000
Shares in issue 6,000 –
Bonus issue (1 for 5) 36,000 30,000
Total shares
Basic EPS £1.56 £1.33
Re-stated EPS for 20X1: £1.33 × 5/6 1 £1.11

d) Dilution to earnings per share (EPS) can arise due to a number of factors, as follows.
Conversion of debentures, preference shares and other financial instruments will
have an impact on wealth effects due to the number of shares issued if the conversion
is offered at less than market value of the shares. However, there are other situations
which may give rise to diluted earnings per share, such as warrants and options.
Presently share ranking does not exist, but it may do in the future for dividend pur-
poses. This might also lead to dilution of EPS if such share-ranking instruments had
conversion rights to ordinary shares.
e) 20X2
Diluted earnings per share (DEPS) £,000
Earnings 56,000
Savings on interest 36,000
92,000
Reduced tax savings on foregone interest: £36m × 33% = £11.88m (11,880)
Adjusted net earnings 80,120
Calculation of debenture:
£36,000,000 × 100 / 12% = 300,000,000
Shares in issue 36,000,000
£300,000,000 / £300 × 20 = 20,000,000
Total shares 56,000,000
Diluted EPS: £80,120,000 / 56,000,000 £1.43
 Answers to end-of-chapter questions 281

10.3 The du-Pont analysis is a technique for analysing the three components of Return on
Equity (ROE):

Net income Sales Assets

× ×
Sales Assets Equity
3,300 19,600 135,000
× ×
19,600 135,000 9,500
16.84% 14.52% 1421.05%
= 34.74%
Return on equity = 34.74%

10.4 a) Rights issue price £1.50

Premium per rights share:1.50 - 1.00 0.5
Closing share premium account £13,500
Opening share premium account £6,000
Premium on rights issue £7,500
Number of rights issue shares (7,500 / 0.50) 15,000
Proceeds from rights issue (15,000 × £1.50) £22,500

b) Share issues
Opening shares in issue 25,000
Bonus issue: 25,000/5 5,000
Number of shares under rights issue 15,000
Total new share issues 20,000
Total weighted number of shares 45,000
Profit for 20X4 £
Closing reserve (as stated in the question) 16,200
Add: Bonus issue 5,000
Add: Dividends paid 6,750
27,950
Less: Closing retained earnings (19,000)
Profit for the period (20X0) 8,950

Chapter 11 – Limitations of published accounts

11.1 Creative accounting is the term used to explain the activity known as earnings manage-
ment. This is a process that can arise intentionally or unintentionally through the choices
made by management during the reporting of an entity’s financial performance.

11.2 Earnings management can arise from four possible sources within the process of reporting
on the financial statements and performances of an entity:
1. Accounting system – the system of accounting does permit the use of choice and judg-
ment which may be exploited by those responsible for the reporting on the financial
performance.
2. Accounting choice – the existence of choice between accounting methods may give rise
to earnings management.
3. Accounting judgment – accounting includes the use of estimation and as a direct result
this personal judgment element may trigger earnings management.
282 Answers to end-of-chapter questions

4. Accounting transaction – some of our transactions are not definitive and include esti-
mation and judgment which can contribute to earnings management.

11.3 a) Luboil has incorrectly credited to sales a £10 million contract entered into with
Seeder Ltd. This is not the correct procedure. Luboil should divide the contract over
five years and post, subject to price variation as agreed with the customer, Seeder
Ltd, as to the price variation. Formal recognition of the agreement on price variation
should be available to the auditor for inspection. Additionally, a fair value approach to
price variation should be used and the contract should be explained in the narratives
to the financial reports.
b) There will be some impact on changes to sales having made the proper treatment of
the account. As the contract is based on supply, there may be legal issues with stop-
ping supply to Seeder Ltd. This has to be taken into consideration.
However, performance ratios such as EPS, ROA, ROE and ROCE will fall, perhaps
considerably once accounting adjustments are made and only £2 million revenue is
accounted for rather than £10 million.

Chapter 12 – Financial reporting within the business environment

12.1 a) XBRL is a web-based technology that facilitates the electronic communication of eco-
nomic and financial information in a manner that cuts down costs, provides a greater
level of efficiency of use, and provides improved reliability to users and suppliers of
information.
XBRL uses the XML (Extensible Markup Language) syntax and related XML tech-
nologies, which are the standard in communicating information between businesses
and the internet. Data can be converted to XBRL by appropriate mapping tools
designed to convert electronic data to XBRL format, or data can be written directly in
XBRL by suitable software.
b) XBRL works on a system of tags. Instead of treating financial information as a block
of text, as in a standard internet page or a printed document, XBRL provides an iden-
tifying tag for each individual item of data. This is computer readable. For example,
company revenues and items of expenses and net profit have their own unique tag.
This enables manipulation by users, through query forms, to generate data and infor-
mation in the required format.
c) Most companies employ the computer desktop and laptop systems as a means for
data capture, analysis, and output. A company would need to ensure that its web
technology is up to date or otherwise invest in new computer systems. XBRL works
on the internet, hence software tools would need to be procured that allow conversion
between applications such as accounting software systems, Microsoft Doc files and
Excel spreadsheets, which can be used to transfer base data into a useable format for
the XBRL system. Comparatively, costs are low; however, maintenance and dedicated
staff may need to be employed to provide expert services to staff and employees.
d) The common platform for XBRL is the internet. XBRL codes are embedded in HTML
source codes and the system works from dedicated websites.
e) XBRL is web-based, hence the running costs of XBRL are quite low and maintenance
costs are relatively cheap. However, the functionality of XBRL-based systems is very
powerful, allowing easy access and conformity to company requirements. Proprietary
software can be used in conjunction with XBRL to manage changes, enhancements
and amendments.

12.2 Pressure on companies to comply with modern business practices demands that they
reflect upon and take appropriate action on environmental and social issues using a pro-
active approach to business activities management. Waste and toxic emissions are dealt
with by law in the UK such as the Environmental Law Act 2006. It may be that current
legislation does not require companies to disclose certain relevant information that may
be useful to users; however, a growing number of entities across all sectors make their
corporate social responsibility public on their website and via other media to communi-
cate with stakeholders. These actions may range from the simple reminder on an e-mail,
 Answers to end-of-chapter questions 283

reminding recipients to reflect upon whether they need to print an email, to much grander
pronouncements and actions.
This has a positive impact on the credibility, integrity, and reputation of a company. In
being proactive, companies can demonstrate to stakeholders their commitment to social
and environmental needs.
A less favourable perspective may regard the engagement with social reporting as the
new and effective marketing tool deployed by entities in the twenty-first century.
a) James is under an obligation as the environmental compliance officer to bring exist-
ing environmental issues to the attention of senior management. He needs to provide
practical solutions as to how the toxic waste could be better managed by investing in
new and improved technology.
By offering alternative courses of action and a carrying out a cost–benefit analy-
sis, James could demonstrate the future benefits of the investment. Additionally, he
needs to underline the ethical and environmental importance of taking proactive
steps and disclosing this to stakeholders, thereby adding reputational capital to the
company.
b) The company could take a series of practical steps to comply with environmental
issue at hand. The company could:
■■ identify areas of concern and draw up policies relevant to the company using
appropriate audit tools, such as GRI or TBL;
■■ use external experts to advise on best and future course of actions;
■■ have effective monitoring and audit policies in place that are regularly updated;
■■ provide training for relevant employees on environmental and social matters; and
■■ disclose systematically and regularly in annual reports the targets and achieve-
ments to date, being clear and honest in doing so.
c) There are many ways a company can report its initiatives. The most common proce-
dure is to disclose its green and social policies through its corporate report. The com-
pany should develop stand-alone reports that concentrate on social, environmental
and ethical issues, explaining how these are achieved or what processes are in place.
This gives a clear indication of targets and timelines.

12.3 a) Company disclosure on listed companies usually features a report on corporate social
responsibility (CSR). This report is separate from the financial report and indicates
company policy towards social, environmental and ethical issues. The CSR report will
also indicate policy, procedure and lines of responsibility. Additionally, it will discuss
targets set and achieved, any deficiencies in policy and practice, and the pragmatic
steps taken to ensure the company complies with legal and ethical requirements.
b) Within the financial report, companies will report on product lines and geographical
operations. This would indicate the exposure the company faces in sourcing its raw
material and the markets to which it sells its products.
The directors’ and CEO’s reports will provide additional information as to the pro-
gress the company is making on CSR issues such as ethical trading and its impact on
the environment. Reports from relevant third parties such as the external auditor will
feature in the financial reports or as part of the wider CSR report giving independent
verification.
Commitment to certification and standards and how they have been applied will
also be indicators of company commitment to the social agenda.
Glossary

Accounting policies Accounting policies are Convertible loan Loan stock that can be
the specific principles, bases, conventions, converted into ordinary shares at a set
rules and practices applied by an entity date or dates at a predetermined price.
in preparing and presenting financial The conversion price is the price of
statements. ordinary shares at which loan stock can
Accruals Provisions for goods and services be converted. The number of ordinary
received but not yet paid for. Accruals are shares received by a loan stock holder on
one of the main accounting principles. conversion of £100 nominal of convertible
Agency theory A theory concerning loan stock is £100 divided by the
the relationship between a principal conversion price.
(shareholder) and an agent of the principal Convertible preference shares Preference
(managers). shares that can be converted into ordinary
Asset An asset is a resource controlled by the shares. A company may issue them
enterprise as a result of past events and to finance major acquisitions without
from which future economic benefits are increasing the company’s gearing or
expected to flow to the enterprise. diluting the earnings per share (EPS) of
Associate A business entity that is partly the ordinary shares. Preference shares
owned by another business entity in potentially offer the investor a reasonable
which the stake holding is at above 20% degree of safety with the chance of capital
but below 51%. gains as a result of conversion to ordinary
Capital and capital maintenance Concept of shares if the company prospers.
financial and physical capital maintenance. Corporate governance The system by which
Financial capital relates to equity, while the companies are directed and controlled. In
physical capital relates to the increase in the UK, the corporate governance system
capital at the end of the year. is based on the UK Code on Corporate
Cash and cash equivalents The mostly Governance 2010.
liquid assets found within the asset Cost of capital The cost to a company
portion of a company’s statement of of the return offered to different kinds
financial affairs. Cash equivalents are of capital. This may be in the form of:
assets that are usually ready to cash interest (for debt capital); dividends and
within three months. participation in the growth of profit (for
Companies Act A set of legal and regulatory ordinary shares); dividends alone (for
requirements that business entities, preference shares); or conversion rights
particularly limited liability entities, must (for convertible loan stock or convertible
adhere to in the course of business. preference shares).
Consolidated accounts When a number of Current asset In the entity’s normal
business entities belong to a parent either operating cycle, a current asset is held
directly or indirectly, the parent entity primarily for trading purposes. It is
prepares a set of consolidated accounts. expected to be realised within 12 months
This has the effect of showing the of the statement of financial position.
financial affairs of the group as though it It can also be cash or a cash-equivalent
were a single business entity, hence intra- asset.
group transactions are cancelled out. Current cost Assets are carried at the amount
Convergence Reducing international of cash or cash equivalent that would have
differences in accounting standards by to be paid if the same or an equivalent asset
selecting the best practice currently were currently acquired. Liabilities are
available, or, if none is available, by carried at the undiscounted amount of cash
developing new standards in partnership or cash equivalents that would be required
with national standard setters. to settle the obligation currently.
 Glossary 285

Current liability This is expected either liquidation. Equity shareholders accept

to be settled in the normal course of the these risks and disadvantages because
entity’s operating cycle, or is due to be they are the legal owners of the company,
settled within 12 months of the statement have voting rights and own any remaining
of financial position. funds after other claims have been met.
Debentures A type of debt instrument They expect to benefit, through growth
that is not secured by physical asset or of dividends and share prices, from the
collateral. The loan may or may not be company’s future success.
repayable. If a debenture is not repayable, External audit A verification process
it may be offered to debenture holders as a conducted by a third party on the
convertible loan (see convertible loan). verification of the financial reports. The
Debt Long-term capital consisting of money external audit is carried out by a registered
lent by investors. Can be called loan stock, external auditor.
loan notes or debentures. Return on debt Fair presentation The faithful
consists of interest (usually at a fixed representation of the effects of
rate), which is payable irrespective of the transactions in accordance with the
financial performance of the company. definitions and recognition criteria for
Secured loan stock holders rank before assets, liabilities, income and expenses set
ordinary shareholders for repayment out in the Framework and can be defined
of capital if the company goes into as ‘Presenting information, including
liquidation. accounting policies, in a manner which
Directors’ report An aspect of the annual provides relevant, reliable, comparable,
financial report produced by the board and understandable information’.
of directors of a business entity required Fair value The measurement of an asset or
under UK company law. It details the state liability or a financial transaction that best
of the company and its compliance with a reflects its price. The price may be on a
set of financial, accounting and corporate market basis or other means acceptable to
social responsibility (CSR) disclosures. a body of users. Fair value must be based
Discontinued operations A component of on IFRS guidelines.
an enterprise that has either been disposed Faithful representation The principle that
of, or is classified as ‘held for sale’. reported financial figures that convey to
Discount rate Cost of capital used to define the user the underlying economic reality
interest rates or to discount cash flows to of the business entity.
find present values. Finance lease A resource controlled by a
Dividends A portion of a company’s business entity for the substantial part
earnings that is returned to shareholders. of its life, from which future benefits will
Double-entry bookkeeping System of debits flow to the company.
and credits that measures assets and Financial ratios A means of evaluating a
liabilities (profit or loss). company’s performance or health that
Earnings management The manipulation uses a standard of comparisons of items
of financial transactions to give a better on the company’s financial statements.
perspective of a business’ financial Ratios can be calculated in financial and
affairs (e.g. increased revenue or non-financial terms (e.g. debtor days
misrepresentation of certain type of outstanding, which is measured in days).
expenses). Framework This conceptual framework
Earnings per share (EPS) The amount of sets out the concepts that underlie the
earnings per each outstanding share in a preparation and presentation of financial
company. In the case of share movement statements for external users.
in a period, the EPS is stated on a Gains or losses In the course of business, an
weighted average shareholding basis. entity will make gains or losses on certain
Elements of financial statements Assets, types of transactions such as sale of items
liabilities, equity, revenues and expenses. of PPE classified as being ‘held for sale’ or
Equity shares With equity shares the profit or loss on currency translations etc.
payment of dividends is not guaranteed, Generally Accepted Accounting Principles
and the amount of dividends depends on (GAAP) Refer to the standard framework
the company’s financial performance. of guidelines for financial accounting used
Equity shareholders are last in line for in any given jurisdiction.
payment of dividends and for repayment Going concern An accounting concept
of capital if the company goes into under which financial reports are prepared
286 Glossary

on the assumption that a business will not ordinary shares for distribution of capital
be liquidated within the next 12 months. in the event of liquidation.
Goodwill The difference between the Present value The amount of money at
consideration (price paid for an asset) and today’s date that is equivalent to a sum
its carrying value. of money in the future. It is calculated by
Harmonisation Reconciles, to a certain discounting the future sum to reflect its
extent, with national differences timing and the cost of capital.
and provides preparers of accounting Principal financial statements These
information a common framework and include the statement of comprehensive
the opportunity to deal with major issues income, statement of financial position,
in a similar manner globally. statement of changes to equity and the
Historical cost The amount of cash or cash statement of cash flows.
equivalents paid for an asset, or the fair Property, plant and equipment Items of
value of other considerations given to non-current assets, land and buildings
acquire it. held for use that are stated in the
International Accounting Standards statement of financial position at their
Board (IASB) The body that sets IFRSs. cost, less any subsequent accumulated
The IASB may make amendments to depreciation and subsequent accumulated
existing accounting standards or issue impairment losses.
new standards with reference to new Realisable value Assets are carried at the
accounting issues or to ensure more amount of cash or cash equivalent that
clarity for existing and new accounting could currently be obtained by selling the
matters. asset in an orderly disposal. Liabilities are
International Financial Reporting carried at their settlement values – that
Standards (IFRSs) Set of accounting is, the undiscounted amounts of cash or
standards that provide the basis for cash equivalents expected to be required to
reporting accounting and financial settle the liabilities in the normal course
information. of business.
Inventory Is the stock in trade of a business Relevance Accounting information should
entity. Inventory is either raw material or be able to influence the economic
finished goods. It must be valued at the decisions of users. Relevant accounting
lower of cost or net realisable value. information should have predictive and/or
Liability Obligation of an entity arising from confirmatory value.
past transactions or events, the settlement Reporting entities Business and some
of which may result in the transfer or non-business entities that are required
use of assets, provision of services or to prepare and submit to a relevant
other yielding of economic benefits in the government agency the results of their
future. financial transactions (e.g. sole traders,
Net present value (NPV) The sum of partnerships and limited companies).
the present values of all the cash flows Retained earnings Profits reinvested
associated with an investment project. in the business instead of being paid
Non-controlling interest If a parent out as dividends. They belong to
company owns, say, 80% of another the shareholders and form part of
business entity, and the other 20% belongs shareholders’ funds, together with equity
to minority shareholders, the latter is the capital subscribed by shareholders and
non-controlling interest. reserves. The cost of retained earnings
Offsetting The concept of reporting is the same as the cost of other forms of
separately assets, liabilities, expenses and equity capital included in shareholders’
revenue to give users a clearer picture of a funds.
company’s transactions. Revenue The gross inflow of economic
Operating lease A lease whose term is short benefits (cash, receivables, other assets)
compared to the useful life of the asset or arising from the ordinary operating
piece of equipment activities of an entity.
Preference shares Non-equity shares, with Rights issue An issue of shares to existing
a (usually fixed) dividend paid – subject shareholders, usually at a discount to the
to the availability of distributable profits market price.
– before ordinary share dividends can be Segmental reporting Financial reporting
paid. Preference shares do not normally of revenues generated based on either
have voting rights, but rank before geographical or product basis.
 Glossary 287

Stakeholders Parties to a company who is the principle that is used in guidelines

have a vested interest in that company ranging from auditing and financial
(e.g. employees, management, customers, standards to the Companies Act.
suppliers and lenders). Value-in-use The discounted present value
Standardisation The process by which rules of the future cash flows expected to arise
are developed for standard setting for from the continuing use of an asset, and
similar items globally. from its disposal at the end of its useful
Subsidiary A business entity wholly or partly life.
owned (e.g. 51% or more) by another XBRL A web-based language that serves as
business entity, where the majority a platform for business reporting using
shareholding belongs to the ‘parent’ common Internet language tools. Referred
company. to as eXtensible Business Reporting
True and fair view Used to describe the Language, it is embedded in the HyperText
required standard of financial reporting Markup Language (HTML).
but equally to justify decisions that require
a certain amount of arbitrary judgment. It
Directory

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Further reading
Basioudis, I. G., Financial Accounting – A Practical Guide (Prentice Hall, 2010).
Holmes, G., Sugden, A. and Gee, P., Interpreting Company Reports and Accounts, 10th edition
(Prentice Hall, 2008).
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2011).

Magazines, journals and newsletters

Accountancy
This is the monthly journal of the ICAEW. It covers a wide range of topics.

CA Magazine
This is the monthly magazine of the ICAS.
290 Directory

Accounting and Business

This is the monthly magazine from ACCA. It covers business and professional developments
worldwide.

Financial Management
This is CIMA’s professional magazine. It focuses on management accounting methods and
technology, and has good coverage of some of the topics in the ICSA course (e.g. capital invest-
ment appraisal). It is available from the magazine department at CIMA’s headquarters.

Public Finance
This is the monthly magazine on public sector financial management from CIPFA.
Financial Times newspaper

Professional bodies and useful organisations

The specialist financial accounting bodies in the UK are the Institute of Chartered Accountants
in England and Wales (ICAEW) and the Institute of Charted Accountants of Scotland (ICAS).
Other professional accounting bodies are the Association of Chartered Certified Accountants
(ACCA), the Chartered Institute of Management Accountants (CIMA) and the Chartered
Institute of Public Finance and Accounting (CIPFA).
All these accounting bodies include financial management elements in their examination
schemes and many of their members are employed in financial management roles in industry,
commerce and the public sector.
All the organisations listed below post additional information and resources on their web-
sites. Many of the professional bodies also have international sites and offices that can provide
students with additional local or regional material.

Association of Chartered Certified Accountants (ACCA)

29 Lincoln’s Inn Fields
London WC2A 3EE
Tel +44(0)20 7059 5000
www.accaglobal.com

Chartered Institute of Management Accountants (CIMA)

26 Chapter Street
London SW1P 4NP
Tel +44(0)20 8849 2251
www.cimaglobal.com

The Chartered Institute of Public Finance and Accountancy (CIPFA)

3 Robert Street
London WC2N 6RL
Tel +44(0)20 7543 5600
www.cipfa.org
Index

A vertical analysis 176–9, 190, 276–7

accountability 41–3, 42 see also ratio analysis
accountants AOL-Time Warner 33–4
changing role of 19 asset turnover ratios 196–8
and ethics 254–5 non-current asset turnover ratio 201–2
accounting total asset turnover ratio 202–3
accountability of businesses 41–3 assets
defined 40–1 cash-generating units (CGUs) 103
objectives of information 42 combination of businesses based on 137
principal statements 44–6 contingent 83
reporting entities 43–4 current 52
suppliers of information 43–4 defined 27
uses of information 42 fair value 71, 148–9
accounting policies impairment of 32–3, 101–3
change in 64–7, 265 intangible 83–4
change in accounting estimates 66–7 non-current, held for sale 104–6
consistency of 59 property, plant and equipment as 73
defined 58–9 segmental reporting 110
differences between 35–7 valuing 28–31
earnings per share 100 associated companies 159–63
events following reporting period 69–70 assumption, underlying 26, 37, 258
fair value measurement 71–3 audits
financial instruments 97–8 environmental 15–17
impairment of assets 101–3 external 12–13, 13, 19, 240–2, 257
income taxation 90–3
intangible assets 83–4 B
inventories 59–60, 60 balance sheet. see statement of financial
leases, accounting for 93–5 position
non-current assets held for sale 104–6 Bloomberg database 244
prior period errors 67–8 boards of directors 13–14, 173
property, plant and equipment 73–8 bonus issue of shares 223
provisions, accounting for 81–3 business environment
purpose of 58 corporate social responsibility (CSR)
revenue, accounting for 78–81 249–51
selection and application of 59 ethics in 251–5
Accounting Standards Board (ASB) 9 eXtensible Business Reporting Language
acid test ratio 184, 190, 276 (XBRL) 247–9, 255–6, 282
adjusting events 88, 263 Global Reporting Initiative (GRI) 250
agency theory 10 social, ethical and environmental issues
Amadeus 244 250–1, 256, 282–3
amortisation 86–7 subscription databases 244–52
analysis and interpretation of accounts triple bottom line framework 250
cash operating cycle 199–206
exceptional items 178–9 C
horizontal analysis 173–6, 190, 277 capital and capital maintenance 33–4, 37,
need for 172 258–9
stewardship 172–3, 189, 275 capital expenditure per share 218
subsidiary ratios 191–6 carrying amount 73
trend analysis to time series 179 cash and cash equivalents 114–15
292 Index

cash flow analysis 145–6 consolidated statement of profit or loss

cash-flow based ratio analysis 214–20 157–8, 272–3
cash flow per share 217–18 constraints on information provision 26
cash flows, statement of 46, 129–32, 267–71 contingent assets 83
as accounting statement 46, 113–14 contingent liabilities 83
cash and cash equivalents 114–15 control of an investee 135
components of 115–16 corporate governance 10, 13–14, 19, 173,
direct method 116–19, 117 240–1, 257
discontinued operations 128 corporate social responsibility (CSR) 17–18,
financing activities 116 249–51, 256, 282–3
indirect method 120, 112–14, 128 cost defined 73
interpretation of 119–20 costs of information provision 26
investing activities 116 creative accounting 236, 242, 281
limitations of 128 current cost 28
main headings 113 current ratio 184, 275–6
operating activities 115, 117, 114–19
preparation methods 116–27 D
presentation of specific items 119 databases, subscription 244–6
purpose 114 Datastream 244
and ratios 215–17, 219–20 debt, doubtful 66
cash-generating units (CGUs) 103 debt factoring 237–8
cash operating cycle debt service coverage ratio 218–19
inventory 199 deferred tax 91–3
non-current asset turnover ratio 201–2 depreciable amount 76
ratios in calculating 199 depreciation 76–8
trade payables 199–201 diluted earnings per share (DEPS) 225
trade receivables 199–201 direct expenses 210
cash recovery rate 217 disclosure in segmental reporting 108
changes in equity, statement of 46, 54–5 discontinued operations 112, 266
classification of national accounting systems non-current assets held for sale 104–6
5–7 statement of cash flows 128
clubs as reporting entities 44 diversification 108
Code on Corporate Governance 10 dividends out of pre-acquisition earnings
common size analysis 176–9 142–3
Companies Act 2006 9 see also shares
company comparisons 213–14, 214 doubtful debt 66
comparability of information 25, 258 du-Pont formula 205, 227, 281
comparisons between company 213–14, 214
comprehensive income 51, 57, 106–7, 262 E
Conceptual Framework for Financial earnings management 231–6, 242, 281–2
Reporting earnings per share 100, 220–8
accounting policies, differences between Eco Management and Audit Scheme (EMAS)
35–7 15–17
aims and development of 20–1 elements of financial statements 26–32
capital and capital maintenance 33–4 employees, commitment and retention of
elements of financial statements 26–32 252
emergence of 22–3 environmental, social and ethical issues
qualitative characteristics of information 250–1, 256, 282–3
24–6, 37, 258 Environmental Protection Act 1990 14
scope of 22 environmental reporting 14–15
underlying assumption 26, 37, 258 equipment. see property, plant and
users of financial information 23 equipment
consignment stock 237 equity
consistency of information 25, 258 changes in equity, statement of 46, 54–5,
consolidated accounts 139–41 57, 259
see also group accounting defined 27
consolidated financial statements 135 instruments 98
consolidated statement of financial position equity method of accounting 160–3, 163
145–56, 176–7, 273–4 errors, prior period 67–8
 Index 293

estimates, change in accounting 66–7 UK 9

ethical, social and environmental issues USA 9
250–1, 256, 282–3 Global Reporting Initiative (GRI) 250
ethics in business 251–5 going concern concept 26
European Commission 9 goodwill 148–51, 167
exceptional items 178–9 gross profit margin ratio (GPM) 182–3, 190,
expenses defined 27 275–6
eXtensible Business Reporting Language group accounting
(XBRL) 247–9, 255–6, 282 assets, combination based on 137
external audits 12–13, 13, 19, 240–2, 257 associated companies 159–63
consolidated accounts 139–41
F consolidated financial statements 135
factoring 237–8 consolidated statement of financial
fair value 57, 148–9, 261 position 145–56
faithful representation of information 24 consolidated statement of profit or loss
FAME (Financial Analysis Made Easy) 244–5 157–8
finance leases 93, 94 consolidation adjustments 141–7
financial accounting control of an investee 135
comprehensive income 51 definitions 135, 135–7
defined 43 dividends out of pre-acquisition earnings
offsetting 47 142–3
prescribed format for statements 48–9 equity method of accounting 160–3, 163
presentation of statements 47–8 goodwill 148–51, 167
principal statements 44–6 group defined 135–7
profit or loss statements 45, 259 intercompany loans 141
reporting entities 43–4 investment entities 135
statement of cash flows 46 joint ventures 163–6
statement of changes in equity 46, 54–5 legal and economic forms 138
statement of financial position 45, 51–4 non-controlling interest 153–6, 167
use and users of information 46–7 parent entities 135, 136, 139, 169, 274
financial instruments 97–8 post-acquisition profits 151–3, 167
financial position, statement of 51–4, 57, 259 power 135
associated companies 160 protective rights 135
consolidated 168–9, 273–4 shares, combination based on 137
group accounting 139–41, 145–56 standards relevant to 135
parent company’s 139–41 statement of financial position 139–41,
purpose of 45 145–56, 160, 168–9, 273–4
Financial Reporting Council (FRC) transfers of goods 141
financial reporting standards (FRSs) 9 unrealised earnings, inter company 142
financial statements
assets 27 H
equity 27 harmonisation of accounting practices 6–7
expenses 27 hierarchy of inputs 72
income 27 historical cost 28
liabilities 27 horizontal analysis of accounts 173–6, 190,
mandatory items 48 277
measurement of elements 28–33 horizontal integration 107
prescribed format for 48–9
purposes of 41 I
valuing assets and liabilities 28–31 impairment loss 73, 87, 262
format for financial statements 48–9, 51–3 impairment of assets 101–3
free from error 24–5 income
full consolidation 157–8 comprehensive 51
full cost approach 211–12 defined 27
measurement and recognition of 49–51
G statement of comprehensive income
gearing ratio 191–5 106–7
generally accepted accounting principles income taxation 90–3
(GAAPs) 4 indirect expenses 210
294 Index

intangible assets 83–4 N

integration, horizontal and vertical 107 national differences in financial reporting
intellectual property rights (IPR) 253 4–7
inter-company comparisons 213–14, 214 net realisable value (NRV) 60
intercompany loans 141 neutral depiction 24
interest cover ratio 196 non-audit services by auditors 241–2
internal:external finance ratio 219 non-controlling interest 153–6, 167
International Accounting Standards Board non-current assets
(IASB) 7–9, 19, 257 capitalisation of expenditure on 88, 262
International Financial Reporting Standards held for sale 104–6, 112, 266
(IFRSs) 4, 8–9 measurement of 88, 262
interpretation of accounts. see analysis and statement of cash flows 116
interpretation of accounts; ratio analysis turnover ratio 201–2
inventories non-recurring items 112, 266
accounting for 59–60, 60
cash operating cycle 199 O
rate of inventory turnover 196–7 offsetting 47
undervaluation/overvaluation 204 operating leases 93, 94
investment entities defined 135 operating profit margin ratio (OPM) 182–3,
ISO 14000 14 190, 275–6
ISO 26000 249–50 operating segments 112, 264, 266–7

J P
joint ventures 163–6 parent entities 135, 136, 139–41, 169, 274
partnerships as reporting entities 43–4
L plant. see property, plant and equipment
leases, accounting for 93–5 policies, accounting
liabilities change in 64–8, 265
contingent 83 change in accounting estimates 66–7
current 52 consistency of 59
defined 27 defined 58–9
fair value 71, 148–9 differences between 35–7
segmental reporting 110 events following reporting period 69–70
valuing 28–31 fair value measurement 71–3
limitations of published accounts financial instruments 97–8
creative accounting 236, 242, 281 impairment of assets 101–3
earnings management 231–6, 242, 281–2 income taxation 90–3
and external audits 240–2 intangible assets 83–4
main 229–30 inventories 59–60, 60
ratio analysis 230–1 leases, accounting for 93–5
subjectivity 231 non-current assets held for sale 104–6
substance over form principle 237–40 prior period errors 67–8
limited companies as reporting entities 44 property, plant and equipment 73–8
line-by-line consolidation 157–8 provisions, accounting for 81–3
liquidity ratios 183–6, 196, 276 purpose of 58
loans, intercompany 141 revenue, accounting for 78–80
selection and application of 59
M policies, revenue, accounting for 78–80
management post-acquisition profits 151–3, 167
earnings management 231–6, 242, 281–2 power defined 135
role of 173 present value 28
management accounting defined 43 presentation of statements 47–8
material items 112, 265 price, fair value, measurement of 71
measurement primary liquidity ratio 183–6, 189–90,
fair value 71–3 275–6
and recognition of revenue 49–51 primary operative ratios (GPM and OPM)
reliability 27 182–3
metadata 248 principal-agent relationship 10
money laundering regulations 254–5 prior period adjustment 54
 Index 295

prior period errors 67–8 internal:external finance ratio 219

probability reliability 27 limitations of 230–1
profit or loss statements 88, 112, 264–5, 265 limitations of traditional 214–15
consolidated statement of profit or loss liquidity ratios 183–6, 189–90, 196, 276
157–8, 168, 272–3 non-current asset turnover ratio 201–2
information in 45 operating profit margin ratio (OPM) 190
profit ratios primary operative ratios (GPM and OPM)
gross profit margin ratio (GPM) 182–3, 182–3
190, 203–5, 275–6 profit ratios 182–3, 190, 203–5, 275–6
operating profit margin ratio (OPM) proprietorship ratio 195–6
182–3, 190, 275–6 pyramid of ratios 205–6
property, plant and equipment rate of collection of trade receivables 198
as assets 73 rate of inventory turnover 196–7
cost model 75 rate of payment of trade payables 198
definitions 73 rate of return on gross assets 205
depreciation 76–8 relationship between ratios 205–6
fraudulent accounting 74 return on capital employed (ROCE) 186,
initial recognition cost of 73 190, 205, 275–6
revaluation model 75–6 return on equity (ROE) 187, 190, 275–6
proprietorship ratio 195–6 return on shareholders’ equity 212–13,
protective rights defined 135 226–8, 279–81
provisions, accounting for 81–3 segmental analysis 209–13
prudence 101 shareholder funding ratio 219–20
pyramid of ratios 205–6 statement of cash flows 215–17, 219–20
total asset turnover ratio 202–3
Q use of 181–2, 189, 275–6
qualitative characteristics of information usefulness of 180–1
comparability 25, 258 realisable value 28
constraints on information provision 26 recognition of revenue 49–51
enhancing 25–6, 258 regulation, IFRS framework 4
faithful representation 24–6 reliability of probability and measurement 27
fundamental 24–5 reporting entities 43–4, 57, 262
relevance 24 residual value 77
timeliness of information 25, 258 return on capital employed (ROCE) ratio
understandability of information 25, 258 186, 190, 205, 275–6
verifiability of information 25, 258 return on equity (ROE) ratio 187, 190,
quick ratio 184 275–6
return on shareholders’ equity 212–13,
R 226–8, 279–81
rate of collection of trade receivables 198 revaluation model for property, plant and
rate of inventory turnover 196–7 equipment 75–6
rate of payment of trade payables 198 revenue
rate of return on gross assets 205 accounting for 78–81
ratio analysis 145–6, 206–8, 277–9 defined 79
acid test ratio 184, 190, 276 measurement and recognition of 49–51,
asset turnover 196–8, 201–3 57, 261
capital expenditure per share 218 recognition of 80–1
cash-flow based 214–20 rights issue of shares 224
cash flow per share 217–18
cash operating cycle 199–205 S
cash recovery rate 217 sale and leaseback arrangement 237
debt service coverage ratio 218–19 sale and repurchase arrangement 238
du-Pont formula 205 segmental analysis of ratios 209–13
earnings per share 220–8, 279–81 segmental contribution approach 210–12
gearing ratio 191–5 segmental reporting 107–10, 109, 264–7
gross profit margin ratio (GPM) 182–3, shareholder funding ratio 219–20
190, 275–6 shares
inter-company comparisons 213–14, 214 bonus issue 223
interest cover ratio 196 capital expenditure per share 218
296 Index

cash flow per share 217–18 subjectivity 231

combination of businesses based on 137 subscription databases 244–6
diluted earnings per share (DEPS) 225 subsidiary ratios 191–5
dividends out of pre-acquisition earnings substance over form principle 237–40
142–3 suppliers of information 43–4
earnings per share 100
full market price at issue 222–3 T
issues 54, 222–4 tax, income 90–3
return on shareholders’ equity 212–13, theoretical framework of accounting 10
226–8, 279–81 timeliness of information 25, 258
rights issue 224 total asset turnover ratio 202–3
social, ethical and environmental issues trade payables
250–1, 256, 282–3 cash operating cycle 199–201
social accounting 17–18, 19, 249–51, 256, rate of payment of 198
257, 283 trade receivable days 198
Social Audit Network (SAN) 18 trade receivables
societies as reporting entities 44 cash operating cycle 199–201
sole traders as reporting entities 43 rate of payment of 198
stakeholders, needs of 252 transactions, fair value, measurement of 71
standards 19, 257 transfers from reserves 54
arguments for and against 10–11 transfers of goods 141
generally accepted accounting principles trend analysis
(GAAPs) 4, 9 horizontal analysis 173–6
harmonisation 6–7 to time series 179
IFRS framework 4 vertical analysis 176–9
international bodies 7–9 triple bottom line framework 250
national differences in financial reporting
4–7 U
standardisation 6 UK Code on Corporate Governance 10
statement of cash flows 129–32, 267–71 underlying assumption 26
as accounting statement 46, 113–14 understandability of information 25, 258
cash and cash equivalents 114–15 United States, GAAPs in 9
components of 115–16 unrealised earnings, inter company 142
direct method 116–19, 117 use and users of information 23, 46–7
discontinued operations 128 useful life 76
financing activities 116
indirect method 112, 112–14, 128, 170, V
275 valuation, fair value, measurement of 72
interpretation of 119–20 value
investing activities 116 assets and liabilities 28–31
limitations of 128 fair value measurement 71–3
main headings 113 present 28
operating activities 115, 117, 114–19, 170, realisable 28
275 residual 77
preparation methods 116–27, 128 value-in-use 32–3
presentation of specific items 119 verifiability of information 25, 258
purpose 114 vertical analysis of accounts 176–9, 190,
and ratios 215–17, 219–20 276–7
statement of changes in equity 46, 54–5, vertical integration 107
112, 259, 264
statement of financial position 51–4, 57, 259 W
associated companies 160 working capital ratio 184
consolidated 168–9, 273–4
group accounting 139–41, 145–56 X
parent company’s 139–41 XBRL (eXtensible Business Reporting
purpose of 45 Language) 247–9, 255–6, 282
stewardship 172–3, 189, 275