ACCA

FINANCIAL ACCOUNTING
BY PRESTON
TOPIC 17: PREPARING FINANCIAL STATEMENTS FOR SOLE TRADERS:
By the end of this topic, you should be able to prepare the following financial statements for sole traders
with adjustments:
1. Statement of Profit or Loss for sole traders.
2. Statement of Financial Position for sole traders.

Example 1:
The following balances were extracted from the books of Mike Moit at 30 June 20X5:
$
Capital 59,100
Land and buildings 48,000
Motor vehicles (at cost) 4,200
Office equipment (at cost) 9,000
Gross profit 63,600
Rates and insurance 4,860
Bad debts written off 330
Utilities 480
Bad debt recovered 420
Rent receivable 14,160
Provision for doubtful debts 1,395
Personal expenses 20,730
Cash in hand 510
Bank balance 660
Discounts received 2,760
Discount allowed 2,400
Accumulated depreciation on motor vehicle 1,200
Accumulated depreciation on office equipment 3,105
Trade receivables 15,900
Trade payables 27,300
Salaries and wages 24,210
Investments 20,400
Sundry expenses 6,720
Additional information:
1. As at 30 June 20X5. Inventory was valued at $.14, 640.This inventory include items valued at $3, 000
which had been sold and invoiced to a customer on 30 June 20X5.
2. The sales returns day book had been overcast by $ 90.
3. Discounts allowed amounting to $360 had been posted to the discounts allowed account, but not to the
trade receivables account.
4. Depreciation is to be provided as follows:
Motor vehicle – 20% per annum on cost

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 Office equipment – 15% per annum on cost
5. Rent received amounting to $300 had not been recorded in the accounts since the proprietor converted
the amount for personal use.
6. The sales day book had overcast by $ 450.
Required:
(a) Income statement for the year ended 30 June 20X5.
(b) Statement of financial position as at 30June 20X5.
Example 2:
The following trial balance was extracted from the ledger of Stephen Chee, a sole trader, as at 31 May
20X1 – the end of his financial year.
Stephen Chee trial balance as at 31 may 20x1
Dr $ Cr $
Property, at cost 120,000
Equipment, at cost 80,000
Accumulated depreciation (as at 1 June 20X0)
– on property 20,000
– on equipment 38,000
Purchases 250,000
Sales 402,200
Inventory, as at 1 June 20X0 50,000
Discounts received 4,800
Returns out 15,000
Wages and salaries 58,800
Irrecoverable debts 4,600
Loan interest 5,100
Other operating expenses 17,700
Trade payables 36,000
Trade receivables 38,000
Cash in hand 300
Bank 19,300
Drawings 24,000
Allowance for receivables 500
17% long-term loan 30,000
Capital, as at 1 June 20X0 121,300
667,800 667,800
The following additional information as at 31 May 20X1 is available:
a. Inventory as at the close of business has been valued at cost at $42,000.
b. Wages and salaries need to be accrued by $800.
c. Other operating expenses are prepaid by $300.
d. The allowance for receivables is to be adjusted so that it is 2% of trade receivables.
e. Depreciation for the year ended 31 May 20X1 has still to be provided for as follows.
f. Property: 1.5% per annum using the straight line method
g. Equipment: 25% per annum using the reducing balance method

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Required:Prepare Stephen Chee's statement of profit or loss for the year ended 31 May 20X1 and his
statement of financial position as at that date.
END OF TOPIC 17
TOPIC 18.0: INTRODUCTION TO COMPANY ACCOUNTING:
18.1: LIMITED LIABILITY AND ACCOUNTING RECORDS:
There are some important differences between the accounts of a limited liability company and those of sole
traders or partnerships.

Fundamental differences in the accounts of limited liability companies:

 The national legislation governing the activities of limited liability companies tends to be very
extensive. Such legislation may define certain minimum accounting records which must be
maintained by companies.
 They may specify that the annual accounts of a company must be filed with a government bureau
and so be available for public inspection.
 They often contain detailed requirements on the minimum information which must be disclosed in a
company's accounts. Businesses which are not limited liability companies (non-incorporated
businesses) often enjoy comparative freedom from statutory regulation.

Unlimited and limited liability:

Unlimited liability means that if the business runs up debts that it is unable to pay, the proprietors will
become personally liable for the unpaid debts and would be required, if necessary, to sell their private
possessions to repay them.
Sole traders and partnerships mostly have unlimited liability, except for the LLPs.

Limited liability means that the owners are liable, but the liability is limited up to a certain amount. There is a
maximum amount that an owner stands to lose, in the event that the company becomes insolvent and
cannot pay off its debts.
Liability is limited by:
i. Guarantee.
ii. Share capital held by the member.

The accounting records of limited companies

Companies are normally required by law to keep accounting records which are sufficient to show and
explain the company's transactions.

To be sufficient, the records would normally have the following qualities.

1. Disclose the company's current financial position at any time.
2. Contain:
(i) Day to day entries of money received and spent
(ii) A record of the company's assets and liabilities
(iii) Where the company deals in goods:
a. A statement of inventories held at the year end, and supporting inventory count records

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 b. With the exception of retail sales, statements of goods bought and sold which identify the sellers
and buyers of those goods

3. Enable the managers of the company to ensure that the final accounts of the company give a true and
fair view of the company's profit or loss and statement of financial position

The detailed requirements of accounting records which must be maintained will vary from country to
country.

SHARE CAPITAL:
In preparing a statement of financial position you must be able to deal with:
 Ordinary and preference share capital
 Reserves
 Loan stock

The capital of limited liability companies

The owners’ capital in a limited liability company consists of share capital.
When a company is set up for the first time, it issues shares, which are paid for by investors, who then
become shareholders of the company.

1. The par value of shares:

Shares are denominated in units with a certain agreed value.
The 'face value' of the shares is called their par value, the nominal value or the legal value.

For example, when a company is set up with a share capital of, say, $100,000, it may be decided to issue:
(a) 100,000 shares of $1 each par value; or
(b) 200,000 shares of 50c each; etc.

2. Issue price:
This is the value at which the shares are issued.
The amount at which the shares are issued may exceed their par value.
For example, a company might issue 100,000 $1 shares at a price of $1.20 each. Subscribers will then pay
a total of $120,000.
 The issued share capital of the company would be shown in its accounts at par value, $100,000.
 The excess of $20,000 is described not as share capital, but as share premium.

3. The market value of shares:

The par value of shares will be different from their market value, which is the price at which someone is
prepared to purchase shares in the company from an existing shareholder. If Mr A owns 1,000 $1 shares in
Z Co he may sell them to Mr B for $1.60 each.

This transfer of existing shares does not affect Z Co's own financial position in any way whatsoever. Apart
from changing the register of members, Z Co does not have to bother with the sale by Mr A to Mr B atall.

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AUTHORISED, ISSUED, CALLED-UP AND PAID-UP SHARE CAPITAL
1. Authorised share capital:
Authorised (or legal) capital is the maximum amount of share capital that a company is empowered to
issue. The amount of authorised share capital varies from company to company, and can change by
agreement.
For example, a company's authorised share capital might be 5,000,000 ordinary shares of $1 each . This
would then be the maximum number of shares it could issue.
2. Issued share capital:
Issued capital is the par amount of the authorised share capital that has been issued to shareholders .
 The amount of issued capital cannot exceed the amount of authorised capital.
 Continuing the example above, the company with authorised share capital of 5,000,000 ordinary
shares of $1 might have issued 4,000,000 shares . This would leave it the option to issue 1,000,000
more shares at some time in the future.
 When share capital is issued, shares are allotted to shareholders. The term 'allotted' share capital
means the same thing as issued share capital.
3. Called-up capital:
When shares are issued or allotted, a company do es not always expect to be paid the full amount for the
shares at once. It might instead call up only a part of the issue price, and wait until a later time before it
calls up the remainder.
For example, if a company allots 400,000 ordinary shares of $1, it might call up only, say, 75 cents per
share. The issued share capital would be $400,000, but the called-up share capital would only be
$300,000.
4. Paid-up capital.
 Investors are not always prompt or reliable payers . When capital is called up, some shareholders
might delay their payment (or even default on payment).
 Paid-up capital is the amount of called-up capital that has been paid.
 For example, if a company issues 400,000 ordinary shares of $1 each, calls up 75 cents per share,
and receives payments of $290,000.

Summary of the above:

Allotted or issued capital 400,000
Called-up capital 300,000
Paid-up capital 290,000
Unpaid-up 10,000

The statement of financial position of the company would appear as follows.

$
Assets:
Called-up capital not paid 10,000
Cash (called-up capital paid) 290,000

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 300,000
Equity:
Called-up share capital (400,000 ordinary shares of $1, with 75c per share called up) 300,000
In a limited liability company's statement of financial position the owners' capital is called equity.

18.2: ORDINARY SHARES AND PREFERENCE SHARES:

At this stage we need to distinguish between the two types of shares most often encountered: preference
shares and ordinary shares.

1. PREFERENCE SHARES:
Preference shares are shares which confer certain preferential rights on their holder.
Preference shares carry the right to a final dividend which is expressed as a percentage of their par value:
e.g. a 6% $1 preference share carries a right to an annual dividend of 6c.

Preference dividends have priority over ordinary dividends.

If a company wish to pay a dividend, it must pay any preference dividend first.

The rights vary from company to company and country to country, but typically:
 Preference shareholders have a priority right to a return of their capital over ordinary shareholders
if the company goes into liquidation.
 Preference shares do not carry a right to vote.
 If the preference shares are cumulative, it means that before a company can pay an ordinary
dividend it must not only pay the current year's preference dividend but must also make good any
arrears of preference dividends unpaid in previous years.

Classification of preference shares:

Preference shares may be classified in one of two ways.
1. Redeemable
2. Irredeemable

1. Redeemable preference:
 Redeemable preference shares mean that the company will redeem (repay) the nominal value of
those shares at a later date.
 For example, 'redeemable 5% $1 preference shares 20X9' means that the company will pay these
shareholders $1 for every share they hold on a certain date in 20X9.
 The shares will then be cancelled and no further dividends paid.
 Redeemable preference shares are treated like loans and are included as non-current liabilities in
the statement of financial position.
 Remember to reclassify them as current liabilities if the redemption is due within 12 months.
Dividends paid on redeemable preference shares are treated like interest paid on loans and are
included in financial costs in the statement of profit or loss.

2. Irredeemable preference shares:

Irredeemable preference shares are treated just like other shares.

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They form part of equity and their dividends are treated as appropriations of profit.

2. ORDINARY SHARES:
 Ordinary shares are by far the most common type of share.
 They carry no right to a fixed dividend but are entitled to all profits left after payment of any
preference dividend.
 However, only a part of such remaining profits is distributed, the rest being kept in reserve.
 The amount of ordinary dividends normally fluctuates from year to year.
 Should the company be wound up, any surplus not distributed is shared between the ordinary
shareholders.
 Ordinary shares normally carry voting rights.
 Ordinary shareholders are thus the effective owners of a company. They own the 'equity' of the
business, and any reserves of the business belong to them.
 Ordinary shareholders are sometimes referred to as equity shareholders.

Dividends on ordinary shares and preference shares:

Garden Gloves Co has issued 50,000 ordinary shares of 50 cents each and 20,000 7% preference shares
of $1 each.
Its profits after taxation for the year to 30 September 20X5 were $8,400. The management board has
decided to pay an ordinary dividend which is 50% of profits after tax and preference dividend.
Required
Show the amount in total of dividends and of retained profits, and calculate the dividend per share on
ordinary shares.
Solution:
$
Profit after tax 8,400
Preference dividend (7% of $1 / 20,000) (1,400)
Earnings (profit after tax and preference dividend) 7,000
Ordinary dividend (50% of earnings) (3,500)
Retained earnings (also 50% of earnings) 3,500

The ordinary dividend is 7 cents per share ($3,500 / 50,000 ordinary shares).

The appropriation of profit would be as follows.

$ $
Profit after tax 8,400
Dividends: preference 1,400
Ordinary 3,500 (4,900)
Retained earnings 3,500
18.3: LOAN NOTES:
These are long-term liabilities.
In some countries they are described as loan capital because they are a means of raising finance, in the
same way as issuing share capital raises finance.

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They are different from share capital in the following ways.
Shareholders are members of a company, while providers of loan capital are lenders.
Shareholders receive dividends whereas the holders of loan capital are entitled to a fixed rate of interest,
an expense charged against revenue.
Loan note holders can take legal action against a company if their interest is not paid when due, whereas
shareholders cannot enforce the payment of dividends.
Loan notes are often secured on company assets, whereas shares are not.
18.4: RESERVES:
Share capital and reserves are 'owned' by the shareholders. They are known collectively as 'shareholders'
equity'.
Shareholders' equity consists of the following.
i. The par value of issued capital (minus any amounts not yet called up on issued shares)
ii. Other equity
Other equity' consists of the reserves:
i. Share premium
ii. Revaluation surplus
iii. Retained earnings
iv. Other Reserves, like General reserves.

The share premium account:

 In this context, 'premium' means the difference between the issue price of the share and its par
value.
 A share premium account is an account into which sums received as payment for shares in excess
of their nominal value must be placed.

Revaluation surplus:
This is as a result of an upward revaluation of a non-current asset.
This reserve is non distributable, as it represents unrealised profits on the revalued assets. It is another
capital reserve.

Statutory & Non-statutory reserves:

1. Statutory reserves:
Statutory reserves are reserves which a company is required to set up by law, and which are not available
for the distribution of dividends.
Statutory reserves are capital reserves, e.g. share premium, revaluation.
2. Non-statutory reserves:
Non-statutory reserves are not required by law and are reserves consisting of profits which are distributable
as dividends, if the company so wishes.
Non-statutory reserves are revenue reserves. E.g. Retained earnings, general reserves, etc

18.5: DIVIDENDS
Dividends are appropriations of profit after tax.
Many companies pay dividends in two stages during the course of their accounting year:
i. Interim dividend:

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In mid-year, after the half-year financial results are known, the company might pay an interim dividend.

ii. Final / proposed dividend:

At the end of the year, the company might propose a further final dividend.
The total dividend to be included in the financial statements for the year is the sum of the dividends actually
paid in the year.

The proposed dividend does not appear in the accounts but will be disclosed in the notes in accordance
with IAS 10 Events After the Reporting Period

18.6: BONUS AND RIGHTS ISSUES:

A company can increase its share capital by means of a bonus issue or a rights issue.
Bonus issues:
 A company may wish to increase its share capital without wishing to raise additional finance by
issuing new shares.
 The existing shareholders are given free share a financed by a reserve account.
 It results to a reclassification some of the reserves as share capital.
 This is purely a paper exercise which raises no funds.
Advantages:
 Increases capital without diluting current shareholders' holdings
 Capitalises reserves, so they cannot be paid as dividends
Disadvantages:
 Does not raise any cash
 Could jeopardise payment of future dividends if profits fall

Rights issues:
A rights issue is an issue of shares for cash.
The 'rights' are offered to existing shareholders, who can sell them if they wish.
This is beneficial for existing shareholders in that the shares are usually issued at a discount to the current
market price
Advantages
 Raises cash for the company
 Keeps reserves available for future dividends
Disadvantage
 Dilutes shareholders' holdings if they do not take up rights issue

END OF TOPIC 18

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TOPIC 19: PREPARATION OF FINANCIAL STATEMENTS FOR COMPANIES

19.1: IAS 1 PRESENTATION OF FINANCIAL STATEMENTS:

IAS 1 lists the required contents of a company's financial statements. It also gives guidance on how items
should be presented in the financial statements.

A complete set of financial statements includes the following.

1. Statement of financial position
2. Statement of profit or loss and other comprehensive income
3. Statement of changes in equity
4. Statement of cash flows
5. Notes.

How items are disclosed

IAS 1 specifies disclosures of certain items in certain ways.
i. Some items must appear on the face of the statement of financial position or statement of profit or
loss.
ii. Other items can appear in a note to the financial statements instead.
iii. Recommended formats are given which entities may or may not follow, depending on their
circumstances.

Identification of financial statements:

The entity should identify each component of the financial statements very clearly.
IAS 1 also requires disclosure of the following information in a prominent position:
i. Name of the reporting entity (or other means of identification)
ii. Whether the accounts cover the single entity only or a group of entities
iii. The reporting date or the period covered by the financial statements (as appropriate)
iv. The reporting currency used in presenting the figures in the financial statements

Reporting period:
Entities normally present financial statements annually. IAS 1 states that they should be prepared at least
as often as this.

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1. THE STATEMENT OF FINANCIAL POSITION
IAS 1 specifies what should be included in a statement of financial position and includes a suggested
format. IAS 1 gives the following suggested format for a statement of financial position .
XYZ LTD
STATEMENT OF FINANCIAL POSITION
AS AT ……………………………………………..
$'000'
ASSETS:
Non-current assets:
PP&E xx
Goodwill xx
Other Intangible assets xx
Investment in Associates xx
Investment in equity instrument xx xx
Current Assets
Inventories xx
Trade receivables xx
Cash at bank xx xx
TOTAL ASSETS XX
EQUITY & LIABILITIES:
Equity:
Share capital xx
Share premium xx
Retained earnings xx
General Reserves xx
Revaluation Reserve xx
Other components of equity xx xx
Non- Current liabilities:
Loan xx
Deferred tax xx
Debentures xx xx
Current Liabilities:
Trade and other payables xx
Current tax xx
Short term borrowing xx
Other current liabilities xx xx

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TOTAL EQUITY & LIABILITIES XX

2. THE STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE INCOME

IAS 1 specifies what should be included in a statement of profit or loss and other comprehensive income
and includes a suggested format.
Some items must be disclosed on the face of the statement.

IAS 1 gives the following suggested format for a statement of profit or loss and other comprehensive
income:

XYZ GROUP
SPL & OCI
FOR THE YEAR ENDE D ………………………………………….

NOTE $'000'
Revenue xx
Cost of sales (xx)
Gross profit xx
Other income xx
XX
Distribution costs (xx)
Administrative costs (xx)
Finance costs (xx)
Other expenses (xx)
Profit before tax XX
Tax expense (xx)
Profit after tax for the year XX
Other comprehensive income
Gain on property revaluation xx
Forex translation gain or loss xx
Others xx
Other comprehensive income for the year xx
TOTAL COMP. INCOME FOR THE YEAR XX

As a minimum, IAS 1 requires the following line items to be disclosed on the face of the statement of profit
or loss:
i. Revenue

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 ii. Finance costs
iii. Share of profits and losses of associates and joint ventures accounted for using the equity method.
iv. Tax expense
v. A single amount for the total of discontinued operations.
Taxation:
 Taxation affects both the statement of financial position and the statement of profit or loss.
 The charge for income tax on profits for the year is shown as a deduction from profit for the year.
(tax expense)
 In the statements of financial position, tax payable to the Government is generally shown as a
current liability, as it is usually due within 12 months of the year end.
Gains on property revaluation
Gains on property revaluation arise when a property is revalued. The revaluation is recognised in the other
comprehensive income part of the statement of profit or loss and other comprehensive income and shown
in the statement of changes in equity as a movement in the revaluation surplus.

For example, an asset originally cost $10,000 and was revalued to $15,000. The gain on the revaluation is
recognised in the statement of profit or loss and other comprehensive income (in the other comprehensive
income section) and then shown as a movement in the revaluation surplus in the statement of changes in
equity, as shown below.

Statement of profit or loss and other comprehensive income

For the year ended 31 December 20x8 – extract
20X8
$'000
Profit before tax 15
Income tax expense (3)
Profit for the year 12
Other comprehensive income:
Gains on property revaluation 5
Total comprehensive income for the year 17

Statement of changes in equity – extract

Revaluation Retained
surplus earnings Total
$'000 $'000 $'000
Balance at 1.1.X8 – 10 10
Changes in equity for 20X8:
Total comprehensive income for the year* 5 12 17
Balance at 31.12.X8 5 22 27

* The total comprehensive income for the year is split into the gains on revaluation of property, which is
credited to the revaluation surplus, and the profit for the year, which is credited to retained earning

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3. STATEMENT OF CHANGES IN EQUITY

 IAS 1 requires an entity to provide a statement of changes in equity. The statement of changes in
equity shows the movements in the entity's equity for the period.
 The statement of changes in equity simply takes the equity section of the statement of financial
position and shows its movements during the year.
 The format statement of changes in equity is shown below.

XYZ GROUP
STATEMENT OF CHANGES IN EBUITY:
FOR THE YEAR ENDED…………………

Share Share Retained Revaluation General TOTAL

Capital prem. Earnings Reserve Reserves EQUITY
$''000'' $''000'' $''000'' $''000'' $''000''

Opening bal. XX XX XX XX XX
Changes in Equity
Issue of shares xx xx
Share premium xx
Dividends (xx)
(xx)
Profit for the year xx xx
Transfer to general reserves (xx) xx xx
Total comprehensive income xx xx xx
Closing Bal XX XX XX XX XX XX

4. NOTES TO THE FINANCIAL STATEMENTS

Disclosure notes are included in a set of financial statements to give users extra information about the
financial statements.

IAS 1 suggest a certain order for notes to the financial statements:

i. Statement of compliance to IFRSs.
ii. Statement of measurement basis and accounting policies applied.
iii. Supporting information for items presented in each financial statement in the same order as each
line of item and each financial statement.
iv. Other disclosures, e.g:
 Contingent liabilities, commitments and other financial disclosures.
 Non-financial disclosures.

The following disclosure requirements are relevant for this course:

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1. Tangible non-current assets:
i. A reconciliation of the opening and closing amounts at the beginning and end of the period
ii. The measurement bases used for determining the amounts at which depreciable assets are stated,
along with the other accounting policies.
iii. For each class of property, plant and equipment
 Depreciation methods used
 Useful lives or the depreciation rates used
 Total depreciation allocated for the period
 Gross amount of depreciable assets and the related accumulated depreciation at the beginning
and end of the period

iv. For revalued assets:

 Effective date of the revaluation
 Whether an independent valuer was involved
 Carrying amount of each class of depreciated property, plant and equipment revalued.
 Revaluation surplus.
2. Intangible non-current assets:
i. A reconciliation of the carrying amount of intangible assets at the beginning and end of the period.
ii. The accounting policies for intangible assets that have been adopted
iii. For each class of intangible assets (including development costs), disclosure is required of the
following:
 The method of amortisation used
 The useful life of the assets or the amortisation rate used
 The gross carrying amount, the accumulated amortisation and the accumulated impairment
losses as at the beginning and end of the period
 The carrying amount of internally generated intangible assets
 The line item(s) of the statement of profit or loss in which any amortisation of intangible assets
is included.
3. Provisions:
i. Disclosures required in the financial statements for provisions fall into two parts.
ii. Disclosure of details of the change in carrying amount of a provision from the beginning to the end
of the year, including additional provisions made, amounts used and other movements.
iii. For each class of provision, disclosure of the background to the making of the provision and the
uncertainties affecting its outcome, including:
 A brief description of the nature of the provision and the expected timing of any resulting
outflows relating to the provision.
 An indication of the uncertainties about the amount or timing of those outflows and, where
necessary to provide adequate information, the major assumptions made concerning future
events.
 The amount of any expected reimbursement relating to the provision and whether any asset
has been recognised for that expected reimbursement.
4. Contingent liabilities:
Unless remote, disclose for each contingent liability:
i. A brief description of its nature; and where practicable

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 ii. An estimate of the financial effect
iii. An indication of the uncertainties relating to the amount or timing of any outflow
iv. The possibility of any reimbursement
5. Contingent assets:
Where an inflow of economic benefits is probable, an entity should disclose:
i. A brief description of its nature; and where practicable
ii. An estimate of the financial effect
6. Events after the reporting period:
i. The nature of the event
ii. An estimate of its financial effect (or a statement that an estimate cannot be made)

7. Inventory:
The financial statements should disclose the following.
i. Accounting policies adopted in measuring inventories, including the cost formula used.
ii. Total carrying amount of inventories and the carrying amount in classifications appropriate to the
entity.
iii. Carrying amount of inventories carried at net realisable value (NRV)

Example 1:

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TOPIC: IFRS 20 REVENUE FROM CONTRACTS WITH CUSTOMERS:

IFRS 15 is concerned with reporting the nature, amount, timing and uncertainty of revenue and cash flows
resulting from contracts with customers.

Revenue from contracts with customers arises from fairly common transactions:
1. The sale of goods
2. The rendering of services

Generally revenue is recognised when the entity has transferred contro l of goods and services to the buyer.
Control of an asset is described in the standard as ‘the ability to direct the use of, and obtain substantially
all of the remaining benefits from, the asset'.

The five-step approach for revenue recognition:

Revenue from the sale of goods and/or provision of services should be recognised based upon application
of the five-step approach:
1. Identify the contract
2. Identify the separate performance obligations within a contract
3. Determine the transaction price
4. Allocate the transaction price to the performance obligations in the contract
5. Recognise revenue when (or as) a performance obligation is satisfied

Illustration
On 1 December 20X1, Wad Co received an order from a customer for the purchase of a computer plus
technical support for 12 months. Wad Co delivered the computer (and transferred control of the computer)
on 1 December 20X1.
The customer paid a total of $420 immediately, which comprised $300 for the computer and $120 for
technical support. Both the computer and technical support could be purchased separately.
Wad Co has an accounting year end of 31 March 20X2.

Below is how the five steps would be applied to this transaction:

Step 1 – Identify the contract
There is an agreement between Wad Co and its customer for the provision of goods (supply of computer)
and services (twelve months of technical support).
ACCA: FINANCIAL ACCOUNTING: OSHWAL COLLEGE: MR. PRESTON 18
Step 2 – Identify the separate performance obligations within a contract
There are two performance obligations (promises) within the contract:
i. Wad Co has agreed to supply a computer
ii. Wad Co has agreed to the supply of technical support for 12 months

Step 3 – Determine the transaction price

The total transaction price agreed was $420.

Step 4 – Allocate the transaction price to the separate performance obligations in the contract
Based upon the individual sale price of the computer and technical support, $300 should be allocated to the
sale of the computer and $120 should be allocated to the supply of technical support.

Step 5 – Recognise revenue when (or as) a performance obligation is satisfied

Revenue is recognised either at a point in time, or over a period of time.

The performance obligation to sell a computer is a performance obligation that is satisfied at a point in time
– i.e. on 1 December 20X1. Control of the computer was transferred to the customer on 1 December so the
revenue of $300 can be recognised on that date.

The performance obligation to supply technical support is recognised over a period of time – i.e. for 12
months commencing 1 December 20X1.
In the year ended 31 March 20X2, revenue of $40 (4/12 × $120) should be recognised from the provision of
technical support.

As the customer paid $420 immediately, the total recognised as revenue for the year ended 31 March 20X2
is $340 ($300 + $40), leaving deferred income of $80 (included within current liabilities as at 31 March
20X2).

Recognition of revenue – further detail:

Revenue is recognised either at a point in time or over a period of time.

According to IFRS 15, an entity satisfies a performance obligation and recognises revenue over time, if any
one of the following criteria is met:
1. The customer simultaneously receives and consumes the benefits provided by the entity’s
performance of its obligations, or
2. The entity’s performance creates or enhances an asset that the customer controls as the asset is
created or enhanced (for example, work in progress), or
3. The entity’s performance does not create an asset with an alternative use to the entity and the
entity has an enforceable right to payment for performance completed to date.

The following are indicators of the transfer of control:

i. The entity has a present right to payment for the asset
ii. The customer has legal title to the asset

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 iii. The entity has transferred physical possession of the asset
iv. The customer has the significant risks and rewards of ownership of the asset
v. The customer has accepted the asset.

IFRS 15 Disclosure requirements:

i. The accounting policy for revenue recognition should be disclosed.
ii. Significant judgements made to apply the 5-step approach required by IFRS 15 should be
disclosed.
iii. The total amount of revenue recognised, broken down into significant categories should be
disclosed.
Example 2:
During the year ended 30 June 20X4, AMS Co entered into the following transactions:
AMS Co agreed to sell goods to Customer A.
The goods were delivered on 20 June 20X4 at a price of $1,000 plus sales tax of 20%. The cash was
received from Customer A on 31 July 20X4.
AMS Co agreed to sell goods plus a 6-month maintenance agreement to Customer B at a total price of
$1,500. If the goods and maintenance contract were sold separately, they would be sold for $900 and $600
respectively. The goods were supplied on 1 May 20X4, and the maintenance contract commenced on that
day. Customer B paid the total amount due, plus 20% sales tax, on 15 July 20X4.

AMS Co acted as an agent on behalf of another entity to arrange the sale of goods to Customer C. The
goods were delivered to Customer C on 25 June 20X4 at a total price of $600, inclusive of sales tax of
20%. AMS Co is entitled to 10% commission on the sales price as soon as the goods are delivered.
Required:
a) How much revenue can AMS Co recognise in its financial statements for the year ended 30 June
20X4 in relation to the transaction with Customer A?
b) What was the amount included within trade receivables at 30 June 20X4 in relation to the contract
with Customer A?
c) How much revenue can AMS Co recognise in its financial statements for the year ended 30 June
20X4 in relation to the transaction with Customer B?
d) How much revenue can AMS Co recognise in its financial statements for the year ended 30 June
20X4 in relation to the transaction with Customer C?

SOLUTION:

(a) $1,000
Revenue of $1,000 recognised at a point in time when control was transferred on 20 June 20X4.
Remember that revenue excludes sales tax.
(b) $1,200
Remember that trade receivables should include sales tax charged as that is the total amount due from the
customer. This is outstanding as at 30 June 20X4.
(c) $1,100
Revenue of $900 on the supply of goods can be recognised at a point in time when control of the goods
has been transferred i.e. on 1

ACCA: FINANCIAL ACCOUNTING: OSHWAL COLLEGE: MR. PRESTON 20

May 20X4. Revenue on the supply of services should be recognised over a period of time from the date
supply commenced i.e. from 1 May 20X4. By 30 June 20X4, 2/6 × $600 = $200 can be recognised.
Therefore, total revenue recognised by 30 June 20X4 re Customer B is $1,100.

(d) $50
The net sales value of the transaction, excluding sales tax, is 100/120 × $600 = $500. As the goods were
delivered on 25 June 20X4, AMS Co is entitled to commission of 10% × $500 = $50.

END OF TOPIC 20

TOPIC 21: EVENTS AFTER THE REPORTING PERIOD (IAS 10)

AS 10 Events After the Reporting Period defines events after the reporting period as 'those events,
favourable and unfavourable, that occur between the end of the reporting period and the date when the
financial statements are authorised for issue'

Adjusting and non-adjusting events

According to IAS 10, Events After the Reporting Period are classified in to adjusting and non-adjusting
events.

1. ADJUSTING EVENTS
These events provide additional evidence of conditions existing at the reporting date.
For example, any receivables at the reporting date which are subsequently regarded as possibly not being
collectable may help to quantify the allowance for receivables required as at the reporting date.
If a material adjusting event is identified, the financial statements must be amended to reflect the relevant
condition.
Examples of adjusting events
i. The settlement after the reporting date of a court case which confirms a year end obligation.
ii. The receipt of information after the reporting date that indicates that an asset was impaired at the
reporting date.
iii. The bankruptcy of a customer after the reporting date that confirms that a year-end debt is
irrecoverable.
iv. The sale of inventories after the reporting period at a price lower than cost.
v. The determination after the reporting date of the cost of assets purchased or proceeds from assets
sold before the reporting date.
vi. The discovery of fraud or errors showing that the financial statements are incorrect.

2. NON-ADJUSTING EVENTS:
These are events arising after the reporting date but which do not concern conditions existing at the
reporting date.
Such events will not, therefore, have any effect on items in the statement of profit or loss or statement of
financial position.

ACCA: FINANCIAL ACCOUNTING: OSHWAL COLLEGE: MR. PRESTON 21

However, in order to prevent the financial statements from presenting a misleading position, some form of
additional disclosure is required if the events are material, by way of a note to the financial statements
giving details of the event.

Examples of non-adjusting events:

i. Announcing a plan to discontinue an operation.
ii. Major purchases of assets.
iii. The destruction of assets after the reporting date by fire or
iv. Entering into significant commitments or contingent liabilities.
v. Commencing a court case arising out of events after the reporting date.

Disclosure of material, non-adjusting events

According to IAS 10, if a non-adjusting event is identified and it is material, it should be disclosed by way of
a note to the financial statements. The note should describe:
i. The nature of the event
ii. An estimate of the financial effect, or a statement that such an estimate cannot be made.

Example:
Which of the following are adjusting events for Big Co? The accounting year end is 30 June 20X6 and the
financial statements are approved on 18 August 20X6.
1. Sales of year-end inventory on 2 July 20X6 were at less than cost.
2. The issue of new equity shares on 4 July 20X6.
3. A fire in the main warehouse occurred on 8 July 20X6. A small quantity of inventory was destroyed.
4. A major credit customer was declared bankrupt on 10 July 20X6.
5. All of the share capital of a competitor, Teeny Co was acquired on 21 July 20X6.
6. On 1 August 20X6, $500,000 was received in respect of an insurance claim dated 13 February 20X6.

A: 1, 4 and 6
B: 1, 2, 4 and 6
C: 1, 2, 5 and 6
D: 1, 4, 5 and 6

END OF TOPIC 21

ACCA: FINANCIAL ACCOUNTING: OSHWAL COLLEGE: MR. PRESTON 22

TOPIC 22: STATEMENT OF CASHFLOWS – IAS 7
Introduction
We need to know the funds coming into the company and what it has done with the resources. In this case
the Statement of Cash flows is necessary.
It is concerned with examining the reason underlying the rise or fall in cash funds over a period.

Definitions:
Cash:
Cash consists of cash in hand and deposits repayable upon demand, less overdrafts.

Cash equivalents:
Cash equivalents are 'short-term, highly liquid investments that are readily convertible to known amounts of
cash and are subject to an insignificant risk of changes in value'

Cash flows:
Cash flows are 'inflows and outflows of cash and cash equivalents' (IAS 7,para 6)

Items reported in cash flow statements.

1. Cash flows from operating activities.
2. Cash flows from investing activities.
3. Cash flows from financing activities

1. Cash flow from operating activities.

Includes all cash inflows and outflows that are related to the Profit.
They relate to:
 Profits (represented by incomes and expenses)
 Increase in stock
 Decrease in stock
 Decrease in debtors
 Increase in debtors
ACCA: FINANCIAL ACCOUNTING: OSHWAL COLLEGE: MR. PRESTON 23
  Increase in creditors
 Decrease in creditors.
 Taxes paid

2. Cash flow from investing activities

This is movement of cash that is related to acquisition or disposal of Tangible noncurrent assets.
Inflows
 Disposal or sale of PP&E.
 Disposal of investing activities.
 Interest from investments.
Outflows
 Acquisition of PP&E
 Acquisition of Investments
3. Cash flows from financing activities
These represent inflow and outflows that are related to how cash was raised and deployed in financing the
company’s business.
Inflows:
 Cash from owners after issue of equity and securities.
 Cash from creditors in terms of borrowing, mortgages and bond’s
Outflows
Cash paid to:
 Owners for dividends.
 Repayment of borrowed funds
 Finance costs / interest on loan

Usefulness of a cash flow statement

 Provide feedback about cash inflows and outflows to investors, creditors and other investors.
 Required by decision makers to estimate the amounts the company generates for decision making
 Provide useful information on the company’s borrowing patterns and subsequent payments.
 Helps to asses financial strengths of a business.

The drawbacks of a statement of cash flows

i. The statement of cash flows uses historic cash flows (a limitation that can be levied at all
components of the financial statements).
Users of the accounts are particularly interested in the future.
ii. No interpretation of the statement of cash flows is provided within the accounts. Users are required
to draw their own conclusions as to the relevance of the figures contained within it.
iii. Non-cash transactions, e.g. bonus issues of shares and revaluations of assets are not highlighted
in the statement of cash flows (although they are disclosed elsewhere.

FORMAT OF CASH FLOW STATEMENT

There are TWO methods applied:

1. Direct method

ACCA: FINANCIAL ACCOUNTING: OSHWAL COLLEGE: MR. PRESTON 24

2. Indirect method

1. Direct method:
The direct method is no longer recommended by IAS 7.

Net Cash Flow from Operating Activities: $ $

Cash generated from Operations:
Cash receipts from customers xx
Less: Cash paid to suppliers (xx)
(Less: Cash paid to employees (xx)
xx
Less: Interest Paid (xx)
Less: Income Tax Paid (xx) xx / (xx)
Net Cash from/ used in Investing Activities xx/(xx)
Net cash from/used in Financing Activities xx/(xx)
Net change in Cash and Cash Equivalents xx/(xx)
Add: Cash and Cash Equivalents bal. b/d xx
Cash and Cash Equivalents bal. c/d xx

Example 1:

ACCA: FINANCIAL ACCOUNTING: OSHWAL COLLEGE: MR. PRESTON 25

2. Indirect method-
It starts with net income and makes adjustments for expenses and other items that did not entail cash
payment or receipt.
FORMAT OF THE INDIRECT METHOD:

ABC STATEMENT OF CASH FLOWS FOR THE YEAR ENDED ………………..

I: Net cash flows from operating activities:

Profit Before Tax Xx

Adjustments: xx
Finance Costs
Investment Income (xx)

Depreciation charge xx

Impairment loses xx
Amortization of intangible assets xx
Loss/Profit on Disposal of NCA xx

ACCA: FINANCIAL ACCOUNTING: OSHWAL COLLEGE: MR. PRESTON 26

 Working capital changes:
Increase/Decrease in Inventories (xx)/xx
Increase/ Decrease in Receivables (xx)/xx

Increase/ Decrease in Payables xx/(xx)

xx
Tax paid (xx) XX

II: Net cash flows from investing activities:

-Sale of PP&E xx
-Sale for debt equity and securities xx
- Sale of other investments xx
- Interest received xx
-Purchase of PP&E (xx)
- Purchase of investments (xx) XX
III: Financing activities:
-Issue of shares xx
-Issuance of bonds xx
-Acquisition of loans xx
-Shareholders dividend paid (xx)
- Loan repayment (xx)
-Redeemed long term bonds (xx) XX
Net change in cash & cash equivalents XX
Add: cash & cash equivalents balance b/d XX
Cash & cash equivalents balance c/d XX

Example 2:

ACCA: FINANCIAL ACCOUNTING: OSHWAL COLLEGE: MR. PRESTON 27

Required:
Statement of cash flows for the year ended 31 st December 20X7 using the indirect method.
END OF TOPIC 22

TOPIC 23: INTERPRETATION OF FINANCIAL STATEMENTS - RATIO ANALYSIS

Users of financial statements can gain a better understanding of the significance of the information in
financial statements by comparing it with other relevant information.
Interpretation of financial information can be done by ratio analysis.

TYPES OF RATIOS
Ratios provide information through comparison.
Accounting ratios help to summarise and present financial information in a more understandable form.
Broadly speaking, basic ratios can be grouped into five categories.
i. Profitability and return ratios
ii. Liquidity ratios
iii. Efficiency (turnover ratios)

ACCA: FINANCIAL ACCOUNTING: OSHWAL COLLEGE: MR. PRESTON 28

 iv. Debt and gearing ratios

1. PROFITABILITY & RETURN RATIOS:

The ratios measure the ability of the firm to generate profit or return on investments.
They include:
i. Return on capital employed.
ii. Return on Equity
iii. Gross profit margin
iv. Net profit Margin
v. Net Asset turnover ratio

1. Return on capital employed (ROCE)

It states the profit as a percentage of the amount of capital employed. ROCE measures the overall
efficiency of a company in employing the resources available to it.

ROCE = Profit before interest and taxation

Capital employed × 100%

Capital = Shareholders' equity plus long-term liabilities

Employed (or total assets less current liabilities)

2. Return on equity (ROE)

Return on equity (ROE) gives a more restricted view of capital than ROCE, but it is based on the same
principles.
ROE = Profit after tax and preference dividend
Equity shareholder’s funds

3. Gross profit margin

GP Margin = Gross profit
Sales revenue × 100%

Changes in this ratio may be attributable to:

 Selling prices
 Product mix
 Purchase costs
 Production costs
 Inventory valuations.

4. Net profit margin (net profit)

The operating profit margin or net profit margin = PBIT
Sales revenue × 100%

5. Net asset turnover

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It measures management’s efficiency in generating revenue from the net assets at its disposal.
The net asset turnover = Sales revenue
Capital employed (net assets) (TIMES P.A.)
2. LIQUIDITY RATIOS
These ratios assess the liquidity/solvency of a business (i.e. the ability to meet debt obligations).
They are:
1. Current ratio
2. Quick ratio.

i.. Current ratio

The current ratio measures the adequacy of current assets to meet the entity’s short-term liabilities. It
reflects whether the entity is in a position to meet its liabilities as they fall due.

Current ratio/ working capital ratio = Current assets

Current liabilities Ideal ratio here is 2:1
ii. Quick ratio
It is also known as the liquidity and acid test) ratio.

Quick ratio = Current assets - Inventory

Current liabilities Ideal ratio here is 1:1

3. EFFECIENCY RATIOS:
These ratios how efficiently the entity manages its working capital resources.
They include”:
i. Inventory turnover period
ii. Receivables collection period:
iii. Payables payment period:

i. Inventory turnover period

This simply measures how efficiently management uses its inventory to produce and sell goods. An
increasing number of days implies that management are holding onto inventory for longer. This could
indicate lack of demand or poor inventory control.

Inventory turnover period = Inventory

COS × 365 = X days

Alternative:
An alternative is to express the inventory turnover period as a number of times:
i.e Inventory turnover = Cost of sales
Inventory (Times p.a.)

ii. Receivables collection period:

This is normally expressed as a number of days:

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Receivables collection period = Trade receivables
Credit sales × 365 = X days

The ratio shows, on average, how long it takes to collect cash from customers following the sale of goods
on credit.
The collection period should be compared with:
 The stated credit policy
 Previous period figures
 Industry average or competitor.

Increasing accounts receivables collection period is usually a bad sign suggesting lack of proper credit
control which may lead to irrecoverable debts.

iii. Payables payment period:

This is usually expressed in number of days.

Payables payment period = Trade payables
Credit purchases × 365 = X days

This represents the credit period taken by the entity from its suppliers.

The ratio is always compared to previous years:

 A long credit period may be good as it represents a source of free finance.
 A long credit period may indicate that the entity is unable to pay more quickly because of liquidity
problems.

If the credit period is long:

 The entity may develop a poor reputation as a slow payer and may not be able to find new
suppliers
 Existing suppliers may decide to discontinue supplies
 The entity may be losing out on worthwhile cash discounts

4. DEBT AND GEARING RATIOS:

Debt ratios are concerned with how much the company owes in relation to its size, whether it is getting into
heavier debt or improving its situation, and whether its debt burden seems heavy or light.
 When a company is heavily in debt, banks and other potential lenders may be unwilling to advance
further funds.
 When a company is earning only a modest profit before interest and tax, and has a heavy debt
burden, there will be very little profit left over for shareholders after the interest charges have been
paid.
 This might eventually lead to the liquidation of the company.
These are the big reasons why companies should keep their debt burden under control.

ACCA: FINANCIAL ACCOUNTING: OSHWAL COLLEGE: MR. PRESTON 31

These ratios are:
i. Debt ratio:
ii. Gearing ratio:
III. Leverage Ratio:
iv. Interest cover:

i. Debt ratio:
The debt ratio is the ratio of a company's total debts to its total assets.

Debt ratio = Total debts

Total assets x 100

 Assets consist of non-current assets plus current assets.

 Debts consist of all payables, whether they are due within one year or after more than one year.
You can ignore long-term provisions.

ii. Gearing ratio:

 Gearing or leverage is concerned with a company's long-term capital structure.
 It is the proportion of total long-term debt to total capital employed (equity + long term debt)
 Assets must be financed by long-term capital of the company, which is either:
i. Shareholders' equity
ii. Long-term debt

The gearing ratio = Total long-term debt

Shareholders' equity + total long-term debt × 100

III. Leverage Ratio:

Leverage is the term used to describe the converse of gearing, i.e. the proportion of total assets financed
by equity, and which may be called the equity to assets ratio.

Leverage Ratio = Shareholders' equity

Shareholders' equity + total long - term debt × 100%

iv. Interest cover:

The interest cover ratio shows whether a company is earning enough PBIT to pay its interest costs
comfortably, or whether its interest costs are high in relation to the size of its profits, so that a fall in PBIT
would then have a significant effect on profits available for ordinary shareholders.

Interest cover = Profit before interest & Tax

Interest charges

LIMITATIONS OF RATIO ANALYSIS

ACCA: FINANCIAL ACCOUNTING: OSHWAL COLLEGE: MR. PRESTON 32

1. Information problems
 The base information is often out of date, so timeliness of information leads to problems of
interpretation.
 Historical cost information may not be the most appropriate information for the decision for which
the analysis is being undertaken.
 Information in published accounts is generally summarised information and detailed information
may be needed.
 Analysis of accounting information only identifies symptoms, not causes, and is therefore of limited
use.

2. Comparison problems: trend analysis

 Effects of price changes make comparisons difficult unless adjustments are made.
 Impacts of changes in technology on the price of assets, the likely return and the future markets.
 Impacts of a changing environment on the results reflected in the accounting information.
 Potential effects of changes in accounting policies on the reported results.
 Problems associated with establishing a normal base year with which to compare other years.

3. Comparison problems: across companies

 Selection of industry norms and the usefulness of norms based on averages.
 Different firms having different financial and business risk profiles and the impact on analysis.
 Different firms using different accounting policies.
 Impacts of the size of the business and its comparators on risk, structure and returns.
 Impacts of different environments on results, eg different countries or home-based versus
multinational firms.

QUESTION 1:

ACCA: FINANCIAL ACCOUNTING: OSHWAL COLLEGE: MR. PRESTON 33

 Required:

END OF TOPIC 23

ACCA: FINANCIAL ACCOUNTING: OSHWAL COLLEGE: MR. PRESTON 34