CAF5 Financial Accounting and Reporting I - Studytext PDF
CAF5 Financial Accounting and Reporting I - Studytext PDF
CAF5 Financial Accounting and Reporting I - Studytext PDF
FINANCIAL ACCOUNTING
AND REPORTING I
STUDY TEXT
CAF-05
ICAP
Notice
Emile Woolf International has made every effort to ensure that at the time of writing the
contents of this study text are accurate, but neither Emile Woolf International nor its directors
or employees shall be under any liability whatsoever for any inaccurate or misleading
information this work could contain.
ii
C
Contents
Page
Chapter
1
IAS 2: Inventories
27
81
105
135
183
205
Branch accounts
231
281
Index
331
iii
iv
Syllabus objective
and learning outcomes
CERTIFICATE IN ACCOUNTING AND FINANCE
FINANCIAL ACCOUNTING AND REPORTING I
Objective
To provide candidates with an understanding of the fundamentals of accounting theory and
basic financial accounting with particular reference to international pronouncements.
Learning Outcomes
On the successful completion of this paper candidates will be able to:
1
account for simple transactions related to inventories and property, plant and
equipment in accordance with international pronouncements.
understand the nature of revenue and be able to account for the same in
accordance with international pronouncements.
Grid
Weighting
18-22
15-20
25-35
Revenue accounting
12-18
Branch accounts
8-12
8-12
Total
Contents
Level
100
Learning Outcomes
Preparation of components
of financial statements with
adjustments included in the
syllabus
Preparation of statement of
financial position (IAS 1)
Preparation of statement of
comprehensive income (IAS 1)
Preparation of statement of
cash flows (IAS 7)
vi
Contents
Preparation of accounts from
incomplete records
Level
2
Learning Outcomes
LO1.5.1: Understand situations that might
necessitate the preparation of accounts from
incomplete records (stock or assets destroyed,
cash misappropriation or lost, accounting
record destroyed etc.)
LO1.5.2: Understand and apply the following
techniques used in incomplete record
situations:
vii
Contents
Measurement of inventories
(lower of cost or net realizable
value)
Level
2
Learning Outcomes
LO2.3.1: Describe net realizable value (NRV)
LO2.3.2: Explain the situation when the cost of
inventories may not be recoverable
LO2.3.3: Demonstrate the steps in measuring
inventory at lower of cost or NRV
LO2.3.4: Post journal entries for adjustments
in carrying value (excluding reversal of write
downs).
Presentation of inventories in
financial statements
Depreciation - depreciable
amount, depreciation period
and depreciation method
straight-line,
diminishing balance
the units of production
viii
Contents
Level
Learning Outcomes
LO2.7.4: Prepare journal entries and ledger
accounts.
De-recognition
Revenue accounting
Revenue (IAS-18)
sale of goods;
rendering of services
use by others of entity assets yielding
interest, royalties and dividends.
Branch accounts
Branch accounts (excluding
foreign branches)
Introduction to cost of
production
Meaning and scope of cost
accounting
ix
Contents
Analysis of fixed, variable and
semi variable expenses
Level
2
Learning Outcomes
LO5.2.1: Explain using examples the nature
and behaviour of costs
LO5.2.2: Explain using examples fixed,
variable, and semi variable costs.
CHAPTER
IAS 2: Inventories
Contents
1 Inventory
2 Measurement of inventory
3 FIFO and weighted average cost methods
INTRODUCTION
Learning outcomes
To provide candidates with an understanding of the fundamentals of accounting theory and
basic financial accounting with particular reference to international pronouncements.
LO 2
LO2.1.1:
Cost formulas: Understand and analyse the difference between perpetual and
periodic inventory systems.
LO2.1.2:
Cost formulas: Understand and analyse the difference between FIFO and
weighted average cost formulas and use them to estimate the cost of
inventory).
LO2.1.3:
Cost formulas: Account for the application of cost formulas (FIFO/ weighted
average cost) on perpetual and periodic inventory system
LO2.1.4:
LO2.2.1:
LO2.2.2:
Cost of inventories: Identify relevant and irrelevant cost from data provided.
LO2.3.1:
LO2.3.2:
LO2.3.3:
LO2.3.4:
LO224.1:
INVENTORY
Section overview
Definition of inventory
Assets held for sale. For a retailer, these are items that the business sells
its stock-in trade. For a manufacturer, assets held for sale are usually
referred to as finished goods
IAS 2: Inventories sets out the requirements to be followed when accounting for
inventory.
Recording inventory
In order to prepare a statement of comprehensive income it is necessary to be
able to calculate gross profit. This requires the calculation of a cost of sales
figure.
There are two main methods of recording inventory so as to allow the calculation
of cost of sales.
Each method uses a ledger account for inventory but these have different roles.
Year 1
Year 2
Rs.
Rs.
X
X
(X)
(X)
Any loss of inventory is automatically dealt with and does not require a special
accounting treatment. Lost inventory is simply not included in closing inventory
and thus is written off to cost of sales. There might be a need to disclose a loss
as a material item of an unusual nature either on the face of the incomes
statement or in the notes to the accounts if it arose in unusual circumstances
Example:
Faisalabad Trading had opening inventory of Rs. 10,000.
Purchases during the year were Rs. 30,000.
During the year inventory at a cost of Rs. 28,000 was transferred to cost of sales.
Closing inventory at the end of Year 2 was Rs. 12,000.
The following entries are necessary during the period.
Inventory account
Balance b/d
Cash or creditors
(purchases in the year)
Rs.
10,000 Cost of sales
30,000
Closing balance c/d
Rs.
28,000
40,000
12,000
12,000
40,000
Rs.
100,000
Rs.
Returns to supplier
500,000
15,000
20,000 Cost of goods sold
Normal loss
Closing balance c/d
635,000
112,000
18,000
500,000
5,000
112,000
635,000
Inventory cards
The receipts and issues of inventory are normally recorded on an inventory
ledger card (bin card). In modern systems the card might be a computer record.
Example: Inventory ledger card
On 1 January a company had an opening inventory of 100 units.
During the month it made the following purchases:
5 April: 300 units
14 July: 500 units
22 October: 200 units
During the period it sold 800 units as follows:
9 May: 200 units
25 July: 200 units
23 November: 200 units
12 December: 200 units
Each of these can be shown on an inventory ledger card as follows:
Date
1 January b/f
5 April (purchase)
Receipts
(units)
Units
100
300
9 May (issue)
14 July (purchase)
Issues
(units)
Units
200
Balance
(units)
Units
100
300
400
(200)
200
500
500
700
25 July (issue)
22 Oct (purchase)
200
(200)
500
200
200
23 November (issue)
12 December (issue)
1,100
200
700
(200)
200
500
(200)
800
300
Inventory ledger cards also usually record cost information. This is covered in
section 3 of this chapter.
Perpetual inventory
method
Opening inventory
Closing inventory as
measured and
recognised brought
forward from last period
Purchase of inventory
Dr Purchases
Dr Inventory
Entry
Cr Payables/cash
Freight paid
Dr Carriage inwards
Cr Payables/cash
Return of inventory to
supplier
Dr Payables
Sale of inventory
Dr Receivables
Cr Payables/cash
Dr Inventory
Cr Payables/cash
Dr Payables
Cr Purchase returns
Cr Inventory
Dr Receivables
Cr Sales
Cr Sales
and
Dr Cost of goods sold
Cr Inventory
Return of goods by a
supplier
Dr Sales returns
Cr Receivables
Dr Sales returns
Cr Receivables
and
Dr Inventory
Cr Cost of goods sold
Normal loss
No double entry
Abnormal loss
Closing inventory
Dr Abnormal loss
Dr Abnormal loss
Cr Purchases
Cr Inventory
Dr Inventory (statement
of financial position)
Cr Cost of sales (cost
of goods sold)
Theft of inventory.
2,800,000
96,000
(136,000)
2,760,000
The accounting policy adopted for measuring inventories, including the cost
measurement method used.
MEASUREMENT OF INVENTORY
Section overview
Introduction
Cost of inventories
2.1 Introduction
The measurement of inventory can be extremely important for financial reporting,
because the measurements affect both the cost of sales (and profit) and also
total asset values in the statement of financial position.
There are several aspects of inventory measurement to consider:
cost, or
plus transport, handling and other costs directly attributable to the purchase
(carriage inwards), if these costs are additional to the purchase price.
The purchase price excludes any settlement discounts, and is the cost after
deduction of trade discount.
10
1,140,000
60,000
5,000
Delivery cost
Cost of inventory
1,205,000
other costs incurred in bringing the inventories to their present location and
condition.
You may not have studied cost and management accounting yet but you need to
be aware of some of the costs that are included in production overheads (also
known as factory overheads). Production overheads include:
costs of indirect labour, including the salaries of the factory manager and
factory supervisors
costs of carriage inwards, if these are not included in the purchase costs of
the materials
11
Note that the process of allocating costs to units of production is usually called
absorption. This is usually done by linking the total production overhead to some
production variable, for example, time, wages, materials or simply the number of
units expected to be made.
Example: Conversion costs
Kasur Consumer Electrics (KCE) manufactures control units for air conditioning
systems.
The following information is relevant:
Each control unit requires the following:
1 component X at a cost of Rs 1,205 each
1 component Y at a cost of Rs 800 each
Sundry raw materials at a cost of Rs. 150.
The company faces the following monthly expenses:
Rs.
Factory rent
16,500
Energy cost
7,500
10,000
Each unit takes two hours to assemble. Production workers are paid Rs.
300 per hour.
Production overheads are absorbed into units of production using an
hourly rate. The normal level of production per month is 1,000 hours.
The cost of a single control unit is as follows:
Materials:
Rs.
Component X
1,205
Component Y
800
150
2,155
600
2 hours
48
2,803
The selling and administrative costs are not part of the cost of inventory
12
Flow of information
Production overhead is recognised in an expense account in the usual way.
Production overhead is then transferred from this account to an inventory
account (perhaps via a work-in-progress account) as units are produced.
Illustration: Production overhead double entry
Debit
Production overhead
Cash/payables
Credit
X
X
Production overhead
Inventory
Being the transfer of inventory cost to cost of sales
13
Rs.
Other costs
Fixed production overhead
126
(Rs. 1,000,000/100,000 units)
Unit cost
10
136
Note:
Rs.
750,000
1,000,000
250,000
The Rs. 250,000 that has not been included in inventory is expensed (i.e.
recognised in the statement of comprehensive income).
14
This may seem a little pointless at first sight. After all the cost incurred of Rs.
1,000 is the same as the cost recognised in the statement of profit or loss (Rs.
750 + Rs. 250). However, the Rs. 250 in the statement of profit or loss is
expensed. In other words, it is not part of the cost of inventory.
Example: Normal production capacity (under absorption)
A business plans for fixed production overheads of Rs. 1,000,000 per annum.
The normal level of production is 100,000 units per annum but due to supply
difficulties the business was only able to make 75,000 units in the current year.
Other costs per unit were Rs. 126.
The company sold 50,000 of the units leaving a closing inventory of 25,000 units
at the year-end.
The cost per unit is:
Rs.
Other costs
126
10
Unit cost
136
Rs.
10,200,000
250,000
10,450,000
(3,400,000)
7,050,000
Rs.
6,800,000
250,000
7,050,000
15
The above example considers the situation where the fixed production incurred in
the period is more than that absorbed (under-absorption). The opposite could
also be true.
Example: Normal production capacity (over-absorption)
A business plans for fixed production overheads of Rs. 1,000,000 per annum.
The normal level of production is 100,000 units per annum.
The business made 110,000 units in the current year.
Other costs per unit were Rs. 126.
The company sold 90,000 units in the period (leaving 20,000 units in inventory at
the year-end).
The cost per unit is:
Rs.
Other costs
Fixed production overhead (Rs. 1,000,000/100,000 units)
126
10
Unit cost
136
Note:
Rs.
1,100,000
1,000,000
100,000
The extra Rs. 100,000 that has been included in inventory is credited to
the statement of comprehensive income.
The cost of sales would be as follows:
Rs.
14,960,000
(100,000)
14,860,000
(2,720,000)
12,140,000
Rs.
12,240,000
100,000
12,140,000
16
The cost and net realisable value should be compared for each separatelyidentifiable item of inventory, or group of similar inventories, rather than for
inventory in total.
Example:
A business has four items of inventory. A count of the inventory has established
that the amounts of inventory currently held, at cost, are as follows:
Inventory item A1
Inventory item A2
Inventory item B1
Inventory item C1
Rs.
Cost
8,000
14,000
16,000
6,000
Sales price
7,800
18,000
17,000
7,500
Selling costs
500
200
200
150
Lower of:
8,000 or (7,800 500)
14,000 or (18,000 200)
16,000 or (17,800 500)
6,000 or (7,000 200)
Rs.
7,300
14,000
16,000
6,000
43,300
Net realisable value might be lower than cost so that the cost of inventories may
not be recoverable in the following circumstances:
17
Credit
Inventory
18
Credit
X
X
Cost formulas
Profit impact
Illustration
On 1 January a company had an opening inventory of 100 units which cost Rs.50
each.
During the month it made the following purchases:
5 April: 300 units at Rs. 60 each
14 July: 500 units at Rs. 70 each
22 October: 200 units at Rs. 80 each.
During the period it sold 800 units as follows:
9 May: 200 units
25 July: 200 units
23 November: 200 units
12 December: 200 units
This means that it has 300 units left (100 + 300 + 500 + 200 (200 + 200 +
200 + 200 + 200)) but what did they cost?
FIFO and AVCO are two techniques that provide an answer to this question.
Note:
First in, first out (FIFO) tends to be used in periodic inventory systems but
may be used in perpetual inventory systems also.
19
the date that units of inventory are received into inventory, the number of
units received and their purchase price (or manufacturing cost)
the date that units are issued from inventory and the number of units
issued.
With this information, it is possible to put a cost to the inventory that is issued
(sold or used) and to identify the cost of the items still remaining in inventory.
Since it is assumed that the first items received into inventory are the first units
that are used, it follows that the value of inventory at any time should be the cost
of the most recently-acquired units of inventory.
Example: FIFO (returning to the previous example)
On 1 January a company had an opening inventory of 100 units which cost Rs.50
each.
During the month it made the following purchases:
5 April: 300 units at Rs. 60 each (= Rs. 18,000)
14 July: 500 units at Rs. 70 each (= Rs. 35,000)
22 October: 200 units at Rs. 80 each (= Rs. 16,000)
During the period it sold 800 units as follows:
9 May: 200 units
25 July: 200 units
23 November: 200 units
12 December: 200 units
The cost of each material issue from store in October and the closing inventory
using the FIFO measurement method is as follows:
FIFO measures inventory as if the first inventory sold is always the first inventory
purchased.
Consider the flow of units:
Bf
5
14
22
April
July
October
(units)
(units)
(units)
(units)
Purchased
100
300
500
200
Issues on:
9 May (200)
(100)
25 Jul (200)
(100)
(200)
23 Nov (200)
(200)
12 Dec (200)
(200)
Closing inventory
20
100
200
Cost of issue
Rs.
5,000
6,000
11,000
Issues on 25 July
200 units purchased on 5 April
Cost of issue
12,000
12,000
Issues on 23 November
70
14,000
Cost of issue
14,000
Issues on 12 December
70
14,000
Cost of issue
14,000
Closing inventory
70
7,000
80
16,000
23,000
This looks more complicated than it needs to be. This is because the cost of each
individual issue has been calculated. However, usually we would not be
interested in the cost of individual issues so much as the overall cost of sale and
closing inventory. When this is the case the calculations become much easier.
This is because the total costs of buying the inventory are known so only the
closing inventory has to be measured. This is done assuming that it is from the
most recent purchases (because FIFO assumes that the inventory bought earlier
has been sold).
Example (continued): Measuring closing inventory only
Rs.
5,000
69,000
74,000
Value of closing inventory (31 December)
(200 purchased on 22 October @ Rs.80)
(100 purchased on 14 July @ Rs.70)
16,000
7,000
(23,000)
21
51,000
Receipts
Issues
Date
Qty
Rs.
1 Jan
b/f
100
50
5 Apr
300
60
Qty
Rs.
5,000
100
50
5,000
18,000
300
60
18,000
400
50/60
23,000
9 May
14 Jul
500
70
Qty
100
50
5,000
100
50
5,000
100
60
6,000
100
60
6,000
200
50/60
11,000
(200)
50/60
(11,000)
200
60
12,000
500
70
35,000
700
60/70
47,000
(200)
60
12,000
500
70
35,000
200
80
16,000
700
70/80
51,000
(200)
70
(14,000)
500
70/80
37,000
14,000
(200)
70
(14,000)
51,000
300
70/80
23,000
200
200
80
200
12 Dec
200
Note:
1,100
74,000
minus
800
800
74,000
60
12,000
16,000
23 Nov
1,100
Rs.
35,000
25 Jul
22 Oct
Balance
minus
22
70
70
14,000
equals
51,000
300
equals
23,000
Items currently in store are the items in store immediately before the new
delivery is received.
Example: FIFO (returning to the previous example)
On 1 January a company had an opening inventory of 100 units which cost Rs.50
each.
During the month it made the following purchases:
5 April: 300 units at Rs. 60 each (= Rs. 18,000)
14 July: 500 units at Rs. 70 each (= Rs. 35,000)
22 October: 200 units at Rs. 80 each (= Rs. 16,000)
During the period it sold 800 units as follows:
9 May: 200 units
25 July: 200 units
23 November: 200 units
12 December: 200 units
Required
(a)
What was the cost of the material issued from store in the year, using the
weighted average cost (AVCO) measurement method?
(b)
23
The weighted average method calculates a new average cost per unit after each
purchase. This is then used to measure the cost of all issues up until the next
purchase.
This can be shown using an inventory ledger card as follows.
Example: Inventory ledger card (weighted average method)
Receipts
Issues
Date
Qty
Rs.
1 Jan
b/f
100
50
5 Apr
300
60
Qty
Rs.
5,000
100
50
5,000
18,000
300
60
18,000
9 May
Qty
200
14 Jul
500
70
200
200
80
57.5
400
57.5
23,000
(200)
57.5
(11,500)
200
57.5
11,500
500
70
35,000
700
66.43
46,500
(200)
66.43
(13,286)
500
66.43
33,214
200
80
16,000
700
70.31
49,214
(200)
70.31
(14,062)
500
70.31
35,152
14,062
(200)
70.31
(14,062)
52,910
300
70/80
21,090
11,500
66.43
13,286
16,000
23 Nov
200
12 Dec
200
1,100
Rs.
35,000
25 Jul
22 Oct
Balance
74,000
70.31
70.31
800
14,062
Figures in bold have been calculated as an average cost at the date of a purchase.
Note:
1,100
minus
800
74,000
minus
equals
52,910
300
equals
21,090
Summary
Rs.
5,000
69,000
74,000
Value of closing inventory, 31 October (see above)
(21,090)
24
52,910
5,000
5,000
Purchases
69,000
69,000
74,000
74,000
Closing inventory:
FIFO
(23,000)
AVCO
(21,090)
Cost of sales
(51,000)
49,000
Gross profit
(52,910)
47,810
25
26
CHAPTER
27
INTRODUCTION
Learning outcomes
To provide candidates with an understanding of the fundamentals of accounting theory and
basic financial accounting with particular reference to international pronouncements.
LO 2
LO2.5.1:
LO2.5.2:
LO2.6.1:
LO2.7.1:
LO2.7.2:
LO2.7.3:
Depreciation: Compute depreciation for assets carried under the cost and
revaluation models using information provided including impairment.
LO2.7.4:
LO2.8.1:
LO2.8.2:
28
Introduction
Initial measurement
Exchange transactions
Subsequent expenditure
Components of cost
1.1 Introduction
Rules on accounting for property, plant and equipment are contained in IAS 16
Property, plant and equipment.
Definitions
Property, plant and equipment are 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
its purchase price after any trade discount has been deducted, plus any
import taxes or non-refundable sales tax; plus
the directly attributable costs of bringing the asset to the location and
condition necessary for it to be capable of operating in the manner intended
by management (IAS 16 Property, plant and machinery). These directly
attributable costs may include:
testing costs
29
When the entity has an obligation to dismantle and remove the asset at the
end of its life, its initial cost should also include an estimate of the costs of
dismantling and removing the asset and restoring the site where it is
located.
The cost of a non-current asset cannot include any administration costs or other
general overhead costs.
Example: Cost
A company has purchased a large item of plant.
The following costs were incurred.
List price of the machine
1,000,000
50,000
Delivery cost
Installation cost
100,000
125,000
200,000
Architects fees
15,000
Administration expense
150,000
125,000
200,000
Architects fees
Decommissioning cost
15,000
250,000
1,640,000
The definition of cost for property, plant and equipment has close similarities
with the cost of inventories, although property, plant and equipment will often
include more items of other expense within cost.
For example when a business entity acquires a new building the cost of the
building might include professional fees such as the fees for an architect and
surveyor.
Costs are no longer recognised when the item is ready for use. This is when it is
in the location and condition necessary for it to be capable of operating in the
manner intended by management.
30
the fair value of neither the asset received nor the asset given up is reliably
measurable.
If the new asset is measured at fair value, the fair value of the asset given up is
used to measure the cost of the asset received unless the fair value of the asset
received is more clearly evident.
If the new asset is not measured at fair value, its cost is measured at the carrying
amount of the asset given in exchange for it. This would be the case when the
exchange lacked commercial substance or when the fair value of either asset
cannot be measured.
Lack of commercial substance
The determination of whether an exchange transaction has commercial
substance depends on the extent to which future cash flows are expected to
change as a result of the transaction. If there is minimal impact on future cash
flows then the exchange lacks commercial substance.
is for a replacement part (provided that the part that it replaces is treated as
an item that has been disposed of).
31
2,000
3 years
Airframe
1,500
10 years
Fuselage
1,500
20 years
500
5 years
Fittings
5,500
Cost model - Property, plant and equipment is carried at cost less any
accumulated depreciation and any accumulated impairment losses.
The above choice must be applied consistently. A business cannot carry one
item of property, plant & equipment at cost and revalue a similar item. However, a
business can use different models for different classes of property, plant &
equipment. For example, companies might use the cost model for plant and
equipment but use the revaluation model for property.
This chapter proceeds to explain the depreciation which is an important
component of both models before continuing to explain the revaluation model in
more detail.
32
Depreciation
Impairment
2.1 Depreciation
A business invests in assets in order to generate profit.
The accruals concept results in the recognition of revenue and the cost of
earning that revenue in the statement of comprehensive income in the same
accounting period.
Depreciation is an expense that matches the cost of a non-current asset to the
benefit earned from its ownership. It is calculated so that a business recognises
the full cost associated with a non-current asset over the entire period that the
asset is used. In effect, the cost of the asset is transferred to the statement of
comprehensive income over the life of the asset. This may be several years.
Depreciation is a method of spreading the cost of a non-current asset over its
expected useful life (economic life), so that an appropriate portion of the cost is
charged in each accounting period.
Definitions (from IAS 16)
Depreciation: The systematic allocation of the depreciable amount of an asset over
its useful life.
Depreciable amount: The cost of an asset (or its revalued amount, in cases where a
non-current asset is revalued during its life) less its residual value.
Residual value:The expected disposal value of the asset (after deducting disposal
costs) at the end of its expected useful life.
Useful life: The period over which the asset is expected to be used by the business
entity.
Carrying amount: The amount at which an asset is recognised after deducting any
accumulated depreciation and accumulated impairment losses. (Net book value
(NBV) is a term that is often used instead of carrying amount).
Example: Depreciation
An item of equipment cost Rs. 300,000 and has a residual value of Rs. 50,000 at
the end of its expected useful life of four years.
Depreciation is a way of allocating the depreciable amount of Rs. 250,000 (= Rs.
300,000 - Rs. 50,000) over the four years of the assets expected life.
33
Commencement of depreciation
Depreciation of an asset begins when that asset is available for use. This means
when the asset is in the location and condition necessary for it to be capable of
operating in the manner intended by management.
This might be before the asset is actually used.
Residual value
In practice, the residual value of an asset is often insignificant and therefore
immaterial in the calculation of the depreciable amount.
However, in some cases, the residual value may be equal to or greater than the
asset's carrying amount. In this case the depreciation charge would be zero.
34
Credit
X
X
35
(X)
Accounts in the ledger for property, plant and equipment and accumulated
depreciation
There are separate accounts in the general ledger for each category of property,
plant and equipment (for example, an account for land and buildings, an account
for plant and machinery, an account for office equipment, an account for motor
vehicles, and so on) and the accumulated depreciation for each of these
categories of property, plant and equipment.
This means that each category of property, plant and equipment can be shown
separately in the financial statements.
Example: Accounting for depreciation
A company purchases a non-current asset in Year 1 for Rs. 90,000.
In Year 1, the depreciation charge is Rs. 15,000.
These transactions should be recorded as follows:
Asset account
Year 1
Cash/creditors
Rs.
90,000 Balance c/f
90,000
Year 2
Balance b/f
Rs.
90,000
90,000
90,000
Accumulated depreciation account
Year 1
Balance c/f
Rs.
15,000 Depreciation account
15,000
Rs.
15,000
15,000
Balance b/f
15,000
Year 2
Depreciation account
Year 1
Accumulated depreciation
Rs.
15,000 Statement of
comprehensive income
15,000
Rs.
15,000
15,000
At the end of Year 1, the carrying amount of the asset in the statement of
financial position is:
Non-current asset at cost (or valuation)
Less: Accumulated depreciation
Carrying amount
Rs.
90,000
(15,000)
75,000
36
Example continued:
The depreciation charge In Year 2 is also Rs. 15,000.
The ledger accounts in Year 2 will be as follows:
Asset account
Year 2
Balance b/f
Rs.
90,000 Balance c/f
90,000
Year 3
Balance b/f
Rs.
90,000
90,000
90,000
Accumulated depreciation account
Year 2
Balance c/f
Rs.
Balance b/f
30,000 Depreciation account
30,000
Rs.
15,000
15,000
30,000
Balance b/f
30,000
Year 3
Depreciation account
Year 2
Accumulated depreciation
Rs.
15,000 Statement of
comprehensive income
Rs.
15,000
At the end of Year 2, the carrying amount of the asset in the statement of
financial position is:
Non-current asset at cost (or valuation)
Less: Accumulated depreciation
Rs.
90,000
(30,000)
Carrying amount
60,000
Practice question
An item of equipment cost Rs. 40,000 at the beginning of Year 1. It has an
expected life of 5 years.
The annual depreciation charge is Rs. 8,000.
Complete the following ledger accounts for Years 1 and 2 and calculate the
carrying amount of the asset at the end of each period.
a
b
c
equipment account
accumulated depreciation of equipment account
depreciation of equipment account
37
2.3 Reviews of the remaining useful life and expected residual value
Review of useful Life
IAS 16 requires useful lives and residual values to be reviewed at each year-end.
Any change is a change in accounting estimate. The carrying amount (cost minus
accumulated depreciation) of the asset at the date of change is written off over
the (revised) remaining useful life of the asset.
Example:
Chiniot Engineering owns a machine which originally cost Rs. 60,000 on 1
January 2010.
The machine was being depreciated over its useful life of 10 years on a straightline basis and has no residual value.
On 31 December 2013 Chiniot Engineering revised the total useful life for the
machine to eight years (down from the previous 10).
Required
Calculate the depreciation charge for 2013 and subsequent years.
Answer
The change in accounting estimate is made at the end of 2013 but may be
applied to the financial statements from 2013 onwards.
Cost on 1 January 2010
Depreciation for 2010 to 2012 (60,000 3/10)
Carrying amount at end of 2012
Rs.
60,000
(18,000)
42,000
38
Practice question
A machine was purchased three years ago on 1 January Year 2. It cost
Rs.150,000 and its expected life was 10 years with an expected residual
value of Rs.30,000.
Due to technological changes, the estimated life of the asset was reassessed during Year 5. The total useful life of the asset is now expected to
be 7 years and the machine is now considered to have no residual value.
The financial year of the entity ends on 31 December.
What is the depreciation charge for the year ending 31 December Year 5?
2.4 Impairment
Both the cost model and the revaluation model refer to impairment losses.
IAS 36 Impairment of assets contains detailed guidance on impairment.
Definition
Impairment loss: The amount by which the carrying amount of an asset (or a cashgenerating unit) exceeds its recoverable amount.
An impairment loss is a write down in the value of an asset to its recoverable
amount. IAS 36 operates to ensure that assets are carried in the financial
statements at no more than their recoverable amount. (This is very similar to the
rule that requires inventory to be measured at the lower of cost and net realisable
value).
The recoverable amount of an asset is defined as the higher of its:
Fair value less costs to sell (the amount that would be received for the
asset in an orderly transaction between market participants less costs of
selling it); and
Value in use (the present value of future cash flows from using an asset,
including its eventual disposal).
You will not be asked to compute these figures in the exam but you might be
given the two amounts and be expected to identify the recoverable amount and
account for any impairment loss.
Example: Impairment
The following information relates to 3 assets.
Asset 1
Carrying amount
80,000
Asset 2
120,000
Asset 3
140,000
Value in use
150,000
105,000
107,000
60,000
90,000
110,000
Recoverable amount
150,000
105,000
110,000
nil
15,000
30,000
Impairment loss
39
Approach
Impairment of an asset should be identified and accounted for as follows.
If there are such indications, the business should estimate the assets
recoverable amount.
When the recoverable amount is less than the carrying amount of the
asset, the carrying amount should be written down to this amount. The
amount by which the value of the asset is written down is an impairment
loss.
40
Introduction
Straight-line method
3.1 Introduction
The depreciation method used should reflect the way in which the economic
benefits of the asset are consumed by the business over time.
The main choice is between the straight line method and the reducing balance
method (also known as the diminishing balance method).
The reducing balance method is often chosen for assets such as vehicles which
lose greater amounts of value in their early years. The reducing balance method
reflects this with larger depreciation charges in earlier years.
With the straight-line method, the annual depreciation charge is the same for
each full financial year over the life of the asset (unless the asset is subsequently
re-valued during its life).
This is the most common method in practice, and the easiest to calculate.
Example: Straight line depreciation
A machine cost Rs. 250,000. It has an expected economic life of five years and an
expected sale value of Rs. 50,000 at the end of that time.
Annual depreciation is:
Depreciation charge
250,000 50,000
5 years
41
250,000
5 years
12
Rs. 16,667
42
1
Useful life
100
Carrying amount at
the start of the year
Fixed %
The annual depreciation charge is highest in Year 1 and lowest in the final year
of the assets economic life.
Example: Reducing balance method
A machine cost Rs. 100,000 on the first day of an accounting period. It has an
expected life of five years, and it is to be depreciated by the reducing balance
method at the rate of 30% each year.
Annual depreciation and carrying amount over the life of the asset will be as
follows.
Year
Carrying amount
at start of year
Annual depreciation
charge (at (30% of
the reducing balance)
Carrying amount
at end of year
Rs.
100,000
Rs.
30,000
Rs.
70,000
70,000
21,000
49,000
49,000
14,700
34,300
34,300
10,290
24,010
100,000 30%
30,000
30,000 70%
21,000
21,000 70%
14,700
14,700 70%
10,290
This is a useful short cut but be careful because it only works if the
previous years depreciation was for the whole year.
43
Year
Carrying
amount at
start
Annual
depreciation
charge
Carrying
amount at
end
Rs.
Rs.
Rs.
100,000
30% 3/12
7,500
92,500
92,500
30%
27,750
64,750
64,750
30%
19,425
45,325
45,325
30%
13,598
31,727
Note that the depreciation in the year after the first full years depreciation
(year 2) can be calculated by multiplying the previous years charge by (1
the reducing balance percentage).
3
27,750 70%
19,425
19,425 70%
13,598
44
Where:
x = The reducing balance percentage
n = Expected useful life.
Rs.
10,000
Rs.
2,750
Rs.
7,250
7,250
1,994
5,256
5,256
1,445
3,811
3,811
1,048
2,763
2,763
763
2,000
45
Number of units
produced in period
46
Answer
The change in accounting estimate is made at the end of 2013, but is applied to
the financial statements from 1 January 2013. The reducing balance method of
depreciation is applied to the 2013 statements.
Cost on 1 January 2010
Depreciation for 2010 to 2012 (30,000 3/10)
Carrying amount at end of 2012
Rs.
30,000
(9,000)
21,000
Depreciation for 2013 will therefore be Rs. 21,000 25% = Rs. 5,250.
Practice questions
1
47
For example, a companys policy might be to value all its motor vehicles at cost,
but to apply the revaluation model to all its land and buildings.
Revaluation model Issues
The following accounting issues have to be addressed when using the
revaluation model:
What happens to the other side of the entry when the carrying amount of an
asset is changed as a result of a revaluation adjustment? An asset value
may increase or decrease. What happens in each case?
How is the carrying amount of the asset being revalued changed?. The
carrying amount is located in two accounts (cost and accumulated
depreciation) and it is the net amount that must be changed so how is this
done?
48
Land
Other
compreh
ensive
income
statement
of
comprehens
ive income
At start
Adjustment
100
30
30 Cr
31/12/13
130
30 Cr
Double entry:
Debit
30
Land
Revaluation surplus
Credit
30
130
30
49
Land
At start
Adjustment
100
(10)
31/12/13
90
Other
compreh
ensive
income
statement
of
comprehens
ive income
10Dr
Double entry:
Statement of comprehensive income
Land
Debit
10
Credit
10
Complication
An asset might be carried at an amount lower than its original cost as a result of
being revalued downwards. If the asset is later revalued upwards, the revaluation
increase is recognised in the statement of comprehensive income to the extent of
the previously recognised expense. That part of any increase above the
previously recognised expense is recognised in other comprehensive income in
the usual way.
Similarly, an asset might be carried at an amount higher than its original cost as a
result of being revalued upwards. If the asset is later revalued downwards, the
revaluation decrease is recognised in other comprehensive income to the extent
of the previously recognised surplus. That part of any decrease above the
previously recognised surplus is recognised in the statement of comprehensive
income the usual way.
50
Rs.
100
Valuation as at:
31 December 2013
31 December 2014
130
110
31 December 2015
31 December 2016
95
116
Debit
30
Credit
30
As at 31 December 2014
Other comprehensive income
Debit
20
Credit
20
Debit
10
5
Credit
15
Debit
21
Credit
5
16
51
Land
Other
compreh
ensive
income
At start
Double entry
100
30
30 Cr
31/12/13
130
b/f
130
Adjustment
(20)
20Dr
31/12/14
110
b/f
Adjustment
110
(15)
10Dr
5Dr
31/12/15
95
b/f
Adjustment
95
21
16Cr
5Cr
31/12/16
116
Statement of
comprehensive
income
Step 2: Change the balance on the asset account to the revalued amount.
52
Example:
A building owned by a company is carried at Rs.8,900,000 (Cost of Rs, 9m less
accumulated depreciation of Rs.100,000. The companys policy is to apply the
revaluation model to all its land and buildings.
A current valuation of this building is now Rs.9.6 million.
Step 1
Rs. (000)
Accumulated depreciation
Rs. (000)
100
Asset
100
Step 2
Asset (Rs.9.6 Rs.8.9m)
700
700
600
Accumulated depreciation
100
700
Example:
An office building was purchased four years ago for Rs.3 million.
The building has been depreciated by Rs.100,000.
It is now re-valued to Rs.4 million. Show the book-keeping entries to record the
revaluation.
Answer
Building account
Opening balance b/f
Revaluation account
Opening balance b/f
Rs.
3,000,000 Accumulated
depreciation
1,100,000 Closing balance c/f
4,100,000
4,000,000
Rs.
100,000
4,000,000
4,100,000
Rs.
100,000 Opening balance b/f
Rs.
100,000
Revaluation surplus
Rs.
Revaluation account
Rs.
1,100,000
53
Practice question
A company owns a building which was purchased three years ago for Rs.1
million. The building has been depreciated by Rs.60,000.
It is now to be re-valued to Rs.2 million. Show the book-keeping entries to
record the revaluation.
(b)
(c)
Answer
Annual depreciation originally (for Years 1 3)
= Rs.(100,000 10,000)/6 years = Rs.15,000.
Cost
Rs.
100,000
(45,000)
55,000
120,000
65,000
54
Rs.
120,000
(35,000)
85,000
Each year a business might make a transfer from the revaluation surplus to the
retained profits equal to the amount of the excess depreciation.
Illustration:
Debit
Revaluation surplus
Credit
Retained earnings
55
Example:
An asset was purchased two years ago at the beginning of Year 1 for Rs.600,000.
It had an expected life of 10 years and nil residual value.
Annual depreciation is Rs.60,000 (= Rs.600,000/10 years) in the first two years.
At the end of Year 2 the carrying value of the asset -Rs.480,000.
After two years it is re-valued to Rs.640,000.
Double entry: Revaluation
Debit
40
Credit
120
160
Each year the business is allowed to make a transfer between the revaluation
surplus and retained profits:
Double entry: Transfer
Debit
20
Credit
20
56
by sale, or
Disposal can occur at any time, and need not be at the end of the assets
expected useful life.
The effect of a disposal on the statement of financial position (or accounting
equation) is that:
The carrying amount of the asset is therefore removed from the accounting
equation.
There is a gain or loss on disposal of the asset, as follows:
Illustration: Gain or loss on disposal
Sale proceeds on disposal
Rs.
X
(X)
Asset at cost
Less: Accumulated depreciation
X
(X)
(X)
57
Example:
A non-current asset originally cost Rs.75,000. Accumulated depreciation is
Rs.51,000.
The asset is now sold for Rs.18,000. Disposal costs are Rs.500.
What is the gain or loss on disposal?
Answer
Gain or loss on disposal
Sale proceeds on disposal
Less Disposal costs
Net disposal value
Asset at cost
Less: Accumulated depreciation
Carrying amount at date of disposal
Loss on disposal
Rs.
Rs.
18,000
(500)
17,500
75,000
(51,000)
(24,000)
(6,500)
Practice question
A non-current asset cost Rs.96,000 and was purchased on 1 June Year 1.
Its expected useful life was five years and its expected residual value was
Rs.16,000. The asset is depreciated by the straight-line method.
The asset was sold on 1 September Year 3 for Rs.68,000. There were no
disposal costs.
It is the company policy to charge depreciation on a monthly basis.
The financial year runs from 1 January to 31 December.
What was the gain or loss on disposal?
Practice question
A non-current asset was purchased on 1 June Year 1 for Rs.216,000. Its
expected life was 8 years and its expected residual value was Rs.24,000.
The asset is depreciated by the straight-line method. The financial year is
from 1 January to 31 December.
The asset was sold on 1 September Year 4 for Rs.163,000. Disposal costs
were Rs.1,000.
It is the company policy to charge a proportionate amount of depreciation
in the year of acquisition and in the year of disposal, in accordance with the
number of months for which the asset was held.
What was the gain or loss on disposal?
58
Credit
X
X
Disposal account
Credit
Credit
X
X
Step 5: The balance on the disposal account is the gain or loss on disposal. This
is transferred to the statement of comprehensive income.
59
Example:
A non-current asset cost Rs.82,000 when purchased. It was sold for Rs.53,000
when the accumulated depreciation was Rs.42,000. Disposal costs were Rs.2,000.
Required
Show the book-keeping entries to record the disposal.
Answer
Disposal of asset account
Non-current asset account
Disposal expenses (Bank)
Gain on disposal
(statement of
comprehensive income)
Rs.
82,000 Accumulated depreciation
account
2,000 Sales value (Receivables)
11,000
Rs.
42,000
95,000
95,000
53,000
Opening balance
Rs.
82,000
Disposal account
Rs.
42,000
Receivables account
Rs.
Disposal account
(sale value of disposal)
Rs.
53,000
Bank account
Rs.
Rs.
Disposal account
(disposal expenses)
60
2,000
Rs.
11,000
Non-current asset accounts in the general ledger are usually maintained for a
category of assets rather than for individual assets. This means that when a noncurrent asset is disposed of, there will be a closing balance to carry forward on
the asset account and the accumulated depreciation account.
Example:
In the previous example, suppose that the balance on the non-current asset
account before the disposal was Rs.500,000 and the balance of the accumulated
depreciation account was Rs.180,000.
The accounting entries would be as follows:
Property, plant and equipment account
Rs.
Opening balance b/f
500,000 Disposal account
Closing balance c/f
500,000
Opening balance b/f
418,000
Accumulated depreciation account
Rs.
Disposal account
42,000 Opening balance b/f
Closing balance c/f
138,000
180,000
Opening balance b/f
Rs.
82,000
418,000
500,000
Rs.
180,000
180,000
138,000
Practice question
A motor vehicle cost Rs.80,000 two years ago. It has been depreciated by
the reducing balance method at 25% each year. It has now been disposed
of for Rs.41,000. Disposal costs were Rs.200.
The balance on the motor vehicles account before the disposal was
Rs.720,000 and the balance on the accumulated depreciation of motor
vehicles account was Rs.250,000.
Show the book-keeping entries to record the disposal.
61
the fair value of neither the asset received nor the asset given up is reliably
measurable.
If the new asset is measured at fair value, the fair value of the asset given up is
used to measure the cost of the asset received unless the fair value of the asset
received is more clearly evident.
In the case of transactions involving a trade in allowance, the fair value of the
asset being given up is measured as the value of the allowance (price reduction
received).
Example: Cost of new asset
Entity X bought a new car with a cash price of Rs.50,000 but paid for it with Rs.
46,000 cash plus another car which it had owned for some time.
The cost of the new car received is as follows:
Rs.
Cash paid
46,000
4,000
50,000
62
The disposal value of the old asset is the amount that the seller of the new
asset allows in part-exchange for the new asset.
The cost of the new asset is the full purchase price, but the double entry is
partly to bank/payables (for the cash payment) and partly to the disposal
account for the old asset (for the part-exchange value).
Example:
Entity X has several motor cars that are accounted for as property, plant and
equipment.
As at 1 January Year 5, the cost of the entitys cars was Rs.200,000 and the
accumulated depreciation was Rs.80,000.
On 2 January Year 5, Entity X bought a new car costing Rs.50,000.
The car dealer accepted a car owned by Entity X in part-exchange, and the partexchange value of this old car was Rs.4,000.
This car originally cost Rs.30,000 and its accumulated depreciation is Rs.25,000.
Required
(a)
(b)
Show how the purchase of the new car and the disposal of the old car will be
recorded in the ledger accounts of Entity X.
Answer
(a)
Rs.
Sale proceeds on disposal (part-exchange
value)
Less Disposal costs
Net disposal value
Asset at cost
Less: Accumulated depreciation
Rs.
4,000
0
4,000
30,000
(25,000)
(5,000)
Loss on disposal
(1,000)
63
Answer
(b)
Disposal of asset account
Motor vehicles account
Rs.
30,000 Accumulated
depreciation account
Motor vehicles
account
(Trade-in value)
Loss on disposal
(statement of
comprehensive
income)
30,000
Rs.
25,000
4,000
1,000
30,000
Rs.
200,000 Disposal account
Rs.
30,000
46,000
Closing balance
4,000
50,000
250,000
220,000
250,000
220,000
Accumulated depreciation account
1 January
Disposal account
Closing balance
Rs.
25,000 Opening balance
55,000
80,000
Rs.
80,000
Opening balance
55,000
80,000
2 January
Bank account
Rs.
Motor vehicles
account
(Cash paid for new
car)
Statement of comprehensive income
Rs.
Disposal account
1,000
(Loss on disposal)
64
Rs.
46,000
Rs.
Practice question
A company has several motor cars that are accounted for as non-current
assets. As at 1 January Year 2, the cost of the cars was Rs.120,000 and the
accumulated depreciation was Rs.64,000.
During January the company bought a new car costing Rs.31,000 and was
given a part-exchange allowance against an old car of Rs.8,000. The car
being part exchanged originally cost Rs.28,000 and its accumulated
depreciation is Rs.18,000.
Required
(a)
(b)
Show how the purchase of the new car and the disposal of the old car
will be recorded in the ledger accounts.
65
A reconciliation between the opening and closing values for gross carrying
amounts and accumulated depreciation, showing:
Impairment losses
The following is an example of how a simple table for tangible non-current assets
may be presented in a note to the financial statements.
An entity must also disclose:
the existence and amounts of restrictions on title, and property, plant and
equipment pledged as security for liabilities;
66
Illustration:
Property
Rs. m
Cost
At the start of the year
Plant and
equipment
Rs. m
Total
Rs. m
7,200
2,100
9,300
Additions
920
340
1,260
Disposals
(260)
(170)
(430)
7,860
2,270
10,130
Accumulated depreciation
At the start of the year
800
1,100
1,900
Depreciation expense
120
250
370
Accumulated depreciation on
disposals
At the end of the year
(55)
865
(130)
1,220
(185)
2,085
Carrying amount
At the start of the year
6,400
1,000
7,400
6,995
1,050
8,045
for each revalued class of property, plant and equipment, the carrying
amount that would have been recognised had the assets been carried
under the cost model; and
the revaluation surplus, indicating the change for the period and any
restrictions on the distribution of the balance to shareholders.
the gross carrying amount of any fully depreciated property, plant and
equipment that is still in use;
the carrying amount of property, plant and equipment retired from active
use and held for disposal; and
when the cost model is used, the fair value of property, plant and
equipment when this is materially different from the carrying amount.
67
QUESTION PROBLEMS
Section overview
Multiple assets
Working backwards
Correcting errors
X
X
68
2012
80,000
80,000
2013
50,000
Assets sold:
300,000 10% 3/12
7,500
57,500
25,000
500,000 10%
50,000
20,000
Depreciation charge
80,000
105,000
127,500
69
2012
2013
160,000
128,000
64,000
9,600
73,600
50,000
90,000
40,000
Depreciation charge
160,000 178,000
203.600
Rs.
300,000 20%
60,000
48,000
9,600
117,600
70
Rs.
1 January: Balance b/f
31 August: Disposal
31 December
Balance c/f
200,000
30,667
31 December
384,000 Charge for the year
414,667
214,667
414,667
Disposal
Rs.
Rs.
31 August: Cash
31 August: Cost
Profit on disposal
75,000
30,667
105,667
Further information:
Assets are depreciated at 20% reducing balance.
The accumulated depreciation at the start of the year represents
depreciation charged on assets owned from the beginning of the previous
period.
The assets disposed of were all owned at the start of the year.
There were additions this year on 31 March.
Required: Construct the cost account for this category of non-current assets
71
Example
Step 1: Draw the cost T account and fill in any easy detail (double entries that you
know about from the other accounts, narrative for other entries etc.)
Cost
Rs.
Rs.
100,000
You should now try to calculate the missing figures in order of difficulty
Example
Step 2: Calculate the opening balance.
The question tells us that the opening accumulated depreciation is that charged on
assets owned from the beginning of the previous period.
If this statement is true, there cannot have been any additions or disposals last
year.
Therefore the accumulated depreciation (Rs. 200,000) is 20% of the assets held at
the start of last year and these were still held at the end of the year.
Grossing this up provides the cost of assets.
Rs. 200,000 100/20 = Rs. 1,000,000.
Cost
Rs.
1 January: Balance b/f
Rs.
1,000,000
31 March: Additions
31 August: Disposal
31 December
Balance c/f
72
100,000
Example
Step 3: Calculate the depreciation on additions.
The question gives the depreciation charge for the year.
The total charge is the sum of depreciation on assets held for the whole year plus
assets up to the date of disposal plus assets from the date of purchase.
The question gives the total and gives information which allows you to calculate the
first two. Therefore the depreciation on assets from the date of purchase can be
found as a balancing figure.
This can be grossed up to give the cost of the additions.
Rs.
Depreciation on assets held for the whole year
(1,000,000 100,000) 80% 20%
Depreciation on assets sold (1 January to 31 August)
100,000 80% 20% 8/12
Depreciation on assets purchased (31 March to 31
December) a balancing figure
Total depreciation charge for the year
144,000
10,667
60,000
214,667
Rs.
1,000,000
400,000
31 August: Disposal
31 December
Balance c/f
1,400,000
73
100,000
1,300,000
1,400,000
7.3 Errors
Questions often feature mistakes made in terms of a transaction incorrectly
classified as capital or as repair.
Example: Error: Repair incorrectly capitalised
The balance on a businesss plant account as at 31 December is as follows.
Rs.
Cost
1,200,000
Accumulated depreciation
(500,000)
Carrying amount
700,000
The company has discovered that a repair which cost Rs. 200,000 was
incorrectly capitalised on 31 July.
Depreciation is charged at 15% reducing balance.
Correction of the error:
The amount capitalised would have been depreciated so the amount
must be removed from cost and the depreciation incorrectly charged
must be removed.
The correcting journals are:
Dr
Cr
Statement of comprehensive income:
line item to which repairs are charged
200,000
Plant cost
200,000
and
Accumulated depreciation
(200,000 15% 5/12)
Statement of comprehensive income:
Depreciation expense
12,500
12,500
1,200,000
Accumulated depreciation
(500,000)
Carrying amount
700,000
74
(200,000)
12,500
1,000,000
(487,500)
512,500
(500,000)
Carrying amount
700,000
Dr
Plant cost
Statement of comprehensive income:
line item to which repairs are charged
Cr
200,000
200,000
and
Statement of comprehensive income:
Depreciation expense
12,500
Accumulated depreciation
(200,000 15% 5/12)
12,500
After (Rs.)
1,200,000
200,000
1,400,000
Accumulated depreciation
(500,000)
(12,500)
(512,500)
Carrying amount
700,000
75
887,500
Solution
a
Equipment account
YEAR 1
Rs.
Rs.
40,000
Cash
40,000
YEAR 2
Balance b/d
40,000
40,000
40,000
40,000
Balance b/d
b
Rs.
Rs.
Balance c/d
8,000
Depreciation (40,000 / 5)
8,000
8,000
8,000
YEAR 2
Balance b/d
16,000 Depreciation (40,000 / 5)
16,000
Balance b/d
8,000
16,000
16,000
Balance b/d
c
8,000
Depreciation expense
YEAR 1
Rs.
Rs.
Acc. depreciation
To statement of
comprehensive
8,000
income
8,000
8.000
8,000
To statement of
comprehensive
8,000
income
8,000
8.000
8,000
YEAR 2
Acc. depreciation
Year 1 (Rs.)
Year 2 (Rs.)
Cost
40,000
40,000
Accumulated depreciation
8,000
16,000
Carrying amount
32,000
24,000
76
Solution
Original depreciation=(150,000 30,000) /10 = Rs.12,000 per annum
Carrying amount at start of year 5 = 150,000 (12,000 3) =
Rs.114,000
If the total useful life is anticipated to be 7 years then there are four
years remaining.
Depreciation charge for year 5 =Rs.114,000/4 = Rs.28,500
Solutions
1
Rs.
Asset at cost
1,260,000
680,000
Carrying amount
580,000
Rs.
Cost of the asset
64,000
(16,000)
48,000
(12,000)
36,000
(9,000)
27,000
Solution
a
Building account
Rs.(000)
Balance b/d
Revaluation surplus
(Rs.2m Rs. 1m)
Balance b/d
Rs.(000)
1,000
1,000 Balance c/d
2,000
2,000
2,000
2,000
77
Accumulated depreciation
Rs.(000)
Revaluation surplus
Rs.(000)
60
60 Balance b/d
60
60
Revaluation surplus
YEAR 1
Balance c/d
Rs.(000)
Rs.(000)
Building account
1,060 Accumulated depreciation
1,060
1.000
60
1,060
Balance b/d
1,060
Solution
Annual depreciation = Rs.(96,000 16,000)/5 years = Rs.16,000.
Monthly depreciation = Rs. 16,000/12 = Rs. 1,333.33.
Rs.
Rs.
68,000
96,000
(36,000)
60,000
Gain on disposal
8,000
Solutions
Annual depreciation = Rs.(216,000 24,000)/8 years = Rs.24,000.
Rs.
Rs.
Disposal value
163,000
(1,000)
162,000
14,000
48,000
16,000
78,000
216,000
138,000
Gain on disposal
24,000
78
Solution
Rs.
Cost of the asset
80,000
(20,000)
(15,000)
Rs.
20,000
60,000
15,000
35,000
Disposal account
Rs.
Motor vehicles account
Bank (disposal costs)
Rs.
35,000
200 Receivables
Statement of
comprehensive income
(loss on disposal)
41,000
80,200
b
4,200
80,200
Motor vehicles
Rs.
Opening balance b/d
Rs.
80,000
640,000
720,000
640,000
Rs.
250,000
Opening balance b/d
250,000
79
215,000
Solution
Rs.
Sale proceeds on disposal (part-exchange value)
Rs.
8,000
Asset at cost
28,000
(18,000)
(10,000)
Loss on disposal
(2,000)
Disposal account
Rs.
Rs.
Accumulated depreciation
28,000 account
Motor vehicles account
(Trade-in value)
8,000
Loss on disposal
2,000
28,000
18,000
28,000
Motor vehicles
Rs.
Opening balance
Bank (31,000 8,000)
Disposal of asset
account
Rs.
Opening balance
c
28,000
123,000
151,000
151,000
Rs.
Disposal account
Closing balance
46,000
64,000
64,000
Opening balance
80
64,000
46,000
CHAPTER
81
INTRODUCTION
Learning outcomes
LO 3
Understand the nature of revenue and be able to account for the same
in accordance with international pronouncements.
LO3.1.1:
LO3.1.2:
LO3.1.3:
82
Reliability of measurement
The IASB Conceptual Framework states that an element (asset, liability, equity, income
or expense) should be recognised in the statement of financial position or statement of
comprehensive income when it:
Items that fail to meet the criteria for recognition should not be included in the financial
statements. However, some of these items may have to be disclosed as additional
details in a note to the financial statements.
The criteria for recognition are as follows:
It must be probable that the future economic benefit associated with the item will
flow either into or out of the entity.
The item should have a cost or value that can be measured reliably.
83
84
Measurement of revenue
Revenue is income that arises in the ordinary course of activities and it is referred
to by a variety of different names including sales, fees, interest, dividends and
royalties.
IAS 18 Revenue defines revenue as the gross inflow of economic benefits
during the period 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.
It adds that revenue relates only to economic benefits receivable by the entity for
its own account. Amounts collected on behalf of a third party, such as sales tax
collected on behalf of the government, must be excluded from revenue because
they do not result in an increase in equity.
If a sale is a cash sale, the revenue is the immediate proceeds of the sale.
If a sale is a normal credit sale, the revenue is the expected future receipt.
However, in some cases when the payment is deferred, the fair value might be
less than the amount of cash that will eventually be received.
The difference between the nominal sale value and the fair value of the
consideration is recognised as interest income.
85
1
= Rs. 4,449,982
(1 0.06) 2
Rs. 5m
Debit
4,449,982
Receivables
Revenue
Credit
4,449,982
31 December 2015
Recognition of interest revenue
Rs. 4,449,982 @ 6%
Debit
266,999
Receivables
Revenue interest
= 266,999
Credit
266,999
Rs.
4,449,982
266,999
Carried forward
4,716,981
31December 2016
Recognition of interest revenue
Rs. 4,716,981 @ 6%
Debit
283,019
Receivables
Revenue interest
= 283,019
Credit
283,019
Rs.
4,716,981
(5,000,000)
Carried forward
283,019
86
a sale has taken place which is measured at the present value of the cash
received; and
Another typical example is where a single amount is paid for an item, where a
free service is included with the item purchased.
Where a revenue transaction is entered into with a customer who is offered
extended credit terms, the measurement of the revenue must reflect the time
value of money, if it is material.
This means that, even if the revenue transaction states that there is no interest
charged or reflects a very low interest charge, the interest income should be
separated from the total revenue to be received and measured using the effective
interest rate method and apportioned for time.
For example a sale on extended credit where the legal documents -show SALE
and include a clause to the effect that no interest is charged and another clause
that states that the customer need only pay for the goods in three years time, ,it
is in substance two transactions:
Sale of goods: to be measured at the cash price (or present value of future
receipts); and
In other words, in the above example income from a sale and income from
interest is recognised.
87
Debit
Accounts receivable
Sales income
1 000
Credit
1 000
1 000
Accounts receivable
1 000
Debit
Accounts receivable
Sales income
909
Credit
909
45
45
46
46
1 000
Accounts receivable
1 000
88
Amount
outstanding at
the beginning of
the year
909
Interest
recognised per
year
(given)
91
Receipt due
at the end
of the year
Amount
outstanding at the
end of the year
(1 000)
Comment: Notice that the effective annual interest is 91, but it has been
apportioned for time since the year-end falls within the 12-month extended
settlement period.
1
2
Amount outstanding
at the beginning of
the year
W1
Receipt due at
the end of the
year
Amount
outstanding at
the end of the
year
272 727
0
24 793
(0)
27 273
(300 000)
52 066
(300 000)
Comment: Notice that the sales revenue (the original present value) of Rs.
247,934 plus the interest revenue of Rs. 52,066 equals the total to be received:
Rs. 300,000.
247 934
272 727
Interest
revenue per
12 months
89
Debit
20X1 Journals
1 September 20X1
Accounts
W1
receivable
Sales revenue
Recording the sale of goods (extended credit terms
material)
31 December 20X1
Accounts
receivable
Interest revenue
(W2: 24 793 x 3/12)
Recording the interest earned on sale on extended
terms:
Credit
247 934
247 934
6 198
6 198
20X2 Journals
31 December 20X2
Accounts
receivable
Interest revenue
(W2: 24 793 x 9/12 + W2:
27 273 x 3/12)
Recording the interest earned on sale on extended
terms:
25 413
25 413
20X3 Journals
31 August 20X2
Accounts
receivable
Interest revenue
(W2: 27 273 x 9/12)
Recording the interest earned on sale on extended
terms:
Bank
Instalment received
Accounts
receivable
Instalment received in full and final settlement
20 455
20 455
300 000
300 000
Comment: Notice that although the terms of the sale spanned 2 years, the
interest revenue of 52 066 (W2) was recognised over 3 years (see journals) due to
the fact that the dates of the sale and the final receipt did not coincide with the
year-end: 6 198 + 25 413 + 20 455.
40 000
50 000
29 700
The present value of these payments (using a discount rate of 10%) amounts to
100 000.
All the recognition criteria are met. The year end is 31 December.
90
Required:
A. A. Calculate the amount of sales revenue from the sale transaction and interest
B.
revenue from the financing transaction to be recognised over the period of
C.
three years.
D. B. Show the related journal entries for the year ended 31 December 20X1, 20X2
E.
and 20X3.
F.
G. Solution to example: sales income and interest income (calculations)
20X1 Journals
Debit
Credit
1 January 20X1
Debtors (A)
100 000
Sales (I)
100 000
10 000
Interest (I)
10 000
40 000
Debtors (A)
40 000
7 000
Interest (I)
7 000
50 000
Debtors (A)
50 000
2 700
Interest (I)
2 700
29 700
Debtors (A)
29 700
91
The entity has transferred to the buyer the significant risks and rewards of
ownership of the goods. This normally occurs when legal title to the goods
or possession of the goods passes to the buyer.
The entity does not retain effective control over the goods sold, or retain a
continuing management involvement to the degree usually associated with
ownership.
The costs incurred (or to be incurred) for the transaction can be measured
reliably.
the receipt of revenue may be contingent on the buyer selling the goods on;
the buyer has the right to rescind and the seller is uncertain about the
outcome.
If legal title does not pass but the risks and rewards do, a sale is recognised.
A seller may retain the legal title to the goods to protect the collectability of
the amount due but if the entity has transferred the significant risks and
rewards of ownership, the transaction is a sale and revenue is recognised.
Cost recognition
Revenue and expenses must be recognised simultaneously.
Expenses can normally be measured reliably when other conditions for revenue
recognition have been satisfied.
Revenue cannot be measured when the related expenses cannot be measured
reliably. In such cases proceeds should be recognised as a liability not a sale.
92
Illustrations
The implementation guidance to IAS 18 includes specific guidance on how the
rules in the standard would be applied to revenue recognition in a series of
circumstances.
The following examples are based on this guidance.
Example: Simple transaction
X Plc has received an order for a grade 1 widget machine under the following
terms for a sale price of Rs. 100,000 with delivery on 30 September.
When should X Plc recognise revenue from this sale?
Analysis:
Assuming that there are no significant risks or rewards remaining with X Plc; and
that X Plc will have no continuing involvement with the units, the risks and
rewards of ownership pass to the customer when the machine is delivered.
Revenue should be recognised on delivery being 30 September.
Example: Sale with right of inspection
X Plc has received an order for a grade 1 widget machine under the following
terms for a sale price of Rs. 100,000 with delivery on 30 September.
The customer has the right to inspect and test the delivery before accepting the
goods.
When should X Plc recognise revenue from this sale?
Analysis:
Assuming that there are no significant risks or rewards remaining with X Plc; and
that X Plc will have no continuing involvement with the units the risks and
rewards of ownership pass to the customer upon completion of inspection and
testing and acceptance by the customer.
Example: Goods supplied on sale or return basis
Goods are sold by a manufacturer to a retailer.
The retailer has the right to return the goods if he is unable to sell them. (The
goods are supplied on a sale or return basis.)
Analysis:
The manufacturer retains significant risks of ownership until the retailer sells the
goods.
Revenue should be recognised when the customer sells the goods, and not
before.
93
94
Subscriptions to publications
Where a series of publications is subscribed to and each publication is of a
similar value revenue is recognised on a straight-line basis over the period in
which the publications are despatched
If the value of each publication varies revenue is recognised on the basis of the
sales value in relation to the estimated sales value of all items covered by the
subscription
Example: Subscriptions to publications
A publisher of a monthly magazine has received Rs. 480,000 in annual
subscriptions in advance and has produced four issues by the year end 31 March
2015.
The advance payments are non-refundable.
What revenue should be recognised for the year ended 31 March 2015?
Analysis:
Revenue for the magazines should be recognised in the periods in which they are
despatched.
The revenue recognised in the year ended 31 March 2015 = Rs. 120,000 (Rs.
480,000 3/12).
The fact that the amount received is non-refundable does not affect how revenue
is recognised.
95
96
It is probable that the economic benefits associated with the transaction will
flow to the service provider.
The costs already incurred for the transaction and the costs that will be
incurred to complete the transaction can be measured reliably.
the proportion of costs incurred to date to the estimated total costs of the
transaction.
97
98
Agency
A person or company might act for another company. In this case the first
company is said to be an agent of the second company and the second company
is described as the principal.
An agent might sell goods for a principal and collect the cash from the sale. The
agent then hands the cash to the principal after deducting an agency fee.
The agent is providing a selling service to the principal. The agent should not
recognise the whole sale price of the goods but only the fee for selling them.
An entity acts as principal only where it is exposed to the significant risks and
rewards associated with the sale of goods. If this is not the case the entity is
acting as agent. The risks and rewards to be considered include responsibility for
fulfilling the order, inventory risk, ability to set the selling price and credit risk.
Example: Agency
Peshawar Sales Factors (PSF) distributes goods for Marden Manufacturing (MM)
under an agreement with the following terms.
1.
PSF is given legal title to the goods by MM and sells them to the retailers.
2.
MM sets the selling price and PSF is given a fixed margin on all sales.
3.
4.
5.
During the year ended 31 December 2015 MM transferred legal title of goods to
PSF which cost MM Rs. 1,000,000. These are to be sold at a mark-up of 20%. PSF
is entitled to 5% of the selling price of all goods sold.
As at 31 December PSF had sold 90% of the goods and held the balance of the
inventory in its warehouse. All amounts had been collected by PSF but the
company has not yet remitted any cash to MM.
Analysis:
In substance PSF is acting as an agent for MM. MM retains all significant risks and
rewards of ownership of the goods transferred to PSF.
PSF would recognise:
Dr
Cr
1,080,000
54,000
Liability
1,026,000
MM would recognise:
Dr
Receivable
Cr
1,026,000
Revenue
1,026,000
99
Franchising
Definition: Franchise
Franchising is a form of business by which the owner (franchisor) of a product,
service or method obtains distribution through affiliated dealers (franchisees).
The franchisor provides the franchises with a licensed right to carry out a
business activity under the franchisors name. The franchisee owns a business
which from the outside looks as if it is part of a much larger entity.
The franchisor provides services such as training and marketing and supplies
inventory to the franchisee. The franchisee pays a fee for the services.
Example: Franchise
Subway is a large international franchise with many outlets in Pakistan.
Each outlet is owned by an investor and operated under the Subway umbrella.
The franchisor must recognise franchise fees in a way that reflects the purpose
for which the fee is charged.
Example: Franchising
Juicy Kebab of Lamb (JKL) is a successful food retailing business.
It has expanded greatly by offering people the opportunity to open JKL outlets
across Pakistan and in other countries.
Any person setting up a franchise must pay JKL an initial fee of Rs. 2,000,000 and
a quarterly fee of 15% of gross revenue.
The initial fee covers:
1. Training (Rs. 100,000)
2. Supply and installation of assets (cookers, shop fittings, signage, etc. Rs.
500,000);
3. Management assistance over first year of the business (Rs. 10,000 per month);
4. Advertising costs (covering local advertising for the launch of the business
(Rs.200,000) and a contribution to JKL national advertising over the first two
years of the business (Rs.45,000 per month).
Analysis:
JKL would recognise revenue as follows:
Training as the training is delivered (reflecting the pattern of delivery)
Supply and installation of assets On completion of installation of each
asset.
Management service On a monthly basis.
Adverting costs:
Local advertising as the advertising is delivered
National advertising On a monthly basis or to reflect advertising activity.
Quarterly fee As earned in relation to sales made.
100
84,848
715,152
Total revenue
800,000
101
1,019,407
60,577
(70,000)
1,009,984
1,009,984
60,017
(1,070,000)
Debit
Receivables
Credit
1,000,000
Cash
1,000,000
50,000
Receivables
50,000
59,424
59,424
102
Royalties
Revenue from royalties should be recognised on an accruals basis, in
accordance with the terms of the royalty agreement.
Example: Royalties
Peshawar Software Design (PSD) has developed a strategy game that is played on
mobile phones. PSD has a 31 December year end.
Pineapple Inc. a major multi-national manufacturer pre-installs the game on the
smart phones which they manufacture and pays PSD a royalty of Rs. 50 per smart
phone sold.
The payment is made based on Pineapple Inc.s monthly sales. Cash is received
two weeks after the end of each month.
In December Pineapples monthly sales were 1,800,000 units.
PSD would recognise revenue of Rs. 90,000,000 (1,800,000 Rs. 50) in
December.
Receivables
90,000,000
Revenue
90,000,000
Dividends
Revenue from dividends should be recognised when the right to receive the
dividend is established.
Example: Dividends
Karachi International Investments (KII) owns shares in two foreign companies.
It owns 5% of the ordinary shares of Overseas Inc. and 10% of shares in Foreign
Ltd. These companies operate in different jurisdictions.
The directors of Foreign Ltd declared a dividend that would translate into
Rs.2,000,000 on 15 November 2015. Foreign Ltd operates in a jurisdiction where
the declaration of a dividend must be approved by the shareholders in a general
meeting. Foreign Ltd will hold the next shareholders meeting in February.
The directors of Overseas Inc. declared a dividend that would translate into
Rs.1,000,000 on 21 December 2015. Overseas Inc. operates in a jurisdiction
where there is no requirement for further approval before a dividend is paid.
What amount of dividend income should Karachi International Investments
recognise in its 13 December 2015 financial statements?
Rs.
Dividend from Foreign Ltd
nil
50,000
50,000
103
104
CHAPTER
105
INTRODUCTION
Learning outcomes
To provide candidates with an understanding of the fundamentals of accounting theory and
basic financial accounting with particular reference to international pronouncements.
LO 1
LO1.1.1:
LO1.2.1:
106
The balances on all the accounts in the general ledger (nominal ledger or
main) are extracted into a trial balance. (A list of balances on all ledger
accounts for assets, liabilities, capital, income and expenses).
The adjusted income and expense balances are entered into a statement of
comprehensive income to establish the profit or loss for the period.
The adjusted asset, liability and capital balances, together with the retained
profit for the year, are entered into a statement of financial position as at
the end of the reporting period.
107
a statement of cash flows statement of cash flows (dealt with in the next
chapter); and
the date of the end of the reporting period or the period covered by
the statement, whichever is appropriate
the level of rounding used in the figures (for example, whether the
figures thousands of rupees or millions of rupees).
108
Introduction
Current liabilities
2.1 Introduction
IFRS uses terms which are incorporated into this study text. However, it does not
forbid the use of other terms and you might see other terms used in practice.
IAS 1 sets out the requirements for information that must be presented in the
statement of financial position or in notes to the financial statements, and it also
provides implementation guidance. This guidance includes an illustrative format
for a statement of financial position. This format is not mandatory but you should
learn it and use it wherever possible.
The entity expects to realise the asset, or sell or consume it, in its normal
operating cycle.
The entity expects to realise the asset within 12 months after the reporting
period.
109
The operating cycle of an entity is the time between the acquisition of assets for
processing and their realisation in cash or cash equivalents. When the entity's
normal operating cycle is not clearly identifiable, it is assumed to be twelve
months. This is almost always the case.
The entity expects to settle the liability in its normal operating cycle.
The liability is held primarily for the purpose of trading. This means that all
trade payables are current liabilities, even if settlement is not due for over
12 months after the end of the reporting period.
It is due to be settled within 12 months after the end of the reporting period.
The entity does not have the unconditional right to defer settlement of the
liability for at least 12 months after the end of the reporting period.
(b)
Investment property
(c)
Intangible assets
(d)
(e)
Investments accounted for using the equity method (not in this syllabus)
(f)
Biological assets
(g)
Inventories
(h)
(i)
Liabilities
(j)
(k)
Provisions
(l)
Financial liabilities, excluding any items in (j) and (k) above: (for example,
bank loans)
(m)
(n)
Deferred tax liabilities (but possibly assets). These are always non-current.
110
Equity
(o)
Issued capital and reserves attributable to the owners of the entity. (The
term owners, refers to the equity holders.)
For example:
111
Rs. m
205.1
10.7
6.8
222.6
Current assets
Inventories
Trade and other receivables
Other current assets
Cash and cash equivalents
17.8
13.3
2.0
0.7
33.8
Total assets
256.4
50.0
60.6
31.9
Total equity
Non-current liabilities
Long-term borrowings
Deferred tax
142.5
30.0
4.5
34.5
Current liabilities
Trade and other payables
Short-term borrowings (bank overdraft)
Current portion of long-term borrowing
Current tax payable
67.1
3.2
5.0
4.1
79.4
Total liabilities
113.9
256.4
112
IAS 1 allows an entity to present the two sections in a single statement or in two
separate statements. If two separate statements are used they should include all
the information that would otherwise be included in the single statement of
comprehensive income.
The statement of profit or loss shows the components of profit or loss, beginning
with Revenue and ending with Profit (or Loss) for the period after tax.
Examples of other comprehensive income
In this syllabus the only gains and losses that are recognised in the statement of
other comprehensive income are those arising on the revaluation of property.
plant and equipment under the rules in IAS 16. This was covered in more detail in
chapter 3 of this text.
There are many other transactions which must be recognised in the statement of
other comprehensive income but these are not in the scope of this syllabus. You
will study them in papers at a higher level.
Definition of total comprehensive income
Total comprehensive income during a period is the sum of:
113
revenue
(b)
(c)
tax expense
(d)
(e)
(f)
(g)
114
Rs. 000
678
250
428
44
(98)
(61)
(18)
(24)
271
(50)
221
46
267
IAS 1 encourages entities to show this analysis of expenses on the face of the
statement of comprehensive income, rather than in a note to the accounts.
Material items that might be disclosed separately include:
a write-down of inventories from cost to net realisable value, or a writedown of items of property, plant and equipment to recoverable amount
discontinued operations
litigation settlements
a reversal of a provision.
115
Cost of sales
Distribution costs
Revenue
Other expenses
Administrative expenses
Other income
Debit
Rs. 000
6,214
3,693
Credit
Rs. 000
14,823
248
3,901
22
Required
Show the first part of Entity Reds statement of comprehensive income using the
cost of sales analysis method.
Entity Red: Statement of comprehensive income for the year ended 30
June 20X5
Rs. 000
Revenue
14,823
Cost of sales
6,214
Gross profiit
8,609
Other income
22
Distribution costs
(3,693)
Administrative expenses
(3,901)
Other expenses
(248)
Profit before tax
789
The basis for separating these costs between the functions would be given in the
question.
116
depreciation.
Items of expense that on their own are immaterial are presented as other
expenses.
There will also be an adjustment for the increase or decrease in inventories of
finished goods and work-in-progress during the period.
Other entities (non-manufacturing entities) may present other expenses that are
material to their business.
An example of a statement of comprehensive income, showing expenses by their
nature, is shown below, with illustrative figures included.
Example: Analysis of expenses by nature
The following is an alternative method of presenting the accounts of Entity Red.
Increase in inventories of finished goods and work-in-progress
Revenue
Raw materials and consumables
Depreciation
Other income
Staff costs
Other operating expenses
Rs. 000
86
14,823
5,565
1,533
22
4,926
2,118
Required
Show the first part of Entity Reds statement of comprehensive income using the
nature of expenditure method, down to the operating profit level.
Entity Red: Statement of comprehensive income for the year ended 30 June
20X5
Rs. 000 Rs. 000
Revenue
14,823
Other income
22
14,845
Changes in inventories of finished goods and work-inprogress (reduction = expense, increase = negative
expense)
(86)
Raw materials and consumables used
5,565
Staff costs (employee benefits costs)
4,926
Depreciation and amortisation expense
1,533
Other operating expenses
2,118
14,056
Profit before tax
789
117
Introduction
4.1 Introduction
In this exam you will be expected to prepare a statement of financial position and
statement of comprehensive income from a trial balance. These questions are
usually quite time pressured so you need to develop a good technique in order to
execute such tasks in an effective way.
The rest of this chapter use the following example to illustrate how such
questions might be approached. You will need to choose an approach and
practice it.
The example includes several straightforward year-end adjustments for
illustrative purposes. In the exam you will face more complicated adjustments
than these.
You will have come across the content of this section in your previous studies. If
you are comfortable with the preparation of basic statements of financial position
and statements of profit or loss from a trial balance then you may not need this
section. It is simply provided to provide you with a refresher of basic technique.
118
Example:
ABC Trial balance as at 31 December 2013
Rs.
Sales
Purchases
Rs.
428,000
304,400
64,000
Rent
14,000
5,000
15,000
Drawings
22,000
4,000
Non-current assets
146,000
Accumulated depreciation:
32,000
Trade receivables
51,000
Trade payables
42,000
Cash
Capital as at 1 January 2013
6,200
121,600
627,600
627,600
Further information:
a)
b)
c)
d)
It is decided that a bad debt of Rs. 1,200 should be written off, and
that the allowance for doubtful debts should be increased to Rs.
4,500.
Depreciation is to be provided for the year at 10% on cost
e)
119
The journals
The business needs to process the following double entries to take account of
the further information given above.
Example: Closing journals
a)
Debit
Accrual
Heating and lighting expense
Credit
400
Accrual
Being: Accrual for heating and lighting expense
b)
400
Rent prepayment
Prepayment
Rent expense
700
700
1,200
1,200
500
500
Depreciation
Depreciation expense
Accumulated depreciation
14,600
14,600
Closing inventory
Inventory (asset)
16,500
16,500
120
Rs.
428,000
304,400
64,000
Rent
Heating and lighting
14,000
5,000 + 400a
15,000
Drawings
22,000
700b
4,000+ 500c
146,000
32,000 +
14,600d
Accumulated depreciation:
Trade receivables
51,000
Trade payables
1,200c
42,000
Cash
Capital as at 1 January 2013
6,200
121,600
627,600
627,600
400a
Accruals
700b
Prepayments
Bad and doubtful debt expense
1200c + 500c
Depreciation expense
14,600d
16,500e
16,500e
Step 2: Draft pro-forma financial statements including all of the accounts that you
have identified. (A pro-forma is a skeleton document into which you can copy
numbers later)
Step 3: Copy the numbers from the trial balance into the pro-forma statements.
Note that if a number copied onto the financial statements is made up of a
number provided in the original trial balance that has been adjusted, you must
show the marker what you have done. This may involve adding in an additional
explanation below the main answer or may be shown on the face of the
statements.
121
Rs.
Assets
Non-current assets
Cost
146,000
(46,600)
99,400
Current assets
Inventories
16,500
49,800
(4,500)
45,300
Prepayments
700
Cash
6,200
68,700
Total assets
168,100
121,600
26,100
(22,000)
125,700
Current liabilities
Trade payables
42,000
400
42,400
168,100
122
Rs.
428,000
Opening inventory
15,000
Purchases
304,400
319,400
Closing inventory
(16,500)
(302,900)
Gross profit
125,100
Expenses:
Wages and salaries
Depreciation (W1)
64,000
14,600
13,300
5,400
1,700
(99,000)
26,100
Workings
W1 Depreciation: 10% of 146,000 = 14,600
123
Rs.
Assets
Non-current assets
Cost
146,000
6,200
Total assets
Equity and liabilities
Capital
At start of year
121,600
(22,000)
Current liabilities
Trade payables
42,000
124
Rs.
428,000
Opening inventory
15,000
Purchases
304,400
319,400
Closing inventory
Gross profit
Expenses:
Wages and salaries
64,000
Depreciation
Rent (14,000
Heating and lighting (5,000
Bad and doubtful debts
125
Rs.
Assets
Non-current assets
Cost
146,000
(46,600)
99,400
Current assets
Inventories
16,500
49,800
(4,500)
45,300
Prepayments
700
Cash
6,200
68,700
Total assets
168,100
121,600
26,100
Drawings
(22,000)
125,700
Current liabilities
Trade payables
42,000
400
42,400
168,100
126
Rs.
428,000
Opening inventory
15,000
Purchases
304,400
319,400
Closing inventory
(16,500)
(302,900)
Gross profit
125,100
Expenses:
Wages and salaries
Depreciation (W1)
64,000
14,600
13,300
5,400
1,700
(99,000)
26,100
Workings
W1 Depreciation: 10% of 146,000 = 14,600
127
Taxation on profits
The statement of financial position reports the amount of taxation that the
company owes to the tax authorities as at the end of the reporting period.
400,000
(100,000)
300,000
128
Example:
Rs.
Profit from operations
Rs.
460,000
Interest
(60,000)
400,000
Tax:
Adjustment for under-estimate of tax in the
previous year
Tax on current year profits
3,000
100,000
(103,000)
297,000
Rs.
X
X
X
(X)
129
Example:
Fresh Company has a financial year ending on 31 December. At 31 December
Year 5 it had a liability for income tax (= tax on its profits) of Rs. 77,000. The tax
on profits for the year to 31 December Year 6 was Rs. 114,000.
The tax charge for the year to 31 December Year 5 was over-estimated by Rs.
6,000.
During the year to 31 December Year 6, the company made payments of Rs.
123,000 in income tax.
Required
Calculate:
the tax charge for the year to 31 December Year 6, to include in the
statement of comprehensive income
Answer
(a)
Tax:
Adjustment for over-estimate of tax in the previous year
Tax on current year profits
Rs.
(6,000)
114,000
108,000
Rs.
77,000
108,000
(b)
185,000
(123,000)
62,000
The tax payable will appear as a current liability in the statement of financial
position.
130
the entity receives cash from the issue, or possibly assets other than cash
(for which a carrying value is determined).
The issue price of new equity shares is usually higher than their face value or
nominal value. The difference between the nominal value of the shares and their
issue price is accounted for as share premium, and credited to a share premium
reserve. (This reserve is a part of equity).
Illustration: Share issue double entry
Debit
Bank (cash received)
Credit
Transaction costs of issuing new equity shares for cash should be debited
directly to equity.
The costs of the issue, net of related tax benefit, are set against the share
premium account. (If there is no share premium on the issue of the new shares,
issue costs should be deducted from retained earnings).
Example:
A company issues 200,000 shares of Rs. 25 each at a price of Rs. 250 per share.
Issue costs are Rs. 3,000,000.
The share issue would be accounted for as follows:
Dr (Rs. 000)
50,000
5,000
45,000
3,000
Cash
Cr (Rs. 000)
3,000
131
(X)
Gross profit
Other income
Distribution costs
(X)
(X)
Administrative expenses
Other expenses
(X)
Finance costs
(X)
Taxation
(X)
132
Other income
Changes in inventories of finished goods and work-in-progress
(X)
(X)
Other expenses
(X)
Finance costs
(X)
Taxation
(X)
133
X
X
X
X
X
X
X
X
X
Total assets
Rs. m
X
X
X
X
X
X
X
X
X
X
X
X
X
X
134
CHAPTER
135
INTRODUCTION
Learning outcomes
To provide candidates with an understanding of the fundamentals of accounting theory and
basic financial accounting with particular reference to international pronouncements.
LO 1
LO1.3.1:
LO1.3.2:
LO 1.3.1:
LO 1.3.2:
LO1.3.3:
LO1.3.4:
136
Overall approach
A business can make a loss but still survive if it has sufficient cash or
access to liquidity (cash, assets that can be quickly turned into cash and
new sources of borrowing).
There are items of cash flow that do not appear in the statement of
comprehensive income. Examples are:
137
It also shows whether there was an increase or a decrease in the amount of cash
held by the entity between the beginning and the end of the period.
Illustration:
Cash from operating activities
Cash used in (or obtained from) investing activities
Cash paid or received in financing activities.
X/(X)
X/(X)
X/(X)
X/(X)
X/(X)
X/(X)
Cash = cash in hand (= petty cash and other cash not in the bank) + cash
in the business bank account
Cash equivalents = items that are the equivalent of cash and could be
converted into cash very quickly without risk of loss (= for example cash in
a deposit account or a savings account)
138
139
Format
2.1 Format
IAS 7 does not include a format that must be followed. However it gives illustrative
examples of formats that meet the requirements in the standard.
Illustration: Statement of cash flows
Rs.
Net cash flow from operating activities
Rs.
75,300
(5,000)
(35,000)
6,000
1,500
(32,500)
30,000
10,000
(17,000)
(25,000)
(2,000)
40,800
5,000
45,800
Indirect method
For clarity, what this means is that there are two approaches to arriving at the
figure of Rs. 75,300 in the above example.
You are expected to understand both methods.
140
141
Rs.
Rs.
80,000
20,000
2,300
(6,000)
4,500
100,800
(7,000)
2,000
3,000
98,800
(21,000)
(2,500)
75,300
Rs.
348,800
(70,000)
(150,000)
(30,000)
98,800
(21,000)
(2,500)
75,300
The remainder of the statement of cash flows using the direct method is exactly
the same as for the indirect method.
142
Non-cash items
the carrying amount (net book value) of the asset at the date of disposal.
The effect of the gain or loss on disposal (a non-cash item) from the operating
profit is removed by:
143
The relevant cash flow is the net cash received from the sale. This is included in
cash flows from investing activities as the net cash flows received from the
disposal of non-current assets.
Example:
A company disposed of an item of equipment for Rs. 40,000. The equipment had
originally cost Rs. 60,000 and the accumulated depreciation charged up to the
date of disposal was Rs. 32,000.
Cost
Accumulated depreciation
Rs.
60,000
(32,000)
28,000
(40,000)
Gain on disposal
12,000
In the statement of cash flows, the gain on disposal of Rs. 12,000 is deducted as
an adjustment to the operating profit.
The cash proceeds of Rs. 40,000 is included as a cash inflow under the heading:
Cash flows from investing activities.
Practice question
A company made a loss on the disposal of a company motor vehicle of Rs.
8,000.
The vehicle originally cost Rs. 50,000 and at the date of disposal,
accumulated depreciation on the vehicle was Rs. 20,000.
What are the items that should be included for the disposal of the vehicle in
the statement of cash flows for the year:
a) in the adjustments to get from operating profit to cash flow from
operations?
b) under the heading: Cash flows from investing activities?
144
X
X
X
(X)
X
Take a few minutes to make sure that you are happy about this. The same
approach is used to calculate other figures.
The interest liability at the start of the year and the interest charge during the year
is the most the business would pay. If the business had paid nothing it would owe
this figure. The difference between this amount and the liability at the end of the
year must be the amount that the business has paid.
An aside taxation paid
The tax paid is the last figure in the operating cash flow calculation.
There is no adjustment to profit in respect of tax. This is because the profit figure
that we start with is profit before tax; therefore tax is not in in it to be adjusted!
However, there is a tax payment and this must be recognised as a cash flow. It is
calculated in the same way as shown above.
145
Example:
A company had liabilities in its statement of financial position at the beginning and
at the end of 2013, as follows:
Liabilities
Beginning of 2013
End of 2013
Interest accrual
Rs. 4,000
Rs. 3,000
Taxation
Rs. 53,000
Rs. 61,000
During the year, interest charges in the statement of comprehensive income were
Rs. 22,000 and taxation on profits were Rs. 77,000.
The amounts of interest payments and tax payments (cash flows) for inclusion in
the statement of cash flows can be calculated as follows:
146
Tax
Rs.
53,000
77,000
Interest
Rs.
4,000
22,000
130,000
(61,000)
26,000
(3,000)
69,000
23,000
Working capital
Changes in inventory
Lack of detail
inventories; and
Assuming that the calculation of the cash flow from operating activities starts with
a profit (rather than a loss) the adjustments are as follows:
Increase in balance from start
to the end of the year
Receivables
Inventory
Payables
Balance
These are known as the working capital adjustments and are explained in more
detail in the rest of this section.
147
Cash
Trade payables
(X)
Working capital
taxation payable.
Interest charges and payments for interest are presented separately in the
statement of cash flows, and so accrued interest charges should be excluded
from the calculation of changes in trade payables and accruals.
Similarly, taxation payable is dealt with separately; therefore taxation payable is
excluded from the calculation of working capital changes.
Accrued interest and accrued tax payable must therefore be deducted from the
total amount for accruals, and the net accruals (after making these deductions)
should be included with trade payables.
Changes in working capital and the effect on cash flow
When working capital increases, the cash flows from operations are less than the
operating profit, by the amount of the increase.
Similarly, when working capital is reduced, the cash flows from operations are
more than the operating profit, by the amount of the reduction.
This important point will be explained with several simple examples.
148
subtract the increase in receivables during the period (the amount by which
closing receivables exceed opening receivables); or
add the reduction in receivables during the period (the amount by which
opening receivables exceed closing receivables).
(3,000)
17,000
Proof
Cash flow from operations can be calculated as follows:
Receivables at the beginning of the year
Sales in the year
Rs.
6,000
50,000
56,000
47,000
(30,000)
(9,000)
149
17,000
Adjust the profit for the movement on the allowance as a non-cash item and
adjust the profit figure for the movement in receivables using the gross
amounts (i.e. the balances before any deduction of the allowance for
doubtful debts); or
2012
(Rs. m)
5,000
2013
(Rs. m)
7,100
(500)
(600)
Net-amount
4,500
6,500
Receivables
Rs. m
Profit before taxation
or
Rs. m
10,000
10,000
100
10,000
10,100
Increase in receivables:
Gross amounts: (7,100 5,000)
(2,100)
(2,000)
8,000
150
8,000
subtract the increase in inventories during the period (the amount by which
closing inventory exceeds opening inventory); or
add the reduction in inventories during the period (the amount by which
opening inventory exceeds closing inventory).
Example: inventory
A company had inventory at the beginning of the year of Rs. 5,000 and at the end
of the year the inventory was valued at Rs. 3,000.
During the year, sales were Rs. 50,000 and there were no receivables at the
beginning or end of the year.
Purchases were Rs. 28,000, all paid in cash.
The operating profit for the year was Rs. 20,000, calculated as follows:
Sales
Rs.
50,000
Opening inventory
Purchases in the year (all paid in cash)
5,000
28,000
Closing inventory
33,000
(3,000)
Cost of sales
(30,000)
20,000
151
Example (continued)
Rs.
20,000
2,000
22,000
Rs.
50,000
(28,000)
22,000
add the increase in trade payables during the period (the amount by which
closing trade payables exceed opening trade payables);or
subtract the reduction in trade payables during the period (the amount by
which opening trade payables exceed closing trade payables).
152
20,000
Adjustments for:
Increase in payables (6,500 4,000)
2,500
22,500
Rs.
4,000
30,000
34,000
(6,500)
27,500
(50,000)
22,500
The cash flow is Rs. 2,500 more than the operating profit, because trade payables
were increased during the year by Rs. 2,500.
153
Example:
A company made an operating profit before tax of Rs. 16,000 in the year just
ended.
Depreciation charges were Rs. 15,000.
There was a gain of Rs. 5,000 on disposals of non-current assets and there were no
interest charges. Values of working capital items at the beginning and end of the
year were:
Beginning of the year
End of the year
Receivables
Rs. 9,000
Rs. 6,000
Inventory
Rs. 3,000
Rs. 5,000
Trade payables
Rs. 4,000
Rs. 6,500
Rs.
16,000
15,000
(5,000)
26,000
3,000
(2,000)
2,500
29,500
(4,800)
154
24,700
Practice question
During 2013, a company made a profit before taxation of Rs. 60,000.
Depreciation charges were Rs. 25,000 and there was a gain on the disposal
of a machine of Rs. 14,000.
Interest charges and payments of interest in the year were the same
amount, Rs. 10,000.
Taxation payments were Rs. 17,000.
Values of working capital items at the beginning and end of the year were:
Receivables
Inventory Trade payables
Beginning of the year
Rs. 32,000
Rs. 49,000
Rs. 17,000
155
Current assets
Rs. 12,000
Rs. 11,000
Trade payables
Rs. 4,000
Rs. 6,500
16,000
15,000
(5,000)
26,000
1,000
2,500
29,500
(4,800)
156
Rs.
24,700
348,800
(70,000)
Rs.
(150,000)
(30,000)
98,800
(21,000)
(2,500)
75,300
The task is therefore to establish the amounts for cash receipts and cash
payments. In an examination, you might be expected to calculate any of these
cash flows from figures in the opening and closing statements of financial
position, and the statement of comprehensive income.
The cash receipts from sales during a financial period can be calculated as
follows:
157
Illustration:
Rs.
X
X
X
(X)
X
Sales
X
X
158
Balance c/f
X
X
Cost of sales
X
(X)
X
Having calculated purchases from the cost of sales, the amount of cash
payments for purchases may be calculated from purchases and opening and
closing trade payables.
Illustration:
Rs.
Trade payables at the beginning of the year
Purchases in the year (as above)
X
X
X
(X)
Balance c/f
X
X
Balance b/f
Purchases
X
X
Note that if the business had paid for goods in advance at the start or end of the
year they would have an opening or closing receivable but this situation would be
quite unusual.
159
X
X
(X)
X
Balance c/f
Balance b/f
Purchases
If wages and salaries had been paid in advance the business would have a
receivable and the workings would change to the following.
Illustration:
Rs.
Wages and salaries paid in advance at the beginning of the
year
Wages and salaries expenses in the year
(X)
X
X
X
X
X
X
160
Purchases
Balance c/f
X
X
X
X
X
(X)
X
Payables for other expenses should exclude accrued wages and salaries,
accrued interest charges and taxation payable.
161
Example:
The following information has been extracted from the financial statements of
Hopper Company for the year ended 31 December 2013.
Sales
Cost of sales
Gross profit
Wages and salaries
Other expenses (including depreciation Rs. 25,000)
Interest charges
Profit before tax
Tax on profit
Profit after tax
Rs.
1,280,000
(400,000)
880,000
(290,000)
(350,000)
240,000
(50,000)
190,000
(40,000)
150,000
Trade receivables
Inventory
Trade payables
Accrued wages and salaries
Accrued interest charges
Tax payable
At 31 December
2013
Rs.
219,000
124,000
125,000
5,000
45,000
43,000
Required
Present the cash flows from operating activities as they would be presented in a
statement of cash flows using:
a)
b)
162
Rs.
1,294,000
(383,000)
(293,000)
(325,000)
293,000
(49,000)
(35,000)
209,000
Workings
(W1) Cash from sales
Trade receivables at 1 January 2013
Sales in the year
Rs.
233,000
1,280,000
1,513,000
(219,000)
1,294,000
(W2) Purchases
Closing inventory at 31 December 2013
Cost of sales
Opening inventory at 1 January 2013
Rs.
124,000
400,000
524,000
(118,000)
406,000
Rs.
102,000
406,000
508,000
(125,000)
383,000
163
Rs.
8,000
290,000
298,000
(5,000)
293,000
Tax
Rs.
Interest
Rs.
52,000
40,000
30,000
50,000
92,000
(43,000)
80,000
(45,000)
49,000
35,000
Rs.
190,000
25,000
50,000
265,000
14,000
(6,000)
20,000
293,000
(49,000)
(35,000)
209,000
164
Cash paid for the purchase of investments and cash received from the sale of
investments
6.1 Cash paid for the purchase of property, plant and equipment
This is the second part of a statement of cash flows, after cash flows from
operating activities.
The most important items in this part of the statement are cash paid to purchase
non-current assets and cash received from the sale or disposal of non-current
assets but it also includes interest received and dividends received on
investments.
It is useful to remember the following relationship:
Illustration: Movement on non-current assets
Rs.
Carrying amount at the start of the year
Depreciation
Disposals
(X)
(X)
Additions
Revaluation
X/(X)
165
Using cost:
Non-current assets at the end of the year at cost
Non-current assets at the beginning of the year at cost
X
X
Rs.
X
(X)
X
Depreciation
At cost
Rs.
180,000
240,000
Accumulated
depreciation
Rs.
(30,000)
(50,000)
Net book
value
Rs.
150,000
190,000
Rs.
240,000
180,000
60,000
190,000
150,000
40,000
20,000
60,000
Note that in the above example it is assumed that the purchases have been
made for cash. This might not be the case. If the purchases are on credit the
figure must be adjusted for any amounts outstanding at the year end.
166
2012 (Rs. m)
2013 (Rs. m)
4,000
12,000
The cash paid to buy property, plant and equipment in the year can be
calculated as follows:
Rs. m
Additions
60,000
(8,000)
52,000
This can be thought of as the payment of the Rs. 4,000 owed at the start
and a payment of Rs. 48,000 towards this years purchases.
If the payables had decreased the movement would be added to the additions
figure to find the cash outflow.
Example: Cash paid for property, plant and equipment
PM company has purchased various items of property, plant and equipment on
credit during the year. The total purchased was Rs. 60,000.
The statements of financial position of PM company at the beginning and end of
2013 include the following information:
Payables:
Suppliers of non-current assets
2012 (Rs. m)
2013 (Rs. m)
14,000
4,000
The cash paid to buy property, plant and equipment in the year can be
calculated as follows:
Rs. m
Additions
60,000
10,000
70,000
This can be thought of as the payment of the Rs. 14,000 owed at the
start and a payment of Rs. 56,000 towards this years purchases.
167
X
X
Purchases
Example: Cash paid for property, plant and equipment with disposals
The motor vehicles of PM Company at the beginning and the end of its financial
year were as follows:
Accumulated
Carrying
At cost
depreciation
amount
Rs.
Rs.
Rs.
Beginning of the year
150,000
(105,000)
45,000
End of the year
180,000
(88,000)
92,000
During the year a vehicle was disposed of for a gain of Rs. 3,000. The
original cost of this asset was Rs. 60,000. Accumulated depreciation on
the asset was Rs. 45,000.
The cash paid for plant and machinery in the year (= purchases) may be
calculated as follows.
Rs.
Assets at cost at the end of the year
Assets at cost at the beginning of the year
180,000
150,000
30,000
60,000
Purchases
90,000
Rs.
92,000
45,000
47,000
15,000
28,000
Purchases
90,000
168
X
X
X
(X)
X
Example:
The statements of financial position of Grand Company at the beginning and end of
2013 include the following information:
Property, plant and equipment
2012
Rs.
2013
Rs.
At cost/re-valued amount
1,400,000
1,900,000
Accumulated depreciation
350,000
375,000
1,050,000
1,525,000
Carrying value
During the year, some property was re-valued upwards by Rs. 200,000.
An item of equipment was disposed of during the year at a profit of Rs.
25,000. This equipment had an original cost of Rs. 260,000 and
accumulated depreciation of Rs. 240,000 at the date of disposal.
Depreciation charged in the year was Rs. 265,000.
Purchases of property, plant and equipment during the year were as
follows:
Rs.
At cost/re-valued amount, at the end of the year
1,900,000
1,400,000
500,000
260,000
(200,000)
560,000
169
Example (continued)
Alternatively using carrying amount (NBV):
Assets at carrying amount (NBV) at the end of the year
Assets at carrying amount (NBV) at the beginning of the
year
Rs.
1,525,000
1,050,000
475,000
(200,000)
560,000
20,000
265,000
Rs.
X
(X)
If there is a gain on disposal, the net cash from the disposal is more than the net
book value.
If there is a loss on disposal the net cash from the disposal is less than the net
book value.
170
Example:
During an accounting period, an entity disposed of some equipment and made a
gain on disposal of Rs. 6,000.
The equipment originally cost Rs. 70,000 and at the time of its disposal, the
accumulated depreciation on the equipment was Rs. 56,000.
What was the amount of cash obtained from the disposal of the asset?
Disposal of equipment
At cost
Accumulated depreciation, at the time of disposal
Net book value/carrying amount at the time of disposal
Gain on disposal
Net disposal value (assumed cash flow)
Rs.
70,000
(56,000)
14,000
6,000
20,000
This cash flow would be included in the cash flows from investing activities.
Note that in the above example it is assumed that the cash received for the
disposal has been received. This might not be the case. If the disposal was on
credit the figure must be adjusted for any amounts outstanding at the year end.
Practice question
At 1 January 2013, the property, plant and equipment in the statement of
financial position of NC Company amounted to Rs. 329,000 at cost or
valuation.
At the end of the year, the property, plant and equipment was Rs. 381,000
at cost or valuation.
During the year, a non-current asset that cost Rs. 40,000 (and has not been
re-valued) was disposed of at a loss of Rs. 4,000. The accumulated
depreciation on this asset at the time of disposal was Rs. 21,000.
Another non-current asset was re-valued upwards during the year from Rs.
67,000 (cost) to Rs. 102,000.
Calculate the following amounts, for inclusion in the cash flows from
investing activities section of the companys statement of cash flows for
2013:
a) Purchases of property, plant and equipment
b) Proceeds from the sale of non-current assets
171
6.3 Cash paid for the purchase of investments and cash received from the sale
of investments
A statement of cash flows should include the net cash paid to buy investments in
the period and the cash received from the sale of investment in the period.
It is useful to remember the following relationship:
Illustration: Movement on investments
Rs.
Carrying amount at the start of the year
Disposals
(X)
Additions
Revaluation
X/(X)
2012 (Rs. m)
1,000
2013 (Rs. m)
1,500
Additional information:
The investments were revalued upwards during the year. A revalution
gain of Rs. 150m has been recognised.
Investments sold for Rs. 250m resulted in a profit on the sale (measured
as the difference between sale proceeds and carrying amount at the
date of sale) of Rs. 50m
The cash paid to buy investments in the period can be calculated as a
balancing figure as follows:
Investments at the start of the year (given)
Disposal (carrying amount of investments
sold = Rs. 250m Rs. 50m)
Revalution gains (given
Rs. m
1,000
(200)
150
950
550
172
1,500
Rs.
X
Example:
The statements of financial position of Company P at 1 January and 31 December
included the following items:
1 January 2013
Rs.
600,000
800,000
31 December 2013
Rs.
750,000
1,100,000
The cash obtained from issuing shares during the year is calculated as follows.
Share capital + Share premium at the end of 2013
Share capital + Share premium at the beginning of 2013
= Cash obtained from issuing new shares in 2013
173
Rs.
1,850,000
1,400,000
450,000
Remember to add any loans, loan notes or bonds repayable within one year
(current liability) to the loans, loan notes or bonds repayable after more than one
year (non-current liability) to get the total figure for loans, loan notes or bonds.
Illustration:
Rs.
X
Note: The same calculation can be applied to bonds or loan notes that the
company might have issued. Bonds and loan notes are long-term debt.
Example:
The statements of financial position of Company Q at 1 January and 31 December
included the following items:
1 January
2013
Rs.
760,000
1,400,000
31 December
2013
Rs.
400,000
1,650,000
The cash flows relating to loans during the year are calculated as follows.
Loans outstanding at the end of 2013
Loans outstanding at the beginning of 2013
= Net loan repayments during the year (= cash outflow)
174
Rs.
2,050,000
2,160,000
110,000
X
X
(X)
Example:
From the following information, calculate the cash flows from investing activities
for Company X in 2013.
Beginning of
2013
End of
2013
Rs.
400,000
275,000
390,000
Rs.
500,000
615,000
570,000
1,065,000
600,000
1,685,000
520,000
80,000
55,000
The company made a profit of Rs. 420,000 for the year after taxation.
Required
Calculate for 2013, for inclusion in the statement of cash flows:
(a)
(b)
(c)
175
Answer
Workings
Proceeds from new issue of shares
Share capital and share premium:
At the end of the year (500,000 + 615,000)
Rs.
1,115,000
(675,000)
440,000
Repayment of loans
Loans repayable:
At the end of the year (520,000 + 55,000)
At the beginning of the year (600,000 + 80,000)
Rs.
575,000
(680,000)
105,000
Payment of dividends
Retained earnings at the beginning of the year
Profit after taxation for the year
Rs.
390,000
420,000
810,000
(570,000)
240,000
176
Rs.
440,000
(105,000)
(240,000)
Rs.
95,000
X
X/(X)
X
Drawings
(X)
The drawings and capital introduced figures might be provided in the question in
which case you simply have to slot the figures into the cash flow statement.
Other questions might need you to identify one or other of these as balancing
figure.
177
Direct method
Indirect method
IAS 7 does not specify formats for the statement of cash flows. However, it
includes illustrative statements in an appendix.
The illustrations below are based on the illustrative examples but have been
modified to exclude some items not in this syllabus.
Rs.
(X)
(X)
Interest paid
Income taxes paid
(X)
(X)
(X)
X
Interest received
Dividends received
Dividends paid
(X)
178
Rs.
Adjustments for:
Depreciation
Investment income
(X)
Interest expense
(X)
Decrease in inventories
(X)
Interest paid
(X)
(X)
(X)
Interest received
Dividends received
X
(X)
179
Solutions
(a)
In the adjustments to get from the operating profit to the cash flow from
operations, the loss on disposal of Rs. 8,000 should be added.
(b)
Under the heading Cash flows from investing activities, the sale price of the
vehicle of Rs. 22,000 should be included as a cash inflow.
Workings:
Original cost of vehicle
50,000
(20,000)
30,000
Loss on disposal
(8,000)
22,000
Solutions
Rs.
Profit before taxation
60,000
Adjustments for:
Depreciation
25,000
Interest charges
Gain on disposal of non-current asset
10,000
(14,000)
81,000
5,000
Increase in inventories
(4,000)
(6,000)
76,000
Taxation paid
(17,000)
(10,000)
49,000
180
Solutions
Property, plant and equipment purchases
Rs.
381,000
(329,000)
52,000
(35,000)
57,000
Disposal of equipment
40,000
Rs.
At cost
40,000
(21,000)
19,000
Loss on disposal
(4,000)
15,000
181
182
CHAPTER
183
INTRODUCTION
Learning outcomes
To provide candidates with an understanding of the fundamentals of accounting theory and
basic financial accounting with particular reference to international pronouncements.
LO 1
LO1.4.1:
184
Introduction
1.1 Introduction
Many organisations do not exist in order to make a profit. Such organisations
include:
Charities
Trusts
NGOs
Hospitals
Non-profit making organisations (also called not for profit organisations) have
revenue which they raise and costs which must be paid just like other
organisations.
Non-profit making organisations prepare an income and expenditure account (I &
E account) instead of a statement of comprehensive income. This is similar to a
statement of comprehensive income in that it is prepared on the accruals basis
but there are differences.
Different terminology is used.
In the statement of financial position a company would add the profit for the
year (deduct a loss) to an equity account called retained profits. A not for
profit organisation would add the surplus (deduct a deficit) to an equity
account called an accumulated fund (or accumulated surplus of income
over expenditure).
Also the sort of organisation that prepares income and expenditure accounts
might be subject to much less regulation than entities that exist for a profit.
185
Comment on charities
Some charities are very large organisations and are run very professionally. Such
charities may be subject to separate accounting regulation in some jurisdictions
and may maintain detailed accounting records to the same standard as those
expected of a company.
Charities are only mentioned above for completeness. This chapter proceeds to
explain more about income and expenditure account using the circumstances of
clubs and societies.
186
Donation
Repairs
Telephone
Functions
X
X
Sale of land
Bank interest
Furniture
Bequest
Sundry income
Sundry expenses
X
X
Balance c/d
X
X
X
Balance b/d
A receipt and payment account gives far less information than a set of financial
statements based on the accruals concept.
For all practical purposes this is a cash account.
This is not mentioned in the learning outcomes of this syllabus but it is
examinable at a lower level. It is mentioned here for completeness.
187
Format
Subscriptions account
Donations
2.1 Format
An income and expenditure account is an accruals based statement listing the
different types of income of a club followed by the different categories of
expenditure of the club.
A club may have several categories of income including:
Investment income;
Note that if a club has a coffee bar or shop or runs an event the profit from
these is generally calculated separately (in an account known as a trading
account) and presented as a line in the income and expenditure account.
Illustration: Coffee bar trading account
Rs.
Income
Sales
Rs.
X
Opening inventory
Purchases
X
X
Closing inventory
(X)
Cost of sales
(X)
188
Illustration: Income and expenditure account for the year ending XX/XX/XX
Rs.
Rs.
Income
Subscription income
Donations
X
X
Tournament income
Less: Prizes
(X)
X
X
Expenditure
Club expenses
Rent
Electricity
Depreciation
Repairs
X
X
X
189
X
X
X
Rs.
Balance b/d (members
who have prepaid)
Cash
Balance c/d
(members in arrears)
X
X
X
Balance b/d (members
in arrears)
Rs.
Balance b/d:
48,000 Advance payments
Cash
12,000
624,000
576,000
Balance c/d:
Members in arrears
31,200 (16 1,200)
655,200
19,200 Balance b/d:
190
19,200
655,200
31,200
Credit
Subscription account
Rs.
Balance b/d:
48,000 Advance payments
Cash
Balance c/d:
Advance payments
(26 1,200)
Balance c/d:
Members in arrears
31,200 (16 1,200)
679,200
Balance b/d:
191
12,000
624,000
24,000
19,200
679,200
31,200
Credit
Debit
Credit
X
X
X
X
This treatment recognises the amount received as income over several years.
Recognition in an equity reserve (an accumulated fund)
Illustration:
Debit
Bank (cash received)
Life membership fund (an accumulated fund
account in equity)
Credit
X
X
192
2.4 Donations
A club might receive a donation or bequest.
If the donation has not been made for a specific purpose the club might
recognise the donation as income in the period in which it is received.
A club might receive a donation for a particular purpose. For example, a member
might donate money for a new cricket square. In this case the money is credited
to a fund account set up for the purpose.
Illustration:
Debit
Bank (cash received)
Credit
Rs.
Income
Sales
Opening inventory
X
X
Purchases
X
X
Closing inventory
(X)
Cost of sales
(X)
Gross profit
(X)
193
194
Format
Special funds
3.1 Format
A not for profit organisation may or may not prepare a statement of financial
position but if it does so the statement of financial position would be similar to
that of a business. The main difference is in the equity section. The equivalent of
the capital section of a business is called the accumulated fund.
Example: Statement of financial position of a club
Rs.
Assets
Non-current assets
Club house
Current assets
Subscriptions in arrears
Investments
Shop inventory
Prepayments
X
X
Cash
Total assets
Equity and liabilities
Accumulated fund
At start of year
Surplus / (deficit) for the year
X
X
At end of year
Current liabilities
Subscriptions in advance
Accruals
X
X
195
The organisation might also set aside assets (say cash) to match to the fund so
that they can be used for the specified purpose.
Illustration: Receipt of cash for a specified purpose
Debit
Cash
Special fund
Credit
X
X
Cash
The following journals reflect cash being spent on the specified purpose.
Illustration: Receipt of cash for a specified purpose
Debit
Special fund
Cash (or Special fund cash if so allocated)
Credit
X
X
Credit
1,000,000
1,000,000
1,000,000
Cash
1,000,000
196
Credit
X
X
Cash
Debit
Accumulated fund
Special fund (Education fund)
Allocation of assets to the fund
Special fund cash
1,500,000
1,500,000
1,000,000
Cash
1,000,000
Debit
Credit
Credit
50,000
50,000
197
Practice question
The following were the assets and liabilities of the Nawabshar Youth
Movement at 30 April 2014.
Rs. 000
Fixtures and fittings (net)
Inventory of refreshment (coffee bar)
16,340
4,460
Land
51,600
4,900
6,780
Cash at bank
7,466
The accountants receipts and payments account for the year to 30 April 2015
shows the following:
Receipts
Rs. 000
Donations received
500
Rent of hall
5,600
Members subscription
24,000
Sale of brochure:
Sale of dance tickets
1,740
3,400
10,200
Payments
Repairs and maintenance
3,218
6,309
600
Dance expenses
950
19,415
Sundry expenses
10,000
Further information:
(i)
(ii)
(iii)
(iv)
Subscription due but not paid at 30 April 2015 was Rs. 1,900,000
Required:
Prepare the clubs income and expenditure account for the year ended 30 April
2015 and the statement of financial position as at that date.
198
Practice question
The statement of financial position of Peshawar Business Club as at 31
December 2013 is shown as follows:
Cost
Rs.000
Accumulated
depreciation
Rs.000
Carrying
amount
Rs.000
40,000
10,000
30,000
Games Equipment
20,000
7,200
12,800
Motor van
30,000
10,000
20,000
90,000
27,200
62,800
Current Assets:
Cash at bank and at hand
9,200
72,000
Financed by:
Accumulated funds
72,000
The following transactions took place during the period 1 January 2014 to 31
December 2014:
Receipts
Rs. 000
16,000
1,600
10,800
Payments
Electricity
4,000
6,200
3,200
2,080
1,660
2,520
Further information:
(i)
(ii)
Required:
(a)
(b)
199
Rs.000
30,800
500
5,600
1,740
3,400
7,315
49,355
Less expenses
Repairs and Maintenance
Salaries and Wages (W2)
Gifts and Donations
Dance expenses
Sundry expenses
Depreciation of fixtures and fittings
3,218
6,865
600
950
10,000
1,900
(23,533)
25,822
Net surplus
Statement of financial position as at 30 April 2015
Non-current assets
Land
Fixtures and Fittings
Depreciation
Rs.000
51,600
16,340
(1,900)
14,440
66,040
Current Assets:
Inventory of drinks
Subscriptions unpaid
Cash and Bank Balance
14,210
1,900
12,414
94,564
Financed By:
Accumulated Fund (W5)
Surplus of income over expenditure
Current Liabilities : Wages accrued
200
68,186
25,822
94,008
556
94,564
Subscriptions account
Rs. 000
Rs. 000
Balance b/d
30,800 Bank
Balance c/d
30,800
W2
4,900
24,000
1,900
30,800
Rs. 000
6,309 Expenditure
556
Balance c/d
6,865
W3
6,865
6,865
Payables
Rs. 000
Bank
6,780
Expenditure
12,635
19,415
W4 Coffee bar
Sales
Opening inventory
Purchases (W3)
Closing inventory
19,415
10,200
4,460
12,635
(14,210)
(2,885)
7,315
Profit (gross)
W5 Accumulated fund at start of the year
Assets:
Fixtures and Fittings
Inventory of refreshments
Land
Cash and Bank Balances
Liabilities:
Subscription received in Advance
Payables for drinks supplied
16,340
4,460
51,600
7,466
79,866
4,900
6,780
(11,680)
68,186
Accumulated fund
Rs. 000
201
Solution
(a)
Rs. 000
9,200 Electricity
16,000 Expenses for annual
dinner
1,600 New games equipment
4,000
6,200
2,080
1,660
2,520
Balance c/d
37,600
Income and expenditure account
Income:
Subscriptions (W1)
Donations
Sales of dance tickets
17,940
37,600
Rs.000
16,000
1,600
10,800
28,400
Less expenses
Electricity (4,000,000 + 900,000)
Annual expenses
Cleaners wages
Repairs and renewals
Motor van repairs
Depreciation (W)
Net surplus
3,200
202
4,900
6,200
2,080
1,660
2,520
9,320
(26,680)
1,720
Solution (continued)
Statement of financial position as at 30 April 2015
Non-current assets
Cost
Rs.000
40,000
23,200
30,000
93,200
Accumulated
depreciation
Rs.000
14,000
9,520
13,000
36,520
Current Assets:
Cash and Bank Balance
Carrying
amount
Rs.000
26,000
13,680
17,000
56,680
17,940
74,620
Financed By:
Accumulated Fund (W5)
Surplus of income over expenditure
72,000
1,720
73,720
900
74,620
Working: Depreciation
Furniture and Fittings
Game Equipment
Motor Van
203
Rs.000
4,000
2,320
3,000
9,320
204
CHAPTER
205
INTRODUCTION
Learning outcomes
To provide candidates with an understanding of the fundamentals of accounting theory and
basic financial accounting with particular reference to international pronouncements.
LO 1
LO1.5.1:
LO1.5.2:
206
207
Cost structures
or
Assets
Liabilities
L
Equity
Net assets
The accounting equation is an equation. Therefore changes in one side are
matched by changes in the other side.
Profit or loss for a period can be calculated from the difference between the
opening and closing net assets after adjusting for any drawings during the period.
Formula:
Increase in net assets=Profit + capital introduced drawings
Rs.
X
X
X
X
(X)
208
Example:
At 1 January 2013, the business of Tom Canute had assets of Rs. 214,000 and
liabilities of Rs. 132,000.
At 31 December 2013, the business had assets of Rs. 281,000 and liabilities of
Rs. 166,000.
Tom took Rs. 25,000 in cash and Rs. 3,000 in goods out of the business during the
year for his personal use. He did not introduce any new capital.
Required
Calculate the profit of the business in the year to 31 December 2013.
Answer
Rs.
Assets at 31 December 2013
Liabilities at 31 December 2013
Net assets at 31 December 2013
Assets at 1 January 2013
Liabilities at 1 January 2013
Net assets at 1 January 2013
Increase in net assets during the year
Add: Drawings (25,000 + 3,000)
Balance = Profit /(loss) for the year
Rs.
281,000
(166,000)
115,000
214,000
(132,000)
(82,000)
33,000
28,000
61,000
Practice question
The accountant for a sole trader has established that the total assets of the
business at 31 December Year 4 were Rs. 376,000 and total liabilities were Rs.
108,000.
Checking the previous years financial statements, he was able to establish that
at 31 December Year 3 total assets were Rs. 314,000 and total liabilities were
Rs. 87,000.
During Year 4 the owner has taken out drawings of Rs. 55,000.
In December Year 4 the owner had been obliged to input additional capital of
Rs. 25,000.
What was the profit of the business for the year to 31 December Year 4?
209
Rs.
95,000
Inventory
85,000
Receivables
65,000
Liabilities
(55,000)
Rs.
350,000
200,000
Less: Drawings
(120,000)
430,000
Rs.
95,000
Inventory
85,000
Receivables
65,000
Liabilities
(55,000)
190,000
240,000
210
Rs.
1,600
560
50
850
370
90
410
Required
Calculate the capital of the business as at the beginning of the year.
Answer
Rs.
Assets
Motor van (balance sheet valuation)
Inventory
Receivables
Cash in hand
Total assets
Liabilities
Bank overdraft
Trade payables
Payables for other expenses
Rs.
1,600
410
850
50
2,910
560
370
90
Total liabilities
1,020
1,890
211
Practice question
A sole trader has not maintained full records but is able to supply the
following information for two years ended 31 December:
2014
2013
Rs. 000
10
Rs. 000
-
196
130
16
Bank balances
(40)
200
Investment
500
Cash balance
366
106
74
90
1,500
1,500
Delivery van
260
260
Inventories
190
74
300
300
Accrued expenses
Account receivables
Prepaid expenses
Accounts payable
Property
Further information:
(i)
(ii)
(iii)
(iv)
10%
Additional capital of Rs. 250,000 was introduced into the business during
the year.
The owner withdrew a total sum of Rs. 20,000 during the year.
Required:
(a)
(b)
Calculate the capital at the start of the year by preparing a statement of net
assets at that date.
Prepare a statement of net assets at the end of the year.
(c)
212
receivables at the beginning of the year (from last years balance sheet);
receivables at the end of the year, from copies of unpaid sales invoices;
money banked during the year (assumed to be money from customers for
sales);
Where a business makes some sales for cash, there might also be a figure for
cash sales where the money has not been banked. The amount of these cash
sales might be calculated from the sum of:
213
Example:
An accountant is looking through the records of a sole trader who does not have a
bookkeeping system. He has established the following information.
Rs.
650
720
800
58,600
300
The sales for the year can be calculated as the balancing figure in a receivables
memorandum account.
Receivables memorandum account
Opening balance
Sales
Rs.
650
59,770
(= balancing figure,
60,420 650)
Rs.
58,600
300
Money banked
Cash sales, money not
banked
Bad debt written off
800
Closing balance
720
60,420
60,420
70
58,600
300
800
59,770
Practice question
Calculate sales for the period from the following information.
Rs.
Receivables at the start of the period
Receivables at the end of the period
Cash banked during the period
Bad debt written off
2,400
1,800
12,500
200
214
18,700
The purchases for the year can be calculated as the balancing figure in a payables
memorandum account.
Payables memorandum account
Cash paid
Closing balance
Rs.
18,700
1,800
Opening balance
Purchases (balancing
figure)
20,500
Rs.
1,200
19,300
20,500
Rs.
1,200
1,800
Increase/(decrease) in payables
Money paid out of the business bank account
600
18,700
19,300
Practice question
Calculate purchases for the period from the following information.
Rs.
Payables at the start of the period
Payables at the end of the period
Cash paid to suppliers during the period
215
1,400
1,900
11,300
cash in hand and in the bank account at the beginning of the year;
cash in hand and in the bank account at the end of the year;
payments during the period for purchases, salaries and other cash
expenses.
If there is a missing figure for a cash payment, this should emerge as a balancing
figure.
Note: Cash in hand consists of banknotes and coins. Often, it is just petty cash.
However, some businesses hold a large amount of cash in hand because they
sell goods for cash; for example, retail stores may hold fairly large quantities of
cash in hand.
Example:
An accountant is trying to prepare the financial statements of a sole trader from
incomplete records.
A problem is that the owner of the business admits to having taken cash from the
business, but he has not kept a record of how much he has taken.
The accountant has established the following information:
Cash in hand at the beginning of the year
Bank balance at the beginning of the year
Cash in hand at the end of the year
Bank balance at the end of the year
Receipts
Payments to employees
Payments to suppliers
Payments of interest/bank charges
Rs.
200
2,300
500
3,500
42,800
12,800
17,100
400
Required
From this information, calculate the cash drawings by the owner during the year.
216
Answer
The drawings for the year can be calculated as the balancing figure in a cash and
bank memorandum account.
Cash and bank memorandum account
Rs.
Opening balance, cash
in hand
200
2,300
Receipts
42,800
Rs.
Payments to suppliers
17,100
Payments to employees
Payments of interest/bank
charges
Drawings (= balancing
figure)
Closing balance, cash in
hand
Closing balance, bank
12,800
400
11,000
500
3,500
45,300
45,300
Rs.
2,500
42,800
45,300
Payments to suppliers
Payments to employees
Payments for interest/bank changes
17,100
12,800
400
(30,300)
15,000
(4,000)
11,000
Practice question
Calculate drawings for the period from the following information.
Rs.
Cash in hand at the beginning of the year
Bank balance at the beginning of the year
100
2,400
150
5,200
Receipts
51,700
Payments to employees
3,400
Payments to suppliers
38,200
217
Mark-up
Profit margin
Revenue
Cost of sales
100,000
(80,000)
125%
100%
100%
80%
Gross profit
20,000
25%
20%
Example:
A sole trader does not keep a record of sales. However, she does keep a record of
purchases. The accountant has established that the gross profit margin is 20%, and
that:
a)
b)
c)
Sales for the year can be calculated by first calculating the cost of sales figure and
then adding the mark up to it.
20% (= gross profit/sales), the mark-up on cost is 25% of cost (= 20/(100 20)).
Opening inventory
Purchases
Rs.
700
23,500
Closing inventory
24,200
(1,200)
Cost of sales
Gross profit (25% of cost)
23,000
5,750
Sales
28,750
218
Practice question
A business operates on the basis of a mark-up on cost of 40%.
Calculate the sales figure for the year from the following information:
Rs.
3,100
4,000
Opening inventory
Closing inventory
Purchases
42,100
Practice question
Complete the following table.
Opening inventory
Closing inventory
Rs.
1,000
(1,200)
Rs.
2,000
(1,500)
Rs.
1,000
(500)
Rs.
?
(2,000)
Purchases
5,000
8,700
15,000
Sales
8,000
15,000
20,000
Cost of sales
Gross profit
?
?
?
?
?
?
?
5,000
GP as a % of sales
20%
GP as a % of cost
33.3%
219
Type B
Cost of sales
100
154
Gross profit
20
Sales
Type A
600
%
100
Type C
30
Total
1,000
184
Type A
600
120
Cost of sales
100
Gross profit
20
Type B
154
Type C
Total
100
1,000
70
816
30
184
Step 3: Apply the cost structures to calculate cost of sales and gross profits
Type A
%
Type B
%
Type C
%
Total
Sales
600
120
220
100
1,000
Cost of sales
500
100
154
70
816
Gross profit
100
20
66
30
184
Type B
Type C
Total
Sales
600
120
220
100
180
100
1,000
Cost of sales
500
100
154
70
162
90
816
Gross profit
100
20
66
30
18
10
184
220
b)
c)
d)
Required
Calculate the cost of the inventory lost in the fire.
Answer
Gross profit = 25% of cost.
As a proportion of sales, gross profit = (25/(25 + 100)) = 0.20 or 20%.
Sales = Rs. 140,000.
Therefore gross profit = 20% Rs. 140,000 = Rs. 28,000
Cost of sales = 80% Rs. 140,000 = Rs. 112,000.
Rs.
16,000
115,000
Opening inventory
Purchases
131,000
(112,000)
Cost of sales
19,000
(2,000)
17,000
221
Practice question
A business operates on the basis of a mark-up on cost of 40%.
Calculate the closing inventory from the following information:
Opening inventory
Purchases
Rs.
5,000
71,200
Sales
98,000
Practice question
A fire on 31 March destroyed some of the inventory of a company, and its
inventory records were also lost. The following information is available.
The company makes a standard gross profit of 30% on its sales.
Rs.
Inventory at 1 March
Purchases for March
127,000
253,000
351,000
76,000
222
10
Practice question
Rashid owns a shop which sells telephone recharge cards, making a gross
profit of 25% on cost of sales. He does not keep a cash book.
On 1 January 2014, the statement of financial position of his business was
as follows:
Rs. 000
Net non-current assets
200.0
Current assets:
Inventory
100.0
Cash in bank
30.0
Cash in till
2.0
332.0
Financed by:
Capital
320.0
Trade payables
12.0
332.0
Rs. 000
Banking of receipts
417.5
Payments
Trade payables
360.0
Sundry expenses
56.0
Drawings
44.0
Further information:
(i)
There were no credit sales.
(ii)
The following payments were also made in cash out of the till.
Rs.
Trade payables
(iii)
8,000
Sundry expenses
15,000
Drawings
37,000
At 31 December 2014, the business had cash in the till of Rs. 4,500 and
trade payables of Rs.14,000. The cash balance in the bank was not known
and the value of closing inventory has not yet been calculated. There were
no accruals or prepayments. No further non-current assets were purchased
during the year. The depreciation charged for the year was Rs. 9,000.
Required:
Prepare the statement of profit or loss for the year ended 31 December 2014 and
the statement of financial position as at that date.
223
Solution
Rs.
Net assets at 31 December (376,000 108,000)
Net assets at 1 January (314,000 87,000)
268,000
(227,000)
41,000
Drawings
55,000
(25,000)
71,000
Solution
(a)
300
90
(390)
1,896
Rs.000
1,500
260
74
130
16
200
106
2,286
224
Solution (continued)
(b)
Rs.000
1,425
234
500
190
193
366
2,908
Liabilities:
Bank loan
Bank overdraft
Payables
Accrued expenses
300
40
74
10
(424)
2,484
Solution
Receivables memorandum account
Rs.
Opening balance
Sales (bal fig)
12,500
12,100
Bad debt written off
Closing balance
14,500
Rs.
225
200
1,800
14,500
Solution
Payables memorandum account
Rs.
11,300 Opening balance
Cash paid
Closing balance
Rs.
1,400
11,800
13,200
13,200
Solution
Cash and bank memorandum account
Rs.
Opening balance, cash
in hand
Opening balance, bank
Receipts
Rs.
38,200
3,400
51,700
Drawings (= balancing
figure)
Closing balance, cash in
hand
7,250
150
5,200
54,200
54,200
Solution
Cost of sales
Rs.
Opening inventory
3,100
Purchases
42,100
(4,000)
41,200
Mark-up at 40%
16,480
57,680
226
Solution
Rs.
Rs.
Rs.
Rs.
Sales
8,000
15,000
20,000
Opening inventory
1,000
2,000
1,000
2,000
Purchases
5,000
8,700
7,500
15,000
Closing inventory
6,000
(1,200)
10,700
(1,500)
8,500
(500)
17,000
(2,000)
Cost of sales
(4,800)
(9,200)
(8,000)
(15,000)
Gross profit
3,200
5,800
2,000
5,000
GP as a % of sales
40%
38.7%
20%
25%
GP as a % of cost
66.7%
63%
25%
33.3%
Solution
Rs.
98,000
Sales
%
140
Cost of sales
Opening inventory
5,000
Purchases
71,200
(6,200)
70,000
100
Working:
Cost of sales = 100/140 Sales 100/140 98,000 = 70,000
Solution
Rs.
Inventory at 1 March
Purchases for March
127,000
253,000
380,000
Closing inventory
(76,000)
304,000
(245,700)
58,300
227
10
Solution
Statement of profit or loss account for the year ended 31 December 2014
Rs.000
480.0
Sales
Cost of sales
Opening inventory
Purchases
Closing inventory
100.0
370.0
470.0
(86.0)
(384.0)
96.0
Gross profit
Less expenses
Sundry expenses (Rs. 15,000 + Rs. 56,000)
Depreciation
71.0
9.0
(80.0)
16.0
Net profit
Statement of financial position as at December 2014
Non-current assets (Rs. 200,000 Rs. 9,000)
Current Assets:
Inventory
Cash (W1)
Financed By:
Capital at start of the year
Profit for the year
86.0
4.5
90.5
281.5
320.0
16.0
336.0
(81.0)
255.0
Less: Drawings
Capital at end of the year
Current Liabilities :
Payables (W3)
Bank overdraft (W1)
Rs.000
191.0
14.0
12.5
26.5
281.5
228
10
Cash book
Cash
Bank
Cash
Bank
Rs. 000
Rs. 000
Rs. 000
Rs. 000
Balance b/d
Receipts
Sales (cash) (W2)
Balance c/d
2.0
30.0
480.0
417.5
12.5
Banking
Payables
Expenses
Drawings
Balance c/d
482.0
460.0
8.0
15.0
360.0
56.0
37.0
44.0
4.5
460.0
417.5
482.0
W2 Sales (proof)
Rs. 000
417.5
Receipts banked
Add:
Payments out of till
Closing cash balance
Less:
60.0
4.5
482.0
(2.0)
480.0
W3
Payables
Rs. 000
Bank
Balance c/d
Balance c/d
Rs. 000
12
8 Purchase (balance)
370
14
382
382
125
(100)
25
100
25
Margin
125
25
25%
20%
229
230
CHAPTER
Branch accounts
Contents
1 Branch accounts Debtors system
2 Branch accounts Inventory system
3 Separate entity branch accounts
231
INTRODUCTION
Learning outcomes
To provide candidates with an understanding of the fundamentals of accounting theory and
basic financial accounting with particular reference to international pronouncements.
LO 4
LO4.1.1
LO4.1.2
LO4.1.3
232
Introduction
Branch accounting debtors system inventory transferred to branch with a markup (profit margin, profit loading)
1.1 Introduction
A business might set up branches in a series of locations.
An accounting system must provide information to enable the business to:
233
Credit
X
X
Branch account
X
X
Branch account
Bank
Bank
The profit or loss made by the branch is calculated as a balancing figure on the
branch account.
234
Illustration
Branch account (debtors system)
Rs.
Rs.
Balance b/d:
Branch non-current assets
Branch inventory
Branch receivables
Branch cash
X
X
Statement of
comprehensive income
(branch profit)
X
Balance c/d
235
Branch inventory
Branch receivables
X
X
Branch cash
X
X
X
300
400
1,000
1,200
Cash
600
260
All branch sales are on credit and the branch receives cash directly from
branch customers before remitting it to head office.
The following took place during the year ended 31 December 2013:
The head office transferred goods which cost Rs. 10,000 to the branch.
The branch sent cash in the amount of Rs. 10,700 to the head office.
These transactions are recorded and branch profit calculated as follows:
Branch account (debtors system)
Rs.
Rs.
Balance b/d:
Branch non-current assets
Branch inventory
800
Branch receivables
300
400
Branch cash
600
2,100
10,700
Balance c/d
Branch non-current assets
1,760
13,860
236
700
Branch inventory
1,000
Branch receivables
Branch cash
1,200
260
3,160
13,860
Rs.
800
? Disposals
Depreciation
Balance c/d
700
Rs.
300
Balance c/d
1,000
Rs.
400
10,700
260
Rs.
600
Cash received from
? customers
Sales
Balance c/d
237
?
1,100
Rs.
800
Additions
Disposals
Depreciation
100
Balance c/d
700
800
800
Branch inventory (memorandum account)
Rs.
Balance b/d
Rs.
300
9,300
Balance c/d
1,000
10,300
10,300
Branch cash (memorandum account)
Rs.
Balance b/d
Rs.
600
10,700
260
10,960
Rs.
400
Cash received from
11,160 customers
Balance c/d
11,560
10,360
1,200
11,560
Sales
Cost of sales
Branch gross profit
1,860
(100)
1,760
238
Rs.
300
Transfers in
10,000 Receivables
11,160
1,000
12,160
Rs.
400
Cash received from
11,160 customers
Balance c/d
11,560
10,360
1,200
11,560
There is a loss of detail with this approach as it does not identify a cost of sales
figure.
239
Rs.
408,000
304,400
20,000
Branch account
4,000
Branch profit
2,600
62,000
Rent
12,000
5,000
15,000
4,000
Non-current assets
Accumulated depreciation
168,000
32,000
Trade receivables
51,000
Trade payables
42,000
Cash
Capital b/f
6,200
119,000
627,600
627,600
240
Rs.
Rs.
Non-current assets
Cost
168,000
Accumulated depreciation
(32,000)
136,000
Current assets
Inventories
Branch account
16,500
4,000
47,000
Cash
6,200
Total assets
73,700
209,700
119,000
48,700
167,700
Current liabilities
Trade payables
42,000
209,700
Rs.
408,000
Cost of sales
Opening inventory
15,000
284,400
Closing inventory
299,400
(16,500)
(282,900)
Gross profit
125,100
Branch profit
2,600
Expenses:
Wages and salaries
62,000
Rent
12,000
5,000
(79,000)
48,700
241
Debit
Branch account
Credit
Inventory reserve
Branch account
Note: The profit adjustment for closing inventory is recognised at the end
of a period and then released at the start of the next period just as the
inventory itself is.
Goods sent from head office to branch:
Goods sent to branch
Branch account
This might seem a little pointless but its purpose is to allow the head office to see
the profit it has made on sales to the branch for internal reporting purposes.
242
360
400
1,200
1,200
Cash
600
260
The following took place during the year ended 31 December 2013:
The head office transferred goods which cost Rs. 10,000 to the branch at a
mark-up of 20%
The branch sent cash in the amount of Rs. 10,700 to the head office.
These transactions are recorded and branch profit calculated as follows:
Branch account (debtors system)
Rs.
Rs.
Balance b/d:
Branch receivables
Branch cash
600
60
2,160
Goods sent to branch
2,000
10,700
Balance c/d
Balance c/d
Inventory reserve
1,200
Branch receivables
1,200
Branch cash
Branch profit (balancing
figure)
700
1,760
16,120
243
260
3,360
16,120
Additional accounts
The head office will maintain two other accounts in the general ledger:
Rs.
12,000
10,000
12,000
12,000
Inventory reserve
Rs.
Rs.
Balance b/d
Branch account
Balance c/d
60
60
200 Branch account
260
244
200
260
Memorandum accounts
Example: Memorandum accounts
Branch non-current assets (memorandum account)
Rs.
Balance b/d
Rs.
800 Depreciation
100
Balance c/d
700
800
800
Branch inventory (memorandum account)
Rs.
Balance b/d
Rs.
60
2,000
Cost of sales
9,300
1,200
12,560
Rs.
600
10,700
260
10,960
Rs.
400
Cash received from
11,160 customers
Balance c/d
11,560
245
10,360
1,200
11,560
Rs.
360
12,000
Branch receivables
11,160
Balance c/d
1,200
12,360
12,360
Branch receivables (memorandum account)
Rs
Balance b/d
Sales
Rs.
400
Cash received from
11,160 customers
Balance c/d
11,560
10,360
1,200
11,560
Inventory reserve
Rs.
Rs.
Balance b/d
Mark-up on goods sent to
1,860 branch
2,000
200
2,060
2,060
246
60
Complications
Summaries
Note that these accounts may or may not exist at the discretion of the business.
The impact of this is that accounts described as memorandum under the debtors
system are brought into the head offices general ledger.
Branch inventory account
This account records all transfers of inventory to the branch (and returns from the
branch) measured at cost.
Transfers to the branch are a debit into this account. The balance on the account
represents an asset which is the closing inventory held at the branch.
Goods sent to branch account
When the head office buys inventory it debits purchases. When the head office
transfers inventory to the branch it debits the branch inventory account.
Therefore the same inventory is recorded as a debit in two different places. There
must be an adjustment to remove this double counting. This is done by netting off
the balance on the goods sent to branch account against the purchases figure.
(This is the same as under the debtors system).
247
Credit
X
X
248
X
X
Credit
Branch sales:
Cash/receivables
Branch receivables
Alternatively the sales double entries (and sales return double entries) can be
made between the branch receivables and branch inventory account. This
approach results allows a branch gross profit to be extracted from the branch
inventory account but does not show the branch cost of sales figure.
Illustration: Double entries
Debit
Credit
Branch sales:
Cash/receivables
Branch inventory account
X
X
Branch receivables
249
400
600
1,200
260
The following took place during the year ended 31 December 2013:
The head office transferred goods which cost Rs. 10,000 to the branch.
The branch sent cash in the amount of Rs. 10,700 to the head office.
These transactions are recorded and branch profit calculated as follows:
Branch inventory (general ledger account)
Rs.
Balance b/d
Goods sent to branch
Rs.
9,300
1,000
10,300
Rs.
Branch inventory
10,000
10,000
10,000
Rs.
600
10,360 Paid to head office
Balance c/d
10,960
10,700
260
10,960
Rs.
10,360
1,200
11,560
Rs.
Branch receivables
10,000
250
11,160
10,000
Sales
Cost of sales
Branch gross profit
1,860
Rs.
300
11,160
1,000
12,160
Branch receivables
Rs
Balance b/d
Branch inventory (sales)
Rs.
400
Cash received from
11,160 customers
Balance c/d
11,560
10,360
1,200
11,560
This method is usually used. The other approach was explained first for better
understanding.
251
360
400
1,200
1,200
Cash
600
260
The following took place during the year ended 31 December 2013:
The head office transferred goods which cost Rs. 10,000 to the branch at a
mark-up of 20%
These transactions may be recorded as follows with a memorandum selling
price columns in the branch inventory account.
Branch inventory
Memo.
Balance b/d
Goods sent to
branch
360
Rs.
Memo.
Rs.
300
12,000
Branch
receivables
10,000 (sales)
11,160
11,160
12,360
1,200
12,360
1,000
12,160
Branch gross
profit
Branch receivables
Rs
Balance b/d
Branch inventory (sales)
Rs.
400
Cash received from
11,160 customers
Balance c/d
11,560
252
10,360
1,200
11,560
Note that these accounts may or may not exist at the discretion of the business.
Branch inventory account
This account records all transfers of inventory to the branch (and returns from the
branch) measured these at the selling price of the inventory.
Transfers to the branch are a debit into this account. The balance on the account
represents an asset which is the closing inventory held at the branch. As stated
above the inventory is recorded in this account at selling price. This means that
the closing inventory is also at selling price. However, inventory must be
measured at the lower of cost and net realisable value. The balance on the
account must be adjusted to reduce the figure to cost. This will be explained
shortly.
Branch mark-up account
This account is used to record the profit element on transfers from and back to
head office. (This account might also be called the branch profit loading account
or the adjustment account).
The profit made by the branch is transferred from this account to the statement of
comprehensive income of the business.
The closing balance on this account represents the profit element in the branch
closing inventory. This is a credit balance. When the financial statements are
prepared the balance on this account is netted off the balance on the branch
inventory account thus adjusting it to cost. This solves the first of the two
problems mentioned above.
The profit element in the closing inventory has been recognised by the head
office but has not been realised (i.e., not turned into actual profit). It can be
described as unrealised profit. (You will see later that this is an important concept
when it comes to preparing separate entity branch accounts)
Goods sent to branch
This account is used to record the cost of transfers from and back to head office.
The closing balance on this account is netted off purchases to avoid double
counting. This solves the second of the two problems mentioned above.
253
Credit
X
X
X
Mark-up account
X
X
This is simply the reverse of the entries when goods are sent to the branch
Branch sales:
Cash/receivables
Branch inventory account
X
X
254
Example:
Islamabad Electrical Retailers set up a branch in Lahore near the end of its
financial year.
The branch is a selling agency with all records maintained at head office in Lahore.
Head office purchases in the year are Rs. 9,000,000.
Just before the year-end the head office transferred inventory to the branch. This
inventory had cost Rs. 500,000 and is to be sold at a mark-up of 25% (Rs.
125,000). This means that the inventory has a selling price of Rs. 625,000.
The double entry to record the transfer is as follows:
Dr
Branch inventory account (at selling price)
Good sent to branch account (at selling price)
Good sent to branch account (profit element)
Cr
625,0001
625,0002
125,0003
125,0004
If the branch has not sold any of this inventory by the year-end then the
financial statements would contain the following extracts:
Statement of financial position
Rs.
Current assets:
Inventory held at branch (625,0001 125,0004)
Statement of comprehensive income
500,000
Rs.
Cost of sales
Purchases (9,000,000 (625,0002 125,0003)
Branch profit
255
8,500,000
nil
Credit
Mark-up account
Example:
Islamabad Electrical Retailers set up a branch in Lahore near the end of its
financial year.
The branch is a selling agency with all records maintained at head office in Lahore.
Head office purchases in the year are Rs. 9,000,000.
Just before the year-end the head office transferred inventory to the branch. This
inventory had cost Rs. 500,000 and is to be sold at a mark-up of 25% (Rs.
125,000). This means that the inventory has a selling price of Rs. 625,000.
The double entry to record the transfer is as follows:
Dr
Branch inventory account (at selling price)
Good sent to branch account (at cost)
Cr
625,0001
500,0002
125,0003
Rs.
Current assets:
Inventory held at branch (625,0001 125,0003)
Statement of comprehensive income
500,000
Rs.
Cost of sales
Purchases (9,000,000 500,0003)
Branch profit
8,500,000
nil
256
This is the example used several times already to demonstrate different systems.
Example: Branch account (inventory system)
A business recorded the following balances for one of its branches at two period
ends:
Inventory (at mark up of 20%)
Receivables
31 December 2012
360
400
31 December 2013
1,200
1,200
600
260
Cash
The following took place during the year ended 31 December 2013:
The head office transferred goods which cost Rs. 10,000 to the branch at a
mark-up of 20%
The branch sent cash in the amount of Rs. 10,700 to the head office.
These transactions are recorded and branch profit calculated as follows:
Branch inventory
Rs.
Balance b/d
Rs.
360
11,160
1,200
12,360
Rs.
12,000
10,000
12,000
12,000
Branch mark-up
Rs.
Rs.
Balance b/d
Mark-up on goods sent to
1,860 branch
2,000
200
2,060
2,060
257
60
Example:
Branch cash (general ledger account)
Rs.
Balance b/d
Received from customers
Rs.
600
10,360 Paid to head office
Balance c/d
10,960
10,700
260
10,960
Branch receivables
Rs
Balance b/d
Sales
400
Cash received from
11,160 customers
Balance c/d
11,560
Rs.
258
10,360
1,200
11,560
Normal losses; or
Abnormal losses
Normal loss
A normal loss is one that is expected and accepted by the business. It is an
accepted cost of being involved in a certain type of business. For example, a
business that sells glass accepts that employees might occasionally drop a sheet
and break it. Of course the owners of the business do not like this but they have
to accept that breakages are a normal cost of being in this type of business.
Illustration:
Experience shows that for every 100 sheets of glass a business buys, two are
broken.
This means that in order to sell 98 sheets the business has to buy 100 sheets.
The revenue from 98 sheets is matched against the cost of 100 sheets.
This might happen in any business not just those with branches. In businesses
without branches the above matching is achieved automatically because all
purchases are expensed and the closing inventory deducted from them. If a
sheet of glass is broken then there would be no deduction against the number
purchased. In other words, no special treatment is needed.
However, inventory transferred to a branch has been recorded in a special way.
The profit element has been recognised on all transfers and this must be
corrected using the following double entry:
Illustration: Accounting for normal loss (at a branch)
Debit
Mark-up account (selling price of inventory lost)
Branch inventory account (selling price of
inventory lost)
Credit
X
X
It is not immediately obvious how this works but the following example should
make it clear.
259
Example
A business transfers 100 sheets of glass to its branch.
Each sheet costs Rs. 1,000 and is to be sold at Rs. 1,500.
The branch sells all of the sheets except 2 which were broken.
The profit made by the branch can be calculated from first principles as follows:
Rs.
Revenue (98 Rs.1,500)
147,000
Cost of sale:
Purchases (100 Rs.1,000)
100,000
Closing inventory
(100,000)
Gross profit
47,000
The above is not how the business would account for the sale of this glass (it
is only shown so that you can see that the profit using branch accounting is
correct).
The actual accounting would be as follows:
Branch inventory
Rs.
Goods to branch
Rs.
150,000
Branch sales
147,000
3,000
150,000
150,000
Branch mark up
Rs.
Lost inventory (2 1,500)
Branch gross profit
Rs.
50,000
50,000
Rs.
260
100,000
100,000
Abnormal loss
This is different. It has arisen out of an unexpected event. It must be highlighted
as something out of the ordinary so that users can understand its impact. An
inventory loss account is opened to do this.
Illustration: Accounting for abnormal loss (at a branch)
Debit
Mark-up account (mark-up of inventory lost)
Branch inventory account (selling price of
inventory lost as for normal loss)
Inventory loss account (cost of inventory lost)
Credit
X
X
X
Example
A business transfers 100 sheets of glass to its branch.
Each sheet costs Rs. 1,000 and is to be sold at Rs. 1,500.
The branch sells all of the sheets except 2 which were broken in what was
considered to be an abnormal event.
The accounting would be as follows:
Branch inventory
Rs.
Goods to branch
Rs.
150,000
Branch sales
147,000
3,000
150,000
150,000
Branch mark up
Rs.
Lost inventory (2 500)
Branch gross profit
Rs.
50,000
49,000
50,000
50,000
Inventory loss
Rs
Lost inventory (2 1,000)
Rs.
2,000 P&L
2,000
42,000
2,000
Summary:
Rs.
Gross profit
49,000
Abnormal loss
(2,000)
Branch profit
47,000
Note that the loss recognised is the same as before but is presented
differently.
261
2.7 Complications
Branch sales returns from customers direct to branch
A customer to whom a sale has been made might return the goods to the branch.
The following double entry is used if the policy of the company is to record sales
in the branch inventory account:
Illustration: Accounting for sales returns to the branch
Debit
Branch inventory account
Branch receivables (or cash)
Credit
X
X
The inventory will be included as the part of the closing inventory of the branch in
the usual way.
Branch sales returns from customers direct to head office
A customer to whom a sale has been made might return the goods to the head
office. In this case the head office accepts the returned inventory and repays the
customer. The branch no longer has the inventory. This is similar to the branch
returning the goods to head office.
This is accounted for as follows:
Illustration: Accounting for sales returns to the head office
Reverse the sale
Branch inventory account
Branch receivables (or cash)
Debit
Credit
X
X
X
X
+
Mark-up account
Goods in transit
A question might tell you that there are goods in transit from the head office to
the branch at the year-end have not yet been accounted for in the branch
accounts.
Goods in transit should be accounted for as goods sent to branch.
262
2.8 Summaries
Debtors system
Sales double entry between branch receivables
(memorandum) and:
Transfers at cost
Branch
Sales(memorandum)
Cost of sales identified as a
balancing figure in the branch
inventory (memorandum)
account.
Branch inventory
(memorandum)
Branch gross profit
identified as a balancing
figure in the branch
inventory (memorandum)
account.
Cost of sales figure not
identified
Inventory reserve
(memorandum) used to
include mark-up on opening
and closing inventory and
mark-up on goods sent to
and from branch.
263
Balance on inventory
reserve (memorandum) is
branch gross profit.
Inventory system
Sales double entry between branch receivables (GL)
and:
Transfers at cost
Branch Sales(GL)
Cost of sales identified as a
balancing figure in the branch
inventory (general ledger)
account.
264
Introduction
Double entries
3.1 Introduction
A branch might be set up as a semi-independent business with its own set of
records.
The branch will receive inventory from the head office and also might purchase
inventory from other suppliers.
Transactions between the head office and the branch are recorded in current
accounts:
Head office general ledger will include a receivable called Branch current
account;
Branch general ledger will include a payable called Head office current
account. This liability constitutes the capital of the branch.
Debit
X
Branch accounts
Goods from head office (a type of purchase
from the head offices viewpoint).
Debit
Credit
X
Credit
X
X
265
Debit
X
Cash
Credit
X
Branch accounts
Cash
Debit
X
Credit
X
Debit
X
Credit
X
Branch accounts
Head office current account
Debit
X
Cash
Credit
X
Branch profit
Illustration: Branch profit
Head office accounts
Branch current account
Debit
X
Branch accounts
Branch profit and loss
Debit
X
Credit
Credit
X
266
The financial statements of the head office and of the branch are always
prepared from their viewpoint (as will be explained shortly).
The financial statements of the combined entity are constructed by adding those
of the head office and the branch together.
During this exercise the current accounts are cancelled out. If this was not the
case the combined entity would have an asset and liability collectible from and
payable to itself, which is clearly ridiculous.
Similarly the amounts transferred to the branch which appear in the revenue
section of the head offices statement of comprehensive income are cancelled
out against the transfers from head office which appear in the purchases section
of the branchs statement of comprehensive income.
Balances between the head office (HO) and the branch never appear in the
financial statements of the combined entity (CE).
Illustration: Cancellation
Adjustment
HO
Branch
Sales
100
50
Transfers to branch
30
Purchase
65
Dr
Cr
CE
150
30
25
Transfers from HO
30
90
30
The result of the adjustment is that the sales and purchases figures in
the combined entity account are just those to and from third parties.
267
350,000
40,000
At 31 December 2013 Rs.20,000 of the goods sent from head office had
not been received in Larkana. (The branch had received only Rs.
380,000).
Also, Rs.15,000 of cash remitted from Larkana was not received in
Hyderabad until 2 January 2014. (The head office had received only Rs.
335,000).
Show how these transactions would be recorded in the current account
of both Hyderabad and Larkana.
268
Example (continued)
Head office accounts:
Branch current account
Rs.
Rs.
Cash
110,000
335,000
Balance c/d
180,000
550,000
550,000
Balance b/d
35,000
180,000
Adjustments
Goods in transit
20,000
Cash in transit
15,000
Balance c/d
180,000
145,000
180,000
Branch accounts:
Head office current account
Rs.
Rs.
Cash from head office
Goods returned to HO
Cash to head office
380,000
350,000
Profit for the period
Balance c/d
110,000
145,000
530,000
40,000
530,000
The two balances are now equal and can be cancelled out when the
statements of financial position of the head office and the branch are
combined.
The other side of the goods in transit adjustment in the head offices
books is to goods sold to branch. In addition to this the inventory has to
be included in the head office closing inventory.
269
As far as the head office is concerned a sale has been made to a customer
(the branch) at the selling price (cost plus the mark-up).
When the financial statements of the combined entity are prepared the inventory
must be measured at cost to the combined entity. Any unrealised profit must be
eliminated.
Illustration: Unrealised profit
A head office buys inventory for Rs. 200,000 and transfers half of this to its branch
at a mark-up of 20%. Therefore the price charged is Rs. 120,000 (1/2 of 200,000 =
100,000 + 20%).
The branch still holds this inventory at the year end.
HO
Branch
Transfers to branch
120
Purchase
200
Gross profit
CE
120
200
Transfers from HO
Closing inventory
Adjustment
Dr
Cr
120
120
(100)
(120)
20
(200)
(100)
20
20
270
Dr
Cr
Dr
Cr
Rs.
Rs.
Rs.
Rs.
204,000
41,000
Sales
542,000
143,000
170,500
471,000
2,000
49,000
28,000
Payables
64,000
Receivables
Share capital
17,000
Expenses
97,500
5,000
50,000
14,500
3,000
58,000
46,000
150,000
131,000
Cash
12,500
43,000
952,000
14,000
9,000
952,000
230,500
230,500
N/A
54,000
Branch inventory
34,000
28,600
Goods in transit
12,000
9,800
HO inventory
Further information:
Depreciation of 20% of NBV is to be charged for the year.
Required
Profit and loss accounts and balance sheets for the head office, the branch
and the combined entity for the year ending 31.12.X2
271
Step 1
Example:
Step 1: Set up proforma statements of comprehensive income in columnar form for
the head office, branch and the combined entity.
Leave columns for workings as below.
Fill in the easy figures from the trial balances remembering that the numbers for the
head office and the branch are from their own viewpoint.
The combined entity opening inventory is always the sum of the opening inventories
form the trial balance less the opening unrealised profit balance. Put this in the
adjustment column
Add across where possible. Remember that the goods sold to the branch and goods
bought from the head office never appear in the combined entity statement.
Head
office
Branch
Rs.
Rs.
Sales
542,000
143,000
Working
Rs.
Combined
Rs.
170,500
Rs.
712,500
685,000
Cost of sales
Inventories at 1
January 2012
Purchases
49,000
28,000
471,000
2,000
3,000Cr
74,000
473,000
131,000
520,000
161,000
(54,000)
(34,000)
(466,000)
(127,000)
219,000
43,500
43,000
9,000
52,000
Expenses
97,500
14,500
112,000
Depreciation
40,800
8,200
49,000
(181,300)
(31,700)
(213,000)
37,700
11,800
Closing inventory
Gross profit
272
Step 2
Example:
Step 2: Calculate the closing inventory for the combined entity.
The closing inventory the combined entity statement should always be at cost to the
combined entity. (It is often convenient to note the unrealised profit amounts at this
stage).
At this stage the statement of comprehensive income can be almost completed
though there is still some work to do.
Head
office
Branch
Rs.
Rs.
Sales
542,000
143,000
Working
Rs.
Combined
Rs.
170,500
Rs.
712,500
685,000
Cost of sales
Inventories at 1
January 2012
Purchases
49,000
28,000
471,000
2,000
3,000Cr
74,000
473,000
131,000
520,000
161,000
547,000
(54,000)
(34,000)
(92,400)
(466,000)
(127,000)
(454,600)
219,000
43,500
257,900
43,000
9,000
52,000
Expenses
97,500
14,500
112,000
Depreciation
40,800
8,200
49,000
(181,300)
(31,700)
(213,000)
37,700
11,800
44,900
Closing inventory
Gross profit
Cost to branch
HO inventory
not applicable
Cost to combined
entity
54,000
Unrealised
profit
not applicable
Branch inventory
34,000
28,600
5,400
Goods in transit
12,000
9,800
2,200
92,400
7,600
273
Step 3
Example:
Step 3: Enter the adjustments necessary for the goods in transit into one column.
Enter the adjustments necessary for unrealised profit amounts in another column.
This is not double entry. It is simply a working.
Sum the adjustments in the unrealised profit column.
Each line should now cross cast.
Head
office
Branch
Rs.
Rs.
Sales
542,000
143,000
Working
Rs.
Combined
Rs.
170,500
Rs.
712,500
143,000
685,000
Cost of sales
Inventories at 1
January 2012
Purchases
49,000
28,000
471,000
2,000
131,000
520,000
3,000Cr
74,000
473,000
131,000
161,000
547,000
5,400Dr
Closing inventory
(54,000)
(34,000)
(466,000)
(127,000)
219,000
43,500
43,000
9,000
52,000
Expenses
97,500
14,500
112,000
Depreciation
40,800
8,200
49,000
(181,300)
(31,700)
(213,000)
37,700
11,800
Gross profit
274
12,000
2,200Dr
(92,400)
(454,600)
4,600Dr
4,600Dr
257,900
44,900
Step 4
Example:
Step 4: Perform the unrealised profit double entry in the head offices books.
The total posting is as follows:
Provision for unrealised profit:
Posting to the statement of comprehensive income
Rs.
On opening inventory (a credit)
(3,000)
5,400
2,200
4,600
Debit
4,600
Credit
4,600
Branch
Rs.
Rs.
Sales
542,000
143,000
Working
Rs.
Combined
Rs.
170,500
Rs.
712,500
143,000
685,000
Cost of sales
Inventories at 1
January 2012
Purchases
49,000
28,000
471,000
2,000
131,000
520,000
3,000Cr
74,000
473,000
131,000
161,000
547,000
5,400Dr
Closing inventory
(54,000)
(34,000)
(466,000)
(127,000)
219,000
43,500
43,000
9,000
52,000
Expenses
97,500
14,500
112,000
Depreciation
40,800
8,200
49,000
(181,300)
(31,700)
(213,000)
37,700
11,800
Unrealised profit
(4,600)
Gross profit
33,100
275
11,800
12,000
2,200Dr
(92,400)
(454,600)
4,600Dr
257,900
44,900
Step 5
Example:
Step 5: The branch profit is recognised in the head office current account held by the
branch.
The branch profit is recognised in the branch current account held by the head office.
The journals to achieve this are as follows:
Debit
Credit
Branchs books:
Statement of comprehensive income
11,800
11,800
11,800
Branch
Rs.
Rs.
Sales
542,000
143,000
Working
Rs.
Combined
Rs.
170,500
Rs.
712,500
143,000
685,000
Cost of sales
Inventories at 1
January 2012
Purchases
49,000
28,000
471,000
2,000
131,000
520,000
3,000Cr
74,000
473,000
131,000
161,000
547,000
5,400Dr
Closing inventory
(54,000)
(34,000)
(466,000)
(127,000)
219,000
43,500
43,000
9,000
52,000
Expenses
97,500
14,500
112,000
Depreciation
40,800
8,200
49,000
(181,300)
(31,700)
(213,000)
37,700
11,800
Unrealised profit
(4,600)
Gross profit
33,100
11,800
11,800
(11,800)
44,900
276
12,000
2,200Dr
(92,400)
(454,600)
4,600Dr
257,900
44,900
4,900
Step 6
It is now time to construct the statement of financial position.
A lot of the numbers are straight forward and you have already carried out a lot of
work on the other numbers.
The following workings are usually needed:
Reserves
Branch
Rs.
Rs.
Combined
Rs.
Non-current assets
At start (NBV)
204,000
41,000
Depreciation
40,800
8,200
163,200
32,800
196,000
34,000
92,400
5,000
22,000
Branch Current
account
Provision for
unrealised profit
Inventory
Receivables
17,000
Cash
12,500
308,900
Share capital
12,500
71,800
50,000
322,900
50,000
Reserves
194,900
64,000
Overdraft
308,900
277
64,000
14,000
14,000
71,800
322,900
Step 7
Example:
Step 7: Statement of financial position workings
Head offices
books
Branchs books
Branch current
account
(receivable)
Head office
current account
(payable)
58,000
46,000
(12,000)
Branch profit
11,800
11,800
57,800
57,800
5,400
2,200
7,600
Head office inventory
Rs.
Given in question
54,000
12,000
(2,200)
63,800
Reserves
Given in question
150,000
44,900
194,900
278
Step 8
Example: Completing the statement of financial position
Head
office
Rs.
Branch
Combined
Rs.
Rs.
Non-current assets
At start (NBV)
204,000
41,000
Depreciation
40,800
8,200
163,200
32,800
196,000
Current accounts
57,800
Provision for
unrealised profit
(5,400)
Inventory
63,800
34,000
92,400
Receivables
17,000
5,000
22,000
Cash
12,500
308,900
Share capital
Reserves
322,900
50,000
194,900
194,900
57,800
64,000
Overdraft
308,900
71,800
50,000
Current accounts
Payables
12,500
279
64,000
14,000
14,000
71,800
322,900
280
CHAPTER
281
INTRODUCTION
Learning outcomes
To provide candidates with an understanding of the fundamentals of accounting theory and
basic financial accounting with particular reference to international pronouncements.
Cost of production
LO 5
LO 1.1.1
Explain the scope of cost accounting and managerial accounting and compare
them with financial accounting
LO5.1.1:
Meaning and scope of cost accounting: Explain the scope of cost accounting
and managerial accounting and compare them with financial accounting.
LO5.2.1:
LO5.2.2:
LO5.3.1:
Direct and indirect cost: Identify and apply the concept of direct and indirect
costs in given scenarios.
LO5.4.1:
LO5.4.2:
LO5.5.1:
Product cost and period cost: Compare and comment product cost and period
cost in given scenarios.
282
Management, so that managers have the information they need to run the
company
Other users of information, many of them outside the entity. For example, a
company produces accounting information for its shareholders in the form
of financial statements, and financial statements are also used by tax
authorities, investors, trade union representatives and others.
283
Accounting systems are designed to capture data and process it into information.
Illustration: Data and information
A company engages in many different types of transactions (sales, purchases of
materials, expenses, and so on).
Each of these is processed into individual records (for example, sales are recorded
on sales invoices). This would result in thousands of individual records.
An accounting system summarises these in a meaningful manner to produce
information. This is carried out in a series of steps each of which provides
information based ultimately on the original transactions.
Sales day book summarises the total sales made in a specified period.
The receivables control account shows the total owed to the company at any point
in time.
The receivables ledger shows the total amount owed the company by individual
customers at any point in time.
The general ledger is the source of information which can be further processed into
periodic reports (financial statements).
A cost accounting system records data about the costs of operations and
activities within the entity. The sources of cost accounting data within an
organisation include invoices, receipts, inventory records and time sheets.
Many of the documents from which cost data is captured are internally-generated
documents, such as time sheets and material requisition notes.
Illustration:
A ship yard may employ hundreds of workers and be building and refitting several
ships at any one time.
Each worker might be required to complete job sheets which specify the length of
time taken by that worker and on which contract.
This would produce many thousands of individual records (data) which are not very
useful until the facts contained in those records are processed into information.
Thus the system might produce reports (information) to show the labour cost, by
type of labour, by week for each ship.
284
routine reports;
specially-prepared reports;
Understandable
Reliable
Sufficiently complete
Timeliness
285
Comparability
This is the person with the authority to make a decision on the basis
of the information received and who needs the information to make
the decision.
Its value must exceed its cost (Information must be cost effective)
planning;
control; and
decision making.
Planning
Planning involves the following:
The planning process is a formal process and the end-result is a formal plan,
authorised at an appropriate level in the management hierarchy. Formal plans
include long-term business plans, budgets, sales plans, weekly production
schedules, capital expenditure plans and so on.
Information is needed in order to make sensible plans for example in order to
prepare an annual budget, it is necessary to provide information about expected
sales prices, sales quantities and costs, in the form of forecasts or estimates.
286
Control
Control of the performance of an organisation is an important management task.
Control involves the following:
287
2.1 Purpose and role of cost accounting, management accounting and financial
accounting
The terms cost accounting and management accounting are often used as
having the same meaning. However, there is distinction between the two.
Cost accounting
Cost accounting is concerned with identifying the cost of things. It involves the
calculation and measurement of the resources used by a business in undertaking
its various activities.
Cost accounting is concerned with gathering data about the costs of products or
services and the cost of activities. There may be a formal costing system in which
data about operational activities is recorded in a double entry system of cost
accounts in a cost ledger. The cost accounting data is captured, stored and
subsequently analysed to provide management information about costs.
Cost accounting information is historical in nature, and provides information
about the actual costs of items and activities that have been incurred.
Management accounting
Management accounting is concerned with providing information to management
that can be used to help run the business.
288
289
However, the accounts in a cost accounting system are different from the
accounts in the financial accounting systems. This is because the two
accounting systems have different purposes and so record financial
transactions in different ways.
290
INTRODUCTION TO COSTS
Section overview
Types of organisation
Service organisations.
Manufacturing organisations
There are a great many different kinds of manufacturing organisations. They can
be classified by their type of output which in turn implies the type of costing
system they might use.
Type of production
Examples
Costing system
Identical (similar)
products in large
numbers
Basic manufacturing
costing
Garments
Standard costing
Identical products in
large amounts by
passing the product
through a series of
processes
Pharmaceuticals
Process costing
(including joint product
and by-product costing)
Identical products in
large numbers
customised in some way
for different customers
One-off products to a
customers specification
Ships
Paint
Petroleum
Job costing
Airport facilities
Roads
Bridges
Service organisations
Similar to the manufacturing industry there are a great many different kinds of
service organisations. For example:
Healthcare
Financial services
291
One of the key differences between manufacturing and service industries is the
perishability of product manufacturing output is generally tangible and can be
stored whereas output from the service industry is generally perishable. The
service is normally consumed at the time of delivery (production). For example, a
patient visiting a doctor consumes the consultation as it is given.
However, some work-in-progress (WIP) may be recorded for example an
accountant who has spent 10 hours working on a tax advice project that will take
20 hours in total to complete. The first 10 hours would be described as WIP.
Costing systems typically used in service organisations include:
Standard costing
Job costing
The professional will usually apply a standard hourly rate whilst the
total number of hours on each job varies
Terminology
Definitions: Cost object
Cost object: Any activity for which a separate measurement of costs is needed
292
Cost object
Cost unit
Car manufacture
Cars produced
A car
Bakery
Bread produced
Steel works
Steel produced
Tonne of steel
Carpet manufacture
Carpets produced
Retail operation
An item
Passenger transport
service
Cost of transporting
customers
Road haulage
Cost of transporting
items
University
Cost of teaching
Example
A company manufactures tinned foods.
It has two products, tinned carrots and tinned beans. In its costing system, it has
two cost objects, carrots and beans.
1
2
Cost object
Carrots
Beans
Cost unit
Production cost per tin of carrots
Production cost per tin of beans
293
Example:
A transport company has a bus depot.
The company has a cost accounting system that records and measures the cost
of operating the bus depot.
The costs of operating the depot are measured in three ways, as follows:
Cost object
Cost unit
Buses
Bus routes
Bus drivers
Production
Non-production
Selling
Distribution
Administration
Finance
Cost behaviour i.e. how the cost varies at different levels of activity:
Each of these will be explained in turn but before that note that the above
classifications are not mutually exclusive.
Illustration:
A car maker uses steel:
Steel is material.
Steel is a production cost (you cannot make a car without using steel).
Steel is a cost which varies with the number of cars produced.
Steel can be directly attributable to a car.
Steel is a product cost.
294
Production or non-production?
Reporting profit
295
Production costs
Production costs are the costs incurred in manufacturing finished products, up to
the time that the manufacture of the goods is completed, and the goods are
either transferred to the finished goods inventory or delivered immediately to the
customer.
Production costs include:
the material cost of the raw materials and components, purchased from
suppliers and used in the production of the goods that are manufactured
the labour cost of all employees working for the manufacturing function,
such as machine operators, supervisors, factory supervisors and the
factory manager
other expenses of the factory, such as rental costs for the factory building,
energy costs and the cost of depreciation of factory machinery.
Non-production costs
Non-production costs are any items of cost that are not production costs.
Non-production costs can be further classified according to their function as:
selling costs;
distribution costs;
administrative costs;
finance costs.
Administration costs
Administration costs are the costs of providing administration services for the
entity. They might be called head office costs and usually include the costs of
the human relations department and accounting department. They should
include:
the salary costs of all the staff working in the administration departments
the costs of the office space used by these departments, such as office
rental costs
other administration expenses, such as the costs of heating and lighting for
the administration offices, the depreciation costs of equipment used by the
administration departments, fees paid to the companys solicitors for legal
services, costs of office stationery and so on.
296
the wages and salary costs of all employees working in the selling and
distribution departments, including sales commissions for sales
representatives
Finance costs
Finance costs include costs that are involved in financing the organisation, for
example, loan interest or bank overdraft charges.
Finance costs might be included in general administration costs. Alternatively,
finance costs might be excluded from the cost accounting system because they
are relevant to financial reporting (and the financial accounting system) but are
not relevant to the measurement of costs.
Building rental costs, when the same building is used by more than one
function. For example administration staff and sales staff might share the
same offices.
When costs are shared between two or more functions, they are divided between
the functions on a fair basis.
For example, the salary of the managing director might be divided equally
manufacturing costs, administration costs and sales and distribution costs.
Dividing shared costs on a fair basis is called apportionment of the cost.
Practice question
A company uses three categories of functional cost in its cost accounting
system. These are manufacturing costs, administration costs and sales and
distribution costs.
Identify the functional cost category for each of the following costs:
1
2
297
120
230
350
50
Rs m
600
200
400
298
finished goods that have been produced during the financial period but not
yet sold (finished goods inventory); and
work-in-progress.
299
Rs.
25,000
Purchases
150,000
175,000
(20,000)
155,000
Manufacturing wages
100,000
Prime cost
255,000
Overheads
Light and power
72,000
40,000
Depreciation of factory
50,000
162,000
Manufacturing costs
Opening work in progress
417,000
85,000
(95,000)
407,000
Rs.
800,000
50,000
407,000
457,000
(40,000)
Cost of sales
(417,000)
Gross profit
383,000
Administration costs
86,000
94,000
(180,000)
203,000
300
Cost behaviour
Fixed costs
Variable costs
Semi-variable costs
Stepped costs
As a general rule, total costs are expected to increase as the volume of activity
rises.
Management might want information about estimated costs, or about what costs
should have been. An understanding of cost behaviour is necessary in order to:
compare actual costs that were incurred with what the costs should have
been.
The most important classification of costs for the purpose of cost estimation is the
division of costs into fixed costs or variable costs.
The rental cost of a building is Rs.40,000 per month. The rental cost is fixed
for a given period: Rs.40,000 per month, or Rs.480,000 per year.
The salary costs of a worker who is paid Rs.11,000 per month. The fixed
cost is Rs.11,000 per month or Rs.132,000 per year.
Note that as activity levels increase the cost remains fixed. However, the cost per
unit falls because the cost is being spread over a greater number of units.
301
The cost of buying raw material is Rs.500 per litre regardless of purchase
quantity. The variable cost is Rs.500 per litre:
direct labour is a variable cost and the direct labour cost per unit
produced is Rs.10 (= Rs.150 4/60).
Note that as activity levels increase the cost per unit remains fixed. However, the
total cost increases as more units are being made.
302
An item of cost that is a mixed cost is an item with a fixed minimum cost per
period plus a variable cost for every unit of activity or output.
303
Example:
A company uses a photocopier machine under a rental agreement. The
photocopier rental cost is Rs.4,000 per month plus Rs.2 per copy produced.
The company makes 15,000 copies during a month:
Total cost is as follows:
Rs.
Fixed cost
4,000
30,000
34,000
Rs.
3600,000
250,000
Total costs
3,850,000
304
has a fixed cost behaviour pattern within a limited range of activity, and
goes up or down in steps when the volume of activity rises above or falls
below certain levels.
On a cost behaviour graph, step fixed costs look like steps rising from left to right.
Illustration:
Total cost
Activity level
Example:
A company might pay its supervisors a salary of Rs. 20,000 each month.
When production is less than 2,000 hours each month, only one supervisor is
needed:
When production is between 2,001 and 4,000 hours each month, two supervisors
are needed.
When output is over 4,000 hours each month, three supervisors are needed.
The cost profile is as follows:
Activity level:
Rs.
20,000
40,000
60,000
The supervision costs are fixed costs within a certain range of output, but
go up or down in steps as the output level rises above or falls below
certain levels.
305
Practice questions
On the axes provided, on which the vertical axis denotes cost and the
horizontal axis the appropriate level of activity, show the following cost
behaviour graphs:
(a)
Fixed costs
(b)
Variable costs
(c)
Semi-variable costs
(d)
Annual rates bill
(e)
Direct labour cost
(f)
Annual telephone bill
(g)
(h)
(i)
(a)
(b)
(c)
(d)
(e)
(f)
(h)
(i)
(g)
306
Practice questions
1
307
Introduction
Direct costs
Full cost
6.1 Introduction
Costs may also be classified as:
direct costs; or
There are direct and indirect material costs, direct and indirect labour costs and
direct and indirect expenses.
The direct materials cost is the cost of the raw materials and components
that have gone into making the television.
The direct labour cost is the cost of the labour time of the employees who
have been directly involved in making the television.
Direct materials
Definition: Direct materials
Direct materials are all materials that become part of the cost unit.
Direct materials are all materials that can be attributed directly in full to a cost unit.
They are used directly in the manufacture of a product or in providing a service.
308
Direct materials
Pair of shoes
Office chair
Restaurant meal
Ingredients
Car
House
Services might also incur some direct materials costs. For example, with catering
and restaurant services the direct materials include the major items of food (and
drink).
Direct labour
Definition: Direct labour
Direct labour is labour time that can be attributed directly in full to a cost unit.
Direct labour costs are the specific costs associated with the labour time spent
directly on production of a good or service.
Labour costs are direct costs for work done by direct labour employees. Direct
labour employees are employees whose time is spent directly on producing a
manufactured item or service.
Example: Direct labour employees
Cost unit
Direct labour
Car
House
Tonne of coal
309
Direct labour costs also include the cost of employees who directly provide a
service.
Example: Direct labour employees (service industry).
Cost unit
Direct labour
Day of storage
Warehouse staff
Audit (other
consultancy product)
Professional staff
Teaching day
Direct expenses
Definition: Direct expenses
Direct expenses are expenses that can be attributed directly in full to a cost unit.
Direct expenses are expenses that have been incurred in full as a direct
consequence of making a unit of product, or providing a service, or running a
department.
In manufacturing, direct expenses are not common for manufactured units of
output, and direct costs normally consist of just direct materials and direct labour
costs.
Example: Direct expenses
Cost unit
Direct expense
A house
Prime cost
The prime cost of an item is its total direct cost.
Definition: Prime cost
The prime cost of a cost unit is the sum of all of the direct costs of making that
unit.
X
X
Prime cost
310
Practice question
In which of the following types of company would fuel costs be treated as a
direct material cost?
1
2
3
Manufacturing company
Road haulage (road transport) company
Construction company
311
Indirect expenses
Many costs incurred cannot be directly linked to cost units.
For example, the rental costs for a factory and the costs of gas and electricity
consumption for a factory cannot be attributed in full to any particular units of
production. They are indirect production costs (production overheads).
In a manufacturing company, all costs of administration are usually treated as
indirect costs (administration overheads) and all or most sales and distribution
costs are also usually treated as sales and distribution overheads.
Prime cost
Non-production costs
Administration overhead
Notes:
1
Prime cost plus a share of production overheads are the full production cost
or fully absorbed production cost of the cost unit.
312
Example: A retailer
A retailer owns a shop, employs a shop assistant, invests in sales and advertising
and acquires goods for resale.
The cost of goods purchased for resale is product costs and accounted for as
inventory. These are only expensed when the goods are sold (which may be in a
subsequent accounting period).
The sales and advertising costs and the salary of the shop assistant are period
costs which are expensed immediately in the accounting period in which they were
incurred. Note that the salary of the shop assistant would be called an
administration expense.
313
High/low analysis
High/low analysis when there is a change in the variable cost per unit
cost function
y = a + bx
(total cost line)
a = fixed cost
Volume of activity x
314
The total cost function can be used to estimate costs associated with different
levels of activities. This is very useful in forecasting and decision making.
There are two methods of constructing the total cost function equation:
high/low analysis
there are figures available for total costs at two different levels of output or
activity;
it can be assumed that fixed costs are the same in total at each level of
activity; and
the highest recorded output level, and its associated total cost
the lowest recorded output level, and its associated total cost.
It is assumed that these high and low records of output and historical cost are
representative of costs at all levels of output or activity.
The difference between the total cost at the high level of output and the total cost
at the low level of output is entirely variable cost. This is because fixed costs are
the same in total at both levels of output.
The method
Step 1: Take the activity level and cost for:
315
Production (units)
5,800
February
7,700
47,100
March
8,200
48,700
April
6,100
40,600
May
6,500
44,500
June
7,500
47,100
Step 1: Identify the highest and lowest activity levels and note the costs
associated with each level.
Production (units)
March
8,200
48,700
January
5,800
40,300
Step 2: Compare the different activity levels and associated costs and
calculate the variable cost:
Production (units)
March
8,200
48,700
January
5,800
40,300
2,400
8,400
Therefore:
Therefore:
The variable cost per unit = Rs. 8,400/2,400 units = Rs. 3.5 per unit
Step 3: Substitute the variable cost into one of the cost functions (either
high or low).
Total cost of 8,200 units:
Fixed cost + Variable cost = Rs. 48,700
Fixed cost + 8,200 Rs. 3.5 = Rs. 48,700
Fixed cost + Rs. 28,700 = Rs. 48,700
Fixed cost = Rs. 48,700 Rs. 28,700 = Rs. 20,000
Step 4: Construct total cost function
Total cost = a +bx = 20,000 + 3.5x
316
Note that at step 3 it does not matter whether the substitution of variable cost is
into the high figures or the low figures.
Example: Cost of other levels of activity
Returning to step 3 above but this time substituting into the low figures.
Step 3: Substitute the variable cost into one of the cost functions (either
high or low).
Total cost of 5,800 units:
Fixed cost + Variable cost = Rs. 40,300
Fixed cost + 5,800 Rs. 3.5 = Rs. 40,300
Fixed cost + Rs. 20,300 = Rs. 40,300
Fixed cost = Rs. 40,300 Rs. 20,300 = Rs. 20,000
Once derived, the cost function can be used to estimate the cost associated with
other levels of activity.
Example: High/low method
The company is planning to make 7,000 units and wishes to estimate the total
costs associated with that level of production.
Total cost = 20,000 + 3.5x
Total cost of 7,000 units = 20,000 + 3.5 7,000 = Rs. 44,500
317
Practice questions
1
Entity Z is trying to obtain a cost estimate for the costs of repairs. The
following monthly repair costs have been recorded for the past six
months.
Number of
Month
machines repaired
Cost of repairs
1
38
Rs.
31,000
41
32,700
25
26,500
4
5
21
36
23,600
29,900
32
28,900
Required
Use high/low analysis to estimate the fixed costs of repairs each
month and the variable cost per machine repaired.
Estimate the expected costs of repairs in a month when 30 machines
are repaired.
318
add the step in fixed costs to the total costs of the lower level of activity; or
deduct the step in fixed costs from the total costs of the higher level of
activity.
319
High
Low
Production (units)
22,000
17,000
180,000
Step 3: Compare the different activity levels and associated costs and
calculate the variable cost:
High
Production (units)
22,000
Low
17,000
180,000
5,000
15,000
Therefore:
Therefore:
The variable cost per unit = Rs. 15,000/5,000 units = Rs. 3 per unit
Step 4: Substitute the variable cost into one of the cost functions (either
high or low).
Total cost of 22,000 units:
Fixed cost + Variable cost = Rs. 195,000
Fixed cost + 22,000 Rs. 3 = Rs. 195,000
Fixed cost + Rs. 66,000 = Rs. 195,000
Fixed cost = Rs. 195,000 Rs. 66,000 = Rs. 129,000
Step 5: Construct total cost function (unadjusted level) above 19,000 units
Total cost = a +bx = 129,000 + 3x
Step 6: Construct total cost function below 19,000 units
Total cost = a +bx = (129,000 15,000) + 3x
Total cost = a +bx = 114,000 + 3x
The cost functions can be used to estimate total costs associated with a level as
appropriate.
320
321
Production (units)
11,000
8,000
5,000
180,000
Step 2: Choose the pair which is on the same side as the step.
High
Middle
Production (units)
11,000
8,000
240,000
Step 3: Compare the different activity levels and associated costs and
calculate the variable cost:
High
Middle
Production (units)
11,000
8,000
240,000
3,000
36,000
Therefore:
Therefore:
The variable cost per unit = Rs. 36,000/3,000 units = Rs. 12 per unit
Step 4: Substitute the variable cost into one of the cost functions
Total cost of 11,000 units:
Fixed cost + Variable cost = Rs. 276,000
Fixed cost + 11,000 Rs. 12 = Rs. 276,000
Fixed cost + Rs. 132,000 = Rs. 276,000
Fixed cost = Rs. 276,000 Rs. 132,000 = Rs. 144,000
Step 5: Construct total cost function above 7,500 units
Total cost = a +bx = 144,000 + 12x
Step 6: Construct total cost function below 7,500 units
Total cost = a +bx = (144,000 100/120) + 12x
Total cost = a +bx = 120,000 + 12x
The cost functions can be used to estimate total costs associated with a level as
appropriate.
322
8.4 High/low analysis when there is a change in the variable cost per unit
High/low analysis can also be used when there is a change in the variable cost
per unit between the high and the low levels of activity. The same approach is
needed as for a step change in fixed costs, as described above.
When the change in the variable cost per unit is given as a percentage amount, a
third in between estimate of costs should be used, and the variable cost per unit
will be the same for:
High/low analysis may be applied to the two costs and activity levels for which
unit variable costs are the same, to obtain an estimate for the variable cost per
unit and the total fixed costs at these activity levels. The variable cost per unit at
the third activity level can then be calculated making a suitable adjustment for the
percentage change.
323
Production (units)
30,000
25,000
20,000
300,000
Step 2: Choose the pair which is on the same side as the change.
High
Production (units)
30,000
25,000
320,000
Middle
Step 3: Compare the different activity levels and associated costs and
calculate the variable cost:
High
Production (units)
30,000
25,000
320,000
5,000
36,000
Middle
Therefore:
Therefore:
Therefore:
Step 4: Substitute the variable cost into one of the cost functions
Total cost of 30,000 units:
Fixed cost + Variable cost = Rs. 356,000
Fixed cost + 30,000 Rs. 7.2 = Rs. 356,000
Fixed cost + Rs. 216,000 = Rs. 356,000
Fixed cost = Rs. 356,000 Rs. 216,000 = Rs. 140,000
Step 5: Construct total cost function above 24,000 units
Total cost = a +bx = 140,000 + 7.2x
Step 6: Construct total cost function below 24,000 units
Total cost = a +bx = 140,000 + 8x
The cost functions can be used to estimate total costs associated with a level as
appropriate.
324
High-low analysis uses just two sets of data for x and y, the highest value
for x and the lowest value for x. Regression analysis uses as many sets of
data for x and y as are available.
Because regression analysis calculates a line of best fit for all the available
data, it is likely to provide a more reliable estimate than high-low analysis
for the values of a and b.
325
Where:
x, y = values of pairs of data.
n=
the number of pairs of values for x and y.
=
A sign meaning the sum of. (The capital of the Greek letter
sigma).
Approach
Set out the pairs of data in two columns, with one column for the values of
x and the second column for the associated values of y. (For example, x for
output and y for total cost.
Set up a column for x, calculate the square of each value of x and enter
the value in the x column.
Set up a column for xy and for each pair of data multiply x by y and enter
the value in the xy column.
Enter the values into the formulae and solve for b and then a. (It must be in
this order as you need b to find a).
326
5.8
7.7
40.3
47.1
March
8.2
48.7
April
6.1
40.6
May
June
6.5
7.5
44.5
47.1
Required: Construct the equation of a line of best fit for this data.
Working:
x2
xy
January
5.8
40.3
33.64
233.74
February
7.7
47.1
59.29
362.67
March
8.2
48.7
67.24
399.34
April
6.1
40.6
37.21
247.66
May
6.5
44.5
42.25
289.25
June
7.5
47.1
56.25
353.25
41.8
268.3
295.88
1,885.91
= x
= y
= x2
= xy
327
Solutions
1
Solutions
(a)
(b)
(c)
(d)
(e)
(f)
(g)
(h)
(i)
328
Solution
The cost item is a mixed cost. Up to 5,000 units of output, total fixed
costs are Rs.14,000 and the variable cost per unit is Rs.(24,000
14,000)/5,000 units = Rs.2 per unit.
At the 5,000 units of output, there is a step increase in fixed costs of
Rs.6,000 (from Rs.24,000 total costs to Rs.30,000 total costs). Total
fixed costs therefore rise from Rs.14,000 to Rs.20,000. The variable cost
per unit remains unchanged.
At the 10,000 units level, total costs are therefore:
Rs.
Variable costs (10,000 Rs.2)
Fixed costs
Total costs
20,000
20,000
40,000
Solutions
1
329
Solutions
1
Rs.
662,000
615,200
46,800
Cost
Rs.
662,000
312,000
350,000
2
High: Total cost of
Low: Total cost of
Difference: Variable cost of
41 =
21 =
20 =
Rs.
32,700
23,600
9,100
Cost
Rs.
23,600
9,555
14,045
Cost
Rs.
14,045
13,650
27,695
330
I
Index
Cost
accounting
behaviour graphs
behaviour
estimation
formulas for inventory
management accounting
Current
assets
liabilities
a
Accounting for
depreciation
revaluation
Accumulated fund
Administration costs
Analysis of expenses
Assets
AVCO
35
49
195
296
116, 117
110
23
Data
284
Depreciable amount
33
Depreciation as a percentage of cost
42
Depreciation by number of units
produced
46
Depreciation of a re-valued asset
54
Depreciation
33
methods
41
Direct
expenses
310
labour
309
materials
308
method
142, 178
Disposal of property, plant and
equipment
62
233
247
265
c
Carrying amount
Cash equivalents
Cash flow statements
Control
Conversion costs
109
110
b
Branch accounts:
debtors system
inventory systems
Branch accounts: separate entity
288
288
303
301
314
19
289
33
138
137
287
11
331
Incomplete records
dealing with
meaning
nature
techniques
Indirect costs
Indirect method
adjustments for working capital
Information
attributes
Investing activities
Issued shares
e
End-of-year adjustments for inventory 120
Equity shares
131
Equity
111
Exchange of non-current assets
81, 113
Exchange transactions
31
f
FIFO
Finance costs
Financial accounting
Financing activities
First-in, first-out method (FIFO)
Fixed costs
Format of published accounts
Full cost
Functional costs
19
297
9
173
20
301
107
312
298
Labour costs
Lay away sales
Liabilities
Linear regression analysis
Management accounting
Manufacturing costs
Marginal cost
Marketing costs
Mark-up percentage
Material
costs
items
Measurement of
inventory
revenue
Memorandum cash and bank account
Memorandum control accounts
Missing inventory figure
57
207
h
High/low analysis
315
i
IAS 1: Presentation of Financial
Statements
IAS 7: Statements of cash flows
IAS 16 Property, plant
and equipment
IAS 18: Revenue
IASB Conceptual Framework
295
94
109
325
g
Gain or loss on disposal
Gross profit percentage
207
207
207
208
311
141
147
284
5
165
131
107
138
288
288
302
296
218
295
115
10
85
216
213
221
27
85
83
332
17
296
Index
o
One-off decision making
Opening capital
Operating cash flows
Other comprehensive income
Over-estimate or under-estimate of
tax
Overheads
287
211
120
51
129
311
p
Part-exchange of an old asset
Percentage of completion method
Period costs
Perpetual inventory method
Planning
Preparing financial statements
Prime cost
Product costs
Production and non-production costs
Production costs
Profit and cash flow
Purchase cost
62
97
313
4
286
107
310
313
299
296
137
10
296
303
265
196
195
305
41
95
31
87
t
Taxation in the statement of financial
position
Taxation in the statement of
comprehensive income
Taxation on profits
Total comprehensive income
Transaction costs of issuing new
equity shares
r
Recognition in the financial
statements
Recognition of
assets
expenses
income
liabilities
Reducing balance method
Regression analysis formulae
Regression analysis
Reliability of measurement
Residual value
Revaluation model
Revaluation of property, plant and
equipment
Revenue recognition and substance
97
92
85
129
128
128
113
131
83
84
84
84
84
43
326
325
83
34
56
Useful life
38
v
Variable cost
302
48
96
333
w
Weighted average cost (AVCO)
method
Weighted average cost
Working capital adjustments
23
19
147
334
Head Oce-Karachi:
Regional Oce-Lahore: 155-156, West Wood Colony, Thokar Niaz Baig, Raiwind Road, Lahore
Phone: (92-42) 37515910-12, UAN: 111-000-422, e-mail: [email protected]
Islamabad Oce:
Faisalabad Oce:
Multan Oce:
3rd Floor, Parklane Tower, Ocers Colony, Near Eid Gaah Chowk, Khanewal Road, Multan.
Phone: (92-61) 6510511-6510611, Fax: (92-61) 6510411, e-mail: [email protected]
Peshawar Oce:
Gujranwala Oce:
2nd Floor, Gujranwala Business Center, Opp. Chamber of Commerce, Main G.T. Road, Gujranwala.
Phone: (92-55) 3252710, e-mail: [email protected]
Sukkur Oce:
Quetta Oce:
Basic Health Unit (BHU) Building Sector D, New City Mirpur, Azad Jammu and Kashmir
e-mail: [email protected]
2015
FINANCIAL ACCOUNTING
AND REPORTING I
STUDY TEXT