Exp f3 Notes

Notes ACCA P aper F3 Financial Accounting For exams in 2011

theexp theexpgroup.com group.com

ExPress Notes ACCA F3 Financial Accounting

Contents

3

1.

Financial statements

7

2.

Objectives of financial reporting

16

3.

Sources of financial information

21

4.

Double entry bookkeeping: the debits and credits

28

5.

Tangible non-current assets

31

6.

Intangible non-current assets

36

7.

Inventory and purchases

39

8.

Receivables and payables

43

9.

Bank reconciliations

48

10.

Long term finance

51

11.

Page | 2

About ExPress Notes

Accruals and prepayments

53

12.

Provisions and contingencies

56

13.

Sales tax

58

14.

Trial balances and correction of errors

61

15.

Suspense accounts

65

16.

Incomplete records

67

17.

Limited companies

69

18.

Statements of cash flow

73

19.

Partnership accounting

79

20.

Events after reporting date, errors and estimates

86

© 2011 The ExP Group. Individuals may reproduce this material if it is for their own private study use only. Reproduction by any means for any other purpose is prohibited. These course materials are for educational purposes only and so are necessarily simplified and summarised. Always obtain expert advice on any specific issue. Refer to our full terms and conditions of use. No liability for damage arising from use of these notes will be accepted by the ExP Group.



START About ExPress Notes We are very pleased that you have downloaded a copy of our ExPress notes for this paper. We expect that you are keen to get on with the job in hand, so we will keep the introduction brief. First, we would like to draw your attention to the terms and conditions conditions of usage. It’s a condition of printing these notes that you agree to the terms and conditions of usage. These are available to view at www.theexp www.theexpgroup.com. group.com. Essentially, we want to help people get through their exams. If you are a student for the ACCA exams and you are using these notes for yourself only, you will have no problems complying with our fair use policy. You will however need to get our written permission in advance if you want to use these notes as part of a training programme that you are delivering. WAR NI NG! These These notes are not designed to cover everything in the syllabus! They are designed to help you assimilate and understand the most important areas for the exam as quickly as possible. If you study from these notes only, only, you will not have covered covered everything that is in the ACCA syllabus and study guide for this paper. Components of an effective study system On ExP classroom courses, we provide people with the following learning materials:  

 

The ExPress notes for that paper The ExP recommended course notes / essential text or the ExPedite classroom course notes where we have published our own course notes for that paper The ExP recommended exam kit for that paper. In addition, we will recommend a study text / complete text from one of the ACCA official publishers, but we do not necessarily give this as part of a classroom course, as we think that it can sometimes slow people down and reduce the time that they are able to spend practising past questions.

ExP classroom course students will also have access to various online support materials, including: 



The unique ExP & Me e-portal, which amongst other things allows “view again” of the classroom course that was actually attended. ExPand, our online learning tool and questions and answers database

Everybody in the World has free access to ACCA’s own database of past exam questions, answers, syllabus, study guide and examiner’s commentaries commentaries on past sittings. This can be

Page | 3




an invaluable resource. You can find links to the most useful pages of the ACCA database that are relevant to your study on ExPand at www.theexp www.theexpgroup.com. group.com.

How to get the most from these ExPress notes For people on a classroom course, this is how we recommend that you use the suite of learning materials that we provide. This depends where you you are in terms of of your exam preparation for each paper. Your stage in study for each paper

Prior to study, study , e.g. deciding which optional papers to take

At the start of the learning phase

These ExPress notes

Skim through the ExPress notes to get a feel for what’s in the syllabus, the “size” of the paper and how much it appeals to you. Work through each chapter of the ExPress notes in detail before you then work through your course notes. Don’t try to feel that you have to understand everything – just get an idea for what you are about to study. Don’t make any annotations on the ExPress notes at this stage.

Page | 4

Ex P recommended course notes, or ExPedite notes

Ex P recommended exam kit

ACCA online past exams

Don’t use yet

Don’t use yet

Have a quick look at look at the two most recent real ACCA exam papers to get a feel for examiner’s style.

Work through in detail. Review each chapter after class at least once.

Nobody passes an exam by what they have studied – we pass exams by being efficient in being able to prove what we know. In other words, you need to have effectively input the knowledge and be effective in the output of what you know. Exam practice is key to this.

Make sure that you understand each area reasonably well, but also make sure that you can recall key definitions, concepts, approaches to exam questions, mnemonics, etc.

Don’t use at this stage.

Try to do at least one past exam question on the learning phase for each major chapter.




Your stage in study for each paper

Page | 5

These ExPress notes

Ex P recommended course notes, or ExPedite notes

Ex P recommended exam kit

ACCA online past exams

Practice phase

Work through the ExPress notes again, this time annotating to explain bits that you think are easy and be brave enough to cross out the bits that you are confident you’ll remember without reviewing them.

Avoid reading through your notes again. Try to focus on doing past exam questions first and then go back to your course notes/ ExPress notes if there’s something in an answer that you don’t understand.

This is your most Download the important tool two m ost recent at this stage. You real exam should aim to questions and have worked answers. through and Read through the understood at technical least two or three articles written questions on each by the examiner. major area of the syllabus. You pass Read through the two most recent real exams by examiner’s passing mock exams. Don’t be reports in detail. tempted to fall Read through some other older into “passive” revision at this ones. Try to see if stage (e.g. there are any recurring criticism reading notes or he/ she makes. listening to CDs). Passive revision You must avoid tends to be a these! waste of time.

The night before the real exam

Read through the ExPress notes in full. Highlight the bits that you think are important but you think you are most likely to forget.

Unless there are specific bits that you feel you must revise, avoid looking at your course notes. Give up on any areas that you still don’t understand. It’s too late now.

Don’t touch it!

Do a final review of the two most recent examiner’s reports for the paper you will be taking tomorrow.

At the door of the exam room before you go in.

Read quickly through the full set of ExPress notes, focusing on areas you’ve highlighted, key workings, approaches to exam questions, etc.

Avoid looking at them in detail, especially if the notes are very big. It will scare you.

Leave at home.

Leave at home.


theexpgroup.com


Our ExPress notes fit into our portfolio of materials as follows:

Notes Provide a base understanding of the most important areas of the syllabus only.

Notes Provide a comprehensive coverage of the syllabus and accompany our face to face professional exam courses

Notes Provide detailed coverage of particular technical areas and are used on our Professional Development and Executive Programmes.

To maximise your chances of success in the exam we recommend you visit www.theexpgroup.com where you will be able to access additional free resources to help you in your studies.

START About The ExP Group Born with a desire to be the leading supplier of business training services, the ExP Group delivers courses through either one of its permanent centres or onsite at a variety of locations around the world. Our clients range from multinational household corporate names, through local companies to individuals furthering themselves through studying for one of the various professional exams or professional development courses.

As well as courses for ACCA and other professional qualifications, o ur portfolio of expertise covers all areas of financial training ranging from introductory financial awareness courses for non financial staff to high level corporate finance and banking courses for senior executives. Our expert team has worked with many different audiences around the world ranging from graduate recruits through to senior board level positions. Full details about us can be found at www.theexpgroup.com and for any specific enquiries please contact us at [email protected].

Page | 6


theexpgroup.com


Chapter 1

Financial Statements

START The Big Picture Financial statements (more colloquially called accounts) are a crucial part of managing a business and reporting to shareholders. A set of financial statements will need to be produced at least annually for presentation to external stakeholders, but generally much more frequently for management control within the business. Frequent and accurate financial statements can add a great deal to the efficient running of a business. A set of financial statements is produced periodically (often once a year for smaller businesses but as frequently as the users want them). A full set of financial statements for a limited company comprises a number of statements: 



Page | 7

A statement of financial position, generally called a balance sheet. This lists all the assets and liabilities of the business plus the equity of the business (which explains where the assets and liabilities came from). The statement of financial position is a snapshot of the assets and liabilities of a business at a moment in time. A statement of comprehensive income, often referred to as profit and loss account. This shows all the gains and losses that the business has experienced in the period. The statement of comprehensive income is a record of what happened over a period to the net assets of a business.


theexpgroup.com






A statement of cash flows, which shows where the cash and short-term assets very similar to cash came from and went do during the period. Income isn’t always the same as cash, as we’ll see later. Notes to the financial statements , which give further detail to readers who want to know more than the summary story.

Statement of financial position of Sole Trader X at 30 June 20x 1

ASSETS

$

$

Non-current assets Licence to operate

10,000

Land and buildings

35,000

Office equipment

20,000

Motor vehicles

30,000

Fixtures and fittings

10,000 105,000

Current assets Inventory

20,000

Trade receivables

13,000

Less: allowance for doubtful receivables

(1,000) 12,000

Page | 8

Prepayments

4,000

Cash at bank

3,000

Cash in hand

2,000

Total assets

146,000


theexpgroup.com


EQUITY AN D LIABI LITIES Capital Initial capital introduced

30,000

Total cumulative comprehensive income at 1 July 20x0 Less: Cumulative withdrawals at 1 July 20x0

85,700 (24,000)

Total equity at 1 July 20x0

91,700

Total comprehensive income in the current period

16,000

Withdrawals in the current year

(8,000)

Total equity at 30 July 20x1

99,700

Non-current liabilities Bank loans

32,000

Current liabilities Bank overdraft

3,300

Trade payables

8,000

Accruals

Total liabilities

Total equity and liabilities

3,0

46,300

146,000

Principal features of the statement of financial position:

  

Page | 9

It balances, with the total assets equalling equity (ie owner’s interest) plus liabilities Each section is conventionally written in terms of increasing liquidity Non-current assets and liabilities are ones that are expected to remain on the SOFP next year. Current assets and liabilities are expected to be used up or paid within the coming year.


theexpgroup.com


A SOFP may be rearranged into a number of ways. IAS 1 shows a SOFP as given above: Total assets = Equity + total liabilities. Equally validly therefore: Total assets – total liabilities = Equity Given that equity = capital + cumulative profit – cumulative withdrawals, then the equation could be written in any number of ways such as: Total assets – total liabilities = Capital + cumulative profit – cumulative withdrawals Or Cumulative profit = Total assets – total liabilities – capital + cumulative withdrawals. This is sometimes called the “accounting equation” and often comes up in the F3 exam. The task is to drop in the figures that you know and find the missing figure, whatever it might be.

Statement of comprehensive income for the year ended 30 June 20x 1

$

Sales revenue

$

152,000

Cost of sales Opening inventory

30,000

Purchases of inventory

80,000

Delivery costs inwards

10,000

Closing inventory

(20,000) (100,000)

Gross profit

Page | 10

52,000


theexpgroup.com


Sundry income

3,000

Discounts received

2,000 57,000

Less: Expenses

Delivery costs outwards

3,000

Depreciation

6,000

Discounts allowed to customers

1,000

Electricity

4,000

Irrecoverable and doubtful debts

2,500

Mobile phones

500

Motor expenses

2,500

Rent

9,000

Telephone and internet

1,500

Wages and salaries

12,000 (42,000)

Profit for the period before tax

14,000

Other comprehensive income:

Revaluation gain on property Total comprehensive income in the period

2,000 16,000

You may be required in the exam to calculate revenue, cost of sales, gross profit and total comprehensive income from given data.

Page | 11


theexpgroup.com


Unusual items Sometimes, it is necessary for one-off items to be disclosed separately in the financial statements if they are very large or arise from an unusual, often non-recurring, source. Typical examples might be write-off of an unusually large debt as irrecoverable, or business relocation costs. Disclosing it separately allows readers of the accounts a more in-depth understanding of what the business is doing.

KEY KNOWLEDGE Elements of financial statements There are five elements of financial statements, from which all financial statements are produced. These definitions are very useful throughout your ACCA studies and could easily be part of a question in paper F3.

Elements of the statement of financial position: 





Page | 12

An asset is a resource that is controlled by an entity as a result of past events and from which future economic benefits are expected to flow to the entity.

A liability is a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits.

Equity is the residual interest in the assets of the entity after deducting all its liabilities. Depending on the type of business, this may be called just capital (sole trader), partners’ current account (partnership) or share capital and reserves (for a limited company). For a limited company, reserves show the net cumulative gains above cumulative losses, less all dividends paid. This therefore explains the difference between what the net assets were when the share capital was originally paid in and what the net assets are at the reporting date.


theexpgroup.com


Elements of the statement of comprehensive income: 



Income is an increase in economic benefits during the accounting period in the form of inflows or enhancements of assets or decreases of liabilities that result in increases in equity, other than those relating to contributions from equity participants.

An expense is a decrease in economic benefits during the accounting period in the form of outflows or depletions of assets or incurrence of liabilities that result in decreases in equity, other than those relating to distributions to equity participants.

Note that income and expenditure are defined effectively as the reason that a change in net assets happened.

KEY KNOWLEDGE Relationship between the statements: the business equation An increase in net assets of a business will come from a mixture of these sources:

  

Total comprehensive income made in the period (a profit will increase net assets) New capital introduced by the owner (will always increase net assets) Withdrawals made in the period (will always reduce net assets).

This is sometimes called the accounting equation or the business equation. It is a frequent exam question and can be summarised:

Closing net assets =

Opening net assets + total comprehensive income in the period + new capital introduced in the period – withdrawals in the period.

This is also a frequent exam question, with some figures given and the others having to be deduced.

Page | 13


theexpgroup.com


Remember that net assets = equity + liabilities, by definition. So net assets may be given in a question separately as equity and liabilities.

Separate accounting entity Even with a sole trader (a person who runs a business on their own, but the business has never been set up formally to be a separate legal identity), there is a distinction between personal income/ expenses and business income/ expenses. The accounts will largely be maintained so that the sole trader can report business profits to the tax authority. Personal expenditure such as personal holidays is not deductible against tax! The accountant will therefore only record transactions that are considered to be legitimate business transactions; personal transactions will be ignored. In smaller businesses, one of the first steps when producing accounting records for clients is to separate the business transactions from the personal, as the latter will not be recorded anywhere.

Sole traders, partnership and lim ited companies - We’ll look at these in more detail in each chapter, but here’s a summary: Sole trader

Partnership

Limited company

1 (the sole trader!)

Normally limited to about 20

Can be between 1 and an unlimited large number

Number of investors

Must produce accounts for the tax authority Must produce accounts to file with the commercial register Business name

Can offer shares to the public? Equity part of the

Page | 14

Yes

No

Normally just the name of the owner “trading as” the name of the business No

Yes

Maybe, normally not

Yes

Often the names of the original partners. Few legal formalities

Must end Ltd (if private limited company) or plc (if public limited company) Yes, if a plc. No if Ltd.

No



Initial capital

Yes



Each




Share capital

theexpgroup.com


SOFP





Page | 15

Cumulative profit Cumulative withdrawals



partner’s capital account Each partner’s current account (ie cumulative share of profit less cumulative withdrawals)




Reserves: (revaluation reserve, retained earnings, etc).

theexpgroup.com


Chapter 2

Objectives of financial reporting

START The Big Picture Financial reporting is the business of collecting financial information, analysing, summarising it and presenting it in a useful form to a wide range of different users. Different users will have different objectives and therefore slightly different needs. Financial statements are aimed at giving useful information to a wide range of different users, though the investor is the most significant user.

For financial information to be useful, it must exhibit a number of characteristics. It’s important to understand what these are because you may be asked for a definition of them in the exam.

Page | 16


theexpgroup.com


Qualitative characteristic

Our definition

Fair presentation

Items are described in accordance with their true nature. For example, loans repayable within six months are classified as current rather than non-current.

Going concern

The business is expected to trade into the foreseeable future. This means that assets will not have to be sold in a hurry, which would be likely to result in significant impairments in value.

Accruals

Page | 17

A key concept covered in chapter [x]. It means recording transactions in the period when they happened; not necessarily when the cash was settled. It also means matching costs and associated revenues.

Consistency

Items should be reported the same way between periods, so that it’s possible to make meaningful comparisons between years. Similar transactions must be reported the same way within the same accounting period.

Materiality

Materiality means large enough to influence the user’s opinion on the financial statements. Immaterial information should not be disclosed, as it’s a distraction. Material information must be presented accurately and fairly.

Relevance

Irrelevant information is a distraction and should not be presented.

Reliability

Information is useless if it’s not considered to be reliable. Eg an external valuation of property is more reliable than a biased director’s valuation.

Faithful representation

Items should be described in accordance with their true nature. Eg an expense for repairs should not be classified as research costs, even though research costs are more favourably viewed by investors.

Substance over form

Items should be reported in accordance with their commercial substance, rather than their legal form. Eg if a sale is made on credit but legal title remains with the seller until the goods are paid for, it should still be recorded as a sale/ purchase at the time of the transaction, since this is when the obligation arises.

Neutrality

Unbiased – neither excessively optimistic nor excessively prudent.

Prudence

Conservatism. This is no longer a core concept in IFRS accounting, but broadly losses should be recognised more readily


theexpgroup.com


than gains. Completeness

All information that needs to be presented in order to give a full picture has been presented.

Comparability

Financial statements this period should be presented using similar principles to previous years, so that valid comparisons may be made. Company accounts should be comparable with each other. This means that if a company changes its accounting policy, it must restate its previous years’ accounts using the new accounting policy, in order to facilitate comparison between years.

Understandability

Information should be presented in a way that users can understand. Excessive complication reduces usefulness.

Business entity concept

See chapter 1. Even if there is no separate legal entity, as with a sole trader, the business is still considered to be separate to its owners for accounting purposes.

Sometimes, it’s not possible to deliver all of these desirable characteristics. For example, an investor is principally interested in future profits, so this is what is relevant to them. However, estimates of future profit are unreliable, so historical information is given, even though it is less relevant.

KEY KNOWLEDGE Historical accounting Accounting is derived from recording information about transactions that have happened. This means that assets are recorded at their historical cost; ie what the business paid for them. This has the advantage of being objective and relatively easy, but has a number of disadvantages, including:

  

Page | 18

It can give out of date asset valuations for long-lived assets This can result in an unrealistically low depreciation charge Profit trends can be misleading (eg a profit growth of 10% per year isn’t so impressive as it first seems if inflation is 12% per year!)


theexpgroup.com




Where there’s significant inflation and inventory is held for a long time, profit can be reported simply by matching today’s revenues with yesterday’s costs.

There are some large advantages of historical cost accounting, however; principally the fact that people understand it and it is objective. During periods of modest inflation, the weaknesses of historical cost accounting are generally outweighed by its advantages. There are alternative systems of accounting, such as replacement cost accounting. Replacement cost accounting records inventories in the SOFP and at the point of sale at the cost that would be incurred to replace them today. This has many advantages but is complicated to apply so is not common in practice. You will only have to apply historical cost accounting in the paper F3 exam.

KEY KNOWLEDGE Regulation of financial reporting

Some entities have to report under regulated accounting standards. Different countries may have their own systems of GAAP (generally accepted accounting practice) or may follow International Financial Reporting Standards (IFRS) or IFRS for SMEs (SME means smaller and medium sized enterprises).

It is a matter of national regulation which financial reporting standards an entity must use when producing their financial reports. Large plc’s will have to report under a much more extensive financial reporting framework than sole traders.

There are a number of bodies that you need to be aware of for the Paper F3 exam. Their roles are given below.

Page | 19


theexpgroup.com


IASCF: the International Accounting Standards

Page | 20

This has recently been renamed the IFRS Foundation. The Foundation is made up of trustees, who appoint the members of the bodies below.

IASB: International Accounting Standards Board

The IASB issues International Financial Reporting Standards and the IFRS for SMEs. It employs a permanent staff to draft new accounting standards and amendments considered necessary to extant accounting standards.

SAC: Standards Advisory Council

This has recently been renamed the IFRS Advisory Council. It is made up of a cross section of advisors from different user groups. It advises the IASB on the IASB’s work programme.

IFRIC: International Financial Reporting Interpretations Committee

This has recently been renamed the IFRS Interpretations Committee. This body is designed to respond quickly where there are significant differences in interpretation of an extant IFRS. For example, it issued guidance on how to account for loyalty programmes, where users were uncertain to follow the extant accounting standard on revenue recognition, or provisions.


theexpgroup.com


Chapter 3

Sources of financial information

START The Big Picture The accounting system must naturally be fed with raw source data. This data is then analysed, categorised and recorded in the accounting system itself, which may be a fully manual (paper based) system or may be maintained using software. Both use the same system of double entry bookkeeping that we will see later on. For an accounting system to work well, it must be simple to operate and be capable of being fed by non-specialist staff. A key step is therefore ensuring that the right stationery and documentation is in place. The F3 syllabus requires you to be able to define the following:

Page | 21


theexpgroup.com


Document

Purpose

Quotation

To give a potential customer an indication of what a product or service would be likely to cost. It may be a binding quote or just an indicative quote. To record an order from a customer. Signing a booking form for an ExP classroom course is a sales order that ExP will then process. To record an order placed with a supplier. It may require preauthorisation to be valid. To record that an order for inventory for resale has been received. It will normally only be produced once the goods have been inspected at the point of delivery to ensure that they are correct in description and quality. To record that an order from a customer has been sent out.

Sales order

Purchase order

Goods received note

Goods despatched note

Invoice Statement

Credit note

Debit note

Remittance advice

Page | 22

A request for payment from a supplier. Sent by the supplier to the customer. A summary of transactions recorded by a supplier with a customer, including amounts received from the customer. Sent by the supplier to the customer.

Acknowledgement from a supplier that the customer has overpaid and is entitled either to a refund or free goods/ services in the future. To cancel a credit note that previously existed, eg if goods were ordered, paid for and then returned there would initially be a credit note. The refund made would be accompanied with a debit note. Normally included with an invoice. A document that is included with the

Often feeds the accounting information on.... Nowhere. At this stage, there has been no transaction to record; it’s still at the state of being a prospective transaction. Sales (revenue).

Purchases, normally of inventory for resale. Purchases of inventory for resale and payables.

Sales (revenue) and possibly also inventory management, depending on how the accounting system is set up. Payables. Does not generally instigate any recording of a transaction, since all transactions on the statement will have been recorded when goods were ordered. But useful for cross-checking our records with the supplier’s records. Payables.

Receivables.

Receivables.


theexpgroup.com


Receipt

payment (eg if paid by cheque) with details that will allow the recipient of the funds to match the payment to the customer’s account. Issued by the supplier for goods, to acknowledge payment of a debt.

Receivables, payables and purchases.

KEY KNOWLEDGE Data sources / data capture

When a business transaction happens, it is essential that the source data is captured immediately. This does not necessarily mean immediately writing up the books, but it does involve some record being made of the transaction happening.

In very simple accounting systems for sole traders (eg a self-employed builder) it may involve the proprietor keeping pocket books to record things like quotes given and a shoe box used to collect receipts for business expenses. From this source data, the accounting records can then be produced each period. The accountant is often not physically present at the time that transactions happen, so it is essential that there are simple and fool proof systems to ensure a complete and accurate record of business transactions.

KEY KNOWLEDGE Books of original entry

Alternatively called books of prime entry, these will be the bridge between the raw data (eg receipt for cash purchase of some building materials and the accounting system. They may be written up by the accountant, or by a semi-trained member of staff within the client’s business.

Page | 23


theexpgroup.com


The most commonly used books of original entry are:

Book of original entry:

Used to record data on:

Data typically used to feed:

Cash in book

Cash received into the business bank account.

Cash payments book

Cash paid from the business bank account. All sorts of things! Anything that results in cash being paid out of the business.

Petty cash book

Cash in and out of the balance of cash held in notes and coins by the business (normally small). This is often controlled using the imprest system (see later).

Typically, small expenses (eg Friday cakes for staff!) and sundry income.

Sales day book

Sales on credit. Note that sales immediately settled in cash will be recorded in either the cash book (if paid directly into the bank account) or petty cash book (if received in notes and coins).

Sales revenue.

Purchases day book

Purchases of inventory for resale on credit. Note that purchases settled immediately in cash will be recorded immediately in the cash payments book or petty cash book.

Purchases of inventory for resale.

Journal book

Anything not covered by any of the other books of original entry.

Often, this is the book maintained by the accountant, in which “period 13” adjustments like depreciation and bad debts are recorded.

All sorts of things! Anything that may generate cash for the business.

Books of original entry may be recorded in paper form, or using a spreadsheet.

Page | 24


theexpgroup.com


KEY KNOWLEDGE Computerised systems Computerised systems are common and can be cheap. They still require rigorous systems for data capture at the point when transactions happen, as the maxim “garbage in, garbage out” very much applies! Input to a computerised system will not look like a book of original entry, but will require the same data. Software may be more user friendly, for example asking “how much cash was spent?” and “what was this for?”, whilst then offering a drop down menu of choices. The software will still prepare records using the same methodology as the manual recording systems above.

Advantages of using a computerised system include:  

  

Back ups can be made easily Makes producing periodic frequent accounts much less laborious than a manual system Can be user-friendly Analyses sales taxes more easily than manual systems (see later) Can be used to quickly produce lots of reports such as VAT returns and interim management accounts.

Disadvantages of a computerised system include:   

Cost May not be tailored very well to the business own needs Still requires effective data capture and maintenance of the underlying records.

KEY KNOWLEDGE Journal book The journal book is the book of original entry that captures transactions not covered by other books of original entry. Often, it includes adjustments and correction of errors and omissions in the other books of original entry. In a computerised system, there are often restrictions on who can access the journal book.

Page | 25


theexpgroup.com


The journal book records double entry records (see later), with an explanation of the reason. We’ll see an example of it after tackling double entry bookkeeping.

KEY KNOWLEDGE Credit control and memorandum accounts

In parallel with (and thus duplication of) the main accounting system, it is likely that an accounting system will maintain separate records of individual records of customer and supplier balances. This duplicates effort and increases costs, but provides useful information for credit control and a check on the accuracy of data input.

Each supplier or customer will have a supplier or customer code and individual record of transactions with them. This is outside the general ledger (ie double entry system) and in a simple accounting system may be kept using a simple card index box.

KEY KNOWLEDGE Controlling petty cash – the imprest system

Cash balances are prone to error, theft and poor record keeping. A way to ensure that any cash payments out of the petty cash box are recorded is to use the imprest system. The imprest system has these features:

The cash box has a pre-set limit of maximum cash that it ever contains, eg $1,000 

 

Page | 26

Before any cash is taken out of the cash box (which should be guarded by a very diligent and ideally slightly frightening person), the person claiming the cash must provide a receipt and complete an expense voucher. As an expense record is submitted, the same amount of cash is taken out of the box. Under no circumstances is anybody ever allowed to take money out of the tin without completing a petty cash voucher.


theexpgroup.com


The result of this is that at any point in time, the sum of cash plus the expense vouchers will always equal the pre-set limit of $1,000. When cash reaches a low level, more cash is withdrawn from the bank to replenish the sum up to the $1,000 limit. The expense vouchers are then exchanged for the replenishment cash. These movements in petty cash can then be summarised in a petty cash book each period, which will look like this:

PETTY CASH BOOK Reason for cash movement

Date

Cash in/ out

Voucher #

From bank

01/03/2010

1,000.00

03/03/2010

(21.12)

332; Supermarket

12/03/2010

(20.00)

333; Taxi for MD

23/03/2010

(430.00)

334; Stationery shop

25/03/2010

(32.00)

335; Flowers for new baby

27/03/2010

(43.12)

336; Supermarket

31/03/2010

453.76

Subtotal

31/03/2010

546.24

Replenish

546.24

1,000.00

Subtotals

546.24

Staff food & drink

Travel

Stationery

Other

Opening balance (21.12) (20.00) (430.00)

(32.00) (43.12)

(64.24)

(20.00)

(430.00)

(32.00)

Note that any time the cash is replenished, the expense vouchers are taken out of the petty cash box and stored somewhere safe, probably with the accounts department. The accounts department will then use the totals to record the totals in the accounting system each period.

Page | 27


theexpgroup.com


Chapter 4

Double entry bookkeeping: the debits and credits

START The Big Picture The starting point for double entry bookkeeping is to think about assets and liabilities, ie net assets. If there is a change in an asset, there must be an explanation for why it changed.

 



Page | 28

If you win the lottery, you have more cash because you have lottery income. If you buy lunch, you have less cash because you spent money on lunch (ie more expenditure). If you decide that the home you own is worth more, you have more assets because you’ve recognised a revaluation gain.


theexpgroup.com


Many textbooks explain double entry bookkeeping in the framework of double entry meaning that for each transaction, there is an equal and opposite transaction. We think that this is needlessly confusing. The key word in double entry is because.

KEY KNOWLEDGE So why debits and credits? Imagine that we call assets “debits”, only so that people who speak different languages can communicate more effectively with each other. If we now say that we have an asset, or more of an asset because you’ve been paid your salary. This would be recorded as “recognise new or increased asset of cash”. It’s shorter just to say “debit cash”.

There must be a reason for this increase in cash. The reason is that there’s been some income. This can’t be a debit, as what we’re trying to do is explain where the debit came from. The explanation is arbitrarily called a credit.

You may have encountered the words debit and credit in the context of your bank statement. This brings danger, since the bank statement is a record from their own records. This means that it’s upside down. This can cause confusion, so it’s best for the moment if you try to unlearn everything you’ve ever come to think of debits and credits as being. The truth is the opposite way round to the way that lay people use the terms.

KEY KNOWLEDGE Building up the rules Here are the core concepts that you need to be happy with:

 



Page | 29

An asset, or an increase in an asset, is a debit. The opposite of an asset is a liability. The opposite of a debit is a credit. So a liability is a credit. If you have more assets (debit assets), the explanation will be to credit income.


theexpgroup.com


So you may have started to think “debits good, credits bad” or even the other way round. That’s not the way to look at it. Neither is good or bad. A debit can be an asset, but it can also be an expense. So it’s not correct to think of one being good and the other bad. It’s simpler than that. Here’s a table to summarise the rules. Review this and then try to produce is yourself, using the logic of explaining movements in net assets and things being opposites (eg a liability is a credit because an asset is a debit). It will take a while to become familiar with this system, just the way that it takes a while to become familiar with riding a bicycle. Don’t panic – it comes and don’t feel pressured to rush it. There’s not much intrinsically to actually understand here – it’s just a task and a system that becomes really easy with repetition.

Debits mean

Credits mean

What happens to net assets: An increase in assets

A decrease in assets

An increase in liabilities

An increase in liabilities

And the reason for that increase in net assets: An item of expenditure

An item of income

If you’re asked to record a transaction, the first step is to identify what assets and/ or liabilities are in question. Decide one of these first (it’s often easiest at first to start with cash if it’s a cash transaction) and decide if this is a debit or a credit. Then work out the explanation why. If you think that there’s a new liability, that must be a credit to liabilities. That means that the explanation must be a debit, which could be either an asset (eg if you’ve just got some cash in your hand because you borrowed it), or an expense (eg if you just bought dinner on your credit card).

Page | 30


theexpgroup.com


Chapter 5

Tangible non-current assets

START The Big Picture An asset is a resource controlled by an entity that is expected to give inflow of benefits. Many assets will have a period of expected benefit over more than one period. These are non-current assets.

KEY KNOWLEDGE Capital and revenue expenditure

In slang terms, capital expenditure means any cash paid to acquire assets that will result in the acquisition of a new asset, or an increase in the earning capacity of an existing asset. Revenue expenditure means money paid to maintain the existing earning capacity of an existing asset.

Page | 31


theexpgroup.com


The terminology is very confusing here, since it has nothing to do with share capital/ equity or sales revenue! They are commonly used terms, however inaccurately.

KEY KNOWLEDGE Acquisition of a non-current asset The cost of a non-current asset that will initially be recognised will be all the costs necessarily incurred in bringing the asset into its initial working condition, as long as those costs are expected to last more than a year. Any recoverable taxes will be excluded.

KEY KNOWLEDGE Depreciation All assets, with the sole exception of freehold land, wear out over time. This means that the total cost of ownership of the asset must be matched to the revenue stream that the asset generates, or supports. This is done by making an allowance for depreciation and charging depreciation. The aim of depreciation is to match the cost of using the asset to the income stream that it generates. It is not aimed at anything else such as showing the asset at its current market value in the SOFP. The depreciation method chosen for an asset should be the method that most closely matches the cost of the asset to the pattern of revenue that it generates. The SOFP will show the asset at its net book value (NBV). NBV is original cost less cumulative allowance for depreciation.

Page | 32

Method

Annual depreciation calculated as

Straight line

(Cost – estimated residual value)/ expected useful life.

Example w here suitable estimate of revenue generated Office furniture, or anything that does not produce materially greater income when it’s new. This is the most commonly used method of depreciation.


theexpgroup.com


Reducing balance (also known as diminishing balance)

NBV at start of the period x annual depreciation %

Machine hour method

(Cost – estimated residual value) x (Machine hours this period/ estimated total useable hours)

Motor vehicles used by a taxi company. Older cars generate less net revenue as they break down more than new cars and require more maintenance. Where an item of machinery has an estimated maximum useful life.

Ledger accounting Depreciation is charged each year by creating an expense and an allowance for depreciation account. The allowance for depreciation is maintained as a separate account rather than crediting the asset account itself. This is because the original historical cost of assets often needs to be extracted quickly to allow for preparation of non-current asset disclosure notes (see below).

Dr Depreciation expense (SOCI)

$x

Cr Allowance for depreciation (SOFP)

$x

KEY KNOWLEDGE Disposal

When an asset is eventually disposed, it will generally be sold for some cash. This means that a new asset will be recognised in the SOFP (the cash) and another will be derecognised (the NBV of the asset). A gain or loss will arise on this simultaneous recognition and derecognition. If sales proceeds > NBV then a profit on disposal will be recognised If sales proceeds < NBV then a loss on disposal will be recognised.

Page | 33


theexpgroup.com


In effect, a profit or loss on disposal is a correction to the estimated figures each year for depreciation. This means that this is reported in profit or loss, just as depreciation is.

KEY KNOWLEDGE Revaluation

Sometimes, revaluations are made to assets that have increased in value. This is not required, but is possible. Once an asset has been revalued, all similar assets must be revalued and the valuations must be kept up to date. Depreciation must also be based on the new, revalued amount.

KEY KNOWLEDGE Depreciation of revalued asset

A revalued asset will still need to be depreciated. The depreciation charged must be on the higher, revalued amount (a revaluation downwards is an impairment, which is unlikely to feature in the F3 exam). Depreciation expense and allowance for depreciation will therefore increase.

KEY KNOWLEDGE Disposal of revalued asset

On disposal of a revalued asset, a gain or loss will arise as normal. The gain or loss will be the difference between the new revalued amount and the net book value immediately prior to the revaluation.

Page | 34


theexpgroup.com


If there is any remaining revaluation surplus in revaluation relating to the disposed asset, it is normal to transfer this from revaluation reserve to retained earnings, as above.

KEY KNOWLEDGE Disclosure of non-current assets Non-current assets are generally disclosed on the face of the SOFP at their net book value, but with a breakdown in the notes to the financial statements that provide details of cost and allowance for depreciation.

Page | 35


theexpgroup.com


Chapter 6

Intangible non-current assets

START The Big Picture An intangible asset is an asset with no physical substance. Often this is intellectual property rights or a licence to undertake some activity. As with tangible assets, it is necessary to prove that there is sufficient certainty of a future inflow of benefits to categorise this as an asset rather than an expense. Costs that result in something that the entity cannot be reasonably sure of controlling into the future must be written off as an expense.

KEY KNOWLEDGE Research and development costs An asset is a resource controlled by an entity that is expected to generate an inflow of benefit to the entity. The key issues in recognition of an intangible non-current asset therefore tend to be whether the asset is truly controlled by the entity and whether it is likely to generate an inflow of benefit.

Page | 36


theexpgroup.com


Most research and and development fails to produce a commercially commercially viable product. product. It is also difficult to patent (ie restrict commercial use of) knowledge until it has reached a relatively advanced stage. Research costs are costs incurred incurred in the early stages of a development project. project. It is defined in IAS 38 as is original and planned investigation undertaken with the prospect of gaining new scientific or technical technical knowledge and understanding. The key issue here is that it is not reasonably certain that expenditure will generate a viable income stream in the future. The accounting treatment required for research costs is to write them off immediately in profit or loss.

KEY KNOWLEDGE Development costs Development is defined in IAS 38 as “the application of research findings or other knowledge to a plan or design for the production of new or substantially improved materials, devices, products, processes, systems or services before the start of commercial production or use”. The accounting treatment of development costs is to recognise them as an intangible noncurrent asset if they meet the criteria that suggest that they will be likely to generate a profitable income stream in the future and can be reliably separately identified using the mnemonic RAT PIE:      

Resources are adequate to complete the project Ability to complete Technically feasible Probable economic benefit (ie expected to be profitable) Intend to complete the project Expenditure on the project can be separately recorded.

A development cost asset can include i nclude the depreciation on machinery used in the development project. Instead of depreciation depreciation being written off off against profit, it is asset to the cost of the qualifying development cost asset.

Page | 37




KEY KNOWLEDGE Write-off period Intangible assets are written off over the period during which they generate benefits. As with tangible non-current assets, the aim is to match the pattern of cost to the pattern of benefit that the intangible asset generates. Development projects such as drugs patents tend to generate their greatest revenues in the early years of their commercial commercial life. For this reason, amortisation amortisation is often chosen to be by the reducing balance method of amortisation rather than straight line.

Page | 38




Chapter 7

Inventory and purchases

START The Big Picture For most businesses, inventory will be a very short lived asset, which is expected to be sold (or possibly thrown away or stolen!) by the end of the accounting period. When inventory is purchased, it creates an asset, since the inventory is expected to give an inflow of benefit to the the entity and the entity controls controls it. Strictly speaking therefore the correct accounting treatment for inventory would be, using illustrative numbers: Step 1: Inventory is purchased:

Dr Inventory asset (SOFP)

$10,000

Cr Cash/ payables

$10,000

Step 2: Inventor y is sold:

Page | 39

Dr Cost of sales (SOCI)

$12

Cr Inventory asset (SOFP)

$12




For a retailer, this could create practical problems, since each time an item of inventory is sold it would be necessary to identify the historical cost of that specific item of inventory and charge it to cost of sales (step 2 above). above). If the retailer deals with fast moving consumer consumer goods, or perishable goods, then only a very small proportion of inventory purchased during the year would remain in inventory inventory at the year end. In practical terms, journal step 2 above above could be repeated many thousands of times as each individual sale happened. To simplify matters, most accounting systems (and all accounting systems that you can expect to encounter in the F3 exam) take the shortcut of writing inventory purchases off immediately to cost of sales in the SOCI, thus: Single step: Inventory is purchased and treated as an expense:

Dr Cost of sales (purchases expense) expense) $10,000 Cr Cash/ payables

$10,000

At the end of the period, any inventory that remains in stock is then valued in accordance with IAS 2 (see below) and this is lifted out of cost of sales and treated as an asset that will probably be used up in the next period: Dr Inventory asset (SOFP)

$800

Cr Cost of sales (closing inventory) (SOCI)$800

At the start of the next period, this inventory asset is then treated as an expense, since it’s expected that it will be used up (eg by being sold or scrapped) by the end of that period and so becoming an expense of that period: p eriod: Dr Cost of sales (opening inventory) (SOCI)$800 Cr Inventory asset (SOFP)

$800

The effect of these journals is to create the hopefully familiar working for calculating cost of sales: Opening inventory

Add: Purchases in the period

Less: Closing inventory Cost of sales made

Page | 40

0 10,000 (800)

Expense in SOCI Expense in SOCI Reduction in expense in SOCI

9,200




KEY KNOWLEDGE Valuing inventory The purchase price of inventory is normally fairly simple. It will include costs necessary in order to bring the inventory into saleable condition, so including:

  

Cost paid to the supplier Irrecoverable taxes (eg import duties) Costs of delivery inwards (sometimes called carriage inwards).

Where inventory is work-in-progress in a manufacturing process it will also include fair costs of conversion (eg labour costs, production overhead costs). Recoverable sales taxes, non-production administrative costs and one-off costs that do not add anything to the inventory’s value (eg costs of delivery to the wrong location and cost of bringing to the right location) would be excluded from cost of sales, since they are unnecessary to bringing the inventory to saleable condition. By writing inventory off immediately to cost of sales, it is possible to keep inventory outside the accounting system. This simplifies matters considerably. However, it does mean that at the end of each period, inventory must be physically counted and valued, in order to make the necessary adjustments to lift unsold inventory out of cost of sales.

Maximum value: lower of cost and NRV

An asset is only an asset if it is expected to generate an inflow of benefits. This means that if inventory is expected to sell for net proceeds below cost, the maximum valuation of that item of inventory in the SOFP will be the net amount that its sale is expected to generate (called its net realisable value or NRV). 



Page | 41

Any costs incurred up to the date of the accounts might be included within the determination of cost. Any revenues and future costs to be incurred to enable sale will be included within the determination of NRV.


theexpgroup.com


The final valuation for each item of inventory will be the lower of cost and NRV. This has to be estimated on a stock line by stock line basis, so that realised losses on some stock do not mask unrealised expected gains on others.

Page | 42


theexpgroup.com


Chapter 8

Receivables and payables

START The Big Picture We have already looked at how credit sales are often made to encourage sales. The problem with extending credit is that not all receivables will pay. This means that some will become irrecoverable. Before being written off as irrecoverable, some will also look like they may not pay (perhaps by being a month overdue for payment). These are doubtful debts. Remember that an asset is a resource that is expected to give an inflow of benefits. Logically therefore if a receivable is not expected to pay, it cannot be shown as an asset. The SOFP of the receivables cannot exceed the neutral estimate of how much cash is actually expected to be received.

Page | 43


theexpgroup.com


KEY KNOWLEDGE Irrecoverable debts If a debt is not going to pay, for example if a person has died bankrupt, then it must be written out of the accounting records as the receivable is no longer an asset. Removing an asset reduces net assets and so generates an expense, which is normally called irrecoverable debts expense, hence:

Dr Irrecoverable debts expense

$x

Cr Receivables

$x

KEY KNOWLEDGE Recovery of debts written off If a debt is unexpectedly paid having previously been written off, it is likely that the cash received will initially be recorded in the cash received book as a receipt from a debtor. This means that the journal to record the cash will be automatically generated thus:

Dr Bank

$800

Cr Receivables

$800

However, the balance is no longer in receivables, as it was written off. In order for the journal to work, it is then necessary to reinstate the balance that was previously written off. This is a change in accounting estimates, since the estimate last period was there was no realistic chance of the debt being recovered:

Dr Receivables

$800

Cr Irrecoverable debt expense

Page | 44

$800.


theexpgroup.com


There is no attempt to change the previous year’s figures, which include an expense for the write off of the debt, since this was a fair estimate at the time. There will be an expense recorded for the write off in the year when it was written off and a credit to profit or loss when the cash was received. Depending on how the initial cash receipt has been recorded, it may be possible to simplify the above two journals, because there is a debit and credit of the same amount to receivables, thus:

Dr Bank

$800

Cr Irrecoverable debt expense

$800.

KEY KNOWLEDGE Doubtful debts It is likely that some receivables will not pay, even if they have not yet been written off. The business will continue to chase the receivables for full payment and may eventually even sue for the full balance. The amount cannot be written out of debtors, as credit control will need the records of the debt in full to know how much to chase for payment. However, if it’s estimated that there is a 20% chance that a debt will not pay, it would fail to give a true and fair view on the face of the SOFP to show the full amount as an asset. The solution is to create an allowance account, which reduces the value of net receivables on the face of the SOFP without corrupting the records of the actual debtor balance that will be needed to try to obtain payment. Creating, or increasing, an allowance will reduce net assets. This therefore creates an expense. The allowance account itself is a SOFP account, so just like assets and liabilities it will remain on the balance sheet until it is removed.

Page | 45


theexpgroup.com


KEY KNOWLEDGE Control account reconciliations It is possible that an accounting system will maintain memorandum ledgers with individual customer balances outside the main accounting system. This creates duplication of effort and record keeping, but provides a check on accuracy of the figures. The receivables account in the double entry system is often called the “control account”, since it contains only summary figures of lots of transactions, rather than lots of detail of individual transactions. It may alternatively be called the general ledger, or nominal ledger. The memorandum ledger cards are confusing sometimes referred to as the “ledgers”. The double entry system will be kept as simple as possible, with as few figures posted to the ledger accounts (T accounts) as possible, since the fewer transactions there are, the less the chance of error and the less information to seek through in order to find errors when they occur. For this reason, the ledger accounts are normally updated using the totals from the sales day book and cash receipts book, rather than details of individual sales.

KEY KNOWLEDGE Other common items with receivables Interest on overdue debts If a sale agreement with a customer provides for a right to charge penalty interest on an overdue debt, this will increase the amount receivable. Increasing a receivable increases net assets, which therefore generates a source of income. It will normally be recorded as: Dr Receivables Cr Sundry income (or perhaps finance income)

$x $x

Discounts There are two types of discount that you may encounter: trade discounts and settlement discounts. Trade discounts are those given to customers at the point of sale, perhaps because the customer buys in large volumes or is a member of staff. These discounts are

Page | 46


theexpgroup.com


not subject to any uncertainty at the time of sale – it is known for sure that the customer will never pay the list price of the goods or services. The accounting is therefore very simple: they are simply ignored. The sale is recorded at the amount net of the trade discount.

Settlement discounts A settlement discount is an incentive for customers to pay you earlier than they otherwise naturally would. For example, a discount of 5% may be offered on the invoice sent to customers if payment is received within seven days of the invoice being sent. If payment is not received within that period, the offer of the discount lapses. Settlement discounts are uncertain at the point of sale. The actual amount of the debt is gross of the settlement discount, ie before its deduction, since this is the amount that the customer will eventually be chased for if they don’t pay early. If the settlement discount is allowed to the customer, this is similar to the treatment of irrecoverable debts. It is simply a debt that we are voluntarily choosing to write off as partially irrecoverable because of the cash flow advantage of receiving the cash quickly. Settlement discounts are sometimes also called cash discounts for this reason. The terminology can be confusing here. Discounts allowed are settlement discounts that we allow to customers. They are therefore partial write off of debts receivable by us. They are therefore an expense in our books. Discounts received are settlement discounts that our suppliers allow to us. They are therefore partial forgiveness of debts that we owe to other people. They are therefore a source of income in our books.

Page | 47


theexpgroup.com


Chapter 9

Bank reconciliations

START The Big Picture The cash book will record payments in and out of the bank account. Banks, of course, provide bank statements that record all the transactions that they have recorded in the same bank account. This independent record keeping is a powerful check on the accuracy of a business’s accounting records. In a small company scenario, it is likely that each transaction on the bank statements will be manually compared to the transactions on the cash book, ticking off matching transactions. This will then leave only items that don’t agree. In larger businesses that use a computerised accounting system, it is likely that the bank’s transactions will be downloaded in a raw data file (such as a .csv file) and will then be run through the accounting software. The accounting software will then match transactions and run off a report of differences. It is a good accounting practice to reconcile the bank accounts frequently. In some regulated scenarios, such as accounts that are used to hold client money, it is a professional requirement to reconcile the accounting records to the bank statements at least once a month.

Page | 48


theexpgroup.com


To reconcile is to satisfactorily explain a difference between two numbers or records.

Reasons for differences between bank account and cash book

Errors/ omissions

Timing differences

(require correction)

(no action needed)

Errors/ omissions by the company itself

Errors/omissions by the bank

Errors can be almost infinitely varied and can be made by either the bank or the company. If errors are made by the bank, the company will need to notify them, so that the bank can correct their records. If errors are made by the company, the company will need to amend its own records, using the journal book. Typical errors/ omissions made by the company:   



 

Page | 49

Misposting of amounts, eg recording a cash payment of $45 as $54 Omission of cash payments or receipts Omission of standing orders processed by the bank (ie automatic payments of nonvariable amounts) Omission of “direct debit” payments processed by the bank (ie automatic payments of variable amounts) Omission of bank charges Processing errors, eg miscasting manually maintained accounts.


theexpgroup.com


Typical errors/ omissions made by the bank (typically much rarer than the company):  

Incorrect charges Processing payments or receipts incorrectly.

Typical timing differences:  

Payments made into the bank not yet processed (“uncleared lodgements”) Cheques drawn or online payments ordered not yet processed by the bank.

A warni ng about terminology! A bank statement will record positive deposits with the bank as a credit, where the cash book will record them as debit. Both are correct, as a debit is an asset. If the bank holds some of your money, that means that the bank owes you money – ie you are a liability of the bank. So the bank statements will list your balance as a credit. Bank statements are run off from the records of the bank, not of the client. Hence, our debit correctly equals their credit and vice versa.

Page | 50


theexpgroup.com


Chapter 10

Long term finance

START The Big Picture Long-term finance means cash used to operate the business over the long-term. It may be paid into the business by owners, or by providers of loan finance. The former is capital and the latter is debt. Capital is normally only repaid to owners if the owners choose to close down a solvent business. The business has no obligation to pay back ordinary share capital while the business is a going concern.

KEY KNOWLEDGE Long term debt

Debt is a liability, meaning it’s an obligation of the business. Long-term debt may be funds raised from banks, or from other investors who buy loan notes (also called bonds, securities or commercial paper). Debt generally incurs an interest charge and may be redeemable (meaning repayable) over a period of time, on a fixed date or exceptionally irredeemable debt. The last category simply therefore pays interest into perpetuity without ever repaying

Page | 51


theexpgroup.com


the loan principle. It is only ever issued by governments, and then only rarely. Loan notes are often tradable, meaning that the original buyer can get their cash back before redemption by selling the loan note to somebody else for its market value on that day. Any loan principal due for repayment within the current year is a current liability; any debt due for repayment after more than one year is a non-current liability. On the issue of a loan, the cash received will be credited to a loan liability account. No liability is recorded for expected future interest, as the obligation to pay interest only arises as time passes.

KEY KNOWLEDGE Equity

Equity is the residual interest of all assets after deducting all liabilities. For a sole trader, equity is simply termed proprietor’s interest. In a partnership, it is the sum of each partner’s capital account and each partner’s current account. In the case of a company, IFRS and national regulation often require a greater analysis of each component of equity. Equity in total is often termed shareholders’ interest or shareholders’ funds. In a large limited liability company, equity may comprise the sum of the following: Ordinary share capital Preference share capital Reserves: Share premium account o Revaluation reserves o Other reserves o Retained earnings o Companies are required to present a note in their financial statements that reconcile each component of equity at the start of the year to the end of the year. This is another expression of the accounting equation and business equation from chapter 1.   

Page | 52


theexpgroup.com


Chapter 11

Accruals and prepayments

START The Big Picture One of the fundamental assumptions of accounting that we saw in chapter 1 was the accruals concept. There are two aspects to the accruals concept: 



Matching costs to the associated revenues. For example, depreciation and the cost of sales working both do this. Recognising transactions as they are incurred, not necessarily when the cash is paid. This also has the effect of ensuring that a profit calculation for a period will hopefully show a sustainable profit, since all expenses incurred in the period will be matched to all revenues earned, even if the expense hasn’t yet been paid.

Accruals

Where an expense has been incurred, but it’s not yet been paid. Often, an invoice hasn’t yet been received, so an estimate of expense incurred by the year-end will need to be made. This means there is a liability at the period end.

Where an amount has been paid in advance, but that cash payment gives a right to receive benefits beyond the current period end. This means that there is an asset at the period end, since there is a right to receive future benefits.

Examples:

Examples:

 

Page | 53

Prepayments

Estimated water and electricity used Estimated telephone charges for a



Insurance paid in advance for a year’s insurance cover.


theexpgroup.com


traditional landline telephone at a month end.



Prepaid balances on pay-as-you-go mobile telephones.

KEY KNOWLEDGE Accounting treatment at the year end

Accruals

Prepayments

Estimate the cost of goods or services used by the year end but not invoiced. This might be done using typical levels of usage, or done after the period end using invoices that came in after the period end, but before the accounts are prepared.

Calculate the amount of the prepayment from cash paid before the year-end. Determining the amount of the prepayment will normally be easier than estimating the amount of an accrual, since there is an actual cash payment before the period end to base the calculation on.

Recognise this as a liability, since there is an obligation to pay this charge. Recognising the liability reduces net assets, so generates an associated expense:

Recognise the asset (the right to receive future benefits) at the period end. Doing this increases net assets so generates a source of income. In reality, this source of income will be a reduction in the expense recognised so far from posting cash payments from the cash book to expenses.

Dr Expense in SOCI (eg electricity) Cr Accruals in SOFP (liability)

$x Dr Prepayment in SOFP (asset) $x Cr Expense in SOCI (eg insurance)$x

KEY KNOWLEDGE Accounting treatment in the following period In the following period, it’s reasonable to assume at the start of the period that the prepayment asset will be used up (eg the benefit of insurance received) or the liability will be settled by payment of cash. It’s therefore normal at the start of the year to anticipate this by reversing the accrual liability or prepayment asset through profit. This is often done

Page | 54


theexpgroup.com


at the beginning of the following period, but it could be done at the end of the period in some companies. It’s a manual adjustment through the journal book, so it can be done anytime that the company likes. It must be done, however, as otherwise redundant assets and liabilities will be shown on the SOFP forever!

Accruals

Recognise the discharge of the liability in the following period. This increases net assets, so creates a credit to expenses. This means that as cash is paid the following period, not all of it will be recognised as an expense in that period, since an amount equivalent to the opening accrual will already have been reported as an expense the previous year. Reversing the accrual removes any chance of accidental double recognition of the expense. Dr Accruals in SOFP (liability)

Prepayments Recognise the consumption of the asset in the following period. This derecognises the asset that no longer exists. Derecognising the asset reduces net assets, so generates an expense. This will be an expense in period 2 of the cash payment not recognised as an expense in period 1.

Dr Expense in SOCI (eg insurance)$x Cr Prepayment in SOFP (asset) $x

$x

Cr Expense in SOCI (eg electricity)

Page | 55


theexpgroup.com


Chapter 12

Provisions and contingencies

START The Big Picture A liability is defined in IFRS as being: 

 

An obligation at the period end (ie something that is impossible to avoid – not just an intention to do something), and Where an outflow of benefit is expected to arise from that obligation, and A reliable (which in practice means meaningful) estimate of the outflow can be made.

A provision is simply a liability of uncertain timing or amount. Accruals may be a form of provision, if there is no firm data on which to base the estimate of the amount expected to be paid. A provision is valued at the neutral best estimate of what the business expects to pay to settle the obligation. For a one-off liability (eg lawsuit) this will be the single most probable outcome. For a recurring series of similar liabilities (eg lots of goods sold under warranty) it will be the weighted average of outcomes.

Page | 56


theexpgroup.com


Contingent liabilities A contingent liability exists in one of two situations, which are either: It is believed that there is probably no obligating event (<50% probability) but the chances of there being an obligating event are more than remote (>5% probability), or An obligation probably exists, but it is so difficult to obtain an estimate of what the outflow is likely to be that any estimate would be no more reliable than zero. This second situation is very rare. Contingent liabilities are disclosed in the notes to the financial statements but are not shown with any value on the SOFP.

Contingent assets A contingent asset is one where it is uncertain if the asset (ie right to something) even exists. Examples are insurance claims where it’s uncertain if the item being claimed for is covered by the policy at all or a lottery ticket before the lottery draw. Contingent assets are not shown as assets in the SOFP, nor disclosed in the notes to the financial statements.

Movem ent in provisions A provision is a liability. As with any item on the SOFP, it will remain on the SOFP until it is removed. If a provision is increased during the period, the effect will be to reduce profit and net assets: Dr Expense (eg for legal costs)

$ Increase in provision

Cr Provision

$ Increase in provision

The provision is categorised on the SOFP within current liabilities or non-current liabilities, depending upon whether it is expected to be settled within 12 months of the reporting date or longer. If a provision is no longer needed, it will be reversed. This will reduce the profit effect of the cash payment in the period.

Page | 57


theexpgroup.com


Chapter 13

Sales taxes

START The Big Picture Sales taxes, such as Value Added Tax (“VAT”) are a common feature of business. The rules vary considerably between countries, but typically businesses are required to register for sales tax if their expected turnover exceeds a certain limit. Businesses that are not registered for sales tax simply record purchases and sales at whatever cash they pay or receive. Businesses that must register for sales tax have an additional complication in their accounting system. In order to comply with the law, they must very accurately maintain records of sales taxes that they have been required to charge on their sales (their “output tax”) and the tax that they have paid on their purchases of goods and services (their “input tax”). As people who are not registered for sales tax, we may often be unaware of what sales taxes we are suffering, though receipts will normally provide a breakdown of the amount inclusive of the sales tax (“gross”), the amount of the sales tax itself and thus the amount excluding the sales tax (“net”).

Page | 58


theexpgroup.com


Local laws vary on how prices must be quoted. In most countries, the convention appears to be that prices must include sales tax unless they specify otherwise. In the USA, it is normal for prices to be quoted net of sales tax and then the sales tax is added at the point of purchase. In an exam question, it’s first important to know which way the prices have been quoted.

If a business is not registered for sales tax, it does not need to charge sales tax on its outputs, but it cannot recover sales tax on its inputs.

If a business is registered for sales tax, it must charge sales tax on its outputs which it must then pay over to the government periodically. It recovers sales tax on its inputs by netting it off the sales tax payable.

Ledger accounting Purchases and payables would be recorded as:

Dr Purchases (SOCI, so net)

$135,000

Cr Cash/ payables (SOFP, so gross)

$162,000

= > Dr Sales tax control account (SOFP)

$27,000

The sales tax control at any point will show the amount due to or from the tax authority for sales taxes. Sales and receivables would be recorded as:

Cr Sales revenue (SOCI, so net)

$178,000

Dr Cash/ receivables (SOFP, so gross)

$213,600

= > Cr Sales tax control account (SOFP)

$35,600

This leaves a net balance on sales tax control of $8,600.

Page | 59


theexpgroup.com


Recoverable or irrecoverable? Some items will include sales taxes that under local law are not recoverable, as a matter of public policy. These might include business entertaining expenses or sales tax on cars. In the UK for example, sales tax on vans is recoverable for a registered business, but sales tax on purchase of a company car is not. If an item includes irrecoverable sales tax, it is included within the recognised value of the asset or expense.

Page | 60


theexpgroup.com


Chapter 14

Trial balances and correction of errors

START The Big Picture In chapter 4, we prepared simple records of a sole trader and listed all the balances on their accounts at the end of the period. This was a preliminary trial balance. Dr Cash

16,140

Capital Purchases

15,000 3,000

Payables

2,040

Sales income

4,140

Staff costs

Page | 61

Cr

50


theexpgroup.com


Non-current assets Telephone

540 60

Receivables

1,240

Withdrawals

150

Totals

21,180

21,180

The fact that the total debits equal the total of the credits gives us a considerable amount of comfort that the bookkeeping has been done accurately. If the total debits does not equal total credits, it implies that errors have been made i n the recording of transactions, the adding up of the T accounts or the extraction of balances from the T accounts into the trial balance itself. It does not mean that no errors have taken place. These types of errors will not be picked up in a trial balance:

Page | 62



Errors of omission – having totally ignored a transaction or necessary adjustment



Compensating errors – two errors happening to cancel each other out



Errors of principle – treating an expense as an asset, income as liability, or vice versa



Errors of commission – recording the correct journal, but at the wrong amount.


theexpgroup.com


Overview of stages in preparation of financial statements

Record transactions using books of original entry

Periodically total books of original entry and post totals to ledger accounts

Total ledgers and produce preliminary trial balance

Use journal book for corrections and "period 13" adjustments

❶

Final trial balance

Produce financial statements

Reset income and expenditure accounts to zero by transferring balacnes to profit and loss account

Transfer profit and loss T account to equity

Opening trial balance for next period

Page | 63


theexpgroup.com


KEY KNOWLEDGE Correction of errors As professional accountants, much time is spent dealing with correcting errors from draft records prepared by less experienced people. Knowing how to correct errors is therefore a critical skill for a chartered certified accountant. The easiest approach to take is to take three steps and resist the temptation to try to simplify them, as rushing into a simplification normally results in further complication and a poor trail for another person to review the work that you’ve done. So the approach to take is: 1. Work out what has been done to record a transaction and write down the journal that has been recorded, no matter how crazy it might be. 2. Work out what the journal entry should have been. 3. Compare the results from steps 1 and 2 to work out a correcting journal.

Page | 64


theexpgroup.com


Chapter1 5

Suspense accounts

START The Big Picture We saw in previous chapters that if all is working well with an accounting system, the total of the debits will equal the total of the credits when a trial balance is presented. Errors may occur that will result in total debits not being equal to total credits. This may arise in many situations, including:  



One sided jounral (eg Dr Cash $100 only) Posting both sides of a journal on the debit or credit side (eg Dr Receivables $80, Dr Sales $80) Recording different amounts on the debit and credit sides (eg Dr Payables $230, Cr Cash $320).

If a trial balance is produced frequently, it will be possible to spot these errors while they are recent enough to have a good chance of finding them.

Page | 65


theexpgroup.com


In order to highlight the problem, a suspense account is created which will fill the hole in the trial balance. A suspense account is an equity account, which should be eliminated in full before the financial statements are produced. Because a suspense account may arise due to multiple errors, some of which will be a debit to suspense and some a credit to suspense, it really ought to be eliminated in full and this is what you should expect to have to do in the exam. In practice, it’s normal to find that suspense accounts can become very small, when the effort in clearing them becomes disproportionate to the benefit. They are then often written off to profit or loss to clear them once the residual figures become trivially small, as the chance of a difference of $0.10 being the net of two large compensating errors is very small.

Deliberate creation of suspense accounts A suspense account may be used deliberately where a transaction has happened but the bookkeeper is uncertain what it relates to. By recording the transaction in suspense, it can ensure that the records are at least partially correct, but can then be corrected fully when the information necessary is known.

Page | 66


theexpgroup.com


Chapter 16

Incomplete records

START The Big Picture It’s common for smaller businesses not to maintain perfect systems for capturing data that can then be used to produce the financial statements. In some situations as well, it’s common to have to construct financial information to find missing information about transactions that don’t get recorded in the system because of their nature, such as losses due to theft of inventory.

The key techniques to answer exam questions on this are:   

Page | 67

Cost structures of mark-up and margin Use of T accounts to find missing figures Use of the accounting equation/ business equation to find missing figures such as profit (this was covered in chapter 1).


theexpgroup.com


KEY KNOWLEDGE Margin and mark-up There is a terminology distinction here that is important: Mark-up means that you start with the cost of a sale, then add the mark-up % to determine sales price. Margin means that you start with the sales price, of which a specified % will be gross profit.

Mark-up

Margin

Sales revenue

120%

Sales revenue

100%

Cost of sales

100%

Cost of sales

80%

Gross profit

20%

Gross profit

20%

Withdraw al of inventory for ow n use In a smaller business, a proprietor is likely to withdraw inventory for his/ her own use. This is a withdrawal from the business. The purchase of inventory will have been written off to purchases, within cost of sales. However, if the inventory is taken by the proprietor, it has not been sold. A common accounting treatment and the one to use in any exam question is therefore to remove it from cost of sales (at cost) and debit to withdrawals.

Page | 68


theexpgroup.com


Chapter 17

Limited companies

START The Big Picture Separate legal identity A sole trader is a different entity to his/ her business as far as accountants are concerned, but not as far as the law is concerned. The business debts of a sole trader are indistinguishable from the that person’s general debts in the event that the business goes insolvent. A sole trader, or traditional unlimited partnership, is a risky form of enterprise as if it goes bankrupt, the trustee in bankruptcy can seek to recover personal assets to make up the shortfall. This can be a different story with a company, since a company has a legal identity of its own, being an artificial legal person.

Page | 69


theexpgroup.com


Note that lim ited liability does not mean that t he liability of the company to its creditors is limited! It means that the liability of the members to the company is limited. This is developed in greater detail in paper F4 GLO.

The members...

....enjoy limited liability to....

...the limited company....

...which has unlimited liability to...

...its creditors.

Taxation With a sole trader or partnership, taxation expense does not appear in the SOCI. This is because the sole trader’s or partner’s tax liability depends on lots of other things, such as any other sources of income that they may have or tax deductible personal expenses. The business is not the complete story of the owner’s wealth, so the tax liability of that person from business earnings cannot be known. With a company, the tax position is known, since the company itself will have a liability for corporate income tax. This means that it is possible to make an estimate of what tax will be due on profit for the period. This tax: 



Page | 70

Is likely to be an estimate at the year-end as there are often adjustments to accounting profit to agree with the tax authority, clarification to be obtained on whether certain expenses are deductible, if any tax losses can be offset against current year profit, etc, and Is likely to be paid some time after the period end, so is a liability in the SOFP at the period end.


theexpgroup.com


KEY KNOWLEDGE Equity The equity section of the SOFP of a limited company will look different to that of a sole trader. This was outlined in chapter 10. Companies are regulated in law by what dividend they can pay and which reserves dividends can be paid from. Basically, dividends can only be paid out of retained earnings. Retained earnings are the cumulative of recognised profit (not total comprehensive income) less cumulative dividends paid. Other comprehensive income (eg revaluation gains) are transferred to revaluation reserve. See the statement of changes in equity in chapter 10 for an example of this.

Page | 71

Component of equity

What it is

Distributable?

Ordinary share capital

Records the nominal value of the shares issued to date. Ordinary shares generally have only a discretionary dividend and come with voting rights.

No

Preference share capital

Records the nominal value of preference shares issued to date. Preference shares normally carry a fixed dividend but have no voting rights.

No

Share premium account

Records the excess over nominal value of consideration received on the issue of shares.

No

Revaluation reserve

Records cumulative revaluation gains on profit above historical cost. Movements on revaluation reserve will be reported in other comprehensive income within the statement of comprehensive income

No

Retained earnings

Records cumulative recognised profit, less cumulative dividends received.

Other reserves

Some IFRS require some gains and losses to be reported in “other equity”. Sometimes companies may choose to maintain a separate component of retained earnings, or national law requires it, eg some national laws require that 5% of profit each year is transferred to a non-distributable other reserve.


Yes

Partially. Wise to treat as nondistributable.

theexpgroup.com


Note that current mark et price of shares is not relevant to accounting. Only the valuation of consideration (normally cash) received by the company for issue of shares is relevant to the SOFP.

Page | 72


theexpgroup.com


Chapter 18

Statements of cash flow

START The Big Picture Purpose of a statem ent of cash flow In addition to information about profit and other comprehensive income, it is useful to provide investors with analysed information about cash flows. This gives the following benefits: Understandability - Smaller investors in particular are likely to find cash flows easier to understand than total comprehensive income. Business valuation – a common method of valuing businesses is to work out the net present value of cash flows. This is covered in other ACCA papers, but for F3 you need to know that cash flow information feeds into this common type of valuation. Predicting liquidity problems – when companies run out of cash, they are often in serious trouble and may go out of business. If a business is reporting profits but not collecting cash (eg by making sales on excessively generous credit terms) then this needs to be made clear to readers.

Page | 73


theexpgroup.com


KEY KNOWLEDGE What is cash? IAS 7 presents a statement of cash flows using both cash and cash equivalents. A cash equivalent is a short-term, highly liquid short-term investment that is readily convertible into a known amount of cash and is subject to insignificant risk of changes in value. To some extent, this is a subjective definition. In the exam, it will be made clear. Cash and cash equivalents will include:    

Notes and coins Demand deposits at a bank Foreign currency deposits (will not be in paper F3) Government bonds very close to maturity date (will not be in paper F3).

Cash and cash equivalents will exclude:  

Shares in other companies Long-dated bonds.

If a company uses cash to buy a cash equivalent, it will not be reported in the statement of cash flows as a cash movement. If a company uses cash or cash equivalents to buy shares, it will be reported in the statement of cash flows as a cash outflow on investing activities.

Profit v cash flow We have seen already that there are many items within a statement of comprehensive income that do not represent a movement of cash. The method used by most companies to present a statement of cash flows reconciles operating profit (earnings before interest and taxation) to cash generated from operations (ie cash flow from core operations, before buying or selling non-current assets or raising new finance). If a transaction or journal adjustment affects earnings before interest and tax, but does not affect cash from operations, then it is a difference. That difference will be part of the reconciliation.

Page | 74


theexpgroup.com


A number of multiple choice items is likely to focus on this part of preparation of a statement of cash flows under the indirect method, so it’s worth being able to do in full; even if this could not be required in the exam itself.

KEY KNOWLEDGE Direct method or indirect method The cash generated from operations may be presented under IAS 1 using two alternative presentations, both of which reach the same figure, but by different means. The direct method is shorter in presentation but often longer to calculate the figures in an exam.

$ Cash received from customers

$ 28,200

Cash paid to suppliers and employees

(24,500)

Cash generated from operations

3,700

Interest paid

(140)

Income taxes paid

(340)

Net cash from operating activities

3,220

Cash flows from investing activities Purchase of property, plant and equipment Proceeds from sale of equipment Interest received Dividends received

(1,620) 120 80 190

Net cash used in investing activities

Page | 75


(1,230)

theexpgroup.com


Cash flows from financing activities Proceeds from issue of share capital

70

Proceeds from long-term borrowings

180

Dividends paid

(40)

Net cash used in financing activities

210

Net increase in cash and cash equivalents

2,200

Cash and cash equivalents at the start of the period

(1,450)

Cash and cash equivalents at the end of the period

750

Indirect method $ Profit before tax

3,105

Finance costs Profit before interest and tax

$

150 2,995

Adjustments for: Depreciation

Amortisation

100

Increase in inventories

65

Increase in receivables

330

Increase in payables

Cash generated from operations

Page | 76

370

(120)

3,700

Interest paid

(140)

Income taxes paid

(340)


theexpgroup.com


Net cash from operating activities

3,220

Cash flows from investing activities Purchase of property, plant and equipment Proceeds from sale of equipment Interest received Dividends received

(1,620) 120 80 190

Net cash used in investing activities

(1,230)

Cash flows from financing activities Proceeds from issue of share capital

70

Proceeds from long-term borrowings

180

Dividends paid

(40)

Net cash used in financing activities Net increase in cash and cash equivalents Cash and cash equivalents at the start of the period

210 2,200 (1,450)

Cash and cash equivalents at the end of the period

750

Finding cash flows using double entry A multiple choice question may provide you with information about items in the SOFP at the end of this period, the end of the previous period and provide figures from the SOCI. You would then be required to find the cash flow as the balancing item, using T accounts. This is exactly the same technique as used in incomplete records.

Technique to use The technique here is nothing new to learn; it is exactly the same approach as for incomplete records:

Page | 77


theexpgroup.com




 

Page | 78

Identify any asset/ liability accounts in the question where you are given both an opening and closing balance. Write up a T account for this account, including all the data that you are given. Balance off this account to find the information that you are looking for, which will be the cash paid or received relating to that asset/ liability in the period.


theexpgroup.com


Chapter 19

Partnership accounting

START The Big Picture In chapter 1, we looked at the differences between sole traders, partnerships and limited companies. A partnership is basically a collection of sole traders who work together. The UK Partnership Act 1890, upon which partnership questions in the F3 exam are likely to be based defines as partnership as “the relation which subsists between persons carrying on a business in common with a view of profit”. You don’t need to know this definition for the exam, but it helps appreciate what a partnership a relationship between individuals, rather than necessarily being a legal entity in its own right. The flow of transactions and preparation of accounts from chapter 14 is slightly amended when it comes to the equity section of the SOFP. Instead of transferring profit as one figure to capital (or retained earnings if it’s a limited company), there’s an additional step of an appropriation account. The appropriation account is a temporary account with the sole purpose of distributing profit between partners in accordance with the agreement for profit sharing between the partners, the operation of local law, or some combination of both where a partnership agreement is incomplete.

Page | 79


theexpgroup.com


Final trial balance

Produce financial statements

Reset income and expenditure accounts to zero by transferring balacnes to profit and loss account

Transfer profit and loss T account to appropriation account

Share profit from appropriation account to partners' capital following partnership agreement

Opening trial balance of next period

KEY KNOWLEDGE Principal issues to understand in partnerships  

  

Page | 80

What a partnership is (see above) How the equity section of the SOFP differs in a partnership compared with a sole trader and limited company How to divide profit between the partners Recording withdrawals made by partners Recognising goodwill in the partnership accounts and changes in membership of the partnership.


theexpgroup.com


KEY KNOWLEDGE Partnership SOFP and equity The ownership of a partnership is split between each partner’s capital, which records each partner’s “static” investment in the firm and is based on their initial cash introduced and each partner’s current account, which records each partner’s variable investment in the firm. In theory, each partner could withdraw their current account in full at any time. This means that if there are 20 partners, there will be 40 accounts within equity in the general ledger and in the presentation of the SOFP. In the exam, it’s likely that a partnership will comprise only two or three partners.

Partners’ capital accounts

$

Mr Rag

140,000

Mrs Tag

180,000

Miss Bobtail

$

26,000

Total capital

346,000

Partners’ current accounts Mr Rag

90,000

Mrs Tag

72,000

Miss Bobtail

(3,000)

Total current accounts

159,000

Total equity

505,000

Legal terms used in partnerships There are certain legal terms used in partnership agreements. In most jurisdictions, the law provides default terms of the partnership agreement. Generally, the partnership agreement

Page | 81


theexpgroup.com


varies the terms of this agreement but if there is no specific agreement, the law’s default provisions apply. The UK Partnership Act 1890 is used as an exemplar here, but obviously follow the appropriate national law! In the exam, it is likely that the terms of a partnership agreement would be complete.

Term

What it means

Partnership Act 1890 default rule

Interest on loans

Partners may make short-term loans to a firm to tide it over short-term working capital problems. This is an expense in profit rather than an appropriation of profit.

5% annual simple interest on loans.

An expense of the business

Dr Expense (P/L)

$x

Cr Partners’ current a/cs $x Salaries

An appropriation of profit, rather than an expense

A first call on profits of the firm. Note that this is a different meaning to salaries for staff, which is an expense. Salaries for partners are an appropriation of profit rather than an expense.

No salaries awarded to any partner.

Dr Appropriation account $x Cr Partners’ current a/cs $x Interest on capital

An appropriation of profit, rather than an expense

To reward partners with the greatest financial investment in the firm, a first share of profit may be given to partners on their opening capital account.

No interest on capital.

Dr Appropriation account $x Cr Partners’ current a/cs $x Withdrawals/ drawings A reduction in investment. Dr Partner’s current account

Page | 82

Resources taken out of the firm by each Only restriction is partner, the same as withdrawals by a the balance on sole trader. each partner’s current account.


theexpgroup.com


$x Cr Cash or other asset taken $x Interest on withdrawals

A fine on each partner by the partnership; normally if withdrawals are taken out early or above an approved Dr Partner’s current account level. $x

No interest on withdrawals

Cr Appropriation account $x Profit sharing ratio An appropriation of profit. Dr Appropriation account $x Cr Partner’s current account $x

Goodwill An asset

After all prior calls on profit are made, the residual profit is shared in the residual profit sharing ratio between each partner. Most partnership agreements give a higher share of profit to the more senior partners. A partnership agreement may also guarantee a partner a minimum share of profit.

Partners share residual profits and losses equally, regardless of balance on capital account, etc.

An asset representing the value of the firm’s name, etc. Normally not kept on the SOFP, but often introduced at a time of a partnership change (see below).

Not on the SOFP, meaning that it’s an “off balance sheet” asset.

Presentation of w orkings To save time, it’s normal for partnership accounts to be presented using a multi-column approach that effectively combines each partner’s capital account, or current account.

KEY KNOWLEDGE Guaranteed minimum profit share It’s possible that a partnership agreement may guarantee one or more of the partners a minimum profit share. The way to deal with this is:

Page | 83


theexpgroup.com


  

Calculate profit share as normal Check that each partner’s profit share is above the guaranteed minimum If there is any shortfall between allocated profit share and minimum profit share, transfer the shortfall to the partner who is guaranteed the minimum profit share. Split the difference between the other partners in the profit sharing ratio between the other partners whose profit share is being reduced.

The re-allocation between partners is recorded as a transfer within the current accounts of each partner.

KEY KNOWLEDGE Goodwill Goodwill is the value of a business, other than the separate value of its individual net assets. In a partnership, reputation, client list, motivated staff and brand name are all likely to be part of goodwill. Since these things arise as a happy by-product of simply trading, they do not have an identifiable separate cost (eg no cash was ever paid specifically to acquire reputation). Goodwill generated within a business is not normally recognised as an asset on the SOFP, as its valuation is too subjective to be reliable. Partnerships don’t generally have to follow IFRS, but IFRS prohibits recognition of internally generated goodwill on a SOFP. Most partnerships choose to follow this rule.

Calculation of goodw ill There are many ways to estimate goodwill. A larger partnership will often contain provisions for how goodwill is to be calculated. Goodwill is the difference between the business as a whole and the value of the identifiable separate net assets of the business. So it may be calculated as:

Page | 84


theexpgroup.com


$’000 Estimated value of the business as a whole Less: Fair value of individual net asset

1,340 (1,030)

Value of goodwill

310

The value of the business as a whole may be estimated using the P/E ratio of similar businesses, often with some adjustment. The P/E ratio is a measure of confidence in a business, where P is the market price of a share and E is the most recent earnings per share. A P/E ratio of 12 means that the share price is currently 12 times the most recent earnings. Other methods may exist, such as three times the most recent turnover or similar methods. In some industries, there are accepted industry benchmarks for estimating goodwill.

Page | 85


theexpgroup.com


Chapter 20

Events after reporting date, errors and estimates

KEY KNOWLEDGE Events after the reporting date Events after the reporting date are ones that happen between the financial year end and when the financial statements are authorised for issue. They are colloquially referred to by most people as “post balance sheet events”. All material events after the reporting date must be disclosed and explained in the notes to the financial statements. An adjusting event is one that gives further information on conditions that existed at the reporting date. The figures in the financial statements are amended to incorporate the latest available information.

Page | 86


theexpgroup.com


Examples of adjusting events according to IAS 10 Events After the Reporting Period include: 

 





Bankruptcy of a major receivable, as the receivable would be almost certain to have been in trouble at the period end. Sale of inventory after the period end at a loss. Resolution of a matter requiring a provision at the reporting date, such as a litigation in progress at the period end. Any matter which causes the company to no longer be a going concern after the period end will be an adjusting event, even if it would normally be a non-adjusting event. Discovery or fraud or error in the preparation of the financial statements.

Examples of events that would be non-adjusting, but would be disclosed in the notes to the accounts only include:  

Issue of new shares Declaration of a dividend after the reporting date.

KEY KNOWLEDGE Errors and estimates

IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors Accounting policies are the detailed applications of IFRS that a company chooses to apply. Examples: 

 

How similar types of transactions are grouped and reported together (eg classes of non-current asset) At what exact point revenue is recognised What de minimis figure to use when recognising non-current assets.

Accounting estimates are best guesses necessarily made in the preparation of the financial statements, including:   

Page | 87

Expected useful lives of assets Residual value of assets How much a lawsuit is likely to cost the company to settle


theexpgroup.com

Exp f3 Notes

Recommend Documents