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FINANCIAL ACCOUNTING
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TOPIC PAGE
1 INTRODUCTION TO ACCOUNTING 2
2 THE REGULATORY FRAMEWORK 10
3 DOUBLE ENTRY BOOK KEEPING & RECORDING BASIC TRANSACTION 11
4 RETURNS, DISCOUNTS AND SALES TAX 16
5 INVENTORY (IAS-2) 21
6 TANGIBLE NON-CURRENT ASSET 24
7 INTANGIBLE ASSET 31
8 ACCRUALS AND PREPAYMENTS 33
9 RECIEVABLES AND PAYABLES 35
10 PROVISION AND CONTIMGENT LIABILITIES 38
11 CAPITAL STRUCTURE AND FINANCE COST 40
12 CONTROL ACCOUNT RECONCILIATION 44
13 BANK RECONCILIATION 47
14 CORRECTION OF ERRORS AND SUSPENSE ACCOUNT 49
15 INCOMPLETE RECORDS 51
16 STATEMENT OF CASH FLOW 53
17 INTERPRETATION OF FINANCIAL STATEMENT 56
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CHAPTER 1

INTRODUCTION TO ACCOUNTING
Accounting is the system of recording, analysing and summarizing business and financial
transactions and verifying and reporting the results.

 Transactions are recorded in books of prime entry.

 The totals of these books of prime entry are posted to the ledger accounts.
 Finally, transactions are summarised in the financial statements (Statement of
Financial Position, Statement of Profit or Loss and Other Comprehensive Income,
Statement of Cash flows, Statement of Changes in Equity)

NEED FOR ACCOUNTING

Any organization/business/individual that needs to keep track of their income, expenses,
assets and liabilities needs accounting.

BUSINESS ENTITY / ORGANIZATION

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Sole trader
This is the simplest form of business where a business is owned and operated by one
individual. There is no legal distinction between the owner and the business. The owner
receives all of the profits of the business but has unlimited liability for all the losses and
debts. For example, if a sole trader has some capital in his business, but the business now
owes $50,000 which it cannot repay, the trader might have to sell his own property to raise
the money to pay off his business debts.
Partnership
Similar to a sole trader the owners of a partnership receive all the profits and have unlimited
liability for the losses and debts of the business. The key difference is that there are at least
two owners.
Partners share profits and losses in accordance with their agreement. The partners and their
business are legally the same entity and therefore the partners are jointly and severally
liable for the losses of their business. E.g. Accounting firms, law firms, estate agents etc
Limited Liability Companies
Unlike sole traders and partnerships, limited liability companies are established as separate
legal entities to their owners. Limited liability companies are incorporated to take advantage
of ‘limited liability’ for their owners (shareholders). Limited liability means that the owners
(shareholders) are only responsible for the amount to be paid for their shares.
Limited companies are of two types:
1. Public (shares issued to general public)
2. Private (share issue restricted to friends and family)
In all cases, we apply the separate entity concept, i.e. the business is regarded as being
separate from the owner (or owners) and the accounts are prepared for the business itself.

BUSINESS TRANSACTIONS
A transaction is an exchange of goods or services between two persons or parties. It is an
event (measurable in terms of money) that changes the financial position of a business
entity e.g. sale / purchase of goods or services etc.
Recording of transactions:
The primary objective is to know whether business has made a profit or suffered a loss after
a certain period.
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 With a cash transaction, the buyer pays for the goods or services immediately as
they are received or possibly in advance. Cash is directly involved in a cash
transaction e.g., payment through bank or payment through cash in hand.
 With a credit transaction, the buyer doesn’t have to pay for the goods or services on
receipt but is allowed some time. Payments and receipts are postponed for some
future time (credit period) e.g. business buys goods and payment is made after one
month

The Framework

One of the most important documents underpinning the preparation of financial statements
is the Conceptual Framework for Financial Reporting ('the Framework'), which was prepared
by the IASB( regulatory bodies are discussed in chapter 2)

The purpose of the Framework

The purpose of the Framework is to assist the IASB in the development of financial reporting
standards and to assist preparers of financial statements to develop accounting policies
when reporting standards do not provide sufficient guidance, or where there is a choice of
accounting policy

The objective of financial reporting

The main objective is to provide financial information about the reporting entity to users of
the financial statements that is useful in making decisions about providing economic
resources to the entity
Qualitative Characteristics of Financial Information
The Framework splits qualitative characteristics into two categories:

 Fundamental qualitative characteristics

– Relevance
– Faithful representation (complete,neutral and free from error)
 Enhancing qualitative characteristics
– Comparability
– Verifiability
– Timeliness
– Understandability
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The elements of the financial statements

There are FIVE elements of accounting. Accounting of all transactions is based on these five
elements which are assets, liabilities, incomes, expenses and capital.

1. ASSETS
Definition - A present economic resource controlled by the entity as a result of past events
Assets are useful or valuable things owned and controlled by a business to earn income and
profit. A business gets economic benefits out of these items e.g. cash, building, furniture
etc.
Assets are classified into Current and Non Current assets.

Non-Current Assets
These are assets bought with the intention of use rather than resale. They are expected to
be used by a business for more than a year to help generate income. These are held and
used in operations for a long time.
e.g. machinery, building, software etc. A factory building or a machine may be used for
production for many years. Similarly, a computer might be used by administration staff for
many years.
Current Assets
These are assets bought with the intention of resale and are held only for a short time(less
than 12 months). These may be inventory, cash or recievables.
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2. LIABILITIES
Definition - A present obligation of the entity to transfer an economic resource as a result of
past events
Liability is the money owed by the business for resources supplied by people or
organizations other than the owner e.g. amounts payable to suppliers.

Liabilities are also classified into Current and Non Current liabilities.
Non-Current liabilities
These are liabilities payable after more than 12 months’ time from the reporting date e.g.
long term loan .
Current liabilities
These are liabilities payable in less than 12 months’ time from the reporting date e.g. trade
payable, overdraft

3. Equity/ Capital
Definition - residual interest in the assets of the entity after deducting all liabilities.
Capital is basically the amount invested in a business by its owner (the sole
trader/shareholders).
Note that profits made by a business are effectively a return for the sole trader on the
money that they initially invested. Any profits not taken out of the business as drawings*
are therefore in effect extra capital.
*Drawings are a reduction in the liability of business to the owner. If the owner takes out
cash or goods from business for personal use, it reduces the liability of the business towards
owner. These are called drawings.

4. Income

This consists of the increases in assets, or decreases in liabilities, that result in increases in
equity. Example : Sales revenue.

5. Expense
This consists of the decreases in assets or increases in liabilities that result in decreases in
equity.
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Example : purchase of goods, payment of rent.

THE FINANCIAL STATEMENTS

The Statement of financial position
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CALCULATION OF CLOSING CAPITAL

Capital is also known as NET ASSETS. The formula used to derive closing capital is as follows:

The Statement of profit or loss and other comprehensive income

Sales Revenue X
Cost of sales (X)
Gross profit X
Distribution costs (X)
Administrative and selling expenses (X)
Operating profit (Profit before Interest and tax) X
Finance cost (X)
Profit before tax X
Income tax (X)
Net Profit X
Other comprehensive income :
Revaluation surplus in the year X
Total comprehensive income for the year X

THE STATEMENTS OF CHANGES IN EQUITY

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The Statement of Cash Flows

This statement summarises the cash paid and received throughout the reporting period.
Normally, it would be relevant to limited liability companies only, rather than to sole traders
and partnerships. Cash flows are discussed in the chapter The Statement of Cash Flows.

The notes to the financial statements

The notes to the financial statements comprise a statement of accounting policies and any
other disclosures required to enable to the shareholders and other users of the financial
statements to make informed judgements about the business.

THE ACCOUNTING EQUATION

An asset is something that the business OWNS

A liability is something that the business OWES

Capital is how much the business OWES to the owner. (a liability towards owner)
The statement of financial position shows the position of a business at one point in time. A
statement of financial position will always satisfy the accounting equation as shown above.
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Chapter 2

THE REGULATORY FRAMEWORK

Limited liability companies are required by law to prepare and publish financial statements
annually. The form and content of these accounts are primarily regulated by national
legislation. They must also comply with International Accounting Standards (IASs) and
International Financial Reporting Standards (IFRSs).
The development of international accounting rules and regulations, known as IAS or IFRS, is
contributed to by a number of bodies:
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CHAPTER 3

DOUBLE ENTRY BOOKKEEPING, RECORDING BASIC TRANSACTIONS

AND BALANCING THE LEDGERS

The above is a summary of accounting cycle in a business. Following are the steps involved
in it:

 The accounting process starts with ‘recording’ from source document e.g. sale invoice,
purchase invoice, electricity bill etc.

 The regular natured transactions are then recognised in books of prime entry (also known
as day books). Examples include transactions like sales, purchases, sale return, purchase
return etc. These transactions occur frequently in business.

 The irregular natured (infrequently occurring) transactions are recognised in the Journal,
which is a book of prime entry which records transactions which are not routine (and not
recorded in any other book of prime entry) e.g. purchase or sale of noncurrent assets, year--
end adjustments like depreciation charge for the year.

 From these documents data is then transferred to general ledger and ‘classified’ into
relevant accounts. The total of transactions from individual day books is transferred to
general ledger. Here the double entries are recognised. T-Accounts are prepared in general
ledger

 The carried down balances of T-accounts is then transferred to trial balance.

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 The data is then ‘summarised’ and financial statements are prepared.

Books of prime entry
All transactions are initially recorded in a book of prime entry. This is a simple note of the
transaction, the relevant customer/ supplier and the amount of the transaction. Several
books of prime entry exist, each recording a different type of transaction:

General Ledger (Main or Nominal Ledger)

It is the book which contains “Ledger Accounts” of each type of asset, liability, revenue and
expense. Hence, the double entries for transactions are passed in this book. Regular natured
transactions Irregular natured transactions Books of Prime Entry Source document Financial
Statements Extended Trial Balance Trial Balance Transfer Journal (Adjustments) General
Ledger General Journal

THE DUALITY CONCEPT/ DOUBLE ENTRY CONCEPT

Each transaction that a business enters into affects the financial statements in two ways. For
example, a business buys a vehicle for cash. The two effects on the business are:
1. It has increased the vehicle assets
2. There is a decrease in cash

To follow the rules of double entry bookkeeping, each time a transaction is recorded, both
effects must be taken into account. These two effects are equal and opposite and, as such,
the accounting equation(assets=equity+liability) will always be maintained.
Traditionally one effect is referred to as the Debit (abbreviated to Dr) and the other as the
Credit (abbreviated to Cr).
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Ledger accounts, debits and credits

In practice it is far too time consuming to write up the accounting equation each time that
the business undertakes a transaction. Instead the two effects of each transaction are
recorded in ledger accounts.
Transactions are recorded in ledger accounts (or T accounts). There is a ledger account for
each asset, liability, and income and expense item. These individual ledger accounts are all
held in the General ledger.
The left hand side is called the DEBIT side
The right hand side is called the CREDIT side.
We post entries to the Debit or Credit side depending if they are increases or decreases to
the account.

DEBIT AND CREDIT RULES

For every transaction the total amounts of debits must be equal the total amounts of credits
Whether an entry is to the debit or credit side of an account depends on the type of account
and the type of transaction.
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EXAMPLES OF COMMONLY USED DOUBLE ENTRIES – WITH IMPACT ON ELEMENTS OF

ACCOUNTING
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Balancing off a ledger account

 Total both sides of the T-account and find the larger total.
 Take the higher total and make it the total for both sides of the account.
 Insert a balancing figure to the side of the T-account which does not currently
add up to the amount in the total box. Call this balancing figure ‘balance c/f’
(carried forward) or ‘balance c/d’ (carried down).
 Carry the balance down diagonally and call it ‘balance b/f’ (brought forward) or
‘balance b/d’ (brought down)

The larger total is 10250, so put 10250 as the total on both debit and credit side.
The total of the entries on the credit side is 425, so insert a balancing figure of 9825 ( 10250-
425) on the credit side.
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CHAPTER 4

RETURNS, DISCOUNTS AND SALES TAX

Recording sales and purchases returns

 It is normal for customers to return unwanted goods to a business; equally the

business will sometimes return unwanted goods to their supplier
 The double entries arising will depend upon whether the returned goods were
initially purchased on credit or cash :

Discounts
Discounts are a reduction in price of goods or incentive for the buyer.

Accounting For Trade Discounts

Seller perspective - Trade discounts allowed are deducted from sales. Therefore, sales are
recorded net of trade discounts (Sales price - trade discount allowed).
Buyer perspective - Purchases are also recorded net of trade discounts (Purchase cost -
trade discount received).
Accounting for settlement discounts
A settlement discount is different in nature to a trade discount. A trade discount is a definite
reduction in price that is given to the customer. A settlement discount is offered to the
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customer , but there is no way of knowing when the sale is made whether the customer will
take advantage of the discount offered and pay the reduced amount. So the seller does not
know at the time sales revenue is recorded whether the business will receive only the
discounted amount or the full amount.
In real life there are different ways of dealing with this situation, but for FA exam purpose
the approach we take is to prepare the sales invoice for the full amount if the customer is
not expected to pay early and claim the settlement discount. If the customer is expected to
pay early, prepare the invoice for the reduced amount (after applying the settlement
discount).
Seller perspective

Therefore, in examination questions, when dealing with transactions from the perspective
of the seller, it will be stated whether or not a credit customer is expected to take
advantage of settlement discount terms

Purchaser perspective
In examination questions, when dealing with transactions from the perspective of the
purchaser, the purchaser will initially record the full cost of the goods and will then decide
whether or not to take advantage of settlement discount terms offered by the seller. If
advantage of the settlement discount is not taken, the gross amount is payable to the seller.
If advantage is taken of the settlement discount terms offered, discount received should still
be recorded as normal.
Illustration - Settlement discount – purchaser perspective

A company sold goods to a customer on credit at a price of $200, and the customer was
offered 3% settlement discount for settlement within ten days of the invoice date. How
should this be accounted for in the books of the purchaser?
Answer

The purchaser would initially record the purchase of goods as follows:

Debit Purchases 200
Credit Payables 200
(a) If the invoice was paid after 10 days, the full amount would be payable to the
supplier, with the payment recorded as follows:
Debit Payables 200
Credit Bank 200

(b) if the invoice was paid within the 10-day early settlement period, $194 would be
paid to the supplier, and discount received for $6 would be recorded as follows:
Debit Payables 200
Credit Bank 194
Credit Discount received 6
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SALES TAX

Sales tax is an indirect tax on the supply of goods and services which is eventually borne by
the final customer.

Input and Output Tax

a. Output tax
Sales tax charged on goods and services sold by a business is referred to as output tax.
e.g. I sell a mobile phone to you and you will pay me a price + output tax
b. Input tax

Sales tax paid on goods and services ‘bought in’ by a business is referred to as input tax.
e.g. If I buy a computer, I have to pay a price + input tax
If output sales tax exceeds input sales tax, the business pays the difference in tax to the
authorities.
If output sales tax is less than input sales tax in a period, the tax authorities will refund the
difference to the business.
Calculation of sales tax
For a sales tax rate of 20% ,

Net selling price (tax exclusive price) = 100%

Sales tax = 20%
Gross selling price (tax inclusive price) = 120%
Gross price = Net price + sales tax
• The net selling price is the amount that the entity will recognise as sales income.

• The gross selling price is the price charged to customers.

• The difference between the gross and net selling price is tax collected on behalf of the tax
authority which should be paid to it.
ACCOUNTING FOR SALES TAX
Registered businesses charge output sales tax on sales and suffer input sales tax on
purchases.
Sales tax does not affect the statement of profit or loss, but is simply being collected on
behalf of the tax authorities .
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Sales tax paid on purchases (input tax)

The cost of purchases should exclude the sales tax and be recorded net of tax, because it is
not an expense – it will be recovered.
Therefore, if a business purchases goods on credit for $100 + 17.5% sales tax, the
accounting entries would be:
Dr Purchases $100.00

Dr Sales tax $17.50

Cr Cash/trade payables $117.50
Sales tax charged on sales (output tax)
The sales account does not include sales tax because it is not income – it will be paid to the
tax authority.
If a business sells goods for $1,000 + 17.5% sales tax, the accounting entries to record the
sale would be:
Dr Cash/trade receivables(Gross) $1,175
Cr Sales (Net) $1,000

Cr Sales tax $175

HOW TO CALCULATE GROSS PRICE FROM NET PRICE
Sales tax rate is always applied on net amount to calculate Sales tax amount.
If net price = $100 and Sales tax is 20% then gross price?
Since Gross price = Net price + Sales tax

Gross price = 100 + (20% of 100) = 100 + 20

Hence gross price = $120
HOW TO CALCULATE NET PRICE / SALES TAX FROM GROSS PRICE?
If gross price is $240 and Sales tax is 20% then net price?
In this case , the sales tax can be calculated by multiplying the gross amount by 20/120.

Sales tax = Gross price x 20/120

Sales tax =240 x 20/120
Sales tax =40
Net price= Gross price – sales tax
Net price = 200.
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So if the gross amount (inclusive of tax) is given, the Sales tax can be found by multiplying
the gross amount by 20/120. If net amount (exclusive of tax)) is given, the Sales tax can be
found by multiplying the net amount by 20/100

Sales Tax and Discounts

Sales tax is calculated on the amount after all discounts, regardless of whether the discount
is taken or not.

Payment/Recovery of Sales tax

Sales tax is paid to or recovered from the tax authorities periodically.

 Where Sales tax owed to the authorities is paid, the accounting entry is:
Dr Sales tax
Cr Cash

 Where Sales tax recoverable from the authorities is received, the accounting entry is
Dr Cash
Cr Sales tax
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CHAPTER 5

INVENTORY (IAS 2)

Inventory consists of:

➢goods purchased for resale

➢raw materials and components (used in the production process)

➢ partly-finished goods (usually called work in progress –WIP)

➢finished goods (which have been manufactured by the business)

Inventory is only recorded in the ledger accounts at the end of the accounting period.
During the year the relevant sales and purchases are recorded but the increase and
decrease in inventory assets is ignored Inventory brought forward from the previous year is
assumed to have been used to generate assets for sale. The unused inventory at the end of
the year is removed from purchase costs and carried forward as an asset into the next year
Inventory affects the financial statement in two ways:
1. Statement of financial position: it is included as a current asset
2. Statement of profit or loss: opening and closing inventory have a direct impact on cost of
sales and therefore profits.
(The cost of goods sold is calculated as: Opening inventory + Purchases – Closing inventory).
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VALUATION OF INVENTORY
The basic rule as per IAS 2 “Inventories” states that:
Inventories should be measured at the lower of cost and net realisable value(NRV)

Methods of calculating the cost of inventory

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FIFO – first in first out : the first items of inventory received are assumed to be the first ones
sold. Therefore, the cost of closing inventory is the cost of the most recent purchases of
inventory.
AVCO – Average cost : The cost of an item of inventory is calculated by taking the average
of all inventory held. The average cost can be calculated periodically or continuously.
AVCO method is classified into 2 :
a. Continuous average cost method
With this inventory valuation method, an updated average cost per unit is calculated
following a purchase of goods. The cost of any subsequent sales are then accounted for at
that weighted average cost per unit.
b. Periodic average cost method

With this inventory valuation method, an average cost per unit is calculated based upon the
cost of opening inventory plus the cost of all purchases made during the accounting period.
This method of inventory valuation is calculated at the end of an accounting period
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CHAPTER 6
TANGIBLE NONCURRENT ASSETS
Noncurrent assets are distinguished from current assets because they:

• are long term in nature

• could be tangible or intangible (In this chapter, you will study the accounting of Tangible
Non-current assets only)

 They are not normally acquired for resale

• are not normally liquid assets (i.e. not easily and quickly converted into cash without a
significant loss in value).
The accounting treatment of tangible non-current assets is covered by IAS 16: Property,
Plant and Equipment

Capital and revenue expenditure

Capital expenditure items are capitalised as Non current asset in the Statement of Financial
Position.
Revenue expenditure items are recorded as an expense in the Statement of Profit or loss.
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Non-current asset registers

Noncurrent asset registers are a record of the noncurrent assets held by an entity. It
includes details such as the cost, date of purchase, description, carrying amount etc of the
non current assets held by the entity.

Acquisition of Non current assets

When a non-current asset is acquired, the double-entry is: -

Dr Non-Current Asset
Cr Cash/Payables
Tangible non-current assets should initially be recorded at cost.

Depreciation
With the exception of land, every non current asset has to be depreciated.

A charge is made in the statement of profit or loss to reflect the use that is made of the
asset by the business. This charge is called depreciation. The need to depreciate noncurrent
assets arises from the accrual assumption. If money is spent on an asset, then the amount
must be charged against profits.
In simple terms, depreciation spreads the cost of the asset over the period in which it will be
used.
Depreciation has a dual effect which needs to be accounted for

• It reduces the value of the asset in the statement of financial position.

• It is an expense in the statement of profit or loss.
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Some key terms

• Useful life: - the period over which a non current asset is expected to be used by the
entity.
• Depreciable amount: - (cost or revalued amount) – residual value
• Residual value: - the amount the asset is expected to be sold for at the end of its useful
life. It is also known as scrap value

• Carrying Amount : original cost of the noncurrent asset less accumulated depreciation on
the asset to date.

• Accumulated depreciation : Sum of the all depreciation to date.

Methods of calculating depreciation

The two main methods used to calculate depreciation are :
1. Straight Line method

The depreciation charge is the same every year.

Depreciation charge = (Cost – Residual value)/Useful life
Or
it can simply be given as a simple percentage of cost.
Illustration

A trader purchased an item of plant for $1,000 on 1 January 20X1. What is the
depreciation charge if the straight line method of depreciation calculation is used?
Assume residual value of 200 and a useful life of 4 years.

Solution
Depreciation charge = (Cost – Residual value)/Useful life
= (1000-200)/4
= 800/4
=200

2. Reducing balance method

This method is suitable for those assets which generate more revenue in earlier years
than in later years; for example machinery in a factory where productivity falls as the
machine gets older
Under this method the depreciation charge will be higher in the earlier years and reduce
over time.
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Depreciation charge = X % × carrying amount

Illustration
A trader purchased an item of plant for $1,000 on 1 January 20X1 which he depreciates
on the reducing balance at 20% pa. What is the depreciation charge for each of the first
3 years?
Solution

Year 1
Depreciation charge = 20% × $1,000 = 200
Year 2
Carrying amount = 1000-200 = 800
Depreciation charge = 20% × 800 = 160

Year 3
Carrying amount = 800-160 = 640
Depreciation charge = 20% × 640 = 128

Accounting for depreciation

Dr Depreciation expense (SOPL)
Cr Accumulated depreciation (SOFP)
The accumulated depreciation account is a statement of financial position account and as
the name suggests is accumulated, i.e. reflects all depreciation to date

Disposal of non-current assets

IAS 16 says that the carrying amount of an item of property, plant and equipment shall be
derecognised on disposal or when no future economic benefits are expected from its use or
disposal.
Profit/loss on disposal

Proceeds > CA at disposal date = Profit

Proceeds < CA at disposal date = Loss
Proceeds = CA at disposal date = Neither profit nor loss
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Disposal for cash consideration

This is a three-step process:

1. Remove the original cost of the non-current asset from the ‘non-current asset’
account.
Dr Disposals account
Cr NC asset cost account

2. Remove accumulated depreciation on the non-current asset from the ‘accumulated

depreciation’ account.
Dr Accumulated depreciation account
Cr Disposals account

3. Record the proceeds.

Dr Cash account
Cr Disposals account

Disposal through a part-exchange agreement (PEA)

A part exchange agreement is where an old asset is provided as part payment for a new
one, the balance of the new asset being paid in cash.
The first two steps are identical; however steps 3 and 4 are as follows:
3. Record the part-exchange allowance (PEA) as proceeds.
Dr NC assets cost account (= part of cost of new asset)
Cr Disposals account (= sale proceeds of old asset)
4. Record the cash paid for the new asset.
Dr NC asset cost account
Cr Cash account
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Revaluation of non-current assets

So far we have discussed the Cost model of accounting for Non current assets.
According to IAS 16, items of property, plant and equipment can also be measured and
accounted for using the revaluation model.
Some non-current assets, such as land and buildings may rise in value over time. A company
may choose to show this increased value of the asset in its statement of financial position.
This is known as revaluing the asset.
IAS 16 says that 'if an item of property, plant and equipment is revalued, the entire class of
property, plant and equipment to which that asset belongs shall be revalued'
Illustration
ABC owns a building which was purchased in 2010 for $5000. The carrying amount of the
building was $4000 at 1 January 2015. The market value of the building was found to be
$7000 on the same date.
So ABC may choose to revalue the building to $7000 at 1 January 2015. The buildings value
will thus be shown as 7000 in the statement of financial position. This is called revaluation.
The increase in the value of the asset of $3000 (7000-4000) is called Revaluation surplus.

Accounting for Revaluation

Revaluation surplus = Revalued amount – Carrying amount
• Adjust cost account to revalued amount.
• Remove accumulated depreciation charged on the asset to date.
• Put the revaluation surplus to the revaluation reserve.
Dr Accumulated depreciation
Dr Non-current asset
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Cr Revaluation reserve
The revaluation gain for the year is recorded in the Statement of Other Comprehensive
Income. The total revaluation surplus (current year surplus and any surplus from previous
revaluations) is recorded as revaluation reserve under Equity in the Statement of Financial
Position and in the statement of changes in equity (SOCIE).

Depreciation of a revalued asset

The depreciation charge for an asset which has been revalued is calculated as:

New Depreciation charge = (Revalued Value – residual value)/ Remaining useful life
If revaluation is done during the year, then the depreciation expenses should be time-
apportioned.
The excess of the new annual depreciation charge over the old depreciation charge may be
the subject of an annual transfer from revaluation surplus to retained earnings (within the
equity section of the statement of financial position) as follows:
Dr Revaluation surplus
Cr Retained earnings
This transfer is an optional policy decided by the entity which conducts the revaluation. If
the policy is adopted, then the transfer should be made every year.
In exam questions, only do this transfer if it is mentioned in the question that the company’s
policy is to transfer.
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Chapter 7
INTANGIBLE ASSET
IAS 38 Intangible Assets defines an intangible asset as 'an identifiable non-monetary asset without
physical substance'.

Characteristics of an intangible non-current asset are as follows:

• it is a resource controlled by the entity as a result of past events from which the entity expects to
derive future economic benefits

• it lacks physical substance

• it is identifiable and separately distinguishable

Examples are Copyrights, software, patent etc.

Research and development

IAS 38 defines research as 'original and planned investigation undertaken with the prospect of
gaining new scientific or technical knowledge and understanding'.

Development is defined as 'the application of research findings or other knowledge to a plan or

design for the production of new or substantially improved items’.

Accounting treatment of research and development

All research expenditure should be written off to the statement of profit or loss as it is incurred.

Development costs must be capitalised as an intangible asset if they meet the definition of an
intangible asset and also meet the recognition criteria. This will apply if the 'PIRATE' criteria are met:

If the above criteria are not met, development expenditure must be written off to the statement of
profit or loss as it is incurred.

Subsequent treatment of capitalised development expenditure

• The asset should be amortised over the period that is expected to benefit.
 32

• Amortisation should commence with commercial production and charged over the period over
which the business expects to generate economic benefits.

• Each project should be reviewed at the year end to ensure that the ‘PIRATE’ criteria are still met. If
they are no longer met, the previously capitalised expenditure must be written off to the statement
of profit or loss immediately

Measurement of intangible assets

An intangible asset shall be measured initially at cost. IAS 38 permits either the cost model or the
revaluation model to be used for subsequent measurement.

• If the cost model is applied, an intangible asset 'shall be carried at its cost, less any accumulated
amortisation'

• For the valuation model to be applied, 'fair value should be measured by reference to an active
market'. This is not usually available for intangible assets, so intangible assets are usually accounted
for using the cost model.

• In rare situations where the revaluation model can be applied, it is done in a similar way to IAS 16
tangible non-current assets.
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Chapter 8
ACCRUALS AND PREPAYMENTS
The Accruals Concept says that income and expenses should be included in the statement of profit
or loss account of the period in which they are earned or incurred, not when cash is paid or received.

Recording Expenditure and Income

Throughout the year, when an invoice for an expense incurred is paid, this is accounted for by:

Dr Expense

Cr Cash

Similarly, when income is received, this is accounted for by:

Dr Cash

Cr Income

At this stage, consideration is not given to the period to which the invoice or income relates.
Therefore, if the following year’s rent is paid in advance, for example, it is still recorded in the ledger
accounts this year even though it does not relate to the current accounting period.

Accrued Expense

An accrual arises where expenses of the business, relating to the year, have been incurred but not
yet paid by the year end. In this case, it is necessary to record the extra expense relevant to the year
and create a corresponding statement of financial position liability.

Dr Expense account

Cr Accrued Expense

The credit entry creates a current liability in the statement of financial position – an accrual.

The debit entry ensures that the statement of profit or loss includes the expense, thus reducing
profit in it.

Prepaid expense

A prepayment arises where some of the following year’s expenses have been paid in advance in the
current year. In this case, it is necessary to remove that part of the expense which is not relevant to
this year and create a corresponding statement of financial position asset (called a prepayment):

Dr Prepaid expense

Cr Expense account

The debit entry creates a current asset in the statement of financial position – a prepayment.

The credit entry removes the expense relating to the following year from the current year’s
statement of profit or loss, thus increasing the profit for the year.
 34

Accrued Income

Accrued income arises where income has been earned in the accounting period but has not yet been
received. In this case, it is necessary to record the extra income in the statement of profit or loss and
create a corresponding asset in the statement of financial position (called accrued income):

Dr Accrued income (SOFP)

Cr Income (P&L)

Accrued income is a current asset in the statement of financial position.

Prepaid Income

Prepaid income (also known as Deferred Income) arises where income has been received in the
accounting period but which relates to the next accounting period (not earned yet). In this case, it is
necessary to remove the income not relating to the year from the statement of profit or loss and
create a corresponding liability in the statement of financial position (called prepaid income):

Dr Income (P&L)

Cr Prepaid Income (SOFP)

Prepaid income is a current liability in the statement of financial position.

 35

Chapter 9
RECIEVABLES AND PAYABLES
1. Receivables
Cash and credit sales

If a sale is for cash, the customer pays for the goods/services at the point of sale. The accounting
entries for a cash sales are:

Dr Cash

Cr Sales revenue

If the sale is on credit terms the customer will pay for the goods/services after receiving them. For
example a customer is allowed a credit period of 30 days for payment. In this case a current asset
called Receivable is recorded for the amount.

The accounting entries to record the sale of goods on credit are:

Dr Receivables

Cr Sales revenue

When the customer eventually settles the debt the accounting entries will be:

Dr Cash account

Cr Receivables

Irrecoverable debts and allowances

More often than not, credit customers pay the amount that they owe on time. They do this to
maintain a good relationship with their supplier and ensure on-going supply. In some cases,
however, a debt is not paid by the time that the credit term has expired. It may even become
apparent before this time that it will not be paid, for example if a customer has been declared
bankrupt. Where debts remain unpaid, they are considered to be either

 Irrecoverable

 Doubtful

Accounting for irrecoverable debts

An irrecoverable debt is a debt which is, or is considered to be, uncollectable. Irrecoverable debts
are written off as an expense to the statement of profit or loss.

Dr Irrecoverable debts expense

Cr Receivables

 The irrecoverable debts expense is reported below gross profit in the statement of profit or loss

 The receivable amount is removed from both receivables control account and personal ledger.
 36

Accounting for irrecoverable debts recovered

There is a possible situation where a debt is written off as irrecoverable in one accounting period,
and the money, or part of the money, due is then unexpectedly received in a subsequent accounting
period.

When an irrecoverable debt is recovered the double entry is:

Dr Cash

Cr Irrecoverable Debts expense

Allowance for receivables

A doubtful debt is a receivable which a business may not be paid. Thus, at the end of the year there
may be amounts owing to the business, which the accountant considers will become irrecoverable
debts in the future. Prudence requires that an allowance is made for these doubtful debts.

The purpose of this type of adjustment is to ensure that the amount of trade receivables reported
on the statement of financial position is not overstated. An allowance is set up which is a credit
balance. This is netted off against trade receivables in the statement of financial position to give a
net figure for receivables that are probably recoverable.

Accounting for the allowance for receivables

The accounting treatment to create a new allowance or to increase an existing allowance is:

Dr Irrecoverable debts expense

Cr Allowance for receivables

If there is already an allowance for receivables in the accounts (opening allowance), only the
movement in the allowance is charged to the statement of profit or loss (closing allowance less
opening allowance).

As the allowance can increase or decrease, there may be a debit or a credit in the irrecoverable
debts account so the above journal may be reversed.

2. Payables
Cash and credit purchases

If a purchase is for cash,

The double entry for a cash purchase is:

Dr Purchases/expenses

Cr Cash

If the purchase was made on credit terms the business will pay for the goods and services following
delivery. Therefore when purchases are made on credit the cost is recorded with a corresponding
 37

liability that represents the obligation to pay the supplier of the goods/services. The liability is
referred to as a 'payable.'

The double entry is recorded as follows:

Dr Purchases/expenses

Cr Payables

When the payable liability is actually paid the double entry to reflect this is:

Dr Payables

Cr Cash
 38

10 -PROVISION, CONTINGENT LIABILITY AND CONTINGENT ASSET

PROVISION:
A provision is defined as 'a liability of uncertain timing or amount

ACCOUNTING FOR A PROVISION:

The first potential course of action management can take is to recognise a provision in the accounts.
This is done by estimating the potential cost of the uncertain event and recognising it immediately.
As the amount would be settled at a future date, a corresponding liability is recorded, as follows:

Dr Expenses $X

Cr Provision $X

Criteria for recognising a provision:

Contingent liabilities and contingent assets:

A contingent liability is defined as:
(a) 'a possible obligation that arises from past events and whose existence will be confirmed
only by the occurrence or non-occurrence of one or more uncertain future events not wholly
within the control of the entity; or
(b) a present obligation that arises from past events but is not recognised because:
(i) it is not probable that an outflow of resources embodying economic benefits will be
required to settle the obligation, or
(ii) the amount of the obligation cannot be measured with sufficient reliability'

A contingent asset is defined as 'a possible asset that arises from past events and whose existence
will be confirmed only by the occurrence or non-occurrence of one or more uncertain future events
not wholly within the control of the entity'.
 39

Virtually certain > 95%

Probable 51% - 95%

Possible 5% - 50%

Remote <5%
 40

CHAPTER : 11
CAPITAL STRUCTURE AND FINANCE COSTS

 Ordinary ('equity') share capital: this is equity as the directors are under no
obligation to repay the investors (shareholders) or to pay them a dividend.
 Loan notes: under the terms of loan note agreements directors are usually required
to pay the loan holder an annual interest amount and are obliged to repay the full
debt at a fixed point in time.
 Preference shares: these can be either debt or equity, depending on their terms. If
there is any obligation to repay the preference shareholder (redeemable) then this
is evidence of a debt.

Other terminology to be aware of:

 Issued share capital is the share capital that has actually been issued to
shareholders.
 41

 Called-up share capital is the amount of the nominal value paid by the shareholder
plus any further amounts that they have agreed to pay in the future.
 Paid up share capital is the amount of the nominal value which has been paid at the
current date.

ACCOUNTING FOR THE ISSUE OF SHARES:

Dr Cash $X Issue price x no. of shares
Cr Share capital $X Nominal value x no. of shares

In reality companies generally issue shares at a price above their nominal value. This is
referred to as issuing shares at a premium.
The double entry to record such an issue is:

Dr Cash $X Issue price x no.of shares

Cr Share capital $X Nominal value x no.of shares
Cr Share premium $X ( difference between the issue price and premium nominal value x
. no.of shares sold)

RIGHT ISSUES:
Is the offer of new shares to existing shareholders in proportion to their existing
shareholding at a stated price (normally below market values).

BONUS ISSUES:
A bonus issue is the issue of new shares to existing shareholders in proportion to their
existing shareholding. No cash is received from making a bonus issue of shares.

DIVIDENDS:
Dividends represent the distribution of profits to shareholders. They are usually expressed
as an amount per share e.g. 10c per share or 10% of nominal value.
Dividends on preference shares are usually based on a pre-determined amount, such as 5%
of the nominal value of the shareholding.

Dr Retained earnings $X (SOCE)

Cr Bank $X
 42

LOAN NOTES:
A limited company can raise funds by issuing loan notes. These are fixed term loans. The
term 'loan note' simply refers to the document that is evidence of the debt, often a
certificate that is issued to the lender.

PREFERENCE SHARE:
If preference shares are redeemable they are treated the same as loan notes; i.e. they are
recorded as a liability in the statement of financial position and dividend payments are
treated the same as finance charges.
If the preference shares are irredeemable the shareholding and associated dividends are
treated exactly the same as ordinary shareholdings, as explained above.

INCOME TAX:

In the same way that individuals are subject to tax on their income, the income generated
by a business entity is also subject to tax.

In the case of a sole trader or a partnership, the tax charge is imposed upon the individual,
rather than the business.

In the case of a limited liability company, as it is a separate legal entity, if it generates

income, it will be subject to tax. Consequently, the tax charge tax must be reflected in the
statement of profit or loss as an expense and any tax liabilities outstanding must be
reflected in the statement of financial position.
STEPS FOR RECORDING INCOME TAX:
43
 44

Chapter 12
CONTROL ACCOUNT RECONCILIATION

 The General Ledger contains all accounts or a summary of all accounts necessary to produce the
trial balance and financial statements.

 The Accounts receivable ledger contains an account for each credit customer to show how much
each one owes.

 Receivables ledger control account

An account to summarize all the transactions regarding receivables in total is the receivables control
account. It is normally contained within the general ledger. The balance on the receivables control
account at any time will be the total amount due to the business from all its credit customers.

 The Accounts payable ledger contains an account for each credit supplier to show how much we
owe them.
 45

 Payables ledger control account

An account to summarize all the transactions regarding payables in total is the payables control
account. It is normally contained within the general ledger. The balance on this account at any time
will be the total amount owed by business to all its credit suppliers.

Control accounts

Control accounts are ledger accounts that summarise a large number of transactions. The daybooks
are totalled periodically and relevant totals are posted to the control accounts. Their main area of
use is in the receivables and payables section. Note that any entries to the control accounts must
also be reflected in the individual accounts within the accounts receivable and payable ledger.

Control account reconciliations

A key control operated by a business entity is to compare the total balance on the control account at
the end of the accounting period with the total of the balances in the ledger(called List of balances).
The totals in each should be exactly the same. If not, it indicates an error in either the ledger(list of
balance) or the control account. All discrepancies should be investigated and corrected. This is
referred to as a control account reconciliation.

When all errors have been corrected, the revised balance on the control account should agree to the
revised total of the list of individual balances.

Contra Entries

The situation may arise where a customer is also a supplier. Instead of both owing each other
money, it can agree that a contra be made of the balances i.e., they are cancelled. The double entry
for this type of contra is:

Dr Payables ledger control account

Cr Receivables ledger control account

The individual receivable and payable accounts must also be updated to reflect this
 46

Supplier statement reconciliations

Supplier statements are issued to a business entity by a supplier to summarise the transactions that
have taken place during a given period, and also to show the balance outstanding at the end of the
period. Their purpose is to ensure that the amount outstanding is accurate and agrees with
underlying documentation. The payable (individual) ledger account should agree with the total of
the supplier statement. This process of reconciling the supplier statement with the corresponding
payable ledger is called supplier statement reconciliation.
 47

Chapter 13
BANK RECONCILIATION
The objective of a bank reconciliation is to reconcile the difference between:

• the cash book balance, i.e. the business’ record of their bank account, and

• the bank statement balance, i.e. the bank’s record of the bank account.

Note that debits and credits are reversed in bank statements because the bank will be recording the
transaction from its point of view.

Differences between the bank statement and the cash book

When attempting to reconcile the cash book with the bank statement, there are three differences
between the cash book and bank statement:

• unrecorded items

• timing differences

• errors.

Cash book adjustments

These are items which arise in the bank statements before they are recorded in the cash book. Such
‘unrecorded items may include:

• interest

• bank charges

• dishonoured cheques.

• direct debits/standing orders

• direct credits

The cash book must be adjusted to reflect these items.

Bank statement adjustments

These items have been recorded in the cash book, but due to the bank clearing process have not yet
been recorded in the bank statement:

• Outstanding/unpresented cheques

• Outstanding/uncleared lodgements

The bank statement balance needs to be adjusted for these items

Errors in the cash book

The business may make a mistake in their cash book. The cash book balance will need to be adjusted
for these items.
 48

Errors in the bank statement

The bank may make a mistake, e.g., record a transaction relating to a different person within our
business’ bank statement. The bank statement balance will need to be adjusted for these items.

The balance on the both the cash book and the bank statement (the reconciled balance as shown
above) will be equal after the reconciliation process.
 49

Chapter 14
CORRECTION OF ERRORS AND SUSPENSE ACCOUNT
Errors can be classified into 2 categories :

• Errors where the trial balance still balances

• Errors where the trial balance does not balance.

Errors where the trial balance still balances

• Error of omission: A transaction has been completely omitted from the accounting records

• Error of commission: A transaction has been recorded in the wrong account, e.g., Depreciation
expense of $500 has been debited to the rent account in error.

• Error of principle: A transaction has conceptually been recorded incorrectly, e.g., a non-current
asset purchase of $1,000 has been debited to the repair expense account rather than an asset
account.
• Compensating error: Two different errors have been made which cancel each other out, e.g., a
rent bill was overstated by $200 and an error on the sales account has resulted in sales being
overstated by $200.

• Error of original entry: The correct double entry has been made but with the wrong amount, e.g.,
a cash sale of $76 has been recorded as $67.

• Reversal of entries: The correct amount has been posted to the correct accounts but on the wrong
side, e.g., a cash sale of $200 has been debited to sales and credited to bank.

No suspense account is required in order to rectify these errors.

Errors where the trial balance does not balance

• Single sided entry – a debit entry has been made but no corresponding credit entry or vice versa.

• Debit and credit entries have been made but at different values.

• Two debit or two credit entries have been posted.

• An incorrect addition in any individual account, i.e., miscasting.

• Opening balance has not been brought down.

• Extraction error – the balance in the trial balance is different from the balance in the relevant
account or the balance from the ledger account has been placed in the wrong column of the TB.

For the rectification of these errors, a suspense account will be required.

Suspense accounts

A suspense account is used as a temporary account to deal with errors and questions. A suspense
account is an account in which debits or credits are held temporarily until sufficient information is
available for them to be posted to the correct accounts. There are two main reasons why suspense
accounts may be created:
 50

• On the extraction of a trial balance the debits are not equal to the credits and the difference is put
to a suspense account. Example, The debits exceeded the credits by $1000. The $1000 is credited to
a suspense account.

• When a bookkeeper is not sure where to post one side of an entry he or she may debit or credit a
suspense account and leave the entry there until its correct entry is clarified. Example, A machinery
had been purchased during the year for 1000, but the bookkeeper did not know what to do with the
debit entry so he made the entry

Dr Suspense 1000

Cr Bank 1000.

Later when the it is clarified that the debit should have been to the land machinery account, the
suspense account will be removed with the following entry

Dr Machinery 1000

Cr Suspense account 1000

 51

Chapter 15
INCOMPLETE RECORDS
Incomplete records problems involve preparing a set of year end accounts for a business which does
not have a full set of accounting records. Incomplete records problems involve preparing a set of
year end accounts for a business which does not have a full set of accounting records.

If this is the case, you will have to use the best information that is available to you and 'guestimate'
any missing figures

There are a number of different ways which we can use to calculate missing figures and balances,
such as:

• Accounting equation method

• Balancing figure approach

• Using cash/banking data

• Profit ratios – mark-up and margin.

NET ASSETS APPROACH

If given a list of opening and closing balances for assets and liabilities, you can determine opening
and closing capital.

This is done from the Accounting Equation:

 Assets – Liabilities (Net assets) = CAPITAL

Opening capital and closing capital are also linked by the following equation:

 Closing capital = Opening Capital + New Capital + Profits – Drawings

This can be rearranged as:

Closing Capital – Opening Capital = New Capital + Profits – Drawings

“Closing N. Assets minus Opening N. Assets” is often referred to as the “Change in Net Assets”.

 Change In Net Assets = New Capital + Profits – Drawings

What figure you have to determine and which equation(s) you use will be dependent on the
information provided. But you do need to know and understand these relationships. You will be
given sufficient information such that there is only one unknown.

RECONSTRUCTION OF LEDGER ACCOUNTS (TO FIND A BALANCING FIGURE)

The second type of incomplete record activity that may come up revolves around reconstructing
ledger accounts to determine amounts to be reported in the profit and loss account or to determine
closing balances for inclusion in the Statement of Financial Position.

Questions may require you to calculate ‘missing’ figures from the statement of profit or loss, for
example rent and rates values, from a list of information including payments and opening/closing
accruals and prepayments.
 52

Ratios – Mark-up and margin

Exam questions will often provide you with information about gross profit figures and ratios. You will
then be required to calculate a missing figure.

If we know either the mark-up or margin percentage and one of either sales, or cost of sales or gross
profit we should be able to calculate the remaining figures.
 53

Chapter 16
STATEMENTS OF CASH FLOW
DEFINITIONS IN IAS – 7

The standard gives the following definitions, the most important of which are cash and cash
equivalents.

Cash comprises cash on hand and demand deposits

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

Cash flows are inflows and outflows of cash and cash equivalents.

Operating activities are the principal revenue-producing activities of the entity and other activities
that are not investing or financing activities.

Investing activities are the acquisition and disposal of long-term assets and other investments not
included in cash equivalents.

Financing activities are activities that result in changes in the size and composition of the equity
capital and borrowings of the entity.

METHODS OF PREPARATION OF STATEMENT OF CASH FLOWS

The standard offers a choice of method for the “Operating Activities” section of the Statement of
Cash Flows.

1. Direct method.

2. Indirect method.

The statement of cash flows

The format and content of the statement of cash flows are prescribed by IAS 7 Statements of cash
flow. It requires that cash flows are listed under one of three headings:

 Cash flows from operating activities

 Cash flows from investing activities

 Cash flows from financing activities.

 54

Format of a statement of cash flows

Note : The indirect method is used in the above Performa.

 55

DIRECT/GROSS METHOD

The gross method involves adding together operating cash inflows and subtracting outflows to
obtain the operating cash flows.

The total cash flows from operating activities will be the same under both methods.
 56

Chapter 17
INTERPRETATION OF FINANCIAL STATEMENTS
Ratio analysis – Types of ratios
 Profitability ratios

 Liquidity ratios

 Efficiency ratios

 Gearing ratios

PROFITABILITY RATIOS
Gross profit margin

Gross profit is expressed as a percentage of sales. It is also known as the gross profit margin

Operating profit margin (net profit)

The operating profit margin or net profit margin is calculated as:

Return on capital employed (ROCE)

Capital employed can be measured in either of the two following ways:

• Long term debt + Equity

• total assets less current liabilities

Both methods provide the same answer.

Net asset turnover

 57

Relationship between ratios

Liquidity ratios
These ratios assess the liquidity/solvency of a business.

Current ratio

Current ratio is calculated as :-

Quick ratio

Quick ratio (also known as the liquidity and acid test) ratio:

Efficiency ratios
These ratios assess how efficiently the entity manages its working capital resources.

Inventory turnover period

Inventory turnover period is defined as:

This simply measures how efficiently management uses its inventory to produce and sell goods.

Receivables collection period

This is normally expressed as a number of days:

The ratio shows, on average, how long it takes to collect cash from customers following the sale of
goods on credit.
 58

Payables payment period

This is usually expressed as:

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

Cash cycle

We can also consider the cash cycle as part of management of working capital. In effect, it may be
regarded as the interaction of the inventory turnover, receivables collection period and payables
payment period. The cash cycle is important to a business to ensure that it has adequate cash
resources to meet the needs of the business.

The cash conversion cycle ('CCC') can be used to determine how many days cash is tied up on the
working capital cycle as follows:

CCC = inventory holding period + receivables collection period – payables payment period.

Ideally, businesses would like to have cash tied up in working capital for the minimum number of
days possible.

Gearing ratios
When assessing the financial position of a business the main focus is its stability and exposure to
risk. This is typically assessed by considering the way the business is structured and financed. This is
referred to as gearing.
In simple terms gearing is a measure of the level of external debt an entity has (e.g. outstanding
loans) in comparison to equity finance (i.e. share capital and reserves).

There are two methods commonly used to express gearing as follows.

Debt/equity ratio:

Debt/(debt + equity) ratio:

Long term debt includes non-current loan and redeemable preference share liabilities.

Note: Redeemable preference shares are treated as liabilities because they must be repaid and are
therefore debts of the entity. Irredeemable preference shares do not have to be repaid and are
therefore treated the same as ordinary shares and included in equity.
 59

Interest cover

Interest cover indicates the ability of an entity to pay interest out of profits generated.