Acca Notes

8/14/2019 Acca Notes

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Paper 1.1Chapter 1

the Definition, Purpose, and the Regulatory Framework of accounting

well, this report isnt an introduction to accounting as it may seem to be. Its more likea summary to the purpose of studying paper 1.1.

Accounting is a way of recording, analyzing, and summarizing transactions of abusiness.

Transactions are recorded in books of prime entry, and then analyzed and posted tothe ledgers and finally they are summarized in the financial statements.

Yet, the term Accounting not only refers to Financial Accounting, but moreover,

a) Management Accountingb) Financial Managementc) Auditing

The Purpose, of going through the process of preparing financial statements, may notbe required or needed by most companies, yet some must comply to do so by law.Nonetheless, they are prepared so that owners, managers, lenders and otherinterested parties can see how the business is doing. In other words, to provideinformation about the financial position, performance and financial adaptability of anenterprise that is useful to a wide range of users.

Depending on the users of financial statements, many may require access to different

information, but all share some basic needs. Some of the basic users of financial andaccounting information are:

a) Managersb) Shareholdersc) Trade contactsd) Providers of Financee) Governments and their Agencies, e.g. Inland Revenue and Registrar ofCompaniesf) Employeesg) Financial Analysts and Advisorsh) Investors/ Public

As one may imagine, it may be very hard to satisfy all of the different users, yet, thebasic financial statements at the end of the day, are:

a) The Profit and Loss Accountb) The Balance Sheet

Furthermore, some companies may be required to produce annual reports, whichcontain :


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Non-Financial Statements, such as:a) Directors Reportb) Auditors Reportc) Chairmans Report

Limited companies are required by law to prepare and publish accounts annually. The

form and content of the accounts are regulated primarily by the Companies Act 1985,but must also comply with accounting standards.

The Regulatory System

Basically the Company Law requires that all companies must comply with theCompanies Act. Of the many requirements and regulations, it must be brought to ones attention, that the Financial Statements are required to represent a True and Fairview of the state of affairs and Profit and Loss.

The Accounting Standards Board, previously known as the Accounting StandardsCommittee, has issued the Accounting Standards, such as FRSs and SSAPs. Theaccounting standards were developed with the aim of narrowing the areas of

difference and variety in accounting practice.

The Urgent Issues task force is an important part of the ASB in that it is required totackle urgent matters not covered by existing standards. The review panel isconcerned with the examination and questioning of departures from accountingstandards by large companies.

Furthermore, the companies are required to follow the Accounting Policies, set out inFRS 18 and the Companies Act. Those policies are summarized in the diagramabove, but it must be noted that there is a distinction between the accounting policiesand accounting estimates.

The accounting policy is concerned with:

a) the recognitionb) Selection of measurement base andc) Presentation

Of assets, liabilities, gains and losses of an entity. E.g. Prudence or Accruals? Thechoice must be based on which may provide the most true and fair view.

The accounting estimate is the method used to establish the monetary value ofassets, liabilities, gains and losses using the measurement base selected by theaccounting policy,e.g. depreciation (straight line or reducing balance?)

The ASB also developed a Statement of Principles, which is concerned by:

a) the objective of financial statementsb) the reporting entityc) The qualitative characteristics of financial information.

Basically the statement of principles provided a Conceptual Framework, which formsthe theoretical basis for determining which events should be accounted for, how they


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should be measured and how they should be communicated to the user. A conceptualframework is a statement of generally accepted theoretical principles, which form theframe of reference for financial reporting. These theoretical principles provide thebasis for the development of new reporting standards and the evaluation of thosealready in existence. In other words, they are there to provide consistency, clarity andinformation.

Furthermore, companies are required to comply with the regulations of the EuropeanUnion, and various international bodies, and any stock exchange requirementsdepending on their circumstances.

In addition to the Financial Statements, limited companies are required to providecertain notes and disclosures to the accounts, such as:

1. Statement of movements in reserves2. Details of Fixed Assets3. Details of post balance sheet events4. Details of contingent liabilities and contingent assets5. Details of research and development expenditure.

6. Statement of total recognized gains and losses.7. Note on historical cost profits and losses.

The following are the important features of Financial Statements

1- Relevance 3-Reliability 5-Objectivity 7-Comparability2-Comprehensibility 4-Completeness 6-Timeliness

The Qualitative Characteristics of Financial Statements

Contenta) Relevance Info that has the ability to influence decisions, Predictive Value,

Confirmatory Value.b) Reliability Info that is complete and faithful representation. Free from materialerror, faithful representation, neutral, complete, and prudence.

Presentationa) Comparability similarities and differences can be discerned and evaluated.Consistency and Disclosure.b) Understandability the significance of the information can be perceived. Usersabilities, AggregationAnd classification


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Paper 1.1

Chapter 2

The Accounting Concepts Part 1 (The Summary)

Just a basic summary of those little things that we always tend to forget.The Going Concern Concept implies that a business is a going concern, i.e. thatthere is no reason to expect the liquidation of assets. Thus, the business may bevalued at its historical, or current cost, rather than its break-up or replacementvalue. A further example to illustrate the application of the Going Concern concept,may be clearly seen, when stock is valued. It is a practice to value stock at the lowerof its net realizable value or cost of purchase, this is because the going concernconcept implies that the stock is held to be sold at a future date.

The Accruals Concept is based on several ideas or practices, which may be clearly

illustrated, if summarized in the following form:

1. Revenue and Costs must be recognized as they are earned or incurred.2. Revenues must be matched with costs, and vice versa, and dealt with in the profitand loss account of the period to which they relate.

It is for this reason, that we actually disclose the value of the creditors in the BalanceSheet, and the value of debtors. Furthermore, although we may have paid rent ofBD 1000, for the next two years for example, we may only note the amount relevantto this years profit and loss account, and the remaining balance, as a prepayment inthe Balance Sheet.

Furthermore, this is the reason why it is required to account for sales and purchases

when made, even though on credit, rather than when they are paid for.

As well as this, the figure for closing stock is also deducted from the figure ofpurchases because the figure of closing stock relates to the opening stock figure ofnext years accounts.

The Prudence Concept

1. a) Where there are alternative proceduresb) Or alternative valuationsc) The one selected should be the one which gives the most cautious

presentation of the businesss financial position or results.

2. a) Revenues and profits are not anticipated but are related to the period inwhich they occur. E.g. when a sale is made.

b) Provision is made for all known expenses or losses whether these are knownfor certain or just estimates.

What definition means in laymans terms is simply, if the company is in doubt aboutan expense or a liability that it may have, it should create a provision for itimmediately, and if the company anticipates any future gains or profits, from a futuresale for example, it should ignore it, unless realized.


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transaction refers to the buyer as the owner.

The Realization Concept states that revenues and profits are recognized when theyare realized. Basically the Realization Concept refers the question of when does anentity realize a profit or a gain?Simply, revenue may be recognized at the point of sale, when the following

conditions are satisfied:

1. The product or service has been provided to the buyer2. The buyer recognized his liability to pay for the goods3. The ownership of the goods has passed from the seller to the buyer.4. The buyer has indicated his willingness to pay.5. The monetary value of the goods has been established.

Revenue or profits may also be recognized at other situations even if a sale hasntbeen established, such as:

1. Long term Contracts, where profits/revenues are recognized when the productionon a section of the total contract is complete, rather than when the entire project is

complete.2. Retail & Hire Purchase, where an actual sale isnt made unless the buyer finishesall of his installments. In this case, profit would be the interest added to the cost ofthe asset sold.


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Paper 1.1

Chapter 3

The Accounting Concepts - Part 2 (The Statement of Principles)

The accounting concepts and conventions are based on years of practice andjudgment. But that doesnt necessarily mean that they are fool-proof. FRS 18recognizes this fact, and it provided us with a conceptual framework to base ouraccounting standards on. In the previous paper I have explained some of theaccounting concepts which we may have to deal with day in day out, but there are onlytwo accounting standards that have been emphasized by FRS 18, which are GoingConcern, and the Accruals Concept.

The conceptual framework mentioned above is the theoretical basis for determiningwhich events should be accounted for, how they should be measured and how theyshould be communicated to the user.

Yet, prior to the ASBs release of the Statements of Principles, the lack of a conceptual

framework created some of the following problems,

1. Fundamental principles were tackled more than once in different standards, whichhave caused contradictions, ambiguity and as a result, affected the true & fairview of Financial Reporting.2. In the USA for example, the highly detailed number of standards created a set ofrules rather than general principles.

As a result, a basis now exists for reducing the no. of alternative accounting treatmentspermitted by accounting standards and company law. Furthermore, the problemstackled or associated due to the lack of a conceptual framework are now avoided.

Although, many argue that the release of the statement of principles doesntnecessarily make things easier or clearer for its users, but I believe that a futureframework for the development of accounting standards now exist, and auditors maynow confirm whether financial statements are based on accountancy standards or not.

The BPP, suggests, that the end-result of the Statement of Principles is that Objectivitynow exists, which decreases the scope of manipulation. Uniformity means that theresless scope for disagreement between current conventions and new ones, and finallyFamiliarity means that the more people use the accounts, the more theyll get used tothem.

Paper 1.1Chapter 4the Accounting Concepts - Part 3 (Why does the ASB hate Prudence?)

Through time and age, men always seemed to be in contradiction with women, andthats how it is with Accruals and Prudence. The puzzled look on every mans mindwhen the lady asks Do I look fat? is very similar to that of an accountant, whenasked Should we report the worst possible situation, prudence? Or the most likelyposition, matching?!

On a more serious note,


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1. Prudence is in a conflict with the going concern concept because it may not beprudent to assume that the business is a going concern.2. Furthermore, prudence makes it difficult to treat items consistently because at oneperiod, an item may require different treatment than it did in a previous period.E.g. prior year adjustments.3. The prudence concept also contradicts the objectivity concept in that it requires

subjective judgment in prudent situations.4. It is also difficult to value assets at anything but the historical cost conventionbecause it wouldnt be prudent to recognize a gain in revaluation for example.Seems short, and incomplete doesnt it? Well any suggestions are welcomed!


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Paper 1.1

Chapter 5The Accounting Concepts - Part 4 (Historical Cost Accounting vs. CPP vs. CCA)

Traditionally, accounts were prepared to fulfill the needs of the owners of the business

and to assist the managers for the business to make decisions about the future.Yet, it was later made clear that the accounts prepared under the historical costconvention provided misleading information because of the inability to reflect thechanging price levels.

Examples

1. When property appreciates in value, the historical cost convention which values itat its purchase cost wouldnt reflect its true and fair value. This means that unrealizedholding gains are not recognized until the period in which the asset is realized, ratherthan spread over the period during which it was owned.2. Depreciation based on a Fixed Assets Historical Cost may be inadequate tofinance the replacement of the Fixed Asset if the appreciation in value is larger than

the depreciation charged!3. Furthermore, the depreciation charge wouldnt fully reflect the value of the assetconsumed during the accounting period.4. The following example applies to stock appreciation during a period of inflation.

During Inflation No InflationSales (100 Units) $ 500 $ 500Less: Cost of SalesOpening Stock (100 Units) $ 200 $ 200Purchases (100 Units) $ 200 $ 200Closing Stock (100 Units) ($300) ($100) ($200) ($200)

Gross Profit $ 400 $ 300

Basically, the trading account above compares the gross profit of a certain company attwo different accounting periods, one being inflationary whilst the other excludesinflation. At the beginning of the year the trader had 100 units of stock at a cost of$200, during the year the trader purchased 100 units at a cost of $200, and at theyear end, the Historical Cost of the 100 units remaining after the sale of $100 units is$300 due to the appreciation in stock, and thus, inflating profit by $100.

5. HCA ignores any holding gains or losses of net monetary items during a period ofa change in prices/6. The effect of inflation on capital maintenance is not known. Capital maintenanceis the amount of sufficient retained profit to ensure that the net assets at the end ofa period are at least equal to those at the beginning of the period. I.e. to keep the

capital intact.

As a result of all the previous examples, one can see that over time, the inability of theHCA to account for changes in price level means that one cannot obtain realistic, trueand a fair view of the companys accounts from one period to another.

Reasons for Continued Use

1. Easier and cheaper to record transactions, and analyze them based on their HC.


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2. The figures are easy to obtain and they are objective and readily verifiable, beingtied to actual transactions, whereas other methods seem to be subjective.3. HC is easier to understand and users are aware of its limitations.4. Since revaluations of fixed assets are permitted, the problems associated withunderstating the value of property are avoided.

The Current Purchasing PowerThe use of the CPP means that the profit for the year is calculated after an adjustmentdesigned to reflect the effect of general price inflation on the purchasing power ofequity shares. In other words, if you refer back to the example concerning theappreciation in the price level of the closing stock, youd find, that previously, $200would be adequate to purchase 100 units of stock, whereas, now, the 100 units cost$300 to purchase, thus the purchasing power has dropped by $100, or by 1/3rd.

The Current Cost Accounting

This method of accounting doesnt attempt to cater for general prince inflation, instead,profit for the year is to be calculated after allowing for the effects of price increases,specifically on the operating capability of the particular business.

a) In other words, assets are stated at current value, which is what we do when werevalue property.b) Holding gains are excluded from profit in the P&L. how? Well its very simple,lets just look at the example below.


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Paper 1.1

Chapter 6

the Accounting Concepts - Part 5 (Should we depreciate buildings?)

Those Who Say Yes1. The value of the assets at the start of the period is the same at the year end, thusno depreciation is necessary.2. The buildings are well maintained.3. The value exceeds its cost at the year end, since it appreciates in price, and whenthe asset is sold, the sales proceeds would be greater than cost.

Those Who Say No1. Freehold buildings do not last forever!2. The depreciation charge is a means of matching the cost of the asset with therevenue earned over its useful life. This is called the Accruals Concept.
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Paper 1.1

Chapter 7

FRS 3The Structure of the Profit & Loss Account

I have always found this topic to be hard to understand and quite tedious on my brain,until I began writing about it. So probably, that maybe the best option for thosefinding difficulty regarding FRS 3 or any of the other theoretical materials. Thisarticle will cover most of the areas required by Paper 1.1 (as far as I know!).

Well, lets begin.

If we go back through our mind and reorganize the information we have regarding theconcepts behind accounting and the ASBs brief history, wed find that FRS 3 is thenatural step forward after the statement of principles, even if they didnt necessarilycome in that order.

To put it simply, one of the aims of FRSs and accounting conventions is to provide atrue and fair view of the companys financial reports, but to the questionis, to whom?The obvious answer is simply the users of the financial information. As such, FRS 3was developed to enable the users of financial reports to obtain information of higherquality by concentrating on the following matters:

- Continuing, Discontinuing Operations and New Acquisitions- Exceptional and Extraordinary Items- Disclosures by way of notes e.g. STRGL and Historical Cost Profit/Losses

Continued, Discontinued Activities and New Acquisitions

FRS 3 requires an analysis of the P&L A/C as far as the figure of profit on ordinaryactivities before interest, into 3 elements.

1. Continuing Operations, which are activities that will continue to next year.2. Discontinuing operations, which are activities that have ceased during the year.3. New Acquisitions, which are new activities that did not exist last year.

What do those things mean again?

Well, if we consider any kind of business during one accounting period, we mightfind that the business may acquire new assets, dispose of old ones, and obviouslykeep the ones it already uses for the next accounting period.

So basically, the ones it disposes of are referred to as discontinuing operations, theones it keeps are continuing operations and the new acquired assets are under theheading new acquisitions.

Yet, these three elements do not only relate to the purchase, sale of fixed assets, theyrelate to the entire activities of the business. Further examples may be provided at theend of this article. At the moment let us focus on the reasons why FRS 3 requires thatcompanies go through this kind of trouble.
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Well, to make realistic comparisons between one year and another, FRS 3emphasizes the need to differentiate between the turnover, cost of sales and theprofit of the three different elements, because in comparing like with like, someoneneeding to forecast next years turnover and profit can now see how much of this years operations will continue into the future.

The following format of the Profit & Loss Account is a simplified version of thatfound in FRS 3, which relate to discontinuing, continuing and new acquisitions:

19x1 19x1 19x0$m $m $m

TurnoverContinuing Operations 600 400Acquisitions 50

650Discontinued Operations 50 25

700 425Cost of Sales (400) (300)Gross Profit 300 125Net Operating Expenses (140) (85)

Operating ProfitContinuing Operations 110 30Acquisitions 60 30

170 60Discontinued Operations (10) (20)

160 40Profit on sale of properties in continuing operations 10 5Loss on disposal of discontinued operations (15) (10)Profit on ordinary activities before interest 155 35

The profit and loss account seems very had to grasp at first, but that should beremedied through practice questions.


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Paper 1.1

Chapter 8

FRS 3Exceptional & Extraordinary Items

when we previously discussed the structure of the profit and loss account as regardsto the continuing, discontinued operations and new acquisitions, the format we drewup ended with Profit on ordinary Activities Before Interest. We will now continuefrom there.

Profit on ordinary activities before interest XInterest Payable (X)Profit on ordinary activities before taxation XTax on profit on ordinary Activities (X)Profit on ordinary activities after taxation X

Well, what should strike you whilst taking a look at the previous profit and loss

account statements is the use of ordinary activities. The reason simply being is thatif there exists a profit on ordinary activities, there may be profits or losses on not soordinary activities. But are there?

Well FRS 3 states that there are two types of out of the ordinary items, which are:

A) Exceptional ItemsB) Extraordinary Items

Basically Exceptional items are those items that occur during the ordinary course ofthe business but need to be disclosed due to their size or incidence. E.g. a maincustomer goes bankrupt, which may increase our bad debts by 50%. This event is

ordinary in that, many of our debtors accounts return unpaid, which is why we createa bad debts provision. Yet, this event is classified as an exceptional item because ofits shier size.

Furthermore, exceptional items, maybe divided into the following categories:

A) Profit or loss on sale or termination of an operationB) Cost of fundamental reorganizationC) Profit or loss on the disposal of fixed assets.D) Other items, if they are sufficiently material.

Extraordinary items are those that posses a high degree of abnormality which arisefrom events or transactions that fall outside the ordinary activities of the business.

They are so abnormal, that the ASB doesnt even provide us with an example!

Finally, much has been left unsaid, but the basic information has been motioned, andit is up to most of us to enquire further and to obtain more information. Yet, at the endof the day, FRS 3 has put an end to the manipulation of the Profit and Loss accountby limiting the usage of extraordinary items, and providing us with a strict definition ofexceptional items.


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Paper 1.1

Chapter 10

FRS 3Statement of Total Recognized Gains and Losses

Up until this section, FRS 3 has restructured the P&L, defined the difference betweenordinary, exceptional and extraordinary activities. Now, FRS 3 takes us a step further.Let us suppose that we have made a holding gain of $50,000, which means that wehave purchased an asset, and through time, it appreciated in terms of value, and now itis worth $50,000 more than it used to at the time of purchase.

Well, anyone who studied how to revalue assets, which they should before reachingthis topic in their studies, knows that revaluation gains are only recognized if aprofessional external value valued the asset. The holding gain would then betransferred to the revaluation reserve (subject to the deduction of any relatedaccumulated depreciations).

So now, we have $50,000 in a revaluation reserve. How do we know that this 50,000relates to this year? Furthermore, what about other reserves, and other holding gainsor holding losses? Would an average user understand these terminologies and howthey affect the financial position of the company as a whole?

Well, to answer these questions, as well as other reasons, FRS 3 introduced the ideaof a Statement of Total Recognized Gains and Losses, which brings together theinformation from the profit and loss account, the balance sheet and other supportingnotes for asset revaluations. The following format demonstrates how this is done:

Statement of Total Recognized Gains and Losses

Profit for the financial year $M

(I.e. profit after tax and extraordinary items if any) 29Unrealized surplus on revolution of properties 4Unrealized loss on trade investment (3)

30Foreign currency translation differences (2)Total gains and losses recognized since last annual report 28


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Paper 1.1

Chapter 11

Post Balance Sheet Events

The previous topics dealt mostly with the reasons for accounting standards, theirconcepts, how theyre regulated and some of their limitations. Along with FRS 3 andFRS 18, we will now be discussing further accounting issues which are the subject ofstandards.

FRS 3 introduced the idea of disclosure in the form of notes, the reason being is that inorder for the financial statements to provide a true and fair view of the companysactivities they must include all the information necessary for an understanding of thecompanys position.

Yet, up until now, we have only dealt with those events that have occurred during thecurrent accounting period. But what about activities that occur after the balance sheetdate? Well, prudence would have us provide a provision for it, wouldnt it? The accruals

would say if its affecting the position of the company at the balance sheet date, then aprovision too should be provided.

E.g. suppose that at the 10th of January, the company decides to go into liquidation andthe company is yet to publish its accounts for the year up to 31/12/2003. Would thecompany go ahead and publish its financial statements with any adjustments ordisclosure? Please bear in mind that the accounts were initially prepared on the basis ofthe going concern concept.

I believe that you got the idea now. Well, SSAP 17 says okay, any event that occursafter the b/s date is called a post balance sheet event, some of which may need to bedisclosed without adjusting the balance sheet, while some may need to be disclosed

whilst adjusting the balance sheet.

Post Balance Sheet Events are those events, both favorable and unfavorable, whichoccur between the balance sheet date and the date on which the financial statementsare approved by the board of directors.

Well, now that we know what post balance sheet events are, we need to know when theaccounts may need adjustments, or when disclosure in the form if notes is adequateenough.

Those events, that may need adjustments, are referred to as Adjusting Events, andthey are defined as:

Adjusting Events are post balance sheet events which

a) Provide additional evidence of conditions existing at the balance sheet date.b) They include events which because of statutory or conventional requirements arereflected in financial statements.

Well, if there are adjusting events, then there must be non-adjusting events, right? Yes!Non-Adjusting Events are events which


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a) Arise after the b/s date and concern conditions which did NOT exist at that time.b) They do not result in changes in amounts in financial statements.c) Yet they may however, be of such *materiality that their disclosure is required by wayof notes to ensure that financial statements are not misleading.

*An example of the significance of the materiality concept.

Suppose for example a company decides to issue shares after the b/s date, i.e. in thenext accounting period, whilst it is doing so, the accountants are still busy preparing thefinancial statements.

Think with me, do we need to disclose the information?

Well, yes! But subject to the following conditions

1) If they are material enough, which they are!2) If they do not affect the amounts in the previous financial statement.

Finally, a list of examples of Adjusting and Non-Adjusting Events:

Adjusting Events:

1 Resolutions relating to proposed dividends and amounts appropriated to reserves2 The effects of changes in taxation rates3 The declaration, by subsidiaries or associated companies, of dividends relating toperiods prior to the balance sheet date of the holding company.4 The subsequent determination of the purchase price or of sale proceeds of assetspurchased or sold before the year end.5 The valuation of a property which provides evidence of a permanent diminution invalue6 The receipt of a copy of the financial statements or other information in respect of

an unlisted company which provides evidence of a permanent diminution in thevalue of a long-term investment.7 The receipt of proceeds of a sale or other evidence after the balance sheet dateconcerning the net realizable value of stock8 The receipt of evidence that the previous estimate of accrued profit on a long termcontract was materially inaccurate9 The renegotiation of amounts owing by debtors, or the insolvency of a debtor10 Amounts received or receivable in respect of insurance claims which were in thecourse of negotiation at the balance sheet date.11 The discovery of errors or frauds which show that the financial statements wereincorrect

Non-Adjusting Events

1 Issue of Shares and debentures2 Purchases and sales of fixed assets and investments3 Losses of fixed assets or stocks as a result of a catastrophe such as fire or flood4 Opening new trading activities or extending existing trade activities5 Closing a significant part of the trading activities if this was not anticipate at theyear end6 Decline in the value of property and investments held as fixed assets, if it can bedemonstrated that the decline occurred after the year end


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7 Government action, such as nationalization8 Strikes and other labor disputes.


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Paper 1.1

Chapter 12

FRS 12: Provisions, Contingent Liabilities and Contingent Assets

As with the requirements of all financial reporting standards, financial statementsmust provide all the information necessary for an understanding of the companysfinancial position, in order for them to present a true and a fair view of the companysaffairs.

As a continuation to the previous standards, such as FRS 3, the statement of principlesand SSAP 17, FRS 12 takes things further by tackling the subject of provisions,contingent liabilities and contingent assets.

According to FRS 12, a provision is a:

a) Liability of uncertain timing or amount.b) Liability is an obligation of an entity to transfer economic benefits as a result

of past transactions or events.

According to ME, or in laymans terms, a provision is a liability that we are uncertainof, which we may be obliged to settle.

E.g. If a company is obliged to incur clean up costs for environmental damage thathas already been cause, should a provision be made?

Yes, because we incurred the liability of the cleaning costs during a period of time inthe past, and we are now obliged to settle it, but we dont know when or its amount.Thus a provision should be made.

But, when are provisions recognized?

1) When a business has a PRESENT obligation as a result of a past event.2) It is probable that a transfer of economic benefits will be required to settle theobligation.3) A reliable estimate can be made of the obligation.

Good, now we know when to recognize them, but what is their accounting treatment?

Well, once a provision is recognized, the company can do one of three things, one isto provide for the provision and disclose it in our accounts, the next choice is simplydisclose it by way of notes, or to simply ignore it.

If there is a high probability of a transfer of economic benefits and a reliable estimatecould be made for the amount, the company should provide for the provision.

Otherwise, whether there is a remote transfer of economic benefits or not, the inabilityto provide a reliable estimate, means that we could do is to disclose the provision byway of notes.

Worked Example
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This example is provided by FRS 12 concerning the costs of restructuring, and itdefines it as a program that is planned and controlled by management and materiallychanges either:

a) The scope of a business undertaken by an entityb) The manner in which the business is conducted.

Such as:

Sale or termination of a line of business Closure of business locations Changes in the management structure.

Well, should a provision be made for any of these events, knowing that FRS 12 wasmainly introduced to target abuses of provisions for restructuring?

If there is a present obligation, in a form of a contract or a sale agreement, in which areliable estimate can be made for the provision, then a provision should be providedfor, but the costs of the following items should NOT be included:

Marketing Costs Retraining of New Staff The cost of investing in new systems.


FRS 12 refers to n obligation that arises from a past event, which we discussed earlier,as a Contingent Liability.

FRS 12 takes the definition further to include the following:

1) A possible obligation that arises from past events and whose existence will beconfirmed only by the occurrence or non-occurrence of one or more uncertainfuture events not wholly within the entitys control, OR2) A present obligation that arises from past events but is not recognized because,a) It is not probable that a transfer of economic benefits will be requiredto settle the obligation.b) Or the amount of the obligation cannot be measured with sufficientreliability.

In other words, a contingent liability is an event that may occur subject to uncertainevents beyond the companys control or it arises from a present obligation from pastevents, but couldnt be recognized due to points 2 a) and 2 b) above.

This means that contingent liabilities should not be recognized in financial statements,they should only be disclosed.

The required disclosures for a contingent liability are:

A brief description of the nature of the contingent liability An estimate of its financial effect An indication of the uncertainties that exist The possibility of any reimbursement.


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A contingent asset, as a oppose to a contingent liability is:

A possible asset, which arises from past events and whose existence will be confirmed

by the occurrence of one or more uncertain future events not wholly within theentitys control.

Therefore, a contingent asset should not be recognized at all, in fact they could onlybe disclosed.

In conclusion, one can obviously see the application of the prudence concept indealing with provisions, contingent liabilities and contingent assets, and as such thereis no surprise as to the accounting treatment of these items. One must also note thatthe accounting limitations of the prudence concept also apply.


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Paper 1.1

Chapter 13

The Preparation of Financial StatementsThe Application of the Accounting & Business Equations

The first article in this site is basically about the definition and importance ofaccountancy, its purpose and its role. We will now go further to discuss what theactual accounts look like and what they are based on.

But before we do so, one must realize the distinction between the preparation of thefinal accounts and the bookkeeping process. The bookkeeping process is thesteppingstone of accounting, as it is the process by which the transactions arerecorded in the business, and the preparation of the final accounts begins from there.

Therefore one must learn the mechanics of bookkeeping first, and this is the aim ofthe following article.

Setting up a business

Okay, suppose we are required to set up a business, the first thing that we need to dois to take a loan from the bank, or to save enough money before we actually buy anypremises or whatever.

Well, the money we raised through a loan or through any other way is called theCapital. The premises that we have purchased is called an Asset, the loan from thebank is called a Liability.

Capital, Assets and Liabilities are the basis of accounting and they form theAccounting Equation:

Assets = Capital + Liabilities

So basically, an asset is what a business owns, and a liability is what a business owes(in this case to the bank), and capital is the investment of money with the intention ofearning a return.

Strictly, capital is the money owed to the proprietor of the business, due to the entityconcept, which basically means that the business is considered distinct from theowner, i.e. it is considered as a separate entity. Therefore, it isnt surprising when wesay the business decided to do this rather than the owner or the manager.

Okay, now the company is set up, we bought premises or most likely rented it or

leased it. Now we need to purchase some furniture, maybe a teller, and mostimportantly goods to sell!

Well, any expenses in relation to assets such as premises, furniture or teller machinesare referred to as Capital Expenditure which results in the purchase or improvementof fixed assets, which are assets that will provide benefits to the business in more thanone accounting period, and which are not acquired with a view to being resold in thenormal course of trade.
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On the other hand, the expenditure incurred in relation to the purchase of goods isreferred to as Revenue expenditure, which is expenditure incurred for the purpose ofthe trade of the business, such as selling and distribution expenses, administrationexpenses and finance charges.

The distinction between the two types of expenditure is extremely important, since

each is treated differently in accounting.

To summarize what we have just discussed, any transactions that a businessundertakes may either be classified as capital or revenue transactions, (income orexpenditure), and our capital is made up of assets and liabilities.


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Paper 1.1

Chapter 14

the Bookkeeping Process

The process of bookkeeping begins by the issue or the receipt of source documents,such as invoices, purchase orders or sales orders. Once invoices are issued orreceived, the details of that particular invoice are recorded in the appropriate book ofprime entry.

The books of prime entry are summarized above with the inclusion of the journal, whichis shown separately for illustrative reasons only. Well, whenever a sale is made, thedetails of the sales are recorded in the sales day book, and similarly for purchases.Sales returns or purchase returns are similarly recorded in their own books of primeentry. Any cash related payments or receipts are recorded in the cash day book, whichincludes bank related transactions as well.

A separate book is kept for petty cash since most businesses keep a small amount of

cash on the premises to make occasional small payments in cash, e.g. postages, taxifares, etc. the petty cash account can also be the resting place of occasional smallreceipts, such as cash paid by a visitor to make a phone call, etc. As one may imagine,although the amounts involved are small, petty cash transactions still need to berecorded, otherwise the cash float could be abused for personal expenses!

Furthermore, under what is called the imp rest system, the amount of money in pettycash is kept at an agreed sum or float. The imp rest system is a system where a refundis made of total cash paid out in a period. E.g. if the float is agreed to be at $250, thenat the end of the period, whatever is spent, would be refunded back from the cashaccount.

Sales or purchases on credit are not only recorded in books of prime entry, such as thesales or purchase day books, but they are also recorded in what is known asmemorandum accounts or personal accounts. As such, these accounts contain thebalances outstanding for each personal debtor or creditor. These books arent a part ofthe accounting system, but they are necessarily kept for the company to know who topay, and how much, and who to expect payment from, etc.

In addition, on a periodic basis, (daily, weekly, monthly), the business would begin tosummaries the transactions recorded in the books of prime entry, and it would recordthem in the nominal ledger, which consists of a large number of accounts, each accounthaving its own purpose or name and an identity or code. E.g. we could have a ledgeraccount for rent, in which all rent payments are recorded, similarly for telephoneexpenses, etc.

On a monthly basis, or during another periodic basis, the business might begin aprocess of bank reconciliation, which is basically a way of making sure that the amountsreflected in the cash book are equivalent to that found in the bank statement.

The company may also keep a set of control accounts, which refer to an account in thenominal ledger in which a record is kept of the total value of a number of similar butindividual items. Control accounts are used chiefly for debtors and creditors.


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For example, a debtors control account is maintained in which records of transactionsinvolving all debtors in total are kept so that the balance on the debtors control accountat any time will be the total amount due to the business at that time from its debtors.

Basically control accounts are impersonal ledger accounts that will appear in thenominal ledger.

At the end of the year, any necessary adjustments to the accounts, either due to erroror change in accounting policy, or for whatever reasons are recorded in a journal,which is one of the books of prime entry. Hence, the journal entries and the ledgeraccount balances are summarized in a trial balance, which is a list of ledger balancesshown in debit and credit columns. The journal entries and the trial balances are thenused to formulate the profit and loss account and the balance sheet.


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Paper 1.1

Chapter 15

Preparing Financial StatementsTheCost of Sales

The Trading Profit & Loss Account

At the end of the accounting period, when the accountants begin to close off accountsin preparation for the financial statements, there are a few important tasks to do first.The first of which is to calculate the closing stock of the period, to prepare theTrading, Profit & Loss Account, Bank Reconciliation, etc.

Stocktaking

On the bases of the accruals concept, revenues should be matched with their relevantcost as per the corresponding period. As such, any stock that remains unsold at theend of the accounting period isnt included as a part of the cost of sales for thatperiod. Get it? Well, its like a prepayment, u dont actually account for it during the

current period, because it is relevant only to the following period.

Well, for this reason, the company should find out how much stock it has on hand atthe end of the accounting period, this stock is called closing stock, and the process offinding out how much you have of it is called stocktaking.

This process is easy if the company is a relatively small where it could actuallyphysically count each item of stock. Yet as the business grows larger the quantity ofstock held becomes harder to determine.

Therefore a business may wish to close down for a short period for a stock take, or abusiness may prefer to keep a detailed record of stock movements whilst baring the

large related costs and headaches!

In more complicated cases, a business may wish to maintain continuous stock records.This means that a card is kept for every item of stock, showing receipts and issuesfrom the stores, and a running total.

The Cost of Goods Sold

Now that we figured out what the closing stock value is, all we simply need to do is todeduct it from the cost of sales during a period to determine the profit. The cost ofsales, or cost of goods sold is simply the expense incurred purchasing stock during theperiod. It is calculated using the following formula:

Cost of Sales:

Opening StockAdd: PurchasesAdd: Carriage InLess: Returns Inwards / Purchase ReturnsLess: Damaged or Stolen goodsLess: Closing Stock
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Please note that the cost of goods manufactured or purchased is adjusted to allow forincreases or reduction in stock levels during the period. This is why purchases,opening stock and closing stock are used in the formula.The next step is to draw up the Stock Account and the Trading, Profit & LossAccount.

These accounts are usually drawn up at the end of the accounting period once thestocktaking process has ended, and all adjustments to the accounts and correctionshave been made.

The trading profit and loss account has allowed us to calculate the netprofit and the gross profit for the period. If you would look at the date entries, youdnotice that aside from the opening stock, all are at the year-end.

Other expenses would include selling and distribution expenses, administrationexpenses, such as depreciation, bad debts, wages, etc.

Paper 1.1

Chapter 16Stocks and How To Value Them

In this article we would briefly explain how to determine the purchase cost of stocks, theproblems associated in determining how they are valued, and the basic methods usedto solve these problems.

The Purchase Cost of Stocks

basically, when a company purchases stock from a creditor, whether by cash or oncredit, the company would gather the source documents, and enter the details in the

books of prime entry. Thus, the cost paid for each purchase is the purchase cost ofstock, right?

Not necessarily, because first of all, the cost paid for each item purchased may differduring each purchase, either due to discounts, sale, inflation, etc. In addition, imaginepurchasing 100 items of stock every month, and at each month the amount paid foreach item differs slightly, how is it possible to calculate which item was sold and howmuch money we made on each item?

Furthermore, imagine items being returned others being damaged or stolen. Theprocess of thinking about it is tedious enough imagine trying to record it!

NRV, Current Replacement Costs and the Selling Price of Stocks

basically, before we proceed, Stock is valued at the lower of its net realizable value andits historical cost value. The net realizable value is the expected selling price for eachitem of stock less any costs still to be incurred in getting them ready for sale. TheCurrent Replacement Cost is the amount it would cost to replace each item of cost.Historical Cost is simply the cost at which they were originally bought.

The reason why stock is valued at the lower of the net realizable value and historicalcost is due to the prudence concept. The selling price is avoided because it would


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include a profit figure for the business before the stock is even sold!

Furthermore, SSAP 9 encourages the use of two methods FIFO and AVCO, anddiscourages the use of LIFO whilst valuing stock.

FIFO, AVCO and LIFO

FIFO stands for, First in, First Out, and it assumes that materials are issued out ofstock in the order in which they were delivered into stock. In other words, the first itemsupplied is the first item sold. Hence, issues are priced at the cost of the earliestdelivery remaining in stock.

LIFO stands for Last in, First Out, and it assumes that materials are issued out of stockin the reverse order to which they were delivered. In other words most recent deliveriesare issued before earlier ones, and are priced accordingly.

AVCO stands for Cumulative Weighted Average Pricing, which calculates a weightedaverage price for all units in stocks. This could be very helpful in determining the costof consignment stock. Basically a new weighted average price is calculated whenever a

new delivery of materials into store is received.

Well basically it says that at the particular date we either had a receipt of goods into thecompany, or we issued some goods. In other words receipts are purchases and issuesare sales (I used the terms receipts and issues as it was used in the BPP example). Thenumber of units received or issued, their corresponding unit price and their marketvalue on the date of transaction are also presented.

The problem is to put a valuation on the issues of materials, and the closing stock, andhow they would be

valued using FIFO, LIFO and Average Cost.

FIFO

First, entering and calculating the details as per the requirements of each header. Asyou can see, whenever units are issued, we select the balance of the first remaining

LIFO

The process of calculating the closing stock value in terms of LIFO is very similar toFIFO except for a major difference, in that whenever units are issued we select thepricing of the latest units received.

AVCO

The process of using AVCO is slightly more complicated. A new cumulative weightedaverage cost per unit is calculated whenever units are received/purchased/supplied. Itis calculated by dividing the Closing Stock Value by the total balance of units remaining.

Furthermore, whenever items of stock are issued, the cost per item is the cumulativeweighted average cost calculated previously. This cost is also used to calculate the newcumulative average cost whenever units are later received.


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Let us now take this example a little further, in order to realize how the closing stockfigure affects the cost of goods sold and the companys gross profit.

Remember the sale price per unit in the table that includes the summary of thetransactions above?

Well, each unit was uniformly sold for a price of $20, thus since total issues (sales) are1000 units, the figure for sales is $22,000.

To calculate the cost of sales (COGS), we need to obtain the values for opening stock,closing stock, and purchases. The first two are already available. But what aboutpurchases?

A well purchase is simply calculated, by adding up the value of each receipt. Now let ussummarize all this information, into the following profit and loss account:

FIFO LIFO AVCOSales 22,000 22,000 22,000Less Cost of Sales

Opening Stock 3600 3600 3600Purchases 16600 16600 16600Closing Stock (6000) (14200) (5700) (14500) (5874) (14326)Gross Profit 7800 7500 7674

Now, although these calculations may look difficult at first, practicing selected questionsmake them seem really easier. Yet, in reality the calculations may actually be muchmore complicated and more difficult to manage.

The next point that I would like to bring to your attention is how the gross profit differswhen each method is selected. Yet, the continuous use of each method, would meanthat the profit differences are only temporary, since the closing stock values would be

the next periods opening stock values, which would affect the cost of sales and profitsin the future so that the inequalities of the cost of sales each month will eventhemselves out.


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Paper 1.1

Chapter 17

Defining, Finding and Correcting Bookkeeping Errorsthe Trial Balance, Reconciliation and Control Accounts

whilst maintaining records during the bookkeeping process, human error could occurquite easily, and as such, it becomes necessarily important to spot the errors andcorrect them accordingly.

There are various types of errors that may occur, and each is classified under one ofthe following categories:

1. Omission a transaction is not recorded at all2. Error of commission an item is entered to the correct side of the wrong account.3. Error of principle an item is posted to the correct side of the wrong type ofaccount.4. Error of original entry an incorrect figure is entered in the records and then

posted to the correct account5. Reversal of entries the amount is correct, the accounts used are correct, but theaccount that should have been debited is credited and vice versa.6. Addition Errors figures are incorrectly added in a ledger account.7. Posting Errora) an entry made in one record is not posted at allb) an entry in one record is incorrectly posted to another8. Compensating errors two equal and opposite errors leave the trial balancebalancing9. Trial balance errors a balance is omitted, or incorrectly extracted, in preparingthe trial balance.

The Correction of Errors

The Trial Balance

Many of us believe that the trial balance forms the bases of summarizing all the debitsand credits of the companys nominal ledger and journal entries in order for us to simplypull out the data to reproduce the profit and loss account and the balance sheet. Whilethat is so, it is further used to spot any errors that usually cause the trial balance not tobalance. In other words we find that the debits are larger than the credits or vice versa.The following methods are often used to find and correct these errors and to furthertest the accuracy of the accounts. Obviously compensating errors are the hardest tospot since they couldnt affect the balance of debits and credits on the trial balance.

Suspense Accounts

Errors are often corrected by the use of journal accounts or through the use of asuspense account when the trial balance does not balance. Basically a suspenseaccount is a temporary account that may be used to correct any mistakes at the year-end or whilst preparing the draft accounts. An accountant may also use it when he isnot sure of where to post a transaction. Errors 6, 7, and 8, mentioned above, require asuspense account to correct them; otherwise only a journal entry is necessary. Trialbalance errors do not require journal entries or a suspense account, it is simply


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form of bounced cheques, or any form of error.

This process of reconciliation is fairly simple, but may be confusing at start. The firstthing one does is to spot the errors, and the reasons for difference. The reasons arethen divided in the form shown above. The balance on the cashbook and bankstatements are then corrected accordingly, and hopefully they would both match. The

balance on the cashbook will always be the balance shown in the balance sheet.

Debtors and Creditors Control Accounts

another way of checking the accuracy of the bookkeeping process and to locate theerrors is through the use of Control Accounts. Control accounts are impersonalaccounts that will appear in the Nominal Ledger.

A debtors control account is an account in which records are kept of transactioninvolving all debtors in total. In other words the balance on the debtors control accountat ay time will be the total amount due to the business at the time from its debtors. DoesBPP explanations make sense? NOPE. This is why Im writing this article.

Whenever a business makes a sale on credit, the bookkeeper will send out an invoice tothe debtor, and the details of the transaction would be recorded in the debtor s personalaccount. Well, imagine trying to aggregate the total of the outstanding balances of alldebtors at the year end? Imagine the room for error?

Therefore, the bookkeeper may simultaneously open a debtors control account in thenominal ledger, where the accountant would summarize the entire transactions of theday, week or month, depending on the volume of credit sales.

Obviously at the year end when the bookkeeper decides to double check whether thebalance on the debtors account is correct, he may add up the balances on the personalaccounts, if they both match, then obviously the debtors control account is correct.

Otherwise, theres an error that must be corrected.

Furthermore, the multiple-choice questions really test your ability to understand thetopics mentioned above. I have just summarized them but without serious practice,


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1. Do they affect the trial balance?2. What kind of account are they affecting?a) Assets or Expenses?b) Capital, Liabilities or Income?3. What kind of error is it?

Now for the situations, taken from various question papers to give you a goodunderstanding of the errors.

Situation 1

A creditors account had been debited with a $300 sales invoice (which had beencorrectly recorded in the sales account).Sales is an income account, it should have therefore been credited, as such, adebtors account should have been debited. This error does not affect the suspenseaccount, because although the transaction was posted to the wrong account, theaccount was debited with the correct amount.

As such, the journal entry would be

Debit Debtors $300Credit Creditors $300

Situation 2

the heat and light account had been credited with gas paid $150.

The heat and light account, is an expense account, it should have been debited ratherthan credited. This error therefore increases the credits rather than increasing thedebits, as such it involves the use of a suspense account, but how?

Well, let us start by using journal entries first.

Debit Heat and Light $300Credit Suspense Account $300

Situation 3

G Gordon had been credited with a cheque received from G Goldman for $800. Bothare debtors.

Wow, is this slightly confusing or what? Well we are told that both are debtors, so Iassume that instead of crediting G Goldman for $800 we credited the wrong debtor.Thats all. Therefore the transaction doesnt affect the trial balance, only a journal

entry is needed to correct the error, which is:

Debit G Gordon $800Credit G Goldman $800

Situation 4

The insurance account contained a credit entry for insurance prepaid of $500, but thebalance had not been carried down and hence had been omitted from the trial


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balance.

This means that a trial balance wasnt debited with $500, which affects the balance.As such, a suspense account is needed. The journal entries would look like:

Debit Insurance Account $500

Credit Suspense Account $500

Remember a prepaid account is a debit account, and an accrued account is a creditaccount!

Situation 5

The purchase returns account had been over-cast by $700.

Remember a purchase returns account is a credit account, if it has been over-cast by$700, this means, that the credits on the account have been added incorrectly,whereby the credits have been increased by $700. Therefore, the transaction affectsthe trial balance, and needs a suspense account to correct it. The journal entries are:

Debit Purchase Returns $700Credit Suspense Account $700

Situation 6

$8,980, the total of the sales returns book for September 20x8, had been credited topurchase returns account.

We said a purchase returns account is a credit account, and sales returns book is adebit account. Therefore in this case we credited the purchase returns instead ofdebiting the sales returns, in which we increased our credits. Thus a suspense account

is needed, as well as two transactions!

Debit Sales Returns $8980 (this is done to post the correct entry)Credit Suspense Account $8980

Debit Purchase Returns $8980 (this is done to cancel out the error made)Credit Suspense Account $8980

Situation 7

$9600 paid for an item of plant purchased on 1 April 20x8 had been debited to plantrepairs account.

Instead of debiting plant at cost with 9600, we debited plant repairs account, this is anerror of principle, it doesnt affect the trial balance, and it therefore doesnt need asuspense account. The journal entry would be:

Debit Plant at cost $9600Credit Plant Repairs Account $9600


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Paper 1.1

Chapter 19

FRS 1 CashFlow Statements

Cash flow statements concentrate on the sources and uses of cash and are a usefulindicator of a companys liquidity and solvency. In other words it is about a page longand it summarizes the inflows and outflows of cash under specific sections. Mostimportantly though, a cash flow statement distinguishes between profit and cash.

Why?

Well, it has been argued that the figure for profit in the profit and loss account ismisleading because it is calculated after numerous non-cash deductions or additionssuch as depreciation, profit on disposal of assets and accruals, whereas a cash flowstatement simply says, lets just discuss what the company paid or received in termsof cash only.

To illustrate this further, suppose a company made a profit of 1 million pounds, doesthis necessarily mean that it has that amount of money in its bank account? As such,the survival of a business depends not so much on profits as on its ability to pay itsdebts when they fall due.

Obviously a companys net cash flow within a specific period may be measured bydeducting the opening cash balance from the closing cash balance. However, wouldnot one prefer to know the details of the transactions? Or what their effects are?

Without disclosing much information, it is recommended that a cash flow statementsummarizes the inflows and outflows of cash under the following categories:

1. Net Cash Flow from Operating Activities2. Returns on Investments and Servicing of Finance3. Taxation4. Capital Expenditure and Financial Investment5. Acquisitions and Disposals6. Equity Dividends Paid7. Cash Flow before Management of Liquid Resources and Financing8. Management of Liquid Resources9. Financing

Okay, but what do these headlines mean, and where do we get the information tofind the net cash flow for each of these categories?

Operating Activities

operating activities refer to the companys trading activities and day-to-dayoperations, such as selling, distribution, administration expenses, etc. The cash flowstatement attempts to summarize the net cash flow of these transactions, and thismay be done in two distinct ways:

1. The Direct Method2. The Indirect Method
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The direct method of calculating the net cash flow from operating activities is done inthe following way:

Cash received from customersLess: Cash paid to suppliers

Cash paid to and on behalf of employeesEquals: Cash flow from operating activities

The indirect method calculates the net cash flow from operating activities using theinformation from both the balance sheet and the profit and loss account, and it doesso in the following way:

Operating Profit before Interest and TaxAdd: DepreciationLoss on sale of fixed assetsDecrease in stocks and debtorsIncrease in creditorsLess: Profit on sale of fixed assets

Increase in stocks and debtorsDecrease in creditorsEquals: Net cash flow from operating activities

Please Note

1. Depreciation is not a cash expense, similarly for the loss or profits on disposal.2. Increase in stocks or debtors means that the company paid more money during theperiod to do so.3. An increase in creditors means that the company paid less money during the yearfor its purchases.

Returns on Investments and Servicing of Finance

this section includes cash received resulting from the ownership of investments otherthan those invested in joint ventures and payments made to providers of financeother than equity finance. It also includes where appropriate, the interest element ofpayments made under finance leases.

E.g. interest paid for loans, or dividends paid to preference shareholders

Taxation

any taxation paid in respect to the profits of the company less any tax rebates orreturns in respect of overpayments.

Capital Expenditure and Financial Investment

These include the sales proceeds or the payments to purchase fixed assets such asplant, buildings, equipment, motor vehicles, etc, including long-term investmentsmade in the shares or debentures of other companies, unless the acquisition ofother companies is involved.

Acquisition and Disposals


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Cash flows in respect of acquisition and disposals are only related to parentundertakings, such as the acquisition or disposal of any investment in a subsidiary,associate or joint venture.

Equity Dividends paid

these are simply the amount of dividends paid to equity shareholders.

Management of Liquid Resources

Liquid resources are current asset investments that are held as disposable stores ofvalue. They are either

a) readily convertible into known amounts of cash at, or close to, its carrying amountb) traded in an active market

E.g. treasury bills and shares on the stock exchange.

Financing

these represent amounts received from providers of finance, both debt and equityfinance, less principal amounts repaid. This section also covers the capital elementsof payments made under finance leases.

E.g. Receipts from issues of shares or debentures, and any repayments of amountsborrowed.


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Paper 1.1

Chapter 20

An Example of a Cash Flow Statement & Accompanying Notes

Cash flow Statement for the Year Ended 31st December 20x3$000 $000

Cash Flow From Operating Activities (note 1) 15672

Returns on Investments and servicing of finance:Interest Received 858Interest paid (1939)Preference dividend paid (450)Interest element of finance lease rentals (358)

(2239)Taxation (2887)

Capital expenditure and financial investment:

Purchase of tangible fixed assets (3512)Sale of trade investment 1595Sale of plant and machinery 1052

(865)Acquisitions and disposals: (not required for Paper 1.1 Students)Purchase of subsidiary undertaking (12705)Net overdrafts acquired with subsidiary (5516)Sale of business 4208Purchase of interest in a joint venture (3811)

(17824)Equity dividends paid (2606)Cash outflow before use of liquid resources and financing (10399)

Management of liquid resources:Cash withdrawn from 7 day deposit 200Purchase of government securities (5000)Sale of government securities 4300Sale of corporate bonds 1200

700Financing:Issue of ordinary share capital 600Increase in short term borrowings 2006Repayment of secured loan (850)New secured loan repayable in 20x7 1091New unsecured loan repayable 20x5 1442

Capital element of finance lease repayments (1342)2947

Decrease in cash (6752)

Note 1 Reconciliation of operating profit to operating cash flows

Operating Profit 17213Depreciation Charges 3488Increase in stocks (11840)


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Paper 1.1

Chapter 21

Shareand Business Valuation

Breakup Valuation is based on the forced sale of individual assets in the second handmarket. Basically, the current values of all assets are added up together.

The Advantages

1. It represents the minimum value at which the company can be sold2. If company ignores breakup value, an opportunity exists for asset-strippers3. An indication of the min amount of capital that could be obtained for investment

elsewhere.

The Disadvantages1. Ignores that the company is a going-concern

2. Values on assets are estimates3. Sale value of fixed assets is hard to ascertain.

Book Value: Original Share Capital + Reserves

the Advantages

1. The figures are factual as they are based on historical cost2. They are easily obtainable3. The figures for debtors and non-equity liabilities are accurately reflected.

The Disadvantages

1. Inflation means that historical cost is not an accurate measure of current value2. Historical costs aren't very accurate due to inaccurate measures of depreciation.3. The book value of stock is unlikely to reflect its current value, because market valuesoften include an element of profit.4. Ignores the existence of intangible assets such as goodwill.

Replacement Cost: Replacement Cost of Assets less: All Liabilities

The Advantages

Assets are valued at their replacement cost!

The Disadvantages

1. The cooperation of the company is needed to identify assets2. Intangible assets such as goodwill aren't recognized3. Replacement cost may overvalue the company.

Earnings Yield 100 = Annual Earnings Yield X 100 or 1 X 100Required Earnings Yield P/E Ratio
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The value of a company on the earnings-yield basis is the value of the stream of profit,or earnings which the company is expected to generate.

The Disadvantages

1. It is based on predictions, assumptions and estimates.

2. Micro/Macro economic factors may cause distortions in present/future value ofshares.3. Dependant on access to inside information.4. Results achieved in the past don't necessarily reflect future earnings.

Price Earnings = Market Price of One Share (from Stock Exchange)Earning per share (profit after tax/Issued shares )

An unlisted company can therefore be valued by multiplying its earnings by the P/Eratio of a similar company.

The Disadvantages

1. The P/E ratio of an unlisted company is expected to be less than that for acorresponding listed company and so the use of unadjusted quoted ratios can resultsin overvaluation on2. High trading may cause overvaluations of share prices.

Dividend Yield =Dividend for the year(Including Interim Dividend) X 100Quoted Market Price ( In Pence )


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Paper 1.1

Chapter 22

Solvency & Financial Strength

Short-Term Solvency

Working Capital (Current) Ratio = Current Assets: 1Current Liabilities

1. The ability to pay debts as they fall due2. The rate of stock turnover must be considered, since the lower it is, the morestock there is.3. The average ratio for the industry and the economy must also be considered.4. A ratio below 1 means that acompanymay not be able to pay its short term debts

Liquidity (Quick) Ratio = Current Assets - Stock:1Current Liabilities

1. One must carefully consider which of the current assets to include or omit.2. Stocks should be normally excluded, as well as prepayments.3. All liabilities should be included, but one must understand the significance ofincluding tax which is usually paid within 9 months, and an overdraft, which is arevolving source of finance.4. A ratio below 1:1 usually causes a company great difficulty in meeting its debts asthey fall due.5. An excess of 1:1 means that the company is in possession of surplus cash,although solvent, there must be some doubt whether it is making the best use ofavailable resources.

Longer-Term Financial Strength

Proprietorship Ratio = Shareholders' Equity X 100Total Sources of Finance

1. The proportion of business assets financed by shareholders.2. The larger the proportions of business activity financed by shareholders thesmaller are the creditors' claims against the company.3. This said Equity finance is normally repaid only when the company is wound up,and only when there is sufficient finance, although dividends are paid, the companyis not legally obliged to do so.4. One normally expects shareholders to provide at least half the finance.5. It represents, to the creditors, the extent to which a company can stand a fall in the

value of its assets before the creditor's position is prejudiced. E.g. 75% means thatassets must fall by 25% before the creditors' position on liquidation is jeopardized.

Interest Cover = Net Profit before Interest And TaxInterest Charged

1. It stresses the importance of a company to meet its interest charges out ofrevenue, and this is expressed as a multiple of operating profits.2. A low figure indicates that interest payable imposes a heavy burden on the
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Paper 1.1

Chapter 23

Asset Turnover Ratios

Stock Turnover Period = Avg. Stock Level X 365Cost of Goods Sold

1. Measures the speed with which a company turns over its stock2. Multiplying the ratio by 365 represents this ratio in terms of days that elapsebetween the date that goods are delivered by suppliers and dispatched to customers.I.e. the stock holding period.3. Companies must strive to keep the stock holding period as low as possible in orderto minimize associated costs.4. A reduction in the average period for which stocks are held, suggests that thepurchasing, distribution, and selling functions have been streamlined5. Higher sales and market activity, usually increases the stock figure to ensure thatadditional consumer requirements can be met without delay.

6. An increase in sales without a similar increase in stock means that resource whichwould otherwise be tied up in stock, is available for use elsewhere in the business.

Rate of Collection of Debtors (Debtors Payment Period)Avg. Trade Debtors X 365

Credit Sales

1. The higher the figure, the more it is assumed that money tied up in debts areresources that are yielding no return and also losing value during a period of inflation.2. Therefore the reasons for the change should be carefully investigated, to find outwhethera) There was an increase in the credit period to generate more sales

b) There is slackness in the credit-control department.3. Please note that the sales figure in the P&L is exclusive of VAT but the debtorsfigure is inclusive.

Rate of Payment of Creditors = Avg. Trade Creditors X 365Credit Purchases

1. Measures the average period of time taken by companies to pay their suppliers.2. A change in the rate of payment may well reflect an improvement or decline inliquidity.3. Normally it is expected that rate shouldn't vary very much from year to year.The Cash Operating Cycle:

Stock Turnover of Raw MaterialsAdd: Turnover of Work in ProgressTurnover of Finished GoodsRate of Collection of DebtorsLess: Rate of Payment of Creditors

1. A period of time elapses between the payment for goods or raw materials receivedinto stock and the collection of cash from customers in respect of their sale. The gapis known as the Cash Operating Cycle' and, during this period of time, the goods
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acquired, together with the value added in the case of a manufacturer, must befinanced by the company.2. The shorter the length of time between the initial outlay and the ultimate collectionof cash, the smaller is the value of working capital to be financed.

Fixed Asset Turnover = Sales: 1

Avg. Fixed Assets

1. Measures the degree of fixed asset utilization2. The ratio is likely to reveal excess capacity from time to time during the life of abusiness.3. The excess capacity may be unavoidable for a number of reasons, e.g. acquisitionof new assets4. Similarly, the Total Asset Turnover may indicate the same assumptions; it iscalculated by calculating the figure for Total Assets rather tan the Avg. Fixed Assets.


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Paper 1.1

Chapter 24

Profit Ratios

Gross Profit Margin = Gross Profit X 100Sales

1. Since all costs that are deducted when computing the gross profit are directlyvariable with sales, it is assumed that the gross profit margin should remainunchanged.2. Yet this view is less popular for a manufacturer because the COGS includes fixedcosts such as factory lighting and heating, factory rent and rates, and semi-variablecosts.3. The change may occur due to: Price cuts, cost increases, changes in mix, under- orovervaluation of stocks.

Net Profit Percentage = Net Profit before interest and tax X100Sales

1. It is designed to focus attention on the net profit margin arising from businessoperations.2. Net profit, like gross profit, increases with sales, and this increase occurs as apercentage of sales.

Rate of Return on Gross Assets = Net profit before interest and tax X 100Avg Gross Assets(Total Assets less Current Liabilities)

Or = Total Asset Turnover x Net Profit Percentage

Sales X Profit Before Interest & TaxCapital Employed Sales

1. Also known as the Rate of Capital Employed, Shareholder's Equity, Long-TermCapital Employed.2. It measures the extent at which the management makes the most effective use ofavailable resources3. Since Total Asset Turnover multiplied by the Net Profit Percentage is equivalent tothe Return on Gross Assets, one must note that lower asset util ization must becompensated by the profit margins, or vice versa, to effectively manage the Rate onGross Assets. This is why this ratio is described as the primary accounting ratio.

Therefore, it may be necessary to calculate the asset turnover ratio and the net profitmargin to find out why the ROCE is high or low.4. As such theres a tradeoff between the net profit percentage and the total assetturnover, the reasons being, a high net profit percentage, means a higher price perunit, which may not generate a high number of sales, hence, a lower asset turnover.Rate of Return on Shareholder's Equity = Earning (Pre or Post) X 100

Avg. shareholder's Equity (Share Capit

Acca Notes

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