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ICAP
Financial accounting and reporting I
© Emile Woolf International i The Institute of Chartered Accountants of Pakistan

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© Emile Woolf International ii The Institute of Chartered Accountants of Pakistan

Certificate in Accounting and Finance
C
Contents
Page
Chapter
1 Accounting and Reporting Concepts 1
2 IAS 1: Preparation of Financial Statements 9
3 IAS 7: Statement of cash flows 19
4 Income and expenditure account 65
5 Preparation of accounts from incomplete records 83
6 Introduction to Cost of production 103
7 IAS 16: Property, plant and equipment 137
8 Non-Current Assets: Sundry standards 151
9 IAS 36: Impairment of assets 167
10 IFRS 15: Revenue from contracts with customers 175
11 Interpretation of financial statements 203
Index 225
© Emile Woolf International iii The Institute of Chartered Accountants of Pakistan

© Emile Woolf International iv The Institute of Chartered Accountants of Pakistan

1
CHAPTER
Accounting and reporting concepts
Contents
1 The conceptual framework of IASB
© Emile Woolf International 1 The Institute of Chartered Accountants of Pakistan

1 THE CONCEPTUAL FRAMEWORK OF IASB

Section overview
 Overview of the Conceptual Framework of IASB

 Recognition of elements of the financial statements
 Measurements of elements of financial statements
 Concept of capital and capital maintenance
1.1 Overview of the Conceptual Framework of IASB

A conceptual framework is a system of concepts and principles that underpin the preparation of
financial statements. These concepts and principles should be consistent with one another.
The Conceptual Framework deals with:
 the objective of financial reporting;
 the qualitative characteristics of useful financial information;
 the definition, recognition and measurement of the elements from which financial
statements are constructed; and
 concepts of capital and capital maintenance.
The Conceptual Framework sets out the concepts that underlie the preparation and presentation
of financial statements for external users. Its purpose is:
 to assist the International Accounting Standards Board (IASB) in the development of future
IFRSs and in its review of existing IFRSs;
 to assist the IASB in promoting harmonisation of regulations, accounting standards and
procedures relating to the presentation of financial statements by providing a basis for
reducing the number of alternative accounting treatments permitted by IFRSs;
 to assist national standard-setting bodies in developing national standards;
 to assist preparers of financial statements in applying IFRSs and in dealing with topics that
have yet to form the subject of an IFRS;
 to assist auditors in forming an opinion on whether financial statements comply with
IFRSs;
 to assist users of financial statements in interpreting the information contained in financial
statements prepared in compliance with IFRSs; and
 to provide those who are interested in the work of the IASB with information about its
approach to the formulation of IFRSs.
This Conceptual Framework is not an IFRS and nothing in the Conceptual Framework overrides
any specific IFRS.
On very rare occasions there may be a conflict between the Conceptual Framework and an
IFRS. In those cases, the requirements of the IFRS prevail over those of the Conceptual
Framework.
1.2 Recognition of elements of the financial statements

The IASB Framework states that an element (asset, liability, equity, income or expense) should
be recognised in the statement of financial position or in profit and loss (the statement of profit or
loss) when it:
 meets the definition of an element, and also
 satisfies certain criteria for recognition.

Chapter 1: Accounting and reporting concepts
Items that fail to meet the criteria for recognition should not be included in the financial
statements. However, some if these items may have to be disclosed as additional details in a
note to the financial statements.
The criteria for recognition are as follows:
 It must be probable that the future economic benefit associated with the item will flow
either into or out of the entity.
 The item should have a cost or value that can be measured reliably.
Probability of future economic benefit flowing in or out
The concept of probability relates to the degree of certainty or uncertainty that the future
economic benefit associated with the item will flow into or out of the entity.
The degree of certainty or uncertainty should be assessed on the basis of the evidence available
at the time the financial statements are prepared.
For example, if it is considered fairly certain that a trade receivable will be paid at a future date, it
is appropriate to recognise the receivable as an asset in the statement of financial position.
However, there is probably a reasonable degree of certainty that some trade receivables will
become ‘bad debts’ and the economic benefit will not flow into the entity. It would then be
appropriate to recognise an ‘expense’ for the expected reduction in economic benefits (as an
allowance for irrecoverable debts).
Reliability of measurement
An item should be recognised in the financial statements only if it has a cost or value that can be
measured with reliability.
In many cases, the value of an item has to be estimated because its value is not known with
certainty. Using reasonable estimates is an essential part of preparing financial statements, and
provided that the estimates are reasonable, it is appropriate to recognise items in the financial
statements.
However, if it is not possible to make a reasonable estimate, the item should be excluded from
the statement of financial position and statement of profit or loss and other comprehensive
income.
An item that cannot be estimated with reliability at one point in time might be estimated with
greater certainty at a later time, when it would then be appropriate to include it in the financial
statements.
Recognition of assets, liabilities, income and expenses
Recognition of assets
An asset is recognised in the statement of financial position when there is an increase in future
economic benefits relating to an increase in an asset (or a reduction in a liability) which can be
measured reliably.
An asset should not be recognised when expenses have been incurred but it is unlikely that any
future economic benefits will flow to the entity. Instead, the item should be treated as an
expense, and the cost of the asset should be ‘written off’.
Recognition of liabilities
A liability is recognised when it is probable that an outflow of resources that embody economic
benefits will result from the settlement of a present obligation, and the amount of the obligation
can be measured reliably.
Recognition of income
Income is recognised in the statement of profit when an increase in future economic benefits
arises from an increase in an asset (or a reduction in a liability) and this can be measured
reliably.

Recognition of expenses
Expenses are recognised in the statement of profit or loss when a decrease in future economic
benefits arises from a decrease in an asset or an increase in a liability, which can be measured
reliably.
Note that an expense is recognised at the same time as an increase in a liability (for example,
trade payables) or a reduction in an asset (for example, cash).
Expenses are recognised in the statement of profit or loss by means of a direct association
between items of income and the expenses incurred in creating that income.
 Matching of costs and income involves the simultaneous recognition of revenues and
related expenses.
 When economic benefits arise over several accounting periods, and the association with
income can only be decided in broad terms, expenses should be recognised in profit and
loss (the statement of profit or loss) of each accounting period on the basis of ‘systematic
and rational allocation procedures’. For example, depreciation charges for a non-
current asset are allocated between accounting periods on a systematic and rational basis,
by means of an appropriate depreciation policy and depreciation method.
 When an item of expenditure is not expected to provide any future economic benefits, it
should be recognised immediately as an expense in the statement of profit or loss. When
the future economic benefits associated with an asset are no longer expected to arise, the
value of the asset is written off, and the write-off is treated as an expense.
 An expense may also be recognised when a liability arises without the recognition of any
matching asset. For example, a liability might arise when an entity recognises that it will
have to make a payment to settle a legal dispute. The cost of the future liability is treated
as an expense in the period when the liability is recognised.
1.3 Measurements of elements of financial statements

The Conceptual Framework allows that several measurement bases are used for the elements in
financial statements. These include:
 Historical cost. Assets are measured at the amount of cash paid, or at the fair value of
the consideration given to acquire them. Liabilities are measured at:
 the amount of proceeds received in exchange for the obligation (for example, bank
loan or a bank overdraft), or
 the amount of cash that will be paid to satisfy the liability.
 Current cost or current value is the basis used in current value accounting/current cost
accounting. Assets are measured at the amount that would be paid to purchase the same
or a similar asset currently. Liabilities are measured at the amount that would be required
to settle the obligation currently.
 Realisable value (or settlement value). This method of measurement is relevant when an
entity is not a going concern, and is faced with liquidation (and a forced sale of its assets).
Assets are measured at the amount that could be obtained by selling them. Liabilities are
measured at the amount that would be required to settle them currently.
 Present value. Assets might be measured at the value of the future net cash inflows that
the item is expected to generate, discounted to a present value. Similarly, a liability might
be measured at the discounted present value of the expected cash outflows that will be
made to settle the liability.
Historical cost is the most commonly used measurement basis. However, the other bases of
measurement are often used to modify historical cost. For example, inventories are measured at
the lower of cost and net realisable value. Deferred income is measured at present value. Some
non-current assets may be valued at current value.
The Framework does not favour one measurement base over the others.

Fair value
Fair value is a possible basis for the valuation of assets in the financial statements. Although it is
not described in the IASB Conceptual Framework, many IASs and IFRSs require it to be used
instead of historical cost or as an alternative to historical cost.
Fair value may be used in financial statements in the following circumstances:
 After its initial recognition at acquisition, a non-current asset may be re-valued to its fair
value.
 Inventory is measured in the statement of financial position at the lower of cost or net
realisable value. Net realisable value (NRV) is the selling price of the inventory item in the
ordinary course of business, less the estimated further costs to completion and the
expected selling costs. NRV may or may not be the same as fair value.
 Revenue should be measured in the statement of profit or loss at the fair value of the
consideration received or receivable (IFRS 15).
Fair value is often approximately the same as current value, but sometimes fair value and current
value can be very different.
Problems with the use of fair value
Fair value is easy to understand and less complicated to apply than value to the business/current
value. Arguably, it is also more reliable than value to the business, because market value is more
easily verified than (for example) economic value. However, it has some serious disadvantages:
 There may not be an active market for some kinds of asset. Where there is no active
market, estimates have to be used and these may not be reliable.
 It anticipates sales and profits which may never happen (the entity may have no plans to
sell the asset).
 Market values can move up and down quite rapidly. This may distort trends in the financial
statements and make it difficult for users to assess an entity’s performance over time.
A notable example of this problem occurred during 2007 and 2008 with the collapse of the
market for certain types of asset-backed securities (mortgage-related securities known as
CDOs). Many banks, particularly in the US and Europe, announced huge losses, largely due to
the requirement to write down their investments in these financial instruments to fair value, even
though fair value was difficult to assess.
Despite these problems, it looks increasingly likely that the IASB will require greater use of fair
value in future.
1.4 Concepts of Capital and Capital maintenance

The Conceptual Framework states that there are two concepts of capital:
 A financial concept of capital;
 A physical concept of capital.
Different systems of accounts used different capital maintenance concepts. The choice of capital
maintenance has a profound effect on the measurement of profit.
Consider the basic accounting equation.
Formula: Accounting equation

Assets = Liabilities + Equity Or Assets  Liabilities = Equity
A = L + E A  L = E
Net assets

Like any other equation, changes on one side of the accounting equation are matched by
changes in the other side. Therefore, Profit or loss for a period can be calculated from the
difference between the opening and closing net assets after adjusting for any distributions during
the period.
Formula: Profit
Change in equity = Closing equity  Opening equity
Increase in equity = Profit + capital introduced  distributions
Profit = Increase in equity  capital introduced + distributions
This shows that the value ascribed to opening equity is crucial in the measurement of profit.
Financial capital maintenance
With the financial concept of capital maintenance, a profit is not earned during a period unless
the financial value of equity at the end of the period exceeds the financial value of equity at the
beginning of the period (after adjusting for equity capital raised or distributed).
Historical cost accounting is based on the concept of money financial capital maintenance.
Under this concept, an entity makes a profit when its closing equity exceeds its opening equity
measured as the number of units of currency at the start of the period. Note that this is a
separate issue from asset valuation. Assets could be revalued during the period but this would
have no effect on the opening capital position.
An alternative view of financial capital maintenance is used in constant purchasing power
accounting. This system is based on the concept of real financial capital maintenance. Under
this concept, an entity makes a profit when its closing equity exceeds opening equity remeasured
to maintain its purchasing power.
This requires the opening equity to be uplifted by the general inflation rate. This is achieved by a
simple double entry.
Illustration: Adjustment to maintain opening equity
Debit Credit
Statement of profit or loss X
Inflation reserve X
Physical capital maintenance

A physical concept of capital is that the capital of an entity is represented by its productive
capacity or operating capability. Where a physical concept of capital is used, the main concern of
users of the financial statements is with the maintenance of the operating capability of the entity.
With a physical concept of capital maintenance, a profit is not earned during a period unless
(excluding new equity capital raised during the period and adding back any distribution of
dividends to shareholders) the operating capability of the business is greater at the end of the
period than at the beginning of the period.
This requires the opening equity to be uplifted by the specific rates of inflation that apply to the
individual components of the net assets of the company. Again, this is achieved by the same
simple double entry.

The following example should help you to understand this.
Example: Capital maintenance concepts

X Limited commenced business on 1 January with a single item of inventory which
costRs.10,000.
During the year it sold the item for Rs.14,000 (cash).
During the year general inflation was 5% but the inflation specific to the item was 10%.
Profit is calculated under each concept in the following ways.
Capital maintenance concept
Financial Financial (real
(money terms) terms) Physical
Statement of profit or loss Rs. Rs. Rs.
Revenue 14,000 14,000 14,000
Cost of sale (10,000) (10,000) (10,000)
Inflation adjustment (inflation rate applied to opening equity):
5% Rs.10,000 (500)
10% Rs.10,000 (1,000)
4,000 3,500 3,000
Statement of financial position Rs. Rs. Rs.

Net assets 14,000 14,000 14,000
Equity:
Opening equity
Before adjustment 10,000 10,000 10,000
Inflation reserve (see above) 500 1,000
After adjustment 10,000 10,500 11,000
Retained profit (profit for the year) 4,000 3,500 3,000
14,000 14,000 14,000
Commentary on the example

Under historical cost accounting, the profit is Rs.4,000. If the business paid this out as a dividend
it would have Rs.10,000 left.
Rs.10,000 is the opening equity expressed as a number of units of currency. This means that the
company would have maintained its equity expressed as a number of units of currency. However,
inflation in the period has caused the purchasing power of the currency to decline. This means
that Rs.10,000 no longer has the same purchasing power that it had a year ago. The company
has not maintained its capital in real terms.
To maintain its opening equity in real terms the company would have to ensure that it had the
same purchasing power at the year-end as it had at the start. Inflation was 5% so the company
would need Rs.10,500 at the year-end in order to have the same purchasing power as it had at
the start of the year. The company can achieve this by transferring Rs.500 from profit and loss
into an inflation reserve. Profit would then be reported as Rs.3,500.

If the business paid out Rs.3,500 as a dividend it would have Rs.10,500 left. This is not enough
to buy the same asset that it had at the start of the year. The asset has been subject to specific
inflation of 10% therefore the company would need Rs.11,000 at the year-end in order to buy the
same asset.
This means that the company would not hasve the same capacity to operate as it had a year
ago.
To maintain its opening equity in physical terms the company would have to ensure that it had
the same ability to operate at the year-end as it had at the start. In other words it would need to
have Rs.11,000. The company can achieve this by transferring Rs.1,000 from profit and loss into
an inflation reserve. Profit would then be reported as Rs.3,000.
Comparing the two concepts
Neither the IASB Conceptual Framework nor accounting standards require the use of a specific
capital maintenance concept. In practice, almost all entities use money financial capital
maintenance, but both concepts can provide useful information.
Financial capital maintenance is likely to be the most relevant to investors as they are interested
in maximising the return on their investment and therefore its purchasing power.
Physical capital maintenance is likely to be most relevant to management and employees as they
are interested in assessing an entity’s ability to maintain its operating capacity. This is particularly
true for manufacturing businesses, where management may need information about the ability of
the business to continue to produce the same or a greater volume of goods.

CHAPTER
IAS 1: Preparation of financial

statements
Contents
1 Statement of changes in Equity

1 STATEMENT OF CHANGES IN EQUITY (SOCIE)

Section overview
 Overview
 IAS 1 Preparation of Financial Statements
 Purpose and Importance
 The contents of a statement of changes in equity
1.1 Overview
A change in equity is simply the increase or decrease in the net assets of the equity.
The statement of changes in equity separates owner and non-owner changes in equity in the
following manner:
 transactions with owners; and
 non-owner changes in equity, referred to as total comprehensive income.
1.2 IAS 1 Preparation of Financial Statements

IAS 1 prescribes the basis for presentation of financial statements for the comparability of
company’s financial position to last year’s performance or with other entities. It sets the
requirement, guidelines for structure and presentation for the preparation of following statements
A complete set of financial statements consists of:
 a statement of financial position (balance sheet) as at the end of the period;
 a statement of comprehensive income for the period;
 a statement of changes in equity for the period;
 a statement of cash flows for the period
Additionally notes to these statements, consisting of a summary of significant accounting policies
used by the entity and other explanatory information; and comparative information also form part
of the financial statements.
IAS 1 Presentation of Financial Statements specifies what published ‘general-purpose’
financial statements should include, and provides a format for a statement of financial position,
statement of comprehensive income, and statement of changes in equity.
In your earlier studies you have studied about statement of financial position and statement of
comprehensive income. This chapter focus on the preparation of a statement of changes in
equity.
1.3 Purpose and Importance

Statement of changes in equity helps users of financial statement to identify the factors that
cause a change in the owners' equity over the accounting periods.
It is important to note that the Statement of financial position provides information about the
financial position of the business by presenting total assets, liabilities and equity. Income
statement on the other hand provides information about how business has performed during the
year and how much income has been generated against the expenses and liabilities incurred.
But shareholders are interested in knowing how the business’ financial position and financial
performance has impacted their interest in the business. And this is not particularly addressed by
Statement of Financial Position or Income Statement.
Thus statement of changes in equity actually tells the users about the status of owner’s equity at
the beginning of the financial period, how it has changed during the year and the status of equity
at the end of the period.

Chapter 2: IAS 1: Preparation of financial statements
Therefore, through Statement of Changes in Equity users, especially shareholders can get great
insights about the effects of business operations and related factors on the wealth of the owners
invested in the business.
Examples of the information provided in the statement of changes in equity include share capital
issue and redemption during the period, the effects of changes in accounting policies and
correction of prior period errors, gains and losses recognised outside profit or loss, dividends and
bonus shares issued during the period.
1.4 The contents of a statement of changes in equity

A statement of changes in equity shows for each component of equity the amount at the
beginning of the period, changes during the period, and its amount at the end of the period.
Transactions with owners

It includes:
 Share capital
 Share premium
 Redemption
 Dividend
 Bonus shares
 Right issue
Total comprehensive income

It includes:
 Profit for the year
 revaluation surplus
 gains and losses on available for sale financial assets
 actuarial gains and losses on defined benefit plans It is not
examinable at
 gains and losses on effective cash flow hedge
this stage.
 gains and losses on translation of foreign operations
Share capital
Share capital is the sum of all funds raised by the company in the form of ordinary shares and
preference shares. Preference shares confer preferential rights for their holders such entitlement
to a dividend out of profits before ordinary shareholders. Once the preference dividend has been
paid, the remaining profit 'belongs' to the ordinary shareholders at the discretion of the board of
directors of the company. The directors may decide to retain some profits (retained earnings)
within the company or declare the dividend.
Preference Shares
Preference shares are of two types: redeemable and irredeemable. Only irredeemable
preference shares are treated as share capital.
Redeemable Preference shares which the company is entitled to redeem in future are treated as
non-current liabilities
Types of Share Capital
Following are the different types of share capital:
 Authorised share capital
 Issued share capital
 Subscribed share capital
 Paid up share capital

Authorized Share Capital

It is the maximum amount of share capital that a company is authorized to raise. A company
does not usually issue the full amount of its authorized share capital. Instead, some of it is held in
reserve by the company for possible future use.
Issued Share Capital
A company may elect to only issue a portion of the total share capital with the plan of issuing
more shares at a later date. Issued share capital is the total value of the shares a company
sells. The issued share capital of a company is the par value of the shares that have actually
been issued to shareholders.
Subscribed Share Capital
When a company issues its authorised share capital, some part of it may not be subscribed by
the investors. Subscribed share capital is the monetary value of all the shares that the investors
have committed to buy.
Paid up Share Capital
Paid-up share capital is the amount of money a company has received from shareholders in
exchange for its shares.
Share premium
The difference between the par value of a company’s shares and the total amount a company
received for shares is called Share premium.
Example: if a Rs. 10 share is sold for Rs, 12 then Rs. 2 is the share premium.
Redemption
It is the reacquisitions of the entity’s own equity instruments. A company may redeem its shares
for a number of reasons such as to buy out certain shareholders or to provide an exit strategy to
a third party investor.
Dividend
It is the distribution of profits to shareholders.
Many companies pay dividends in two stages during the course of their accounting year.
(a) In mid-year, after the half-year financial results are published, the company might pay an
interim dividend.
(b) At the end of the year, the company might propose a further final dividend.
The proposed dividend is not accounted for, instead it is disclosed in the notes to the accounts.
Bonus shares
These shares are distributed by a company to its current shareholders free of charge. A bonus
issue does not involve any cash inflow. The company converts some of its reserves (share
premium or retained earnings or both) into new fully-paid share capital issued at its par value.
Right issue
It is an invitation to existing shareholders to purchase additional new shares in proportion to their
shareholding in the company at a discount to the market price on a stated future date.
Say a company with a paid up capital of 10 million shares raises funds by issuing 2 million new
shares. It can offer the new shares to existing shareholder in a '1 for 5' rights issue: each existing
shareholder is offered one new share for every five shares currently held (10 million/2 million =
5).

Retained Earnings
Retained earnings comprise the income (profits and gains less losses) that the company retains
within the business, ie, income that has not been paid out as dividends or transferred to any
other reserve. A company might hold retained earnings that it has no intention of distributing to
owners as a dividend at any time in the future in a general reserve rather than in retained
earnings.
A debit balance on the retained earnings account indicates that the company has accumulated
losses.
Revaluation surplus
The result of an upward revaluation of a non-current asset is a 'revaluation surplus'. The amount
accumulated in revaluation surplus is non-distributable, as it represents un-realised profits on the
revalued assets. It is another capital reserve. The revaluation surplus can only become realised if
the asset is sold. The revaluation surplus may diminish if an asset which had previously been
revalued upwards is devalued later.
Reserves
Most of the companies present items on the Statement of changes in equity in the following three
broad classification:
 Share Capital
 Capital reserves
 Revenue reserves
Capital reserves are statutory reserves which a company is required to set up by law, and which
are not available for the distribution of dividends. Examples include: share premium, revaluation,
contingencies.
Revenue reserves are non-statutory reserves consisting of profits which are distributable as
dividends at the discretion of the company. These are also called general reserves.
Profits are transferred to these reserves by making an appropriation out of profits, usually profits
for the year. This is further explained below:
Profit after taxation 300,000
Appropriations of profit:
Dividend (100,000)
Transfer to general reserve (50,000)
(150,000)
Retained earnings for the year 150,000
Retained earnings b/f 500,000
Retained earnings c/f 650,000
Requirements of IAS 1, Presentation of Financial Statements

In accordance with the requirements of IAS 1, an entity is required to present a statement of
changes in equity which includes the following information:
(a) total comprehensive income for the period, showing separately the total amounts
attributable to owners of the parent and to non-controlling interests;

(b) for each component of equity, the effects of retrospective application or retrospective
restatement recognised in accordance with IAS 8
(c) for each component of equity a reconciliation between the carrying amount at the
beginning and the end of period separately disclosing changes resulting from:
 profit or loss;
 other comprehensive income; and
 transactions with owners in their capacity as owners showing separately
contributions by and distributions to owners and changes in ownership interests in
subsidiaries that do not result in a loss of control
Effect of Changes in Accounting Policies

Since changes in accounting policies are applied retrospectively, an adjustment is required in
stockholders' reserves at the start of the comparative reporting period to restate the opening
equity to the amount that would be arrived if the new accounting policy had always been applied.
Say a company decided to change its inventory costing system from last-in-first-out (LIFO) to
first-in-first-out (FIFO). Since the change affects past income, the company must address the
change retrospectively and disclose its impact on the statement of changes in equity).
Please note that IAS 8 which deals with accounting policies, changes in accounting estimates
and errors is not examinable at this stage.
Effect of Correction of Prior Period Error

The effect of correction of prior period errors must be presented separately in the statement of
changes in equity as an adjustment to opening reserves. The effect of the corrections may not be
netted off against the opening balance of the equity reserves so that the amounts presented in
current period statement might be easily reconciled and traced from prior period financial
statements.
An example could be where depreciation of an assembly plant is charged from the date of
production, instead of from the date the plant is ready to be used.
Please note that IAS 8 which deals with accounting policies, changes in accounting estimates
and errors is not examinable at this stage.
The following illustrations briefly show usual items presented in the of statement of changes in
equity in accordance with the IFRS.
Illustration 1:
Statement of changes in equity for the year ended 31 December 2019
Share Share Retained Revaluation Total

Capital Premium earnings Surplus
------------------------- Rs. in million ------------------------
Balance as at 1 January 2019 100 10 60 5 175
Profit after tax for the year - - 20 - 20
Revaluation loss - - - (3) (3)
Balance as at 31 December 2019 100 10 80 2 192

Illustration 2:
Statement of changes in equity for the year ended 31 December 2019 considering there is
redemption, bonus and right issues along with dividends paid during the year
Share Share Retained

Total
Capital Premium earnings
---------- Rs. in million -------
Balance as at 1 January 2019 100 10 60 170
Profit after tax for the year - - 20 20
Bonus issue 10 - (10) -
Right issue 5 - - 5
Redemption (10) - 10 -
Dividends paid during the year - - (20) (20)
Balance as at 31 December 2019 105 10 60 175
Practice Question 1
The equity of SMS Ltd as on December 31, 2018 is as follows:
Rs. in million
Total equity at the beginning of the year:
- Share Capital (@ Rs. 10 fully paid ordinary shares) 3,000
- Share premium 1,900
- Retained earnings 4,500
Profit for the year 400
Dividends declared and paid (300)
Total equity at the end of the year 9,500
The company made a bonus issue of 2 to 1.
Required:
Make the statement of changes in equity using the above figures.

Practice Question 2
The following information pertains to draft financial statements of Pak Ocean Limited (POL) for
the year ended 31 December 2018.
(i) 2018
___Rs in million----
(ii) Shareholders' equity as at 1 January 2018 was as follows:
Share capital (Rs. 100 each) 200
Retained earnings 45
Profit after tax 78
Other comprehensive income 12
Incremental depreciation on revaluation of property, plant and 1.5

equipment
On 30 November 2018, POL issued 25% right shares to its ordinary

shareholders at Rs. 120 per share.
Cash dividend @ 18% was declared on December 21, 2017
(iv) Bonus issue declared during the year ended 31 December 2018:
Interim(declared with half yearly accounts) 10%
Final 25%
Required:
Make the statement of changes in equity using the above figures.

SOLUTIONS TO PRACTICE QUESTIONS

Solution 1
SMS Ltd
Statement of Changes in equity as on December 31, 2019
Total
Capital Premium earnings
------------------------- Rs. in million ------------------------
Balance as at 1 January 2019 3,000 1,900 4,500 9,400
Profit after tax for the year - - 400 400
Bonus shares 6,000 (1,900) (4,100) -
Dividends - - (300) (300)
Balance as at 31 December 2019 9,000 - 500 9,500
Solution 2
Pak Ocean Limited
Statement of Changes in Equity for the year ended 31 December 2018
Total
capital premium earnings
------------- Rupees in million -------------
Balance as at 1 January 2018 200 - 45 245
Total comprehensive income for the year: -
Profit for the year: 78 78
Other comprehensive income 12 12
Transfer from surplus on revaluation of
incremental deprecation for the period 1.5 1.50
Final cash dividend at 18% for the year ended 31
December 2017 (200 × 18%) (36) (36)
Interim bonus issue at 10% for the year ended
31 December 2018 (200 × 10%) 20 - (20) -
25% Right issue at a premium of Rs. 20 per share
(200 + 20) × 25% 55 11 - 66
275 11 80.5 366.5


CHAPTER
IAS 7: Statement of cash flows
Contents
1 Introduction
2 Format
3 Cash flows from operating activities: The indirect method
4 Indirect method: Adjustments for working capital
5 Cash flows from operating activities: The direct method
6 Cash flows from investing activities
7 Cash flows from financing activities

1 INTRODUCTION
Section overview
 Introduction
 What are cash flows?
 What cash flow does not indicate
 Importance of cash flow for business
 Purpose of statements of cash flows
 Profit and cash flow
 Statement of cash flows
 The sections of a statement of cash flows
 Cash flows from operating activities
 Cash flows from investing activities
 Cash flow from financing activities
 Gross or net
 Non-cash transactions
1.1 Introduction
Generating positive, sustainable cash flow is critical for an organisation's long-term success.
Keeping track of cash flows is particularly important for management to project the financial
health of their organisation to potential investors. Analysing the cash flow statement is extremely
valuable because it provides a reconciliation of the beginning and ending cash on the balance
sheet.
1.2 What are cash flows?

Cash flows are inflows and outflows of 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 an insignificant risk of changes in
value.
1.3 What Cash Flow does not indicate?

Cash is one of the major lubricants of business activity, but there are certain things that are not
reflected in cash flows. For example, profit earned after tax during a period because profitability
is composed also of things that are not cash based. Therefore the overall financial well-being of
the company is not indicated in cash flows. Furthermore accounts receivable and accounts
payable are also not reflected in the cash flow statement.
1.4 Importance of cash flow for business

Monitoring the cash flows is one of the most pressing management tasks for any business. The
most common outflow of cash includes payments of salaries and to suppliers. The inflow includes
the receipt from customers and investors.
Businesses must have sufficient cash; otherwise they cannot survive.
 A business can make a loss but still survive if it has sufficient cash or access to liquidity
(cash, assets that can be quickly turned into cash and new sources of borrowing).
 On the other hand, a business that is profitable cannot survive if it cannot pay its
obligations when they fall due, because it does not have enough cash or access to other
sources of liquidity.
Cash flow is therefore extremely important, and it is appropriate that entities should present a
statement of cash flows as a financial statement.

Chapter 3: IAS 7: Statement of cash flows
The purpose of a statement of cash flows is to show what the cash flows of the entity have been.
It can also be used to make assessments of what the cash flows of the entity might be in the
future. In other words, the cash flow statement is a compressed version of the company's check
book that includes a few other items that affect cash, like the financing section, which shows how
much the company spent or collected from the repurchase or sale of shares, the amount of
issuance or retirement of debt and the amount the company paid out in dividends.
1.5 Purpose of statements of cash flows

IAS 1 states that a statement of cash flows is a part of a complete set of the financial statements
of an entity. It provides information about:
 the cash flows of the entity during the reporting period, and
 the changes in cash and cash equivalents during the period.
IAS 7: Statements of cash flows sets out the benefits of cash flow information to users of financial
statements.
 A statement of cash flows provides information that helps users to evaluate changes in the
net assets of an entity and in its financial structure (including its liquidity and solvency).
 It provides information that helps users to assess the ability of the entity to affect the
amount and timing of its cash flows in order to adapt to changing circumstances and
unexpected opportunities.
 It is useful in assessing the ability of the entity to generate cash and cash equivalents.
 It helps users of accounts to compare the performance of different entities because unlike
profits, comparisons of cash flows are not affected by the different accounting policies
used by different entities.
 Historical cash flows are often a fairly reliable indicator of the amount, timing and certainty
of future cash flows.
1.6 Profit and cash flow

When a business makes a profit of Rs. 1,000, this does not mean that it receives Rs. 1,000 more
in cash than it has spent. Profit and cash flow are different, for several reasons:
There are items of cost in the statement of comprehensive income that do not represent a cash
flow. Examples are:
 depreciation and amortisation charges; and
 the gain or loss on the disposal of non-current assets.
There are items of cash flow that do not appear in the statement of comprehensive income.
Examples are:
 Cash flows relating to the acquisition or disposal of investments, such as the purchase of
new non-current assets, and cash from the sale of non-current assets. (The statement of
comprehensive income includes gains or losses on the disposal of non-current assets, but
this is not the same as the cash proceeds from the sale.)
 Cash flows relating to financial transactions, such as obtaining cash by issuing shares or
obtaining loans, the repayment of loans and the payment of dividends to ordinary
shareholders.
1.7 Statement of cash flows

A statement of cash flows provides information about where a business obtained its cash during
the financial period, and how it made use of its cash.
A statement of cash flows groups inflows and outflows of cash under three broad headings:
 cash generated from or (used in) operating activities
 cash obtained from or (used in) investing activities

 cash received from or paid in financing activities.

It also shows whether there was an increase or a decrease in the amount of cash held by the
entity between the beginning and the end of the period.
Illustration:
Cash generated from or (used in) operating activities X/(X)

Cash obtained from or (used in) investing activities X/(X)
Cash received from or (paid in) financing activities. X/(X)
Net cash inflow (or outflow) during the period X/(X)
Cash and cash equivalents at the beginning of the period X/(X)
Cash and cash equivalents at the end of the period X/(X)
A statement of cash flows reports the change in the amount of cash and cash equivalents held by
the entity during the financial period.
Definition: Cash, cash equivalents and cash flows

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 an insignificant risk of changes in value.
Cash flows are inflows and outflows of cash and cash equivalents.
For the purpose of a statement of cash flows, cash and cash equivalents are treated as being the
same thing. This means that cash flows between cash and cash equivalent balances are not
shown in the statement of cash flows. These components are part of the cash management of an
entity rather than part of its operating, investing and financing activities.
Cash and cash equivalents are held in order to meet short-term cash commitments, rather than
for investment purposes or other purposes.
Examples of cash equivalents are:
 a bank deposit where some notice of withdrawal is required
 short-term investments with a maturity of three months or less from the date of acquisition
(e.g. government bills).
Bank borrowings are generally considered to be financing activities. In that case they would be
held outside cash and cash equivalents and movements on the bank borrowings would be shown
under financing activities as a cash inflow if borrowing increase or as a cash outflow if borrowings
fell.
Sometimes, bank overdrafts which are repayable on demand form an integral part of an entity's
cash management. In these circumstances, bank overdrafts are included as a component of
cash and cash equivalents.
Sundry disclosures
An entity must disclose the components of cash and cash equivalents and present a
reconciliation of the amounts in its statement of cash flows with the equivalent items reported in
the statement of financial position.
Any significant cash and cash equivalent balances held by the entity that are not available for use
by the group must be disclosed together with a commentary by management. This might be the
case when a group of companies has a subsidiary whose dividend payments are subject to a
debt covenant or exchange control regulations which would prevent payment of a dividend to the
parent company.

Comment on technique
Theoretically this could be done by analysing every entry in and out of the cash account(s) over
the course of a period. However, the cash account is often the busiest account in the general
ledger with potentially many thousands of entries. Documents that summarise the transactions
are needed.
These documents already exist. They are the other financial statements (statement of financial
position and statement of profit or loss and other comprehensive income).
Illustration:
A business might buy 100 new non-current assets over the year. There would be 100 different
entries for these in the cash account.
However, it should be easy to estimate the additions figure from comparing the opening and closing
balances for non-current assets and isolating any other causes of movement.
For example if we know that property plant and equipment has increased by Rs. 100,000 and that
the only other cause of movement was depreciation of Rs. 15,000 then additions must have been
Rs.115,000.
A lot of the numbers in cash flow statements are derived from comparing opening and closing
positions of line items in the statement of financial position. Other causes of movement can then
be identified leaving the cash double entry as a balancing figure.
1.8 The sections of a statement of cash flows

The content and format of statements of cash flows are specified by IAS 7 Statements of cash
flows. IAS 7 does not specify what the exact format of a statement of cash flows should be, but
it provides suggested layouts in an appendix.
Entities are required by IAS 7 to report cash flows for the period under three headings:
 cash flows from operating activities
 cash flows from investing activities
 cash flows from financing activities.
All cash flows (except for changes from cash to cash equivalents or from cash equivalents to
cash) can be included in one of these three categories.
Together, the cash flows arising from these three categories of activity explain the increase or
decrease in cash and cash equivalents during the financial period.
The cash flows for each category might be positive or negative. The total of the cash flows for all
three categories together explains the overall increase or decrease in cash and cash equivalents
during the period.
A single transaction might include more than one type of cash flow. For example a cash
repayment of a loan might include both interest and capital. In this case the interest element
might be classified as an operating activity and the capital element as a financing activity.
1.9 Cash flows from operating activities

Operating activities are the normal trading activities of the entity. Cash flows from operating
activities are the cash inflows or cash outflows arising in normal trading activities.
Operating activities normally provide an operating profit before tax. However, profit is not the
same as cash flow, and the cash flows from operating activities are different from profit.
A statement of cash flows normally makes a distinction between:
 cash generated from operations, which is the cash from sales less the cash payments
for operating costs, and
 net cash from operating activities, which is the cash generated from operations, less
interest payments and tax paid on profits.

Cash flows from operating activities are primarily derived from the principal revenue-producing
activities of the entity. Therefore, they generally result from the transactions and other events that
enter into the determination of profit or loss.
Examples of cash flows from operating activities are:
 cash receipts from the sale of goods and the rendering of services;
 cash receipts from royalties, fees, commissions and other revenue;
 cash payments to suppliers for goods and services;
 cash payments to and on behalf of employees;
 cash receipts and cash payments of an insurance entity for premiums and claims,
annuities and other policy benefits;
 cash payments or refunds of income taxes unless they can be specifically identified with
financing and investing activities; and
 cash receipts and payments from contracts held for dealing or trading purposes.
Some transactions result in the recognition of a gain or loss in profit or loss (e.g. sale of an item
of plant). However, the cash flows relating to such transactions are cash flows from investing
activities.
Cash payments to manufacture or acquire assets held for rental to others and subsequently held
for sale are cash flows from operating activities. The cash receipts from rents and subsequent
sales of such assets are also cash flows from operating activities.
The amount of cash flows arising from operating activities is a key indicator of the extent to which
the operations of the entity have generated sufficient cash flows to function without recourse to
external sources of financing. In addition, it forms a basis for forecasting future operating cash
flows.
1.10 Cash flows from investing activities

The second section of a statement of cash flows shows cash flows from investing activities.
Investing activities are defined by IAS 7 as ‘the acquisition and disposal of long-term assets and
other investments not included in cash equivalents’. It generally refers to money made or spent
on long-term assets the company has purchased or sold. Investing transactions generate cash
outflows, such as capital expenditures for plant, property and equipment, business acquisitions
and the purchase of investment securities. Inflows come from the sale of assets, businesses and
investment securities. For investors, the most important item in this category is capital
expenditures, made to ensure the proper maintenance of, and additions to, a company's physical
assets to support its efficient operation and competitiveness.
Cash flows from investing activities might also include cash received from investments, such as
interest or dividends received.
The separate disclosure of cash flows arising from investing activities is important because the
cash flows represent the extent to which expenditures have been made for resources intended to
generate future income and cash flows.
Examples of cash flows arising from investing activities are:
 cash payments to acquire property, plant and equipment, intangibles and other long-term
assets (including those relating to capitalised development costs and self-constructed
tangible assets);
 cash receipts from sales of property, plant and equipment, intangibles and other long-term
assets;
 cash payments to acquire equity or debt instruments;
 cash receipts from sales of equity or debt instruments of other entities;
 cash advances and loans made to other parties (other than advances and loans made by
a financial institution which would be an operating activity);

 cash receipts from the repayment of advances and loans made to other parties (other than
advances and loans of a financial institution);
1.11 Cash flow from financing activities

The third section of the statement of cash flows shows the cash flows from financing activities.
These activities are defined by IAS 7 as ‘activities that result in changes in the size and
composition of the contributed equity and borrowings of the entity.’ It measures the flow of cash
between a firm and its owners and creditors. Companies often borrow money to fund their
operations, acquire another company or make other major purchases. Here again for investors,
the most important item is cash dividends paid.
Examples of cash flows arising from financing activities are:
 cash proceeds from issuing shares or other equity instruments;
 cash payments to owners to acquire or redeem the entity's shares;
 cash proceeds from issuing debentures, loans, notes, bonds, mortgages and other short-
term or long-term borrowings;
 cash repayments of amounts borrowed; and
 cash payments by a lessee for the reduction of the outstanding liability relating to a finance
lease.
The separate disclosure of cash flows arising from financing activities is important because it is
useful in predicting claims on future cash flows by providers of capital to the entity.
1.12 Gross or net

Generally, major classes of cash flows arising from investing and financing activities are reported
gross. That is to say that cash receipts and cash payments are shown separately even if from
and to the same party.
However, cash flows arising from the following activities may be reported on a net basis:
 cash receipts and payments on behalf of customers when the cash flows reflect the
activities of the customer rather than those of the entity (for example if rent is collected on
behalf of and paid on to owners of properties); and
 cash receipts and payments for items in which the turnover is quick, the amounts are
large, and the maturities are short (e.g. payments made by credit card companies on
behalf of their customers and receipts from those customers.
It is unlikely that you will see this in a question.
1.13 Non-cash transactions

Investing and financing transactions that do not require the use of cash or cash equivalents shall
be excluded from a statement of cash flows. Such transactions shall be disclosed elsewhere in
the financial statements in a way that provides all the relevant information about these investing
and financing activities.
Illustration:
A business might buy 100 new non-current assets over the year. There would be 100 different
entries for these in the cash account.
However, it should be easy to estimate the additions figure from comparing the opening and closing
balances for non-current assets and isolating any other causes of movement.
For example if we know that property plant and equipment has increased by Rs. 100,000 and that
the only other cause of movement was depreciation of Rs. 15,000 then additions must have been
Rs. 115,000.

2 FORMAT
Section overview
 Format
 The indirect method
 The direct method
2.1 Format
IAS 7 does not include a format that must be followed. However it gives illustrative examples of
formats that meet the requirements in the standard.
Illustration: Statement of cash flows

Rs. Rs.
Net cash flow from operating activities 75,300
Cash flows from investing activities:

Acquisition of shares (debentures, etc.) (5,000)
Purchase of property, plant and machinery (35,000)
Proceeds from sale of non-current assets 6,000
Interest received/dividends received 1,500
Net cash used in investing activities (32,500)
Cash flows from financing activities:

Proceeds from issue of shares 30,000
Proceeds from new loan 10,000
Repayment of loan (17,000)
Dividends paid to shareholders (25,000)
Net cash used in financing activities (2,000)
Net increase/decrease in cash/cash equivalents 40,800
Cash/cash equivalents at the beginning of the year 5,000
Cash/cash equivalents at the end of the year 45,800
Operating cash flows

The operations of the business are probably the most significant source of cash.
IAS 7 allows two approaches to identifying the cash flows from operating activities:
 Direct method; and
 Indirect method
For clarity, what this means is that there are two approaches to arriving at the figure of Rs.
75,300 in the above example.

2.2 The indirect method

The indirect method identifies the cash flows from operating activities by adjusting the profit
before tax figure. It arrives at the cash from operating activities figure indirectly by reconciling a
profit figure to a cash figure. The adjustments remove the impact of accruals and non-cash items
and also relocate some figures to other positions in the statement of cash flows.
The following illustration shows how the net cash flow from operating activities figure seen in the
previous example was arrived at using the indirect method.
Illustration:
Statement of cash flows: indirect method Rs. Rs.
Cash flows from operating activities
Profit before taxation 80,000
Adjustments for:
Depreciation and amortisation charges 20,000
Interest charges in the statement of comprehensive 2,300
income
Gains on disposal of non-current assets (6,000)
Losses on disposal of non-current assets 4,500
100,800
Increase/decrease in:
Increase in trade and other receivables (7,000)
Decrease in inventories 2,000
Increase in trade payables 3,000
Cash generated from operations 98,800
Taxation paid (tax on profits) (21,000)
Interest charges paid (2,500)
2.3 The direct method

The direct method calculates the cash flow from operating activities by calculating cash received
from customers, cash paid to suppliers and so on. The following illustration shows how the net
cash flow from operating activities figure seen in the previous example was arrived at using the
direct method.
Illustration:
Statement of cash flows: direct method Rs.
Cash receipts from customers 348,800
Cash payments to suppliers (70,000)
Cash payments to employees (150,000)
Cash paid for other operating expenses (30,000)
The figures in the two statements are identical from ‘Cash generated from operations’ down to
the end. The only differences are in the presentation of the cash flows that produced the ‘Cash
generated from operations’.

3 CASH FLOWS FROM OPERATING ACTIVITIES: THE INDIRECT METHOD

Section overview
 Profit before taxation

 Non-cash items
 Accruals based figures
 Presentation of interest, taxation and dividends cash flows
3.1 Profit before taxation

The starting point for the statement of cash flows for a company is the operating profit after
deducting interest but before taxation.
This profit figure is adjusted to calculate the amount of cash received by the business or the
amount of cash paid out as a consequence of its trading operations.
The adjustments are to remove the effect of:
 Non-cash items, for example:
 Depreciation and amortisation;
 Gain or loss on disposal of non-current assets;
 Doubtful debts;
 Provision for obsolete inventory; and
 Accruals based figures, for example:
 Interest expense or income;
 Movement on working capital items (receivables, payables and inventory).
3.2 Non-cash items

Depreciation and amortisation
Depreciation and amortisation charges are not cash flows. They are expenses in the statement of
comprehensive income, but do not represent payments of cash.
In order to obtain a figure for cash flow from the figure for profit, charges for depreciation and
amortisation must therefore be added back to the profit figure.
Gains or losses on disposal of non-current assets
Gains or losses on the disposal of non-current assets are not cash flows. The gain or loss is
calculated as the difference between:
 the net cash received from the disposal; and
 the carrying amount (net book value) of the asset at the date of disposal.
The effect of the gain or loss on disposal (a non-cash item) from the operating profit is removed
by:
 deducting gain on disposal; and
 adding back losses on disposal.
The relevant cash flow is the net cash received from the sale. This is included in cash flows from
investing activities as the net cash flows received from the disposal of non-current assets.

Example:
A company disposed of an item of equipment for Rs. 40,000. The equipment had originally cost
Rs. 60,000 and the accumulated depreciation charged up to the date of disposal was Rs. 32,000.
Rs.
Cost 60,000
Accumulated depreciation (32,000)
Carrying value at date of disposal 28,000
Cash proceeds from sale (40,000)
Gain on disposal 12,000
In the statement of cash flows, the gain on disposal of Rs. 12,000 is deducted as an adjustment to
the operating profit.
The cash proceeds of Rs. 40,000 is included as a cash inflow under the heading: ‘Cash flows from
investing activities’.
Practice question 1
A company made a loss on the disposal of a company motor vehicle of Rs. 8,000.
The vehicle originally cost Rs. 50,000 and at the date of disposal, accumulated depreciation
on the vehicle was Rs. 20,000.
What are the items that should be included for the disposal of the vehicle in the statement
of cash flows for the year:
a) in the adjustments to get from operating profit to cash flow from operations?
b) under the heading: ‘Cash flows from investing activities’?
3.3 Accruals based figures

3.3.1 Accruals based figures - Interest
The accruals concept is applied in accounting.
Interest charge in the income statement is an accrual based figure. It is added back to profit and
the actual cash interest paid is deducted further down the cash flow statements.
The final items in the operating cash flows part of a statement of cash flows are the amount of
interest paid and the amount of tax paid (see later).
This figure must be calculated as follows:
Illustration:
Rs.
Interest liability at the beginning of the year X
Interest charge for the year (income statement figure) X
Total amount of interest payable in the year X
Interest liability at the end of the year (X)
Interest paid in the year (cash) X
The same approach is used to calculate other figures.

The interest liability at the start of the year and the interest charge during the year is the most the
business would pay. If the business had paid nothing it would owe this figure. The difference
between this amount and the liability at the end of the year must be the amount that the business
has paid.

Example: Interest paid

A company had liabilities in its statement of financial position at the beginning and at the end of
2017, as follows:
Interest (Rs.)
Beginning of 2017 4,000
End of 2017 22,000
During the year, interest charges in the income statement were Rs.22,000.
The interest payment for inclusion in the statement of cash flows can be
calculated as follows:
Rs.
Liability at the start of the year 4,000
Charge for the year 22,000
Total amount payable in the year 26,000
Liability at the end of the year (22,000)
Cash paid 4,000
Note that this approach would work to find the cash paid in respect of any liability for which
expense was recognised in the statement of profit or loss.
It would not matter if you did not know anything about the type of liability as long as you are told
that there is a movement and you are given the amount recognised in the statement of profit or
loss. For example, instead of the above example being about interest it could be about warranty
provision, gratuity, retirement benefit, health insurance, bonus, and so on.
3.3.2 Accruals based figures - Taxation
The tax paid is the last figure in the operating cash flow calculation.
There is no adjustment to profit in respect of tax. This is because the profit figure that we start
with is profit before tax; therefore tax is not included in it to be adjusted!
However, there is a tax payment and this must be recognised as a cash flow. It is calculated in
the same way as shown above.
Example: Taxation paid

2017, as follows:
Taxation (Rs.)
End of 2017 61,000
During the year, taxation on profits was Rs.77,000.
The tax payment (cash flows) for inclusion in the statement of cash flows can be
Rs.
Taxation liability at the start of the year 53,000
Charge for the year 77,000
Total amount payable 130,000
Taxation liability at the end of the year (61,000)
Cash paid 69,000

Deferred taxation
A question might include deferred taxation. You have not covered this yet but it can still be dealt
with here as its impact on a statement of cash flows at this level is quite straightforward.
A deferred tax balance might be an asset or a liability. Deferred tax liability is more common (in
practice and in questions) so this discussion will be about liabilities.
A deferred tax liability is an amount that a company expects to pay in the future. Therefore it has
had no cash effect to date.
Any movement on the deferred tax liability will be due to a double entry to tax expense in the
profit or loss section of the statement of profit or loss and other comprehensive income. (There
are double entries to other comprehensive income and directly to equity but these are outside the
scope of your syllabus).
There are two possible courses of action in dealing with deferred tax. Either:
 ignore it entirely and work with numbers that exclude the deferred tax (in effect this was
what happened in the example above where there was no information about deferred tax);
or
 include it in every tax balance in the working.
The second approach is usually used.
Example: Deferred tax

2017, as follows:
Taxation (Rs.) Deferred taxation (Rs.)
Beginning of 2017 53,000 20,000
End of 2017 61,000 30,000
The tax expense for the year in the statement of profit or loss was Rs. 87,000. This was made
up of the current tax expense of Rs. 77,000 and the deferred tax expense of Rs.10,000.
The tax payment (cash flows) for inclusion in the statement of cash flows can be calculated as
follows:
Rs.
Liability at the start of the year (53,000 + 20,000) 73,000
Charge for the year (77,000 + 10,000) 87,000
Total amount payable in the year 160,000
Liability at the end of the year (61,000 + 30,000) (91,000)
Cash paid 69,000
3.3.3 Accruals based figures – Dividends

A question might require the calculation of cash paid out as dividends in the year.
This is calculated in the usual way remembering that the dividend charge is a debit in the
statement of changes in equity.
Illustration:
Rs.
Dividend liability at the beginning of the year X
Dividend charge for the year X
Total amount of dividend payable in the year X
Dividend liability at the end of the year (X)
Dividend paid in the year (cash) X

Pakistan
Typically, in Pakistan a company will pay a dividend once a year. Dividend payments in Pakistan
must be approved by the members in a general meeting and this usually takes place after the
year end. This means that the dividend expensed in any one year is the previous year’s dividend
(which could not be recognised last year as it had not yet been approved in the general meeting).
Listed companies often pay an interim dividend part way through a year and a final dividend after
the year end. The actual dividend payment recognised in any one year would then be that year’s
interim dividend and the previous year’s final dividend (which could not be recognised last year
as it had not yet been approved in the general meeting).
A question may tell you that a dividend was declared at just before or just after the year end but
the company is not allowed to recognise that dividend until it is approved. Last year’s figure is
needed.
Example: Dividend paid

2017, as follows:
Dividends (Rs.)
End of 2017 71,000
The company had share capital of Rs. 1,000,000.

The directors recommended a dividend of 20% (2016: 18%) on 25th December 2017.
The company AGM is held in March each year.
The dividend payment (cash flows) for inclusion in the statement of cash flows can be
Rs.
Dividend liability at the start of the year 65,000
Dividend in the year (18% of 1,000,000) 180,000
Total amount payable 245,000
Dividend liability at the end of the year (71,000)
Cash paid 171,000
3.4 Presentation of interest, taxation and dividends cash flows

IAS 7 allows some variations in the way that cash flows for interest and dividends are presented
in a statement of cash flows, although the following should be shown separately:
 interest received
 dividends received
 interest paid
 dividends paid.
Interest payments
IAS 7 states that there is no consensus about how to treat interest payments by an entity, other
than a financial institution such as a bank. Interest payments may be classified as either:
 an operating cash flow, because they are deducted when calculating operating profit
before taxation, or
 a financing cash flow, because they are costs of obtaining finance.

In examples of statements of cash flows in the appendix to IAS 7, interest paid is shown as a
separate line item within cash flows from operating activities. This approach is therefore used
here.
Interest and dividends received
Interest and dividends received may be classified as either:
 an operating cash flow, because they are added when calculating operating profit before
taxation, or
 an investing cash flow, because they represent returns on investment.
In examples of statements of cash flows in the appendix to IAS 7, interest received and dividend
received are shown as separate items within cash flows from investing activities. This approach
is therefore used here.
Dividends paid
IAS 7 allows dividend payments to be treated as either:
 a financing cash flow because they are a cost of obtaining financial resources, or
 a component of the cash flows from operating activities, in order to assist users to
determine the ability of the entity to pay dividends out of its operating cash flows.
In examples of statements of cash flows in the appendix to IAS 7, dividends paid are shown as a
line item within cash flows from financing activities. This approach is therefore used here.
Taxes on profits
Cash flows arising from taxation on income should normally be classified as a cash flow from
operating activities (unless the tax payments or refunds can be specifically associated with an
investing or financing activity).
The examples of statements of cash flows in this chapter therefore show both interest paid and
tax paid as cash flow items, to get from the figure for cash generated from operations to the
figure for ‘net cash from operating activities’.

4 INDIRECT METHOD: ADJUSTMENTS FOR WORKING CAPITAL

Section overview
 Working capital adjustments: introduction

 Working capital
 Changes in trade and other receivables
 Possible complication: Allowances for doubtful debts
 Changes in inventory
 Changes in trade payables
 Lack of detail
4.1 Working capital adjustments: introduction
Definition
Working capital is current assets less current liabilities.
The previous section showed that taxation and interest cash flows can be calculated by using a
figure from the statement of comprehensive income and adjusting it by the movement on the
equivalent balances in the statement of financial position.
This section shows how this approach is extended to identify the cash generated from operations
by making adjustments for the movements between the start and end of the year for:
 trade receivables and prepayments;
 inventories; and
 trade payables and accruals.
Assuming that the calculation of the cash flow from operating activities starts with a profit (rather
than a loss) the adjustments are as follows:
Increase in balance from start to Decrease in balance from start to the

Balance
the end of the year end of the year
Receivables Subtract from profit before tax Add back to profit before tax
Inventory Subtract from profit before tax Add back to profit before tax
Payables Add back to profit before tax Subtract from profit before tax
These are known as the working capital adjustments and are explained in more detail in the rest
of this section.
4.2 Working capital

Working capital is made up of the following balances:
Illustration:
Rs.
Inventory X
Trade and other receivables X
Cash X
Trade payables (X)
Working capital X

Trade and other receivables include any prepayments.

Trade payables include accrued expenses, provided the accrued expenses do not relate to other
items dealt with separately in the statement of cash flows, in particular:
 accrued interest charges; and
 taxation payable.
Interest charges and payments for interest are presented separately in the statement of cash
flows, and so accrued interest charges should be excluded from the calculation of changes in
trade payables and accruals.
Similarly, taxation payable is dealt with separately; therefore taxation payable is excluded from
the calculation of working capital changes.
Accrued interest and accrued tax payable must therefore be deducted from the total amount for
accruals, and the net accruals (after making these deductions) should be included with trade
payables.
Changes in working capital and the effect on cash flow
When working capital increases, the cash flows from operations are less than the operating
profit, by the amount of the increase.
Similarly, when working capital is reduced, the cash flows from operations are more than the
operating profit, by the amount of the reduction.
This important point will be explained with several simple examples.
4.3 Changes in trade and other receivables

Sales revenue in a period differs from the amount of cash received from sales by the amount of
the increase or decrease in receivables during the period.
When trade and other receivables go up during the year, cash flows from operations are less
than operating profit by the amount of the increase.
When trade and other receivables go down during the year, cash flows from operations are more
than operating profit by the amount of the reduction.
In a statement of cash flows presented using the indirect method, the adjustment for receivables
is therefore:
 subtract the increase in receivables during the period (the amount by which closing
receivables exceed opening receivables); or
 add the reduction in receivables during the period (the amount by which opening
receivables exceed closing receivables).
Prepayments in the opening and closing statement of financial position should be included in the
total amount of receivables and therefore does not show separately.
Example: Trade and other receivables
A company had receivables at the beginning of the year of Rs. 6,000 and at the end of the year
receivables were Rs. 9,000.
During the year, sales were Rs. 50,000 in total. Purchases were Rs. 30,000, all paid in cash.
The company holds no inventories. The profit before tax for the year was Rs. 20,000 (Rs. 50,000 –
Rs. 30,000).
The cash flow from operations is calculated as follows:
Rs.
Profit before tax 20,000
Adjustments for:
Increase in receivables (9,000 – 6,000) (3,000)
17,000

Example: Trade and other receivables (continued)

Proof
Cash flow from operations can be calculated as follows:
Rs.
Receivables at the beginning of the year 6,000
Sales in the year 50,000
56,000
Receivables at end of the year (9,000)
Cash received 47,000
Cash paid (purchases) (30,000)
Cash flow from operations 17,000
4.4 Possible complication: Allowances for doubtful debts

A question might provide information on the allowance for doubtful debts at the start and end of
the year.
There are two ways of dealing with this:
 Adjust the profit for the movement on the allowance as a non-cash item and adjust the
profit figure for the movement in receivables using the gross amounts (i.e. the balances
before any deduction of the allowance for doubtful debts); or
 Make no adjustments for the movement on receivables as a non-cash item adjust the profit
figure for the movement in receivables using the net amounts (i.e. the balances after the
deduction of the allowance for doubtful debts).
Example: Cash paid for investments

The following information is available:
2016 (Rs. m) 2017 (Rs. m)
Receivables 5,000 7,100
Allowance for doubtful debts (500) (600)
Net-amount 4,500 6,500
Rs. M or Rs. m
Profit before taxation 10,000 10,000
Adjustments for non- cash items:
Increase in allowance for doubtful debts 100 
10,100 10,000
Increase in receivables:
Gross amounts: (7,100  5,000) (2,100)
Net amounts: (6,500  4,500) (2,000)
8,000 8,000

4.5 Changes in inventory

Purchases in a period differ from the cost of sales by the amount of the increase or decrease in
inventories during the period.
If all purchases were paid for in cash, this means that cash payments and the cost of sales (and
profit) would differ by the amount of the increase or decrease in inventories.
When the value of inventory goes up between the beginning and end of the year, cash flows from
operations are less than operating profit by the amount of the increase.
When the value of inventory goes down between the beginning and end of the year, cash flows
from operations are more than operating profit by the amount of the reduction.
In a statement of cash flows presented using the indirect method, the adjustment for inventories is
therefore:
 subtract the increase in inventories during the period (the amount by which closing
inventory exceeds opening inventory); or
 add the reduction in inventories during the period (the amount by which opening inventory
exceeds closing inventory).
Example: Inventory
A company had inventory at the beginning of the year of Rs. 5,000 and at the end of the year the
inventory was valued at Rs. 3,000.
During the year, sales were Rs. 50,000 and there were no receivables at the beginning or end of
the year.
Purchases were Rs. 28,000, all paid in cash.
The operating profit for the year was Rs. 20,000, calculated as follows:
Rs.
Sales 50,000
Opening inventory 5,000
Purchases in the year (all paid in cash) 28,000
33,000
Closing inventory (3,000)
Cost of sales (30,000)
Rs.
Adjustments for:
decrease in inventory (5,000 – 3,000) 2,000
22,000
Proof: The cash flow from operations is calculated as follows:

Rs.
Cash from sales in the year 50,000
Purchases paid in cash (28,000)

4.6 Changes in trade payables

Payments for purchases in a period differ from purchases by the amount of increase or decrease
in trade payables during the period.
When trade payables go up between the beginning and end of the year, cash flows from
operations are more than operating profit by the amount of the increase.
When trade payables go down between the beginning and end of the year, cash flows from
operations are less than operating profit by the amount of the reduction.
In a statement of cash flows presented using the indirect method, the adjustment for trade
payables is therefore:
 add the increase in trade payables during the period (the amount by which closing trade
payables exceed opening trade payables);or
 subtract the reduction in trade payables during the period (the amount by which opening
trade payables exceed closing trade payables).
Accruals in the opening and closing statement of financial position should be included in the total
amount of trade payables.
However, deduct interest payable and tax payable from opening and closing payables, if the total
for payables includes these items.
Example: Trade payables

A company had no inventory and no receivables at the beginning and end of the year. All its sales
are for cash, and sales in the year were Rs. 50,000.
Its purchases are all on credit. During the year, its purchases were Rs. 30,000.
Trade payables at the beginning of the year were Rs. 4,000 and trade payables at the end of the
year were Rs. 6,500.
The operating profit for the year was Rs. 20,000 (Rs. 50,000 – Rs. 30,000)
Rs.
Adjustments for:
Increase in payables (6,500 – 4,000) 2,500
22,500
Proof: The cash flow from operations is calculated as follows:

Rs.
Trade payables at the beginning of the year 4,000
Purchases in the year 30,000
34,000
Trade payables at the end of the year (6,500)
Cash paid to suppliers 27,500
Cash from sales (50,000)
The cash flow is Rs. 2,500 more than the operating profit, because trade payables were increased
during the year by Rs. 2,500.

Example:
A company made an operating profit before tax of Rs. 16,000 in the year just ended.
Depreciation charges were Rs. 15,000.
There was a gain of Rs. 5,000 on disposals of non-current assets and there were no interest
charges. Values of working capital items at the beginning and end of the year were:
Receivables Inventory Trade payables
Beginning of the year Rs. 9,000 Rs. 3,000 Rs. 4,000
End of the year Rs. 6,000 Rs. 5,000 Rs. 6,500
Taxation paid was Rs. 4,800.

Required
Calculate the amount of cash generated from operations, as it would be shown in a statement of
cash flows using the indirect method.
Answer
Rs. Rs.
Adjustments for:
26,000
Decrease in trade and other receivables 3,000
Increase in inventories (2,000)
Practice question 2
During 2017, a company made a profit before taxation of Rs. 60,000. Depreciation charges
were Rs. 25,000 and there was a gain on the disposal of a machine of Rs. 14,000.
Interest charges and payments of interest in the year were the same amount, Rs. 10,000.
Taxation payments were Rs. 17,000.
Values of working capital items at the beginning and end of the year were:
Receivables Inventory Trade payables
Beginning of the year Rs. 32,000 Rs. 49,000 Rs. 17,000
End of the year Rs. 27,000 Rs. 53,000 Rs. 11,000
Required:
Calculate the net cash from operating activities, as it would be shown in a statement
of cash flows (indirect method).

4.7 Lack of detail

A question might not provide all the detail needed to split out working capital into all of its
component parts. If this is the case the adjustment must be made using whatever totals are
available in the question.
Example:
A company made an operating profit before tax of Rs. 16,000 in the year just ended.
Depreciation charges were Rs. 15,000.
There was a gain of Rs. 5,000 on disposals of non-current assets and there were no interest
charges. Values of working capital items at the beginning and end of the year were:
Current assets Trade payables
Beginning of the year Rs. 12,000 Rs. 4,000
End of the year Rs. 11,000 Rs. 6,500
Taxation paid was Rs. 4,800.

Required
Calculate the amount of cash generated from operations, as it would be shown in a statement of
cash flows using the indirect method.
Answer
Rs. Rs.
Adjustments for:
26,000
Decrease in current assets 1,000

Example:
The following information has been extracted from the financial statements of Hopper Company
for the year ended 31 December 2017.
Rs.
Sales 1,280,000
Gross profit 880,000
Wages and salaries (290,000)
Other expenses (including depreciation Rs. 25,000) (350,000)
240,000
Interest charges (50,000)
Taxation (40,000)
Profit after tax 150,000
Extracts from the statement of financial position:
At 1 January At 31 December
2017 2017
Rs. Rs.
Trade receivables 233,000 219,000
Inventory 118,000 124,000
Trade payables 102,000 125,000
Accrued wages and salaries 8,000 5,000
Accrued interest charges 30,000 45,000
Tax payable 52,000 43,000
Required
Present the cash flows from operating activities using the indirect method.
Answer: Hopper Company

Statement of cash flows Rs.
Adjustments for:
Depreciation charges 25,000
Interest expense 50,000
265,000
Decrease in trade receivables (233,000 – 219,000) 14,000
Increase in inventories (124,000 – 118,000) (6,000)
Increase in trade and other payables 20,000
(125,000 + 5,000) – (102,000 + 8,000)
Taxation paid (W1) (49,000)
Interest paid (W1) (35,000)

Workings
(W1) Interest and tax payments Tax Interest

Rs. Rs.
Liability at the beginning of the year 52,000 30,000
Taxation charge/interest charge for the year 40,000 50,000
92,000 80,000
Liability at the end of the year (43,000) (45,000)
Tax paid/interest paid during the year 49,000 35,000

5 CASH FLOWS FROM OPERATING ACTIVITIES: THE DIRECT METHOD

Section overview
 Cash from sales

 Cash paid for materials
 Cash paid for wages and salaries
 Cash paid for other expenses
5.1 Cash from sales

The format for the direct method of presenting a statement of cash flows is as follows:
Illustration:

Cash receipts from customers 348,800
Cash payments to suppliers (70,000)
Cash payments to employees (150,000)
The task is therefore to establish the amounts for cash receipts and cash payments. In an
examination, you might be expected to calculate any of these cash flows from figures in the
opening and closing statements of financial position, and the statement of profit or loss.
The cash receipts from sales during a financial period can be calculated as follows:
Illustration:
Rs.
Trade receivables at the beginning of the year X
Sales in the year X
X
Trade receivables at the end of the year (X)
Cash from sales during the year X
A T account could also be used to calculate the cash receipt

Receivables
Balance b/f X
Sales X Cash (balancing figure) X
Balance c/f X
X X

5.2 Cash paid for materials

To calculate the amount of cash paid to suppliers, you might need to calculate first the amount of
material purchases during the period.
Illustration: Calculation of purchases in the year
Rs.
Closing inventory at the end of the year X
Cost of sales X
X
Opening inventory at the beginning of the year (X)
Purchases in the year X
Having calculated purchases from the cost of sales, the amount of cash payments for purchases
may be calculated from purchases and opening and closing trade payables.
Illustration:
Rs.
Trade payables at the beginning of the year X
Purchases in the year (as above) X
X
Trade payables at the end of the year (X)
Cash paid for materials X
A T account could also be used to calculate the cash paid

Payables
Balance b/f X
Cash (balancing figure) X Purchases X
Balance c/f X
X X
Note that if the business had paid for goods in advance at the start or end of the year they would
have an opening or closing receivable but this situation would be quite unusual.
5.3 Cash paid for wages and salaries

Cash payments for wages and salaries can be calculated in a similar way.
Illustration:
Rs.
Accrued wages and salaries at the beginning of the year X
Wages and salaries expenses in the year X
X
Accrued wages and salaries at the end of the year (X)
Cash paid for wages and salaries X

Illustration: (continued)

Payables
Balance b/f X
Balance c/f X
X X
If wages and salaries had been paid in advance the business would have a receivable and the
workings would change to the following.
Illustration:
Rs.
Wages and salaries paid in advance at the beginning of the year (X)
Wages and salaries expenses in the year X
X
Wages and salaries paid in advance at the end of the year X
Cash paid for wages and salaries X

Payables
Balance b/f X
Balance c/f X
X X
5.4 Cash paid for other expenses

Other expenses in the statement of profit or loss usually include depreciation charges, which are
not cash flows. Depreciation charges should therefore be excluded from other expenses when
calculating cash payments.
Cash payments for other expenses can be calculated as follows.
Illustration:
Rs.
Payables for other expenses at the beginning of the year X
Other expenses in the year, excluding depreciation and amortisation X
X
Payables for other expenses at the end of the year (X)
Cash paid for other expenses X
Payables for other expenses should exclude accrued wages and salaries, accrued interest
charges and taxation payable.

Example:
The following information has been extracted from the financial statements of Hopper Company
for the year ended 31 December 2015.
Rs.
Sales 1,280,000
Wages and salaries (290,000)
Other expenses (including depreciation Rs. 25,000) (350,000)
240,000
Interest charges (50,000)
Tax on profit (40,000)
Extracts from the statement of financial position:
At 1 January At 31 December
2015 2015
Rs. Rs.
Inventory 118,000 124,000
Accrued wages and salaries 8,000 5,000
Accrued interest charges 30,000 45,000
Tax payable 52,000 43,000
Required
Present the cash flows from operating activities as they would be presented in a statement of cash
flows using:
a) the direct method; and
b) the indirect method.

Answer: Direct method

Cash receipts from customers(W1) 1,294,000
Cash payments to suppliers(W3) (383,000)
Cash payments to employees(W4) (293,000)
Taxation paid (tax on profits)(W5) (49,000)
Interest charges paid(W5) (35,000)
Workings
(W1) Cash from sales Rs.
Trade receivables at 1 January 2015 233,000
Sales in the year 1,280,000
1,513,000
Trade receivables at 31 December 2015 (219,000)
Cash from sales during the year 1,294,000
(W2) Purchases Rs.

Closing inventory at 31 December 2015 124,000
Cost of sales 400,000
524,000
Opening inventory at 1 January 2015 (118,000)
Purchases in the year 406,000
(W3) Cash paid for materials supplies Rs.

Trade payables at 1 January 2015 102,000
Purchases in the year (W2) 406,000
508,000
Trade payables at 31 December 2015 (125,000)
Cash paid for materials 383,000

Answer: Direct method (continued)

(W4) Cash paid for wages and salaries Rs.
Accrued wages and salaries at 1 January 2015 8,000
Wages and salaries expenses in the year 290,000
298,000
Accrued wages and salaries at 31 December 2015 (5,000)
Cash paid for wages and salaries 293,000
(W5) Interest and tax payments Tax Interest

Rs. Rs.
Liability at the beginning of the year 52,000 30,000
Taxation charge/interest charge for the year 40,000 50,000
92,000 80,000
Liability at the end of the year (43,000) (45,000)
Tax paid/interest paid during the year 49,000 35,000
Answer: Indirect method

Statement of cash flows: indirect method Rs.
Adjustments for:
Interest charges in the statement of profit or loss 50,000
265,000
Decrease in receivables (233,000 – 219,000) 14,000
Increase in inventories (124,000 – 118,000) (6,000)
(125,000 + 5,000) – (102,000 + 8,000)
Taxation paid (49,000)

6 CASH FLOWS FROM INVESTING ACTIVITIES

Section overview
 Cash paid for the purchase of property, plant and equipment

 Cash from disposals of property, plant and equipment
 Cash paid for the purchase of investments and cash received from the sale of investments
 Non-cash purchases
6.1 Cash paid for the purchase of property, plant and equipment
This is the second part of a statement of cash flows, after cash flows from operating activities.
The most important items in this part of the statement are cash paid to purchase non-current
assets and cash received from the sale or disposal of non-current assets but it also includes
interest received and dividends received on investments.
It is useful to remember the following relationship:
Illustration: Movement on non-current assets

Rs.
Carrying amount at the start of the year X
Depreciation (X)
Disposals (X)
Additions X
Revaluation X/(X)
Carrying amount at the end of the year X
When there are no disposals or revaluations during the year

When there are no disposals or revaluations of non-current assets during the year, purchases of
non-current assets (normally assumed to be the amount of cash paid for these purchases) may
be calculated as follows:
Illustration:
Using cost: Rs.
Non-current assets at the end of the year at cost X
Non-current assets at the beginning of the year at cost (X)
Additions to non-current assets X
Alternatively carrying amount (NBV) can be used Rs.

Non-current assets at the end of the year at NBV X
Non-current assets at the beginning of the year at NBV (X)
X
Depreciation X
Additions X

Example: Cash paid for property, plant and equipment

The plant and equipment of PM Company at the beginning and the end of its financial year were
as follows:
Accumulated Net book
At cost depreciation value
Rs. Rs. Rs.
Beginning of the year 180,000 (30,000) 150,000
End of the year 240,000 (50,000) 190,000
There were no disposals of plant and equipment during the year.

The cash paid for plant and equipment in the year (additions) may be calculated in either of the
following ways.
Rs. Rs.
At cost at the end of the Carrying amount (NBV) at
year 240,000 the end of the year 190,000
At cost at the beginning of Carrying amount (NBV at
the year 180,000 the beginning of the year 150,000
Additions 60,000 Increase in NBV 40,000
Depreciation charge for the
year
(50,000 – 30,000) 20,000
Additions 60,000
Note that in the above example it is assumed that the purchases have been made for cash. This
might not be the case. If the purchases are on credit the figure must be adjusted for any amounts
outstanding at the year end.

PM company has purchased various items of property, plant and equipment on credit during the
year. The total purchased was Rs. 60,000.
The statements of financial position of PM company at the beginning and end of 2017 include the
following information:
2016 (Rs. m) 2017 (Rs. m)
Payables:
Suppliers of non-current assets 4,000 12,000
The cash paid to buy property, plant and equipment in the year can be
Rs. m
Additions 60,000
Less: increase in payables that relate to these
items (8,000)
Cash paid in the year 52,000
This can be thought of as the payment of the Rs. 4,000 owed at the start and a
payment of Rs. 48,000 towards this year’s purchases.
If the payables had decreased the movement would be added to the additions figure to find the
cash outflow.


PM company has purchased various items of property, plant and equipment on credit during the
year. The total purchased was Rs. 60,000.
The statements of financial position of PM company at the beginning and end of 2017 include the
following information:
2016 (Rs. m) 2017 (Rs. m)
Payables:
Suppliers of non-current assets 14,000 4,000
The cash paid to buy property, plant and equipment in the year can be
Rs. m
Additions 60,000
Less: increase in payables that relate to these
items 10,000
Cash paid in the year 70,000
This can be thought of as the payment of the Rs. 14,000 owed at the start and a
payment of Rs. 56,000 towards this year’s purchases.
When there are disposals during the year

When there are disposals of non-current assets during the year, the purchases of non-current
assets may be calculated as follows:
Rs.
Assets at cost at the beginning of the year X
Disposals during the year (cost) (X)
X
Additions to non-current assets (balancing figure) X
Assets at cost at the end of the year X

Non-current assets at the beginning of the year at NBV X
Depreciation (X)
Disposals during the year (NBV) (X)
X
Non-current assets at the end of the year at NBV (X)

Example: Cash paid for property, plant and equipment with disposals
The motor vehicles of PM Company at the beginning and the end of its financial year were as
follows:
Accumulated Carrying
At cost depreciation amount
Rs. Rs. Rs.
Beginning of the year 150,000 (105,000) 45,000
End of the year 180,000 (88,000) 92,000
During the year a vehicle was disposed of for a gain of Rs. 3,000. The original cost of this asset
was Rs. 60,000. Accumulated depreciation on the asset was Rs. 45,000.
Additions may be calculated as follows:
Cost NBV
Balance at the start of the year 150,000 45,000
Disposals during the year:
At cost (60,000)
At carrying amount: (60,000 – 45,000) (15,000)
Depreciation (88,000 – (105,000 – 45,000) (28,000)
90,000 2,000
Additions (balancing figure) 90,000 90,000
Balance at the end of the year 180,000 92,000
Rs.
Assets at cost at the end of the year 180,000
Assets at cost at the beginning of the year 150,000
30,000
Disposals during the year: original asset cost 60,000
Purchases 90,000
Alternatively using carrying amount (NBV): Rs.

Assets at carrying amount (NBV) at the end of the year 92,000
Assets at carrying amount (NBV) at the beginning of the year 45,000
47,000
Disposals during the year (carrying amount):
(60,000 – 45,000) 15,000
Depreciation (88,000 – (105,000 – 45,000) 28,000
Purchases 90,000

When there are revaluations during the year

When there are revaluations of non-current assets during the year, the purchases of non-current
assets should be calculated as follows.

Rs.
At cost or valuation, at the beginning of the year X
Disposals during the year (cost) (X)
Upward/(downward) revaluation during the year X/(X)
X
At cost or valuation, at the end of the year X

Non-current assets at the beginning of the year at NBV X
Depreciation (X)
Disposals during the year (NBV) (X)
Upward/(downward) revaluation during the year X/(X)
X
Non-current assets at the end of the year at NBV (X)
Example:
The statements of financial position of Grand Company at the beginning and end of 2017 include
the following information:
Property, plant and equipment 2016 2017
Rs. Rs.
At cost/re-valued amount 1,400,000 1,900,000
Accumulated depreciation 350,000 375,000
Carrying value 1,050,000 1,525,000
During the year, some property was re-valued upwards by Rs. 200,000. An item of
equipment was disposed of during the year at a profit of Rs. 25,000. This equipment had
an original cost of Rs. 260,000 and accumulated depreciation of Rs. 240,000 at the date
of disposal.
Depreciation charged in the year was Rs. 265,000.

Example (continued)
Purchases of property, plant and equipment during the year were as follows:
Rs.
At cost/re-valued amount, at the end of the year 1,900,000
At cost/re-valued amount, at the beginning of the year 1,400,000
500,000
Add: Cost of assets disposed of in the year 260,000
Subtract: Asset revaluation during the year (200,000)
Purchases during the year 560,000
Alternatively using carrying amount (NBV): Rs.

Assets at carrying amount (NBV) at the end of the year 1,525,000
Assets at carrying amount (NBV) at the beginning of the year 1,050,000
475,000
Revaluation during the year (200,000)
Carrying amount of assets disposed of in the year
(260,000 – 240,000) 20,000
Depreciation charged during the year 265,000
When there are other additions during the year

The above example showed the need to take revolution into account when reconciling the
opening and closing balances on non-current assets so as to find the additions figure as a
balancing amount.
This applies to other additions too:
 Transfers from capital work in progress
 These are assets constructed by a company for its own use.
 During the course of construction costs are accumulated in a capital work in
progress account and these are transferred into the relevant category of non-current
asset on completion.
 The cash consequence of capital work in progress is estimated as a separate
exercise.
 Transfers into the relevant category of non-current asset on completion show as an
addition and so must be taken into account when trying to estimate the cash
additions.
 Assets acquired under finance leases. (finance leases are covered in detail in chapter 10).
 A finance lease is capitalised on the statement of financial position as an assets and
as a liability.
 The asset side of the entry will show as an addition into non-current assets and so
must be taken into account when trying to estimate the cash additions.
 The liability is a form of loan. Movements on the liability represent new amounts
borrowed (additions to non-current assets) and repayments of capital.

Example:
Property, plant and equipment 2016 2017
Rs. Rs.
At cost/re-valued amount 1,400,000 1,900,000
Accumulated depreciation 350,000 375,000
Carrying value 1,050,000 1,525,000
Capital work in progress 600,000 620,000
Lease liability 300,000 410,000
During the year:

Property was revalued upwards by Rs. 200,000.
An item of equipment was disposed of at a profit of Rs. 25,000. This equipment had an original
cost of Rs. 260,000 and accumulated depreciation of Rs. 240,000 at the date of disposal.
Depreciation charged in the year was Rs. 265,000.
The company capitalised Rs. 200,000 as capital work in progress and repaid Rs. 50,000 of
the finance lease loan.
Additions may be calculated as follows:
Cost NBV
Balance at the start of the year 1,400,000 1,050,000
Disposals during the year:
At cost (260,000)
At carrying amount: (260,000 – 240,000) (20,000)
Depreciation (265,000)
Revaluation 200,000 200,000
Additions – new assets under finance leases (W) 160,000 160,000
Additions – Transfer from capital WIP (W) 180,000 180,000
1,680,000 1,305,000
Additions (balancing figure) 220,000 220,000
Balance at the end of the year 1,900,000 1,525,000

6.2 Cash from disposals of property, plant and equipment

A statement of cash flows should include the net cash received from any disposals of non-current
assets during the period.
This might have to be calculated from the gain or loss on disposal and the carrying amount of the
asset at the time of its disposal.
Illustration: Disposal of property, plant and equipment
Rs.
At cost (or revalued amount at the time of disposal) X
Accumulated depreciation, at the time of disposal (X)
Net book value/carrying amount at the time of disposal X

Gain or (loss) on disposal X
Net disposal value (= assumed cash flow) X
If there is a gain on disposal, the net cash from the disposal is more than the net book value.
If there is a loss on disposal the net cash from the disposal is less than the net book value.
Example:
During an accounting period, an entity disposed of some equipment and made a gain on disposal
of Rs. 6,000.
The equipment originally cost Rs. 70,000 and at the time of its disposal, the accumulated
depreciation on the equipment was Rs. 56,000.
What was the amount of cash obtained from the disposal of the asset?
Disposal of equipment Rs.
At cost 70,000
Accumulated depreciation, at the time of disposal (56,000)
Net book value/carrying amount at the time of disposal 14,000
Net disposal value (assumed cash flow) 20,000
This cash flow would be included in the cash flows from investing activities.
Note that in the above example it is assumed that the cash received for the disposal has been
received. This might not be the case. If the disposal was on credit the figure must be adjusted for
any amounts outstanding at the year end.
Practice question 3
At 1 January 2017, the property, plant and equipment in the statement of financial position
of NC Company amounted to Rs. 329,000 at cost or valuation.
At the end of the year, the property, plant and equipment was Rs. 381,000 at cost or
valuation.
During the year, a non-current asset that cost Rs. 40,000 (and has not been re-valued) was
disposed of at a loss of Rs. 4,000. The accumulated depreciation on this asset at the time
of disposal was Rs. 21,000.
Another non-current asset was re-valued upwards during the year from Rs. 67,000 (cost) to
Rs. 102,000.
Calculate the following amounts, for inclusion in the cash flows from investing activities
section of the company’s statement of cash flows for 2017:
a) Purchases of property, plant and equipment
b) Proceeds from the sale of non-current assets

6.3 Cash paid for the purchase of investments and cash received from the sale of
investments
A statement of cash flows should include the net cash paid to buy investments in the period and
the cash received from the sale of investment in the period.
Illustration: Movement on investments
Rs.
Carrying amount at the beginning of the year X
Disposals (X)
Additions X
Revaluation X/(X)
Carrying amount at the end of the year X
The issues to be considered in calculating cash paid for investments or cash received on the sale
of investments are very similar to those for the purchase and sale of property, plant and
equipment except for the absence of depreciation.
Example: Cash paid for investments

2016 (Rs. m) 2017 (Rs. m)
Non-current asset investments 1,000 1,500
Additional information:
The investments were revalued upwards during the year. A revalution gain of Rs.
150m has been recognised.
Investments sold for Rs. 250m resulted in a profit on the sale (measured as the
difference between sale proceeds and carrying amount at the date of sale) of
Rs. 50m
The cash paid to buy investments in the period can be calculated as a balancing
figure as follows:
Rs. m
Investments at the start of the year (given) 1,000
Disposal (carrying amount of investments sold = (200)
Rs. 250m – Rs. 50m)
Revalution gains (given) 150
950
Additions (as balancing figure): 550
Investments at the end of the year (given) 1,500
6.4 Non-cash purchases

IAS 7 states that investing and financing transactions that do not require the use of cash must be
excluded from the statement of cash flows, but that details of these transactions should be
disclosed somewhere in the financial statements, possibly as a note to the financial statements.
An example of a non-cash transaction is the acquisition of non-current assets under a finance
lease arrangement. The assets are included in the financial statements at cost, but the lessee
has not paid the purchase price.

IAS 7 therefore suggests that there should be a disclosure, in a note to the financial statements,
of the total amount of property, plant and equipment acquired during the period, and the cash
payments that were made to acquire them. These two amounts are different, because some of
the non-current assets might have been acquired under finance lease arrangements.
Illustration
An example of a note to the financial statements is as follows.
During the period, the company acquired property, plant and equipment with an aggregate cost of
Rs. 250,000, of which Rs. 60,000 was acquired by means of leases. Cash payments of Rs. 190,000
were made to purchase property, plant and equipment.
In this example, Rs. 190,000 would appear as a cash outflow in the statement of cash flows in the
section for cash flows from investing activities for the period.
 The Rs. 190,000 is the amount of cash actually paid for purchases of property, plant and
equipment in the period.
 The cash payments under the terms of the leases are not included in this part of the
statement of cash flows. The treatment of lease payments is explained later.

7 CASH FLOWS FROM FINANCING ACTIVITIES

Section overview
 Examples of cash flows from financing activities

 Cash from new share issues
 Cash from new loans/cash used to repay loans
 Dividend payments to equity shareholders
 Financing of a sole proprietor or a partnership
7.1 Examples of cash flows from financing activities

Examples of cash flows from financing activities are listed below:
Cash payments Cash receipts
Cash payments to redeem/buy back shares Cash proceeds from issuing shares
Cash payments to repay a loan or redeem Cash proceeds from a loan or issue of
bonds bonds
As explained earlier, payments of dividends are also usually included within cash flows from
financing activities, in this part of the statement of cash flows. (Some entities may also include
interest payments in this section, instead of including them in the section for cash flows from
operating activities.)
7.2 Cash from new share issues

The cash raised from new share issues can be established by comparing the equity share capital
and the share premium in the statements of financial position at the beginning and the end of the
year.
Illustration:
Rs.
Share capital + Share premium at the end of the year X
Share capital + Share premium at the beginning of the year X
Cash obtained from issuing new shares in the year X
Example:
The statements of financial position of Company P at 1 January and 31 December included the
following items:
1 January 2017 31 December 2017

Rs. Rs.
Equity shares of Rs. 1 each 600,000 750,000
Share premium 800,000 1,100,000

The cash obtained from issuing shares during the year is calculated as follows.
Rs.
Share capital + Share premium at the end of 2017 1,850,000
Share capital + Share premium at the beginning of 2017 1,400,000
= Cash obtained from issuing new shares in 2017 450,000
7.3 Cash from new loans/cash used to repay loans

Cash from new loans or cash paid to redeem loans in the year can be calculated simply by
looking at the difference between the liabilities for loans and bonds at the beginning and the end
of the year.
 An increase in loans or bonds means there has been an inflow of cash during the year.
 A reduction in loans or bonds means there has been a payment (outflow) of cash.
Remember to add any loans, loan notes or bonds repayable within one year (current liability) to
the loans, loan notes or bonds repayable after more than one year (non-current liability) to get
the total figure for loans, loan notes or bonds.
Illustration:
Rs.
Loans at end of year (current and non-current liabilities) X
Loans at beginning of year (current and non-current liabilities) (X)
Cash inflow or outflow X/(X)
Note: The same calculation can be applied to bonds or loan notes that the company might have
issued. Bonds and loan notes are long-term debt.
Example:
The statements of financial position of Company Q at 1 January and 31 December included the
following items:
1 January 31 December
2017 2017
Rs. Rs.
Loans repayable within 12 months 760,000 400,000
Loans repayable after 12 months 1,400,000 1,650,000
The cash flows relating to loans during the year are calculated as follows.
Rs.
Loans outstanding at the end of 2017 2,050,000
Loans outstanding at the beginning of 2017 2,160,000
= Net loan repayments during the year (= cash outflow) 110,000
7.4 Dividend payments to equity shareholders

These should be the final dividend payment from the previous year and the interim dividend
payment for the current year. The dividend payments during the year are shown in the statement
of changes in equity (SOCIE).

You might be expected to calculate dividend payments from figures for retained earnings and the
profit after tax for the year.
The equity dividend payments can be calculated as follows:
Illustration:
Rs.
Retained earnings at the beginning of the year X
Profit after tax X
Any other transfer into the account X
Increase in the retained earnings reserve X

Retained earnings at the end of the year (X)
Equity dividend payments X
Example:
From the following information, calculate the cash flows from financing activities for Company X in
2017.
Beginning of End of
2017 2017
Rs. Rs.
Share capital (ordinary shares) 400,000 500,000
Share premium 275,000 615,000
Retained earnings 390,000 570,000
1,065,000 1,685,000
Loans repayable after more than 12 months 600,000 520,000
Loans repayable within 12 months or less 80,000 55,000
The company made a profit of Rs. 420,000 for the year after taxation.
Required
Calculate for 2017, for inclusion in the statement of cash flows:
(a) the cash from issuing new shares
(b) the cash flows received or paid for loans
(c) the payment of dividend to ordinary shareholders.

Answer
Workings
Proceeds from new issue of shares Rs.
Share capital and share premium:
At the end of the year (500,000 + 615,000) 1,115,000
At the beginning of the year (400,000 + 275,000) (675,000)
Proceeds from new issue of shares during the year 440,000
Repayment of loans Rs.

Loans repayable:
At the end of the year (520,000 + 55,000) 575,000
At the beginning of the year (600,000 + 80,000) (680,000)
Repayment of loans during the year 105,000
Payment of dividends Rs.

Retained earnings at the beginning of the year 390,000
Profit after taxation for the year 420,000
810,000
Retained earnings at the end of the year (570,000)
Dividends paid during the year 240,000
Cash flows from financing activities can now be presented as follows.
Cash flows from financing activities Rs. Rs.
Proceeds from issue of shares 440,000
Repayment of loans (105,000)
Dividends paid to shareholders (240,000)
Net cash from financing activities 95,000
7.5 Financing of a sole proprietor or a partnership

You may face a question asking for the preparation of a statement of cash flows for a sole
proprietor or partnership. Such a question might require the calculation of cash flows between the
owners and the business. These cash flows would be capital introduced and drawings.
Illustration:
Rs.
Capital at the beginning of the year X
Profit (loss) after tax X/(X)
Capital introduced X
Drawings (X)
Capital at the end of the year X
The drawings and capital introduced figures might be provided in the question in which case you
simply have to slot the figures into the cash flow statement.
Other questions might need you to identify one or other of these as balancing figure.


Solutions 1
(a) In the adjustments to get from the operating profit to the cash flow from operations, the loss
on disposal of Rs. 8,000 should be added.
(b) Under the heading ‘Cash flows from investing activities’, the sale price of the vehicle of Rs.
22,000 should be included as a cash inflow.
Workings:
Original cost of vehicle 50,000
Accumulated depreciation at date of disposal (20,000)
Net book value at the time of disposal 30,000
Loss on disposal (8,000)
Therefore net sales proceeds 22,000
Solutions 2
Rs.
Adjustments for:
Depreciation 25,000
Interest charges 10,000
Gain on disposal of non-current asset (14,000)
81,000
Reduction in trade and other receivables 5,000
Increase in inventories (4,000)
Reduction in trade payables (6,000)
76,000
Taxation paid (17,000)
Cash flows from operating activities 49,000
Solutions 3
Property, plant and equipment purchases Rs.
At cost or valuation at the end of the year 381,000
At cost or valuation at the beginning of the year (329,000)
52,000
Add: Cost of assets disposed of in the year 40,000
Subtract: Asset revaluation during the year (102,000 – 67,000) (35,000)
Disposal of equipment Rs.

At cost 40,000
Accumulated depreciation, at the time of disposal (21,000)
Net book value/carrying amount at the time of disposal 19,000
Loss on disposal (4,000)
Net disposal value (= assumed cash flow) 15,000

Solutions 4
KK Ltd: Statement of cash flows for the year ended 31 December 2017
Rs. M Rs. m
Net profit before taxation 96
Adjustments for:
Depreciation 37
Amortisation of development expenditure 1
Profit on sale of property, plant and equipment
(21 – 19) (2)
Interest receivable (3)
Interest expense 7
Operating profit before working capital changes 136
Decrease in inventories (140 – 155) 15
Increase in receivables (130 – 110) (20)
Increase in payables (220 – 131) 89
Cash generated from operations 220
Interest paid (4)
Interest element oflease payments (3)
Income taxes paid (W1) (16)
Net cash from operating activities 197
Cash flows from investing activities
Purchase of property, plant and equipment (104)
Receipts from sale of tangible non-current assets 21
Interest received 3
Net cash used in investing activities (80)
Cash flows from financing activities
Proceeds from issue of share capital (W2) 13
Payment of lease liabilities (W3) (7)
Purchase of investments (80 – 20) (60)
Dividends paid (20)
Net cash used in financing activities (74)
Net increase in cash and cash equivalents 43
Cash and cash equivalents at beginning of period (W4) (17)
Cash and cash equivalents at end of period (W4) 26
Workings
W1 Income tax paid
Rs. m
Liability at the start of the year 10
Charge for the year 22
Total amount payable in the year 32
Liability at the end of the year (16)
Cash paid 16

CHAPTER
Income and expenditure account
Contents
1 Not for profit organisations
2 Income and expenditure account
3 Statement of financial position

1 NOT FOR PROFIT ORGANISATIONS
Section overview
 Introduction
 Receipts and payments account
1.1 Introduction
Many organisations do not exist in order to make a profit. Such organisations include:
 Clubs and societies; and
 Charities
 Trusts
 NGOs
 Hospitals
Non-profit making organisations (also called not for profit organisations) have revenue which they
raise and costs which must be paid just like other organisations.
Non-profit making organisations prepare an income and expenditure account (I & E account)
instead of a statement of comprehensive income. This is similar to a statement of comprehensive
income in that it is prepared on the accruals basis but there are differences.
Different terminology is used.
 What a statement of comprehensive income would describe as profit for the period, an
income and expenditure account describes as a surplus of income over expenditure.
 What a statement of comprehensive income would describe as loss for the period, an
income and expenditure account describes this as a deficit of income over expenditure.
 In the statement of financial position a company has equity reserves whereas a not for
profit organisation has equity fund accounts.
 In the statement of financial position a company would add the profit for the year (deduct a
loss) to an equity account called retained profits. A not for profit organisation would add the
surplus (deduct a deficit) to an equity account called an accumulated fund (or accumulated
surplus of income over expenditure).
Also the sort of organisation that prepares income and expenditure accounts might be subject to
much less regulation than entities that exist for a profit.
Comment on charities
Some charities are very large organisations and are run very professionally. Such charities may be
subject to separate accounting regulation in some jurisdictions and may maintain detailed
accounting records to the same standard as those expected of a company.
Charities are only mentioned above for completeness. This chapter proceeds to explain more
about income and expenditure account using the circumstances of clubs and societies.
1.2 Receipts and payments account

A clubs or society may not be required to prepare accruals based financial information. They
might choose to do so but they may prepare a receipt and payments account instead.
This is simply a summary of cash receipts and payments during the accounting period. The
accruals concept is not applied.
All cash receipts are recorded on debit side (receipts side) and all cash payments are recorded
on credit side (payments side) of receipts and payments account.

Chapter 4: Income and expenditure account
Illustration
Receipts and payments account

Balance b/d X Donation X
Subscriptions X Repairs X
Functions X Telephone X
Sale of land X Extension of club house X
Bank interest X Furniture X
Bequest X Heat and light X
Sundry income X Salary and wages X
Sundry expenses X
Balance c/d X
X X
Balance b/d X
A receipt and payment account gives far less information than a set of financial statements based
on the accruals concept.
For all practical purposes this is a cash account.
This is not mentioned in the learning outcomes of this syllabus but it is examinable at a lower
level. It is mentioned here for completeness.

2 INCOME AND EXPENDITURE ACCOUNT

Section overview
 Format
 Subscriptions account
 Life membership fee
 Donations
 Surplus from running an operation
 Surplus from running an event
2.1 Format
An income and expenditure account is an accruals based statement listing the different types of
income of a club followed by the different categories of expenditure of the club.
A club may have several categories of income including:
 Membership fees and subscriptions;
 Life membership fees;
 Donations to the club;
 Investment income;
 Surplus from running a coffee bar or a shop;
 Surplus from running an event;
Note that if a club has a coffee bar or shop or runs an event the “profit” from these is generally
calculated separately (in an account known as a trading account) and presented as a line in the
income and expenditure account.
Illustration: Coffee bar trading account
Rs. Rs.
Income
Sales X
Opening inventory X
Purchases X
X
Closing inventory (X)
Cost of sales (X)
Gross profit (this figure to the face of the income
and expenditure account) X

There are no mandatory formats for such a statement. A typical format is illustrated below.
Illustration: Income and expenditure account for the year ended XX/XX/XX
Rs. Rs.
Income
Subscription income X
Donations X
Interest on bank deposit X
Coffee bar/shop profit X
Tournament income X
Less: Prizes (X)
X
X
Expenditure
Club expenses X
Rent X
Electricity X
Depreciation X
Repairs X
X
Surplus (deficit) of income over expenditure X
2.2 Subscriptions account

At each year end there will usually be some members who have paid their subscriptions in
advance and some who are in arrears. These are both included as balances brought down and
carried down on a single subscription account. Cash received is credited to this account and the
balance on the account is transferred to the income and expenditure account (as income for the
year).
Illustration: Subscription account
Subscription account
Rs. Rs.
Balance b/d (members in Balance b/d (members
arrears) X who have prepaid) X
Income and expenditure X Cash X
Balance c/d (members Balance c/d
who have prepaid) X (members in arrears) X
X
Balance b/d (members in Balance b/d (members
arrears) X who have prepaid) X

Example: Subscription account

At 31 March 2016 a cricket club had membership subscriptions in arrears amounting to Rs.48,000
and had received Rs.12,000 subscriptions in advance.
During the year to 31 March 2017 the club received Rs.624,000 including 26 memberships for the
year to 31 March 2018 at Rs.1,200 per annum.
At 31 March 2017 16 members owed subscriptions of Rs.1,200 each.
The transactions would be recorded in the subscriptions ledger account for the year to 31 March
2017 as follows:
Subscriptions
Rs. Rs.
Balance b/d: Balance b/d:
Members in arrears 48,000 Advance payments 12,000
Cash 624,000
Membership fees for the
year (to I&E) 576,000
Balance c/d: Balance c/d:
Advance payments Members in arrears
(26 × 1,200) 31,200 (16 × 1,200) 19,200
655,200 655,200
Balance b/d: 19,200 Balance b/d: 31,200
Write off of subscriptions

Questions often include the write off of subscriptions from members who have stopped attending
the club.
Illustration: Write off of subscriptions
Debit Credit
Income and expenditure account X
Subscription account X
Example: Subscription account

At 31 March 2016 a cricket club had membership subscriptions in arrears amounting to Rs. 48,000
and had received Rs. 12,000 subscriptions in advance.
During the year to 31 March 2017 the club received Rs. 624,000 including 26 memberships for
the year to 31 March 2018 at Rs. 1,200 per annum.
At 31 March 2017 16 members owed subscriptions of Rs. 1,200 each.
Half of the members who were in arrears at the end of the previous period still had not paid by 31
March 2017. It was decided to write these amounts off.
The transactions would be recorded in the subscriptions ledger account for the year to 31 March
2017 as follows:
Subscriptions
Rs. Rs.
Balance b/d: Balance b/d:
Members in arrears 48,000 Advance payments 12,000
Cash 624,000
Membership fees for the
year (to I&E) 600,000 Bad debts (1/2  48,000) 24,000
Balance c/d: Balance c/d:
Advance payments Members in arrears
(26 × 1,200) 31,200 (16 × 1,200) 19,200
679,200 679,200
Balance b/d: 19,200 Balance b/d: 31,200

2.3 Life membership fee

A club should have an accounting policy for these. Possible policies include:
 Recognition as income when received.
 Recognition as income over a specified period.
 Recognition in an equity reserve (an accumulated fund).
Recognition as income when received
Illustration:
Debit Credit
Bank (cash received) X
Recognition as income over a specified period
Illustration:
On receipt: Debit Credit
Deferred income ( accredit account on the face of the
statement of financial position) X
Each year over the a specified future period:

Deferred income X
This treatment recognises the amount received as income over several years.
Recognition in an equity reserve (an accumulated fund)
Illustration:
Debit Credit
Life membership fund (an accumulated fund account in
equity) X
This might then be transferred to the accumulated surplus of income over expenditure over a pre-
defined period or on the death of the member.
2.4 Donations
A club might receive a donation or bequest.
If the donation has not been made for a specific purpose the club might recognise the donation
as income in the period in which it is received.
A club might receive a donation for a particular purpose. For example, a member might donate
money for a new cricket square. In this case the money is credited to a fund account set up for
the purpose.

Illustration:
Debit Credit
Cricket square fund (an accumulated fund account in
equity) X
2.5 Surplus from running an operation

If a club has a coffee bar or shop the “profit” from these is generally calculated separately (in an
account known as a trading account).
Any expenses directly related to the operation of a coffee bar or shop would be deducted from
the gross profit of the operation and the net profit would be presented on a separate line in the
income and expenditure account.
Illustration: Coffee bar trading account
Rs. Rs.
Income
Sales X
Opening inventory X
Purchases X
X
Closing inventory (X)
Cost of sales (X)
Gross profit X
Coffee shop worker’s salary (X)
Net profit (this figure to the face of the income and
expenditure account) X
2.6 Surplus from running an event

If a club runs an event any surplus (or loss) generally calculated separately and presented as a
separate line in the income and expenditure account.
Illustration: Event surplus
Rs.
Sports day entry fees X
Cost of prizes (X)
Surplus/deficit (this figure to the face of the income
and expenditure account) X

3 STATEMENT OF FINANCIAL POSITION

Section overview
 Format
 Special funds
3.1 Format
A not for profit organisation may or may not prepare a statement of financial position but if it does
so the statement of financial position would be similar to that of a business. The main difference
is in the equity section. The equivalent of the capital section of a business is called the
accumulated fund.
Example: Statement of financial position of a club
Rs.
Assets
Non-current assets
Club house X
Current assets
Subscriptions in arrears X
Investments X
Shop inventory X
Prepayments X
Cash X
Total assets X
Equity and liabilities

Accumulated fund
At start of year X
Surplus / (deficit) for the year X
At end of year X
Current liabilities
Subscriptions in advance X
Accruals X
Total accumulated fund and liabilities X
3.2 Special funds

An organisation might also have other funds in addition to the accumulated fund.
These “special” funds arise in a number of circumstances including:
 when an organisation receives cash for a designated purpose; or
 when an organisation sets aside resources for a designated purpose.
The organisation might also set aside assets (say cash) to match to the fund so that they can be
used for the specified purpose.

Illustration: Receipt of cash for a specified purpose
Debit Credit
Cash X
Special fund X
Allocation of assets to the fund

Special fund cash X
Cash X
The following journals reflect cash being spent on the specified purpose.
Illustration: Receipt of cash for a specified purpose
Debit Credit
Special fund X
Cash (or “Special fund cash” if so allocated) X
Example: Special fund

Ali has been very successful in business.
When he was a young man he very much enjoyed playing cricket and has very fond memories of
his days at the village cricket club.
He has donated Rs. 1,000,000 to the club to fund the building of a new club house.
This would be accounted for as follows:
Debit Credit
Cash 1,000,000
Special fund (clubhouse) 1,000,000

Special fund cash 1,000,000
Cash 1,000,000
An organisation itself might set aside funds for a particular purpose.
Illustration: Set up fund for a specified purpose

Debit Credit
Accumulated fund X
Special fund X

Special fund cash X
Cash X

Example: Special fund

A social club in a small town has managed to accumulate a significant balance on its accumulated
fund over the years.
Its members have decided that the club should establish a fund to contribute to the school fees of
children of high promise from the town. Parents of such children would apply to the club for a grant
of Rs.50,000.
Rs. 1,500,000 is to be set aside for this purpose.
This would be accounted for as follows:
Setting up the fund Debit Credit

Accumulated fund 1,500,000
Special fund (Education fund) 1,500,000

Special fund cash 1,000,000
Cash 1,000,000
On the award of a grant. Debit Credit

Special fund (Education fund) 50,000
Special fund cash 50,000
Practice question 1
The following were the assets and liabilities of the NawabsharYouth Movement at 30
April 2017.
Rs. 000
Fixtures and fittings (net) 16,340
Inventory of refreshment (coffee bar) 4,460
Land 51,600
Subscription received in advance 4,900
Payables for drinks supplied (coffee bar) 6,780
Cash at bank 7,466
The accountant’s receipts and payments account for the year to 30 April 2018 shows the following:
Receipts Rs. 000
Donations received 500
Rent of hall 5,600
Members’ subscription 24,000
Sale of brochure 1,740
Sale of dance tickets 3,400
Sale of refreshments (coffee bar) 10,200

Practice question (continued) 1

Payments
Repairs and maintenance 3,218
Salaries and wages 6,309
Gifts and donations 600
Dance expenses 950
Refreshment supplies (coffee bar) 19,415
Sundry expenses 10,000
Further information:
(i) Wages of Rs. 556,000 were due but unpaid at the year-end.
(ii) Inventories of drinks at 30 April 2018 were Rs. 14,210,000
(iii) Provide for depreciation on fixtures and fittings at Rs. 1,900,000
(iv) Subscription due but not paid at 30 April 2018 was Rs. 1,900,000
Required:
Prepare the club’s income and expenditure account for the year ended 30 April 2018 and the
statement of financial position as at that date.
Practice question 2
The statement of financial position of Peshawar Business Club as at 31 December
2017 is shown as follows:
Cost depreciation amount
Rs.000 Rs.000 Rs.000
Furniture and Fittings 40,000 10,000 30,000
Games Equipment 20,000 7,200 12,800
Motor van 30,000 10,000 20,000
90,000 27,200 62,800
Current Assets:
Cash at bank and at hand 9,200
72,000
Financed by:
Accumulated funds 72,000
The following transactions took place during the year 1 January 2018 to 31 December 2018:
Receipts Rs. 000
Subscriptions (10,000 members @ 1,600 each) 16,000
Donations 1,600
Sale of tickets for annual dinner 10,800

Practice question (continued) 2

Payments
Electricity 4,000
Expenses for annual dinner 6,200
New games equipment 3,200
Cleaners’ wages 2,080
Repairs and renewal 1,660
Motor van repairs 2,520
(i) An electricity bill of Rs. 900,000 was owed at 31 December 2018.
(ii) Depreciation should be calculated at 10% of cost of the assets.
Required:
(a) Prepare the receipts and payments account.
(b) Prepare the income and expenditure account and statement of financial position as at 31
December 2018.


Solution 1

Income: Rs.000
Subscriptions (W1) 30,800
Donations 500
Rent of hall 5,600
Sales of brochure 1,740
Sales of dance tickets 3,400
Net income from coffee bar (W4) 7,315
49,355
Less expenses
Repairs and Maintenance 3,218
Salaries and Wages (W2) 6,865
Gifts and Donations 600
Dance expenses 950
Depreciation of fixtures and fittings 1,900
(23,533)
Net surplus 25,822
Statement of financial position as at 30 April 2018

Non-current assets Rs.000
Land 51,600
Fixtures and Fittings 16,340
Depreciation (1,900)
14,440
66,040
Current Assets:
Inventory of drinks 14,210
Subscriptions unpaid 1,900
Cash and Bank Balance 12,414
94,564
Financed By:
Accumulated Fund (W5) 68,186
Surplus of income over expenditure 25,822
94,008
Current Liabilities : Wages accrued 556
94,564

Solution (continued) - Workings 1

W1 Subscriptions account
Rs. 000 Rs. 000
Balance b/d 4,900
Subscriptions for the
period 30,800 Bank 24,000
Balance c/d 1,900
30,800 30,800
W2 Salaries and wages

Rs. 000 Rs. 000
Bank 6,309 Expenditure 6,865
Balance c/d 556
6,865 6,865
W3 Payables
Rs. 000 Rs. 000
Bank 19,415 Balance b/d 6,780
Expenditure 12,635
19,415 19,415
W4 Coffee bar
Sales 10,200
Purchases (W3) 12,635
(2,885)
Profit (gross) 7,315
W5 Accumulated fund at start of the year

Assets:
Fixtures and Fittings 16,340
Inventory of refreshments 4,460
Land 51,600
Cash and Bank Balances 7,466
79,866
Liabilities:
Subscription received in Advance 4,900
Payables for drinks supplied 6,780
(11,680)
Accumulated fund 68,186

Solution 2
(a) Receipts and payments
Rs. 000 Rs. 000
Balance b/d 9,200 Electricity 4,000
Subscription 16,000 Expenses for annual 6,200
dinner
Donations 1,600 New games equipment 3,200
Sale of Tickets for annual 10,800 Cleaner’s wages 2,080
dinner
Repairs and renewals 1,660
Balance c/d 17,940
37,600 37,600

Income: Rs.000
Subscriptions (W1) 16,000
Donations 1,600
Sales of dance tickets 10,800
28,400
Less expenses
Electricity (4,000,000 + 900,000) 4,900
Annual expenses 6,200
Cleaner’s wages 2,080
Repairs and renewals 1,660
Depreciation (W) 9,320
(26,680)
Net surplus 1,720
Statement of financial position as at 30 April 2018

Non-current assets
Cost depreciation amount
Rs.000 Rs.000 Rs.000
Furniture and Fittings 40,000 14,000 26,000
Games and Equipment 23,200 9,520 13,680
Motor Van 30,000 13,000 17,000
93,200 36,520 56,680

Current Assets:
Cash and Bank Balance 17,940
74,620
Financed By:
Accumulated Fund (W5) 72,000
Surplus of income over expenditure 1,720
73,720
Current Liabilities : Electricity accrual 900
74,620
Working: Depreciation
Rs.000
Furniture and Fittings 0.1 @ 40,000,000 4,000
Game Equipment (20,000,000 + 3,200,000) x 0.1) 2,320
Motor Van 30,000,000 @ 0.1 3,000
9,320


CHAPTER
Preparation of accounts from incomplete

records
Contents
1 The nature of incomplete records
2 Techniques for incomplete records

1 THE NATURE OF INCOMPLETE RECORDS

Section overview
 The meaning of incomplete records

 Dealing with incomplete records
1.1 The meaning of incomplete records

Incomplete records, as the term suggests, are accounting records where information is missing.
Problems of incomplete records may arise with small businesses where the owner of the
business has not kept up-to-date accounting records or does not have a double entry book-
keeping system. He might simply keep invoices or receipts for expenses and copies of invoices
to customers. In addition, details of bank transactions can be obtained from a bank statement or
other banking records.
The task of the accountant is to use these invoices, receipts and banking records, together with
other information obtained from the business owner, to prepare financial statements for the year
(and in particular a statement of comprehensive income, which provides a basis for calculating
the taxable income of the business owner from his or her business).
Other circumstances that cause problems include loss of records because of some kind of
disaster, for example a fire in the office.
Another scenario is where records have not been maintained because a dishonest employee has
stolen cash or inventory.
Whatever the cause of the problem the accountant’s task involves piecing together information
that is available in order to produce a set of financial statements or to calculate missing figures.
1.2 Dealing with incomplete records

Questions on incomplete records are a good test of knowledge and understanding of book-
keeping and accounting. The task is often to identify the missing figures that the incomplete
records do not provide.
Possible approaches to establishing missing numbers include:
 establishing the value of assets and liabilities to calculate the business capital, particularly
opening capital at the start of the financial period
 using memorandum control accounts, for receivables or payables, to calculate the sales or
purchases for the period
 using a memorandum account for bank and cash transactions, to establish a missing
figure for cash receipts or cash payments, such as a missing figure for cash taken from the
business by the owner as drawings
 using cost structures (gross profit percentage or mark-up) to establish a cost of sales, or a
missing figure such as the value of inventory stolen or lost in a fire.

Chapter 5: Preparation of accounts from incomplete records
2 TECHNIQUES FOR INCOMPLETE RECORDS

Section overview
 The accounting equation

 Memorandum control accounts
 Memorandum cash and bank account
 Cost structures
 Missing inventory figure
2.1 The accounting equation

The accounting equation is:
Formula: Accounting equation

Assets = Liabilities + Equity Or Assets  Liabilities = Equity
A = L + E A  L = E
Net assets
Profit or loss for a period can be calculated from the difference between the opening and closing
net assets after adjusting for any drawings during the period.
Formula:
Increase in net assets = Profit + capital introduced – drawings
The profit figure can be calculated as follows:
Illustration:
Rs.
Closing assets – liabilities X
Opening assets – liabilities X
Increase/(decrease) in net assets in the period X
Add drawings X
Subtract new capital introduced by the owner(s) (X)
Profit /(loss) for the year X
Example:
At 1 January 2017, the business of Tom Canute had assets of Rs. 214,000 and liabilities of
Rs.132,000.
At 31 December 2017, the business had assets of Rs. 281,000 and liabilities of Rs. 166,000.
Tom took Rs. 25,000 in cash and Rs. 3,000 in goods out of the business during the year for his
personal use. He did not introduce any new capital.
Required
Calculate the profit of the business in the year to 31 D1ecember 2017.

Answer
Rs. Rs.
Assets at 31 December 2017 281,000
Liabilities at 31 December 2017 (166,000)
Net assets at 31 December 2017 115,000
Assets at 1 January 2017 214,000

Liabilities at 1 January 2017 (132,000)
Net assets at 1 January 2017 (82,000)
Increase in net assets during the year 33,000
Add: Drawings (25,000 + 3,000) 28,000
Profit for the year 61,000
Alternatively the profit figure could be calculated using the equation:
Increase in net assets =Profit + Capital introduced – Drawings
Rs. 33,000 = Profit + 0 – Rs. 28,000
Profit = Rs. 61,000
Practice question 1
The accountant for a sole trader has established that the total assets of the business at 31
December Year 4 were Rs. 376,000 and total liabilities were Rs. 108,000.
Checking the previous year’s financial statements, he was able to establish that at 31
December Year 3 total assets were Rs. 314,000 and total liabilities were Rs. 87,000.
During Year 4 the owner has taken out drawings of Rs. 55,000.
In December Year 4 the owner had been obliged to input additional capital of Rs. 25,000.
What was the profit of the business for the year to 31 December Year 4?
Identifying missing balances

The approach can also be used to identify a missing balance at the end of a period.
Example: Missing balance

At the start of the year a business had opening capital of Rs. 350,000.
Profit for the year was Rs. 200,000 and the owner had taken Rs. 120,000 as drawings. No capital
was introduced in the period.
At the end of the year the company cashier disappeared with an amount of cash.
The owner was able to identify the following balances at the year end:
Rs.
Property, plant and equipment 95,000
Inventory 85,000
Receivables 65,000
Liabilities (55,000)
The missing cash balance can be calculated as follows:

Step 1: Work out what closing net assets should be: Rs.
Capital (net assets) at the start 350,000
Less: Drawings (120,000)
Capital (net assets) at the end should be: 430,000

Example: Missing balance (continued)
Step 2: Work out what closing net assets are: Rs.

Inventory 85,000
Receivables 65,000
Liabilities (55,000)
190,000
Step 3: Identify the missing amount: 240,000
The cashier has stolen cash amounting to Rs. 240,000.
Calculation of opening capital

It might be necessary to establish the opening capital of a sole trader. This can be done simply
by obtaining figures for the assets and liabilities of the business at the beginning of the financial
period.
Opening capital is the difference between total assets and total liabilities. (Non-current assets for
this purpose are measured at their carrying amount, i.e. net book value.)
Example:
A sole trader does not keep any accounting records, and you have been asked to prepare a
statement of comprehensive income and statement of financial position for the financial year just
ended. To do this, you need to establish the opening capital of the business at the beginning of the
year.
You obtain the following information about assets and liabilities at the beginning of the year:
Rs.
Motor van (balance sheet valuation) 1,600
Bank overdraft 560
Cash in hand 50
Receivables 850
Trade payables 370
Payables for other expenses 90
Inventory 410
Required
Calculate the capital of the business as at the beginning of the year.

Answer
Rs. Rs.
Assets
Motor van (balance sheet valuation) 1,600
Inventory 410
Receivables 850
Cash in hand 50
Total assets 2,910
Liabilities
Bank overdraft 560
Trade payables 370
Payables for other expenses 90
Total liabilities 1,020
Net assets = Capital 1,890
Practice question 2
A sole trader has not maintained full records but is able to supply the following
information for two years ended 31 December:
2017 2016
Rs. 000 Rs. 000
Accrued expenses 10 -
Accounts receivable 196 130
Prepaid expenses - 16
Bank balances (40) 200
Investment 500 -
Cash balance 366 106
Accounts payable 74 90
Property 1,500 1,500
Delivery van 260 260
Inventory 190 74
Loan from bank 300 300
(i) An allowance for doubtful debts should be established on 31 December 2017 in the
amount of Rs. 3,000.
(ii) Depreciation is to be provided on the carrying amounts as follows:
Property 5%
Delivery van 10%
(iii) Additional capital of Rs. 250,000 was introduced into the business during the year.
(iv) The owner withdrew a total sum of Rs. 20,000 during the year.
Required:
(a) Calculate the capital at the start of the year by preparing a statement of net assets at that
date.
(b) Prepare a statement of net assets at the end of the year.
(c) Calculate the profit for the year.

2.2 Memorandum control accounts

A memorandum account is not a part of a proper ledger accounting system. When there are
incomplete records, a memorandum account can be used to calculate a ‘missing’ figure, such as
a figure for sales or purchases and expenses in the period.
Calculating a missing figure for sales
The records of a sole trader might be incomplete because the trader does not keep any record of
sales in the period. However, it might be possible to obtain the following figures:
 receivables at the beginning of the year (from last year’s balance sheet);
 receivables at the end of the year, from copies of unpaid sales invoices;
 money banked during the year (assumed to be money from customers for sales);
 any bad debts written off.
Where a business makes some sales for cash, there might also be a figure for cash sales where
the money has not been banked. The amount of these cash sales might be calculated from the
sum of:
 the increase in cash in hand at the end of the year; plus
 any expenses paid in cash, for which receipts are available.
Example:
An accountant is looking through the records of a sole trader who does not have a bookkeeping
system. He has established the following information.
Rs.
Receivables at the beginning of the year 650
Receivables at the end of the year 720
Bad debt written off during the year 800
Money paid into the business bank account 58,600
Cash sales where the money was not banked 300
The sales for the year can be calculated as the balancing figure in a receivables memorandum
account.
Receivables memorandum account
Rs. Rs.
Opening balance 650 Money banked 58,600
Sales 59,770 Cash sales, money not 300
banked
(= balancing figure, 60,420 Bad debt written off 800
– 650)
Closing balance 720
60,420 60,420
The same calculation could be presented in a vertical format, as follows:
Rs.
Receivables at the beginning of the year (650)
Receivables at the end of the year 720
Increase/(decrease) in receivables 70
Money paid into the business bank account 58,600
Cash sales where the money was not banked 300
Bad debt written off during the year 800
Sales for the year 59,770

Practice question 3
Calculate sales for the period from the following information.
Rs.
Receivables at the start of the period 2,400
Receivables at the end of the period 1,800
Cash banked during the period 12,500
Bad debt written off 200
Calculating a missing figure for purchase

A similar approach can be taken using knowledge of the payables control account.
Example:
An accountant is looking through the records of a sole trader who does not have a book-keeping
system. He has established the following information.
Rs.
Payables at the beginning of the year 1,200
Payables at the end of the year 1,800
Money paid out of the business bank account to suppliers 18,700
The purchases for the year can be calculated as the balancing figure in a payables memorandum
account.
Payables memorandum account
Rs. Rs.
Cash paid 18,700 Opening balance 1,200
Closing balance 1,800 Purchases (balancing figure) 19,300
20,500 20,500

Rs.
Payables at the beginning of the year 1,200
Payables at the end of the year 1,800
Increase in payables 600
Money paid out of the business bank account 18,700
Purchases for the year 19,300
Practice question 4
Calculate purchases for the period from the following information.
Rs.
Payables at the start of the period 1,400
Payables at the end of the period 1,900
Cash paid to suppliers during the period 11,300

2.3 Memorandum cash and bank account

A memorandum account may also be used to record transactions in cash (notes and coins) and
through the bank account, in order to establish a missing figure for a cash payment or possibly a
cash receipt.
You might be given figures for:
 cash in hand and in the bank account at the beginning of the year;
 cash in hand and in the bank account at the end of the year;
 cash receipts (cash, cheques and other forms of receiving money);
 payments during the period for purchases, salaries and other cash expenses.
If there is a missing figure for a cash payment, this should emerge as a balancing figure.
Note: Cash in hand consists of banknotes and coins. Often, it is just petty cash. However, some
businesses hold a large amount of cash in hand because they sell goods for cash; for example,
retail stores may hold fairly large quantities of cash in hand.
Example:
An accountant is trying to prepare the financial statements of a sole trader from incomplete
records.
A problem is that the owner of the business admits to having taken cash from the business, but he
has not kept a record of how much he has taken.
The accountant has established the following information:
Rs.
Cash in hand at the beginning of the year 200
Bank balance at the beginning of the year 2,300
Cash in hand at the end of the year 500
Bank balance at the end of the year 3,500
Receipts 42,800
Payments to employees 12,800
Payments to suppliers 17,100
Payments of interest/bank charges 400
Required
From this information, calculate the cash drawings by the owner during the year.
Answer
The drawings for the year can be calculated as the balancing figure in a cash and bank
memorandum account.
Cash and bank memorandum account
Rs. Rs.
Opening balance, cash in
hand 200 Payments to suppliers 17,100
Opening balance, bank 2,300 Payments to employees 12,800
Payments of interest/bank
Receipts 42,800 charges 400
Drawings (= balancing figure) 11,000
Closing balance, cash in hand 500
Closing balance, bank 3,500
45,300 45,300


Rs. Rs.
Cash in hand and bank at the beginning of the year 2,500
Receipts during the year 42,800
45,300
Payments for interest/bank changes 400
Total payments recorded (30,300)
15,000
Cash in hand and bank at the end of the year (4,000)
Difference = missing figure = drawings 11,000
Practice question 5
Calculate drawings for the period from the following information.
Rs.
Cash in hand at the beginning of the year 100
Bank balance at the beginning of the year 2,400
Cash in hand at the end of the year 150
Bank balance at the end of the year 5,200
Receipts 51,700
2.4 Cost structures

Missing figures can sometimes be estimated by using cost structures which describe the
relationship that exists between sales, cost of sales and gross profit.
The relationship between revenue and cost of sales can be expressed as a percentage.
There are two ways of doing this:
 Gross profit is expressed as a percentage of cost of sales – this is known as mark-up; or
 Gross profit is expressed as a percentage of sales – this is known as profit margin.
Example: Cost structures
Rs. Mark-up Profit margin

Revenue 100,000 125% 100%
Cost of sales (80,000) 100% 80%
Gross profit 20,000 25% 20%

Example:
A sole trader does not keep a record of sales. However, she does keep a record of purchases. The
accountant has established that the gross profit margin is 20%, and that:
a) opening inventory was Rs. 700 at the beginning of the year
b) closing inventory is Rs. 1,200 at the end of the year
c) purchases during the year were Rs. 23,500.
Sales for the year can be calculated by first calculating the cost of sales figure and then adding the
mark up to it.
20% (= gross profit/sales), the mark-up on cost is 25% of cost (= 20/(100 – 20)).
Rs.
Opening inventory 700
Purchases 23,500
24,200
Gross profit (25% of cost) 5,750
Sales 28,750
Practice question 6
A business operates on the basis of a mark-up of 40%.
Calculate the sales figure for the year from the following information:
Rs.
Closing inventory 4,000
Purchases 42,100
Practice question 7
Complete the following table.
Rs. Rs. Rs. Rs.
Opening inventory 1,000 2,000 1,000 ?
Closing inventory (1,200) (1,500) (500) (2,000)
Purchases 5,000 8,700 ? 15,000
Sales 8,000 15,000 ? 20,000
Cost of sales ? ? ? ?
Gross profit ? ? ? 5,000
Profit margin ? ? 20% ?
Mark-up ? ? ? 33.3%

More than one cost structure

A question might explain that a business has more than one cost structure.
You have to work carefully through the information to establish missing numbers.
Example: Multiple cost structures

A company has sales of Rs. 1,000.
The company sells three types of good.
60% of sales are of type A which is sold at a mark-up of 20%.
Type B goods are sold at a margin of 30%. The cost of type B sold in the year was Rs. 154.
Total gross profit for the year was Rs. 184.
Prepare sales, cost of sales and gross profit workings for each product and in total for the business
and show the margin for type C goods.
Step 1: Set up a table and enter the known facts
Type A % Type B % Type C % Total
Sales 600 100 1,000
Cost of sales 100 154
Gross profit 20 30 184
Step 2: Fill in the easy figures

Sales 600 120 100 1,000
Cost of sales 100 154 70 816
Gross profit 20 30 184
Step 3: Apply the cost structures to calculate cost of sales and gross profits
Sales 600 120 220 100 1,000
Cost of sales 500 100 154 70 816
Gross profit 100 20 66 30 184
Step 4: Complete the table

Sales 600 120 220 100 180 100 1,000
Cost of sales 500 100 154 70 162 90 816
Gross profit 100 20 66 30 18 10 184
2.5 Missing inventory figure

The gross profit margin (or mark-up) can also be used to establish the value of inventory that is
missing or lost, for example due to theft or a fire. In these situations, you might know the value of
sales in the period, purchases during the period and opening and closing inventory.
By calculating the cost of sales from sales and the gross profit margin, it should be possible to
establish the value of missing inventory that is unaccounted for, as a balancing figure.

Example:
A sole trader operates his business from a warehouse, which has been damaged by a fire, which
occurred at the end of the financial year. After the fire, the remaining inventory that is undamaged
amounts to Rs. 2,000 (cost).
The accountant establishes the following information:
a) Inventory at the beginning of the year was Rs. 16,000
b) Purchases during the year were Rs. 115,000
c) Sales during the year were Rs. 140,000
d) The trader sells his goods at a mark-up of 25% of cost.
Required
Calculate the cost of the inventory lost in the fire.
Answer
Gross profit = 25% of cost.
As a proportion of sales, gross profit = (25/(25 + 100)) = 0.20 or 20%.
Sales = Rs. 140,000.
Therefore gross profit = 20% × Rs. 140,000 = Rs. 28,000
Cost of sales = 80% × Rs. 140,000 = Rs. 112,000.
Rs.
Purchases 115,000
131,000
Closing inventory should be 19,000
Actual closing inventory (2,000)
Balancing figure = inventory lost in the fire 17,000
Practice question 8
A business operates on the basis of a mark-up on cost of 40%.
Calculate the closing inventory from the following information:
Rs.
Purchases 71,200
Sales 98,000

Practice question 9
A fire on 31 March destroyed some of the inventory of a company, and its inventory
records were also lost. The following information is available.
The company makes a standard gross profit margin of 30%.
Rs.
Inventory at 1 March 127,000
Purchases for March 253,000
Sales for March 351,000
Inventory in good condition at 31 March 76,000
What was the cost of the inventory lost in the fire?
Practice question 10
Rashid owns a shop which sells telephone recharge cards, making a mark-up of25%.
He does not keep a cash book.
On 1 January 2017, the statement of financial position of his business was as
follows:
Rs. 000
Net non-current assets 200.0
Current assets:
Inventory 100.0
Cash in bank 30.0
Cash in till 2.0
332.0
Financed by:
Capital 320.0
Trade payables 12.0
332.0
The bank statements for the year show the following:

Receipts Rs. 000
Banking of receipts 417.5
Payments
Trade payables 360.0
Sundry expenses 56.0
Drawings 44.0
(i) There were no credit sales.
(ii) The following payments were also made in cash.
Rs.
Trade payables 8,000
Drawings 37,000
(iii) At 31 December 2017, the business had cash in the till of Rs. 4,500 and trade payables of
Rs.14,000. The cash balance in the bank was not known and the value of closing inventory
has not yet been calculated. There were no accruals or prepayments. No further non-current
assets were purchased during the year. The depreciation charged for the year was Rs. 9,000.
Required:
Prepare the statement of profit or loss for the year ended 31 December 2017 and the statement
of financial position as at that date.


Solution 1
Rs.
Net assets at 31 December (376,000 – 108,000) 268,000
Net assets at 1 January (314,000 – 87,000) (227,000)
Increase in net assets 41,000
Drawings 55,000
New capital introduced in the year (25,000)
Solution 2
(a) Net assets (capital) at the start of the year
Assets: Rs.000
Property 1,425
Delivery van 234
Inventory 74
Accounts receivable 130
Prepaid expenses 16
Bank balance 200
Cash balance 106
2,185
Liabilities:
Bank loan 300
Accounts payable 90
(390)
Net assets (capital) 1,795
(b) Net assets (capital) at the end of the year

Assets: Rs.000
Property 1,354
Delivery van 211
Investment 500
Inventory 190
Accounts receivable 193
Cash balance 366
2,814
Liabilities:
Bank loan 300
Bank overdraft 40
Accounts payable 74
Accrued expenses 10
(424)
Net assets (capital) 2,390

Solution (continued) 2
(c) Profit for the year
Rs.000
Net assets (capital) at the year-end 2,390
Net assets (capital) at the start of the year (1,795)
Increase in net assets 595
Drawings 20
Capital introduced (250)
Profit for the year 365
Solution 3
Receivables memorandum account
Rs. Rs.
Opening balance 2,400 Money banked 12,500
Sales (bal fig) 12,100
Bad debt written off 200
Closing balance 1,800
14,500 14,500
Solution 4
Payables memorandum account
Rs. Rs.
Cash paid 11,300 Opening balance 1,400
Closing balance 1,900 Purchases (bal fig) 11,800
13,200 13,200
Solution 5
Cash and bank memorandum account
Rs. Rs.
Opening balance, cash in
hand 100 Payments to suppliers 38,200
Opening balance, bank 2,400 Payments to employees 3,400
Receipts 51,700
Drawings (= balancing figure) 7,250
Closing balance, cash in hand 150
Closing balance, bank 5,200
54,200 54,200

Solution 6
Rs.
Purchases 42,100
Less: closing inventory (4,000)
Mark-up at 40% 16,480
Sales (41,200  140%) 57,680
Solution 7
Rs. Rs. Rs. Rs.
Sales 8,000 15,000 ? 20,000
Opening inventory 1,000 2,000 1,000 2,000
Purchases 5,000 8,700 7,500 15,000
6,000 10,700 8,500 17,000
Closing inventory (1,200) (1,500) (500) (2,000)
Cost of sales (4,800) (9,200) (8,000) (15,000)
Gross profit 3,200 5,800 2,000 5,000
Profit margin 40% 38.7% 20% 25%

Mark-up 66.7% 63% 25% 33.3%
Solution 8
Rs. %
Sales 98,000 140
Cost of sales
Purchases 71,200
Less: closing inventory (balancing figure) (6,200)
70,000 100
Working:
Cost of sales = 100/140× Sales 100/140 × 98,000 = 70,000
Solution 9
Rs.
Inventory at 1 March 127,000
Purchases for March 253,000
380,000
Cost of sales + cost of lost inventory 304,000
Cost of sales (Rs. 351,000  70%) (245,700)
Inventory lost in the fire 58,300

Solution 10
Statement of profit or loss account for the year ended 31 December 2017
Rs.000
Sales 480.0
Cost of sales
Opening inventory 100.0
Purchases 370.0
Closing inventory 470.0
(86.0)
(384.0)
Gross profit 96.0
Less expenses
Sundry expenses (Rs. 15,000 + Rs. 56,000) 71.0
Depreciation 9.0
(80.0)
Net profit 16.0
Statement of financial position as at December 2017

Rs.000
Non-current assets (Rs. 200,000 – Rs. 9,000) 191.0
Current Assets:
Inventory 86.0
Cash(W1) 4.5
90.5
281.5
Financed By:
Capital at start of the year 320.0
Profit for the year 16.0
336.0
Less: Drawings (81.0)
Capital at end of the year 255.0
Current Liabilities :
Payables(W3) 14.0
Bank overdraft(W1) 12.5
26.5
281.5

Solution (continued) - Workings 10

W1 Cash book
Cash Bank Cash Bank
Rs. 000 Rs. 000 Rs. 000 Rs. 000
Balance b/d 2.0 30.0 Banking 417.5 
Receipts  417.5 Payables 8.0 360.0
Sales (cash) (W2) 480.0 Expenses 15.0 56.0
Balance c/d  12.5 Drawings 37.0 44.0
Balance c/d 4.5 
482.0 460.0 482.0 460.0
W2 Sales (proof)
Rs. 000
Receipts banked 417.5
Add:
Payments out of till 60.0
Closing cash balance 4.5
482.0
Less: Opening cash balance (2.0)
480.0
W3 Payables
Rs. 000 Rs. 000
Bank 360 Balance b/d 12
Balance c/d 8 Purchase (balance) 370
Balance c/d 14
382 382
W4 Mark-up and margin

Mark-up Margin
Sales 125 125
Cost (100) 100
Profit 25 25 25
Mark-up (25/100  100) 25%

Margin (25/125  100) 20%


CHAPTER
Introduction to cost of production
Contents
1 Accounting for management
2 Cost and management accounting versus financial
accounting
3 Introduction to costs
4 Cost classification by type and function
5 Fixed and variable costs
6 Direct and indirect costs
7 Product costs and period costs
8 Preparation of manufacturing account

1 ACCOUNTING FOR MANAGEMENT

Section overview
 Introduction to accounting information

 Data and information
 Qualities of good information
 Purpose of management information
1.1 Introduction to accounting information

Accounting is one of the key functions for almost any business; it may be handled by a
bookkeeper and accountant at small firms or by sizable finance departments with dozens of
employees at larger companies.
There are many definitions of accounting.
Definitions: Accounting
The systematic and comprehensive recording of financial transactions pertaining to a business and
the process of summarizing, analysing and reporting these transactions.
A systematic process of identifying, recording, measuring, classifying, verifying, summarizing,
interpreting and communicating financial information.
The process of identifying, measuring, and communicating economic information to permit
informed judgements and decisions by users of the information
The main purposes of accounting may be summarised as follows.

 To provide a record of the financial value of business transactions, and in doing so to
establish financial controls and reduce the risks of fraud
 To assist with the management of the financial affairs of an entity
 To provide information - mainly information of a financial nature.
Accounting information is provided for:
 Management, so that managers have the information they need to run the company
 Other users of information, many of them outside the entity. For example, a company
produces accounting information for its shareholders in the form of financial statements,
and financial statements are also used by tax authorities, investors, trade union
representatives and others.
Cost and management accounting is concerned with the provision of information, mainly of a
financial nature, for management.
1.2 Data and information

Data and information
The terms ‘data’ and ‘information’ are often used as if they have the same meaning. However,
there is a difference between data and information. Data is a term that refers to facts. It must be
turned into information in order for it to become useful. Information is derived from facts that have
been processed, structured and analysed.
 Data consists of unprocessed facts and statistics.
 Data is collected and processed to produce information.
 Data has no meaning until it has been processed into information.

Chapter 6: Introduction to cost of production
 Information has a meaning and a purpose. It is produced from ‘data’. It is processed data
that has relevance to a particular useful purpose.
Accounting systems are designed to capture data and process it into information.
Illustration: Data and information

A company engages in many different types of transactions (sales, purchases of materials,
expenses, and so on).
Each of these is processed into individual records (for example, sales are recorded on sales
invoices). This would result in thousands of individual records.
An accounting system summarises these in a meaningful manner to produce information. This is
carried out in a series of steps each of which provides information based ultimately on the original
transactions.
Sales day book – summarises the total sales made in a specified period.
The receivables control account shows the total owed to the company at any point in time.
The receivables ledger shows the total amount owed the company by individual customers at any
point in time.
The general ledger is the source of information which can be further processed into periodic reports
(financial statements).
A cost accounting system records data about the costs of operations and activities within the
entity. The sources of cost accounting data within an organisation include invoices, receipts,
inventory records and time sheets.
Many of the documents from which cost data is captured are internally-generated documents,
such as time sheets and material requisition notes.
Illustration:
A ship yard may employ hundreds of workers and be building and refitting several ships at any one
time.
Each worker might be required to complete job sheets which specify the length of time taken by
that worker and on which contract.
This would produce many thousands of individual records (data) which are not very useful until the
facts contained in those records are processed into information. Thus the system might produce
reports (information) to show the labour cost, by type of labour, by week for each ship.
Data is analysed and processed to produce management information, often in the form of:
 routine reports;
 specially-prepared reports;
 answers to ‘one-off’ enquiries that are input to a computer system.
Information produced from cost accounting data is management accounting information.
Management accounting systems also obtain information from other sources, including external
sources, but the cost accounting system is a major source of management accounting
information.
1.3 Qualities of good information

Information is only useful to managers if it possesses certain qualities or attributes.
 Accurate
Information should be fair and free from bias. It should not have any arithmetical and
grammatical errors.

 Understandable
 Information should be understandable to the individuals who use it.
 Accounting information must be set out clearly and be properly explained.
 Purpose and relevance
 Unless information has a purpose it has no value at all and it makes no sense to
provide it.
 Information must be relevant for its purpose.
 Reliable
 Users of information must be able to rely on it for its intended purpose.
 Unreliable information is not useful.
 Information does not have to be 100% accurate to be reliable. In many cases,
information might be provided in the form of an estimate or forecast.
 Sufficiently complete
 Information should include all information necessary for its purpose.
 However, information in management reports should not be excessive, because
important information may be hidden in the unimportant information, and it will take
managers too long to read and understand.
 Timeliness
 If information is provided too late for its purpose, it has no value.
 With the widespread computerisation of accounting systems, including cost
accounting systems, it might be appropriate for up-to-date management accounting
information to be available on line and on demand whenever it is needed.
 Comparability
 In accounting it is often useful to make comparisons, such as comparisons of
current year results with previous years, or comparisons of actual results with
planned results.
 To make comparisons possible, information should be prepared on the same basis,
using the same methods and the same ‘rules’.
 Communicated to the right person
 Management information should be communicated to the proper person.
 This is the person with the authority to make a decision on the basis of the
information received and who needs the information to make the decision.
 Its value must exceed its cost (Information must be cost effective)
 Management information has a value (if information has no value there is no point in
having it) but obtaining it involves a cost.
 The value of information comes from improving the quality of management
decisions.
 Information is worth having only if it helps to improve management decisions, and
the benefits from those decisions exceed the cost of providing the additional
information.
1.4 Purpose of management information

The purpose of management accounting is to provide information for:
 planning;
 control; and
 decision making.

Planning
Planning involves the following:
 setting the objectives for the organisation
 making plans for achieving those objectives.
The planning process is a formal process and the end-result is a formal plan, authorised at an
appropriate level in the management hierarchy. Formal plans include long-term business plans,
budgets, sales plans, weekly production schedules, capital expenditure plans and so on.
Information is needed in order to make sensible plans – for example in order to prepare an
annual budget, it is necessary to provide information about expected sales prices, sales
quantities and costs, in the form of forecasts or estimates.
Control
Control of the performance of an organisation is an important management task. Control
involves the following:
 monitoring actual performance, and comparing actual performance with the objective or
plan;
 taking corrective action where appropriate;
 evaluating actual performance.
When operations appear to be getting out of control, management should be alerted so that
suitable measures can be taken to deal with the problem. Control information might be provided
in the form of routine performance reports or as special warnings or alerts when something
unusual has occurred.
Decision making
Managers might need to make ‘one-off’ decisions, outside the formal planning and control
systems. Management accounting information can be provided to help a manager decide what to
do in any situation where a decision is needed.

2 COST AND MANAGEMENT ACCOUNTING VERSUS FINANCIAL ACCOUNTING

Section overview
 Purpose and role of cost accounting, management accounting and financial accounting
 Comparison of financial accounting and cost and management accounting
 Cost accounting cycle
 Factory ledger
2.1 Purpose and role of cost accounting, management accounting and financial
accounting
The terms cost accounting and management accounting are often used as having the same
meaning. However, there is distinction between the two.
Cost accounting
Cost accounting is concerned with identifying the cost of things. It involves the calculation and
measurement of the resources used by a business in undertaking its various activities.
Cost accounting is concerned with gathering data about the costs of products or services and the
cost of activities. There may be a formal costing system in which data about operational activities
is recorded in a ‘double entry’ system of cost accounts in a ‘cost ledger’. The cost accounting
data is captured, stored and subsequently analysed to provide management information about
costs.
Cost accounting information is historical in nature, and provides information about the actual
costs of items and activities that have been incurred.
Management accounting
Management accounting is concerned with providing information to management that can be
used to help run the business.
 The purpose of management accounting is to provide detailed financial information to
management, so that they can plan and control the activities or operations for which they
are responsible.
 Management accounting information is also provided to help managers make other
decisions. In other words, management accounting provides management information to
assist with planning, control and ‘one-off’ decisions.
Management accounting includes cost accounting as one of its disciplines but is wider in scope.
Management accounting information is often prepared from an analysis of cost accounting data,
although cost estimates and revenue estimates may be obtained from sources other than the
cost accounting system.
Management accounting may be forward-looking, and used to provide information about
expected costs and profits in the future.
Financial accounting
Financial accounting is concerned with providing information about the financial performance and
cash flows of an entity in a given period and the financial position of the entity at the end of that
period.
The information is often provided to a wider range of stakeholders (those with an interest in the
business) than those who have access to management information. The most important of these
are the owners of a business who may not take part in the day to day running of the business.

2.2 Comparison of financial accounting and cost and management accounting

Financial accounting
A financial accounting system is used to record the financial transactions of the entity, such as
transactions relating to income, expenses, assets and liabilities.
It provides a record of the assets that the company owns, and what it owes and a record of the
income that the entity has earned, and the expenditures it has incurred.
The financial accounting system provides the data that is used to prepare the financial
statements of the entity at the end of each financial year (the statement of comprehensive
income, statement of financial position, statement of cash flows, and so on).
Managers might use the information in the financial statements, but the main purpose of financial
reporting is for ‘external purposes’ rather than to provide management information. The main
purpose of the financial statements of companies is to inform the company’s shareholders
(owners) about the financial performance, cash flows and financial position of the company. They
are also used as a basis for computation of the tax that the company should pay on its profits.
Financial statements are produced at the end of the financial year. Management need
information much more regularly, throughout the year. They also need much more detailed
information than is provided by a company’s financial statements. They often need forward-
looking forecasts, rather than reports of historical performance and what has happened in the
past.
There is a statutory requirement for companies to produce annual financial statements, and other
business entities need to produce financial statements for the purpose of making tax returns to
the tax authorities.
Managers might find financial statements useful, but the main users of the financial statements of
a company should be its shareholders. Other external users, such as potential investors,
employees, trade unions and banks (lenders to the business) might also use the financial
statements of a company to obtain information.
Cost and management accounting
Whereas financial statements from the financial accounting system are intended mainly for
external users of financial information, management accounting information (obtained from the
cost accounting system) is prepared specifically for internal use by management.
An entity might have a cost accounting system as well as a financial accounting system, so that it
has two separate accounting systems in operation. A cost accounting system records the costs
and revenues for individual jobs, processes, activities and products or services.
 Like the financial accounting system, a cost accounting system is based on a double entry
system of debits and credits.
 However, the accounts in a cost accounting system are different from the accounts in the
financial accounting systems. This is because the two accounting systems have different
purposes and so record financial transactions in different ways.
There is no legal requirement for a cost accounting system. Business entities choose to have a
cost accounting system, and will only do so if the perceived benefits of the system justify the cost
of operating it.
(In business entities where there is no formal cost accounting system, managers still need
management accounting information to run their business. Some management accounting
information might be extracted from the financial accounting system, but in much less detail than
a cost accounting system would provide.)

A comparison of financial and cost accounting systems of companies is summarised in the table
below.
Financial accounting system Cost accounting system
Prepared to meet a legal or regulatory Prepared to meet the needs of

requirement. management.
Used to prepare financial statements for Used to prepare information for

shareholders and other external users. (Might management (internal use only).
also provide some information for management
but this is not their primary purpose).
Content usually specified by a regulatory Content specified by the management of a

framework. company.
Prepared within a time frame specified by a Prepared within a time frame specified by
legal or regulatory framework. management.
Records revenues, expenditure, assets and Records costs of activities and used to
liabilities. provide detailed information about costs,
revenues and profits for specific products,
operations and activities.
Used mainly to provide a historical record of Provides historical information, but also used
performance and financial position. extensively for forecasting (forward-looking).
2.3 Cost accounting cycle

Cost accounts are an expansion of the general accounts. Accounts describing manufacturing
operations are: Materials, Payroll, Factory Overhead Control, Work in Process, Finished Goods
and Cost of Goods Sold. The flow of cost from acquisition of materials, through factory
operations to the cost of products sold is recognised and measured through these accounts. In
cost accounting, extensive use of control accounts is made such as materials accounts, factory
overhead account, Work in process account and finished goods account etc.
1. The costing process starts by using the Materials Account to record amounts for
procurement of direct material for production of the goods and its onward transfer to the
production floor. In case of textile industry, the amount include cost of procuring the yarn,
freight inwards, non-refundable taxes etc. to produce fabric.
Following are some of the materials that fall under this category:
a) Materials which are specifically purchased, acquired or produced for a particular job,
order or process.
b) Primary packing material (e.g. carton, wrapping etc.)
2. The Payroll account is then used to record direct labour (human efforts used for conversion
of materials into finished products), salary paid to production supervisor or fabric cutting cost
to a labour etc.)
3. The Factory overhead account is used for recording indirect material (e.g. cleaning supplies
of a factory), indirect labour (e.g. salary of quality assurance staff_, supplies, rent, insurance,
taxes, repairs and other factory expenses incurred on converting a raw material into finished
goods. It is indirect factory related costs that are incurred when producing a product. It is
basically the costs without which a particular product cannot be made. the Company’s cost
procedure determines the type of subsidiary record that supports the Work in Process
control account.
4. the total of cost of goods completed is transferred from the Work in Process control account
to the Finished Goods account.

5. Finally, the cost of goods sold is transferred from the Finished goods account to the Cost of
Goods Sold
6. At the end of each accounting period, Cost of Goods Sold is closed to Statement of Profit &
Loss.
Illustration: Cost flow
2.4 Factory ledger

A factory ledger is a group of accounts, containing the production costs of a business. These
accounts typically include the following:
 Direct material expenses
 Direct labour expenses
 Factory overhead expense
These accounts may contain the bulk of the expense transactions generated by a business, and
so are of particular interest to the cost accountant or financial analyst who is examining the
financial performance of an organizations.

3 INTRODUCTION TO COSTS
Section overview
 Types of organisation
 Cost classification: Introduction
3.1 Types of organisation

The following classification of organisations is useful for the purpose of learning about costs:
 Manufacturing organisations: and
 Service organisations.
Manufacturing organisations
There are a great many different kinds of manufacturing organisations. They can be classified by
their type of output which in turn implies the type of costing system they might use.
Type of production Examples Costing system

Identical (similar) products in large numbers Bottles of soft drink Basic manufacturing
Mobile phones costing
Garments Standard costing
Identical products in large amounts by passing Pharmaceuticals Process costing

the product through a series of processes Paint (including joint
product and by-
Petroleum
product costing)
Identical products in large numbers Aircraft (which may Job costing
customised in some way for different vary in internal fit
customers and external
painting)
Own-brand foods for
supermarkets
One-off products to a customer’s specification Ships Job costing
Airport facilities
Roads
Bridges
Service organisations
Similar to the manufacturing industry there are a great many different kinds of service
organisations. For example:
 Training and education
 Healthcare
 Travel and tourism
 Financial services
 Entertainment and leisure
One of the key differences between manufacturing and service industries is the perishability of
product – manufacturing output is generally tangible and can be stored whereas output from the
service industry is generally perishable. The service is normally consumed at the time of delivery
(production). For example, a patient visiting a doctor consumes the consultation as it is given.

However, some work-in-progress (WIP) may be recorded – for example an accountant who has
spent 10 hours working on a tax advice project that will take 20 hours in total to complete. The
first 10 hours would be described as WIP.
Costing systems typically used in service organisations include:
 Standard costing
 For example the standard cost of delivering a doctor’s consultation, the standard
cost of a package holiday, the standard cost of a flight between Karachi and London
 Job costing
 For example bespoke consultation projects in the financial services industry or the
cost of an architect designing a ship
 The professional will usually apply a standard hourly rate whilst the total number of
hours on each job varies
The need to know about costs
All organisations need to understand their costs.
An organisation needs to know:
 how much it costs to make the products that it produces, or
 how much it costs to provide its services to customers.
For an organisation that is required to make a profit, it is important to know the cost of items in
order to:
 make sure that the product or service is sold at a profit;
 measure the actual profit that has been made; and
 in the case of some companies, such as manufacturing companies, value inventory at the
end of each accounting period.
For an organisation that is not required to make a profit (a ‘not-for-profit organisation’, such as a
government department, state-owned agency or charity), it is important to know how much items
cost, in order to:
 control the entity;
 measure to what extent it is achieving its objectives; and
 plan expenditure for the future.
Terminology
Definitions: Cost object

Cost object: Any activity for which a separate measurement of costs is needed
Examples of cost objects include:

 The cost of a product
 The cost of a service
 The cost of a department
 The cost of a project
Definitions: Cost unit

Cost unit: A unit of product or service for which costs are determined
A cost unit is the basic unit of production for which costs are being measured.
The term cost unit should not be confused with the term unit cost.

Definitions: Unit cost

Unit cost is the cost incurred by a company to produce, store and sell one unit of a particular
product.
Unit cost includes all fixed costs and all variable costs involved in production
Cost objects and cost units should be selected so as to provide management with the cost
information they require.
Here are some examples of cost objects and cost units
Industry/activity Cost object Cost unit

Car manufacture Cars produced A car
Bakery Bread produced A batch of bread items
Steel works Steel produced Tonne of steel
Carpet manufacture Carpets produced Square metre of carpet
Retail operation Cost of items sold An item
Passenger transport Cost of transporting Cost per passenger/mile
service customers (i.e. average cost of transporting a
passenger one mile)
Road haulage Cost of transporting Cost per tonne/mile
items (i.e. average cost of carrying one tonne of
items for one mile)
University Cost of teaching Cost per student
Example
A company manufactures tinned foods.
It has two products, tinned carrots and tinned beans. In its costing system, it has two cost objects,
carrots and beans.
Cost object Cost unit
1 Carrots Production cost per tin of carrots
2 Beans Production cost per tin of beans
Example:
A transport company has a bus depot.
The company has a cost accounting system that records and measures the cost of operating the
bus depot.
The costs of operating the depot are measured in three ways, as follows:
Cost object Cost unit
1 Buses Operating cost per bus per month
2 Bus routes Operating cost per month for each bus route
3 Bus drivers Cost of operating the depot per month, per bus driver
employed

3.2 Cost classification: Introduction

Costs can be classified in a number of ways including:
 Type of cost (material, labour, other expenses);
 Function of the cost:
 Production
 Non-production
 Selling
 Distribution
 Administration
 Finance
 Cost behaviour – i.e. how the cost varies at different levels of activity:
 costs may stay constant at different levels of activity - fixed costs; or
 costs may stay vary at different levels of activity – variable costs
 Whether the cost can be directly attributed to units of production.
 Whether a cost is recognised in this period (period cost) or is carried forward as part of the
inventory valuation (product cost).
Each of these will be explained in turn but before that note that the above classifications are not
mutually exclusive.
Illustration:
A car maker uses steel:
Steel is material.
Steel is a production cost (you cannot make a car without using steel).
Steel is a cost which varies with the number of cars produced.
Steel can be directly attributable to a car.
Steel is a product cost.

4 COST CLASSIFICATION BY TYPE AND FUNCTION

Section overview
 Cost classification by type

 Cost classification by function
 Production or non-production?
 Usefulness of classifying costs by function
 The importance of separating production and non-production costs
 Reporting profit
 Preparation of manufacturing account
4.1 Cost classification by type

Material costs
Material costs are the costs of any material items purchased from suppliers, with the intention of
using them or consuming them in the fairly short-term future.
In a manufacturing company, material costs include the cost of the raw materials that go into
producing the manufactured output.
In an office, costs of materials consumed include the costs of stationery and replacement printer
cartridges for the office laser printers.
Labour costs
Labour costs are the remuneration costs of all employees employed and paid by the entity. This
includes the wages and salaries of part-time workers and the costs of any bonuses, pension
contributions and other items that are paid in addition to basic wages and salaries.
Other expenses
Other expenses include the costs of any items that are not material costs or labour costs. They
include the cost of services provided by external suppliers (the charges made by sub-contractors,
charges for repairs by external contractors, rental costs, telephone costs, insurance costs, costs
of energy (gas, electricity), travelling and subsistence expenses, and depreciation charges for
non-current assets.
In a cost accounting system, all these items of cost must be recorded, and there needs to be an
organised system for recording them. Cost items need to be grouped into categories of similar
costs.
4.2 Cost classification by function

A manufacturing company would classify costs according to their function: categorised as either:
 production costs (manufacturing costs); and
 non-production costs (non-manufacturing costs).
Production costs
Production costs are the costs incurred in manufacturing finished products, up to the time that the
manufacture of the goods is completed, and the goods are either transferred to the finished
goods inventory or delivered immediately to the customer.
Production costs include:
 the material cost of the raw materials and components, purchased from suppliers and used
in the production of the goods that are manufactured
 the labour cost of all employees working for the manufacturing function, such as machine
operators, supervisors, factory supervisors and the factory manager

 other expenses of the factory, such as rental costs for the factory building, energy costs
and the cost of depreciation of factory machinery.
Non-production costs
Non-production costs are any items of cost that are not production costs.
Non-production costs can be further classified according to their function as:
 selling costs;
 distribution costs;
 administrative costs;
 finance costs.
Selling and distribution costs (marketing costs)
Selling and distribution costs are the costs incurred in marketing and selling goods or services to
customers, and the costs of delivering the goods to customers. The costs of after-sales services,
such as customer support services, are usually included in these costs. Sales and distribution
costs include:
 the wages and salary costs of all employees working in the selling and distribution
departments, including sales commissions for sales representatives
 advertising costs and other marketing costs
 operating costs for delivery vehicles (for delivering finished goods to customers), such as
fuel costs and vehicle repair costs
 other costs, including depreciation costs for the delivery vehicles.
Administration costs
Administration costs are the costs of providing administration services for the entity. They might
be called ‘head office costs’ and usually include the costs of the human relations department and
accounting department. They should include:
 the salary costs of all the staff working in the administration departments
 the costs of the office space used by these departments, such as office rental costs
 other administration expenses, such as the costs of heating and lighting for the
administration offices, the depreciation costs of equipment used by the administration
departments, fees paid to the company’s solicitors for legal services, costs of office
stationery and so on.
Finance costs
Finance costs include costs that are involved in financing the organisation, for example, loan
interest or bank overdraft charges.
Finance costs might be included in general administration costs. Alternatively, finance costs
might be excluded from the cost accounting system because they are relevant to financial
reporting (and the financial accounting system) but are not relevant to the measurement of costs.
4.3 Production or non-production?
Some costs might be partly production costs, partly administration costs and partly selling and
distribution costs. For example:
 The salary of the managing director, because the managing director spends time on all
aspects of the company’s operations.
 Building rental costs, when the same building is used by more than one function. For
example administration staff and sales staff might share the same offices.
When costs are shared between two or more functions, they are divided between the functions
on a fair basis.
For example, the salary of the managing director might be divided equally manufacturing costs,
administration costs and sales and distribution costs.

Dividing shared costs on a fair basis is called apportionment of the cost.
Practice question 1
A company uses three categories of functional cost in its cost accounting system. These are
manufacturing costs, administration costs and sales and distribution costs.
Identify the functional cost category for each of the following costs:
1 Salary of the chief accountant
2 Telephone charges
3 Cost of office cleaning services
4 Cost of warehouse staff
4.4 Usefulness of classifying costs by function

Separating costs into the costs for each function can provide useful information for management.
Functional costs show managers what they are expected to spend on each function (budgeted
costs) and how much they are actually spending.
Example:
Functional costs might be used in an income statement to report the profit or loss of a company
during a financial period, as follows:
Rs m Rs m
Sales revenue 600
Manufacturing cost of sales 200
Gross profit 400
Administration costs 120
Selling and distribution costs 230
350
Net profit (or net loss) 50
4.5 The importance of separating production and non-production costs

Inventory
It is important to separate production costs from non-production costs in a manufacturing
business for the purpose of valuing closing inventory which will consist of:
 finished goods that have been produced during the financial period but not yet sold
(finished goods inventory); and
 partly finished production (work-in-progress or WIP).
The costs of finished goods and work-in-progress consist of their production costs.
Total production costs during a period must therefore be divided or shared between:
 goods produced and sold in the period;
 goods produced but not yet sold (finished goods);
 work-in-progress.
Non-production costs e.g. salaries of sales persons are never included in the cost of inventory.

4.6 Reporting profit

Profit is the revenue for a financial period minus the costs for the period. The profit or loss earned
during a financial period is reported in a statement of comprehensive income (also known as an
income statement).
In most financial accounting examples the cost of sales figure is built from purchases as adjusted
by inventory movement.
It is comprised of the cost of goods manufactured (instead of purchases) as adjusted by finished
goods inventory movement. The cost of goods made is a more complex figure than purchases. It
comprises direct materials used, direct labour and production overheads adjusted by movement
in work in progress in the year. It is often constructed in a manufacturing account. The total from
this account feeds into the statement of comprehensive income.
4.7 Preparation of Manufacturing Account

A manufacturing account shows the cost of producing the goods that are sold during an
accounting period. It is split into the following sections:
 Prime cost - Direct costs of physically making the products (e.g. raw materials)
 Overhead cost - Other indirect costs associated with production but not in a direct manner
The cost of manufacturing the products will be the total of the prime cost and the overhead cost
added together.
Prime cost:
The prime cost covers all direct the costs involved in physically making the products. Common
examples would include:
 Direct materials
 Direct labour/wages
 Other direct costs (e.g. packaging, royalties)
Cost of raw materials consumed
Within the prime cost adjustments will have to be made for opening and closing stocks of raw
materials. There may also be carriage inwards charged on the raw materials and returns
outwards of materials sent back to their original supplier. The overall charge for materials is
referred to as cost of raw materials consumed. The overall movement is shown in the
manufacturing account as illustrated below.
Opening inventory
Add: Purchases
Less: Closing inventory
Raw material consumed
Overhead cost
This section includes all other expenses related to the production of goods in an direct manner.
This means that if the level of production increased, then these expenses may also increase but
not by the same proportion. These are sometimes known as indirect costs, factory overheads or
indirect manufacturing costs. Common examples of overhead costs would include:
 Factory rent
 Indirect labour
 Depreciation of factory plant and equipment
Depreciation of fixed assets should be included in this section only if it is depreciation on assets
included for production. For example, depreciation of machinery would appear as an overhead
cost but depreciation of office equipment would appear in the profit and loss account.

Illustration: Manufacturing account

Rs. Rs.
Raw materials
Purchases 150,000
175,000
Less: Closing inventory (20,000)
Raw materials consumed 155,000
Manufacturing wages 100,000
Prime cost 255,000
Overheads
Light and power 72,000
Depreciation of production machinery 40,000
Depreciation of factory 50,000
162,000
Manufacturing costs 417,000
Opening work in progress 85,000
Closing work in progress (95,000)
Cost of goods manufactured 407,000
The cost of goods made is transferred to the statement of comprehensive income.
Illustration: Statement of comprehensive income to show transfer of cost of goods made.

Rs. Rs.
Sales revenue 800,000
Less cost of goods sold
Opening inventory of finished goods 50,000
457,000
Closing inventory of finished goods (40,000)
Administration costs 86,000
Selling and distribution costs 94,000
(180,000)
Net profit for the period 203,000

Practice Question 5
The following data has been extracted from the books of Beauty Bars Ltd at 31 December 2018:
Dr Cr.
Raw materials 15,000
Work in progress 10,000
Finished goods 25,000
Purchases of raw materials 50,000
Sales 500,000
Direct Labour 20,000
Rent 22,000
Electricity 18,000
Office Salaries 30,000
Depreciation for the year:
Office 7,000
Factory 3,000
Advertisement 16,000
Additional information:
Inventory as on 31.12.2018
Raw materials 11,000
Work in progress 6,000
Finished goods 10,000
Rent and electricity are to be apportioned: Factory 70%, Office 30%
3. Finished goods are to be transferred to the trading account at a profit of 25% on

factory cost.
Make a manufacturing account and statement of comprehensive income for

Beauty Mar Ltd for the year ended December 31, 2018

5 FIXED AND VARIABLE COSTS

Section overview
 Cost behaviour
 Fixed costs
 Variable costs
 Semi-variable costs
 Stepped costs
5.1 Cost behaviour

Cost behaviour refers to the way in which costs change as the volume of activity changes. The
volume of activity may be:
 the volume of sales;
 the volume of production;
 total labour hours worked, machine hours worked;
 the number of production units inspected;
 the number of batches
 the number of journeys (for buses or trains) or deliveries, and so on.
As a general rule, total costs are expected to increase as the volume of activity rises.
Management might want information about estimated costs, or about what costs should have
been. An understanding of cost behaviour is necessary in order to:
 forecast or plan what costs ought to be; and
 compare actual costs that were incurred with what the costs should have been.
The most important classification of costs for the purpose of cost estimation is the division of
costs into fixed costs or variable costs.
5.2 Fixed costs

Fixed costs are items of cost that remain the same in total during a time period, no matter how
many units are produced, and regardless of the volume or scale of activity.
Fixed costs might be specified for a given period of time. In such cases the fixed costs for a
longer period would be scaled up.
Examples of fixed costs include:
 The rental cost of a building is Rs.40,000 per month. The rental cost is fixed for a given
period: Rs.40,000 per month, or Rs.480,000 per year.
 The salary costs of a worker who is paid Rs.11,000 per month. The fixed cost is Rs.11,000
per month or Rs.132,000 per year.
Note that as activity levels increase the cost remains fixed. However, the cost per unit falls
because the cost is being spread over a greater number of units.
5.3 Variable costs

Variable costs are costs that increase, usually by the same amount, for each additional unit of
product that is made or each additional unit of service that is provided.
The variable cost of a cost unit is also called the marginal cost of the unit.

The variable cost per unit is often the same amount for each additional unit of output or unit of
activity.
This means that total variable costs increase in direct proportion to the total volume of output or
activity.
Examples of variable cost items.
 The cost of buying raw material is Rs.500 per litre regardless of purchase quantity. The
variable cost is Rs.500 per litre:
 the total cost of buying 1,000 litres is Rs.500,000
 the total cost of buying 2,000 litres would be Rs.1,000,000.
 The rate of pay for hourly-paid workers is Rs.150 per hour.
 400 hours of labour would cost Rs.60,000; and
 500 hours would cost Rs.75,000.
 The time needed to produce an item of product is 4 minutes and labour is paid Rs.150 per
hour.
 direct labour is a variable cost and the direct labour cost per unit produced is Rs.10
(= Rs.150 × 4/60).
 The cost of telephone calls is Rs.1 per minute.
 The cost of telephone calls lasting 6,000 minutes in total would be Rs.6,000.
Note that as activity levels increase the cost per unit remains fixed. However, the total cost
increases as more units are being made.
Cost behaviour graphs: fixed and variable costs
Cost behaviour for items of cost (or for costs in total) can be shown graphically either showing
the total cost incurred at different activity levels or the cost per item at different activity levels.
Illustration: Cost behaviour graphs for fixed costs and variable costs

5.4 Semi-variable costs

A semi-variable cost, is a cost that is partly fixed and partly variable. A cost behaviour graph
showing the total costs for an item of mixed cost is shown below.
Illustration: Semi variable cost
An item of cost that is a mixed cost is an item with a fixed minimum cost per period plus a
variable cost for every unit of activity or output.
Example:
A company uses a photocopier machine under a rental agreement. The photocopier rental cost is
Rs.4,000 per month plus Rs.2 per copy produced.
The company makes 15,000 copies during a month:
Total cost is as follows:
Rs.
Fixed cost 4,000
Variable cost (15,000 Rs. 2) 30,000
34,000
Mixed costs are important in cost and management accounting. It is often assumed that the total
costs of an activity are mixed costs, consisting partly of fixed costs and partly of variable costs.
For example, it might be assumed that the total selling and distribution costs for a company each
month are mixed costs. If this assumption is used, the total mixed costs can be divided into two
separate parts, fixed costs and variable costs.
If costs can be analysed as a fixed amount of cost per period plus a variable cost per unit,
estimating what future costs should be, or what actual costs should have been, becomes fairly
simple.
Example:
The management accountant of a manufacturing company has estimated that production costs in
a factory that manufactures Product Y are fixed costs of Rs.250,000 per month plus variable costs
of Rs.30 per unit of Product Y output.
The expected output next month is 120,000 units of Product Y.
Expected total costs are therefore:
Rs.
Variable costs (120,000 × Rs.30) 3600,000
Fixed costs 250,000
Total costs 3,850,000

5.5 Stepped cost

A stepped fixed cost is a cost which:
 has a fixed cost behaviour pattern within a limited range of activity, and
 goes up or down in steps when the volume of activity rises above or falls below certain
levels.
On a cost behaviour graph, step fixed costs look like steps rising from left to right.
Illustration:
Total cost
Activity level
Example:
A company might pay its supervisors a salary of Rs. 20,000 each month.
When production is less than 2,000 hours each month, only one supervisor is needed:
When production is between 2,001 and 4,000 hours each month, two supervisors are needed.
When output is over 4,000 hours each month, three supervisors are needed.
The cost profile is as follows:
Activity level: Rs.
2,000 hours or less (1 Rs. 20,000) 20,000
2,001 to 4,000 (2 Rs. 20,000) 40,000
Over 4,000 (3 Rs. 20,000) 60,000
The supervision costs are fixed costs within a certain range of output, but go up
or down in steps as the output level rises above or falls below certain levels.
Practice questions 2
On the axes provided, on which the vertical axis denotes cost and the horizontal axis the
appropriate level of activity, show the following cost behaviour graphs:
(a) Fixed costs
(b) Variable costs
(c) Semi-variable costs
(d) Annual rates bill
(e) Direct labour cost
(f) Annual telephone bill
(g) Direct materials cost if bulk discount is offered on all purchases once the total
purchased exceeds a certain level
(h) Supervisory costs
(i) Labour costs if staff are paid a fixed weekly wage for a 35-hour week and any
additional production is completed in overtime, when staff are paid time and a half.

Practice questions (continued) 2

(a) (b) (c)
(d) (e) (f)
(g)
(h) (i)
Practice questions 3
1 From the information in this cost behaviour graph, describe the behaviour of this item
of cost, and calculate the total cost at 10,000 units of output.

6 DIRECT AND INDIRECT COSTS

Section overview
 Introduction
 Direct costs
 Indirect costs (overheads)
 Full cost
 Journal entries
6.1 Introduction
Costs may also be classified as:
 direct costs; or
 indirect costs (also known as overheads).
There are direct and indirect material costs, direct and indirect labour costs and direct and
indirect expenses.
6.2 Direct costs
Definition: Direct costs

Direct costs: Costs that can be traced in full to a cost unit.
A direct cost can be attributed in its entirety to the cost of an item that is being produced.
For example, in a manufacturing company that produces television sets, the direct cost of making
a television consists of direct materials and direct labour costs, and possibly some direct
expenses.
 The direct materials cost is the cost of the raw materials and components that have gone
into making the television.
 The direct labour cost is the cost of the labour time of the employees who have been
directly involved in making the television.
Direct materials
Definition: Direct materials

Direct materials are all materials that become part of the cost unit.
Direct materials are all materials that can be attributed directly in full to a cost unit.
They are used directly in the manufacture of a product or in providing a service.
Direct materials may consist of either or both:

 raw materials, such as glass, metals and chemicals
 components purchased from an external supplier: for example the direct materials of a
car manufacturer include components purchased from other suppliers, such as windows,
wheels and tyres.

Examples of direct materials include:
Example: Direct materials
Cost unit Direct materials

Pair of shoes Leather, glue, nails, laces
Office chair Wheels, a stand, a seat (with seat cushion), back
rest, arm rests and fabric
Restaurant meal Ingredients
Car Steel, aluminium, windows, lights, gear box, engine,
wheels etc. etc.
House Bricks, wood, cement
Services might also incur some direct materials costs. For example, with catering and restaurant
services the direct materials include the major items of food (and drink).
Direct labour
Definition: Direct labour

Direct labour is labour time that can be attributed directly in full to a cost unit.
Direct labour costs are the specific costs associated with the labour time spent directly on
production of a good or service.
Labour costs are direct costs for work done by direct labour employees. Direct labour employees
are employees whose time is spent directly on producing a manufactured item or service.
Example: Direct labour employees
Cost unit Direct labour

Car Machinists working in the machining department
Assembly workers in the assembly department
Workers in the spray painting shop
House Bricklayers are direct labour employees of a house-building firm
Tonne of coal Miners
Direct labour costs also include the cost of employees who directly provide a service.
Example: Direct labour employees (service industry).
Cost unit Direct labour

Day of storage Warehouse staff
Audit (other consultancy Professional staff
product)
Teaching day Teachers (tutorial staff at a college)
Direct expenses
Definition: Direct expenses

Direct expenses are expenses that can be attributed directly in full to a cost unit.
Direct expenses are expenses that have been incurred in full as a direct consequence of making a
unit of product, or providing a service, or running a department.

In manufacturing, direct expenses are not common for manufactured units of output, and direct
costs normally consist of just direct materials and direct labour costs.
Example: Direct expenses
Cost unit Direct expense

A house Hire of equipment (for example a cement mixer)
Payment of fees to sub-contractors.
Prime cost
The prime cost of an item is its total direct cost.
Definition: Prime cost

The prime cost of a cost unit is the sum of all of the direct costs of making that unit.
Illustration: Prime cost
Rs.
Direct material cost X
Direct labour cost X
Direct expenses X
Prime cost X
6.3 Indirect costs (overheads)
Definition: Indirect cost

An indirect cost (overhead cost) is any cost that is not a direct cost.
Indirect costs (overheads) cannot be attributed directly and in full to a cost unit.
Indirect costs include production overheads and non-production overheads. Each of these might
include indirect materials costs, indirect labour costs and indirect expenses costs.
Indirect material costs
Indirect materials are any materials that are used or consumed that cannot be attributed in full to
the item being costed. Indirect materials are treated as an overhead cost, and may be classified
as production overheads, administration overheads or sales and distribution overheads.
Indirect materials in production include cleaning materials and any materials used by production
departments or staff who are not engaged directly in making a product.
Indirect production materials may also include some items of materials that are inexpensive and
whose cost or value is immaterial. These may include nails, nuts and bolts, buttons and thread,
and so on. The effort of measuring a cost for these materials is not worth the value of the cost
information that would be produced; therefore these ‘direct’ materials are often treated as indirect
materials.

Practice question 4
In which of the following types of company would fuel costs be treated as a direct material
cost?
1 Manufacturing company
2 Road haulage (road transport) company
3 Construction company
4 Motorway fuel station
Indirect labour costs

Indirect labour costs consist mainly of the cost of indirect labour employees. Indirect labour
employees are individuals who do not work directly on the items that are produced or the
services that are provided.
Some factory workers do not work directly in the production of cost units but are necessary so
that production takes place. In a manufacturing environment, indirect labour employees include
staff in the stores and materials handling department (for example, fork lift truck drivers),
supervisors, and repairs and maintenance engineers.
All employees in administration departments and marketing departments (sales and distribution
staff) – including management – are normally indirect employees.
Indirect expenses
Many costs incurred cannot be directly linked to cost units.
For example, the rental costs for a factory and the costs of gas and electricity consumption for a
factory cannot be attributed in full to any particular units of production. They are indirect
production costs (production overheads).
In a manufacturing company, all costs of administration are usually treated as indirect costs
(administration overheads) and all or most sales and distribution costs are also usually treated as
sales and distribution overheads.
6.4 Full cost

The full cost of a unit of product (or unit of service) is a cost that includes both direct costs and
some overheads. The full cost of a unit of product might be analysed as follows:
Illustration: Full cost

Rs.
Direct materials cost X
Direct labour cost X
Direct expenses X
Prime cost X
Manufacturing overhead (or production overhead) X
Full production cost X
Non-production costs
Administration overhead X
Selling and distribution overhead X
Full cost of sale X
Notes:
1 Prime cost plus a share of production overheads are the full production cost or ‘fully
absorbed production cost’ of the cost unit.
2 In cost accounting systems, it is common practice to include production overheads in unit
costs and measure the full production cost per unit. However, administration and selling and
distribution overhead costs are not usually included in the cost of each unit. Instead, they
are treated in total as an expense for the period (‘period costs’ – see below).

6.5 Journal entries

Following journal entries are made in order to record the production and inventory cost in a
manufacturing environment.
Ref Account / Description Debit Credit
1 Raw Materials Inventory X
Cash or Accounts Payable X
Purchased raw materials inventory
2 Factory Payroll X
Wages Payable X
Record accrued wages for the period
3 Manufacturing Overhead X
Accumulated Depreciation / Accounts payable /

X
Cash
Record depreciation Or supplies on credit Or rent paid
4 Work in Process Inventory X
Raw Materials Inventory X
Record Direct Materials Used
Raw Materials Inventory X
Record INDIRECT materials used
Factory Payroll X
Record Direct Labor

Ref Account / Description Debit Credit
Factory Payroll X
Record INDIRECT labor
Manufacturing Overhead X
Record Overhead APPLIED to production
9 Finished Goods Inventory X
Work in Process Inventory X
Record jobs or goods completed (cost of goods manufactured)
10 Cost of goods sold X
Finished Goods Inventory X
Record cost of jobs or goods completed and sold

7 PRODUCT COSTS AND PERIOD COSTS

Section overview
 Product costs and period costs
7.1 Product costs and period costs

Costs are typically classified as either product costs or period costs when preparing financial
statements.
Definition: Product cost

Costs that become part of the cost of goods manufactured are called product costs. Such costs are
incurred on manufacturing process either directly as material and labour costs or indirectly as
overheads. Product costs are costs associated with goods that are produced or purchased for
resale.
Product costs are accounted for as inventory and held on the balance sheet (subject to accounting
valuation rules) until the inventory is sold. Only when the inventory is sold are product costs
expensed in the profit and loss account.
Product costs include the prime cost (direct materials + direct labour + direct expenses) plus the
production overhead.
Definition: Period cost

Period costs are not incurred on the manufacturing process and therefore these cannot be assigned
to cost of goods manufactured. These costs that are deducted as expenses during a particular
period. They do not contribute towards the value of inventory and are therefore not held on the
balance sheet. They are therefore expensed when they occur – i.e. in the period in which they
occurred.
Period costs are the non-production overheads

In summary then
 product costs are expensed when the inventory is sold
 period costs are expensed as soon as they are incurred
Example: A retailer
A retailer owns a shop, employs a shop assistant, invests in sales and advertising and acquires
goods for resale.
The cost of goods purchased for resale is product costs and accounted for as inventory. These are
only expensed when the goods are sold (which may be in a subsequent accounting period).
The sales and advertising costs and the salary of the shop assistant are period costs which are
expensed immediately in the accounting period in which they were incurred. Note that the salary
of the shop assistant would be called an administration expense.


Solutions 1
1 Chief accountant’s salary. Accounting department costs are an administration cost, and the
salary of the chief accountant is treated in full as an administration costs.
2 Telephone charges. These are usually treated as administration costs, unless the charges can
be traced directly to telephones in the manufacturing department or the sales and distribution
department. When charges can be traced directly to telephones in the manufacturing
department, they should be recorded as manufacturing costs.
3 Office cleaning services. These are usually treated as administration costs, unless the charges
can be traced directly to offices used by the sales and distribution staff, or the production
staff.
4 Warehouse staff. These are manufacturing costs when the warehouse is used to store raw
materials and components. They are sales and distribution costs when the warehouse is used
to store finished goods. If the warehouse stores raw materials and finished goods, the wages
costs should be apportioned between production costs and sales and distribution costs.
Solutions 2
(a) (b) (c)
(d) (e) (f)
(g) (h) (i)

Solution 3
The cost item is a mixed cost. Up to 5,000 units of output, total fixed costs are Rs.14,000 and
the variable cost per unit is Rs.(24,000 – 14,000)/5,000 units = Rs.2 per unit.
At the 5,000 units of output, there is a step increase in fixed costs of Rs.6,000 (from
Rs.24,000 total costs to Rs.30,000 total costs). Total fixed costs therefore rise from
Rs.14,000 to Rs.20,000. The variable cost per unit remains unchanged.
At the 10,000 units level, total costs are therefore:
Rs.
Variable costs (10,000 × Rs.2) 20,000
Fixed costs 20,000
Total costs 40,000
Solutions 4
1 Manufacturing company. Fuel costs are an indirect expense. Fuel used in the company’s
vehicles is unlikely to be considered a material cost at all, but would be treated as an overhead
expense.
2 Road haulage company. Since fuel is a major cost of operating a road haulage service, fuel
costs are likely to be treated as a direct material cost of operations.
3 Construction company. Fuel costs are likely to be an indirect expense, for the same reasons
that apply to a manufacturing company.
4 Motorway service station. This sells fuel to customers. In a retail operation, items sold to
customers are direct costs of sale. The cost of the fuel sold is therefore a direct material cost
(= a cost of sale).

Solution 5
Manufacturing account
Rs. Rs.
Raw materials
Purchases 50,000
65,000
Less: Closing inventory (11,000)
Raw materials consumed 54,000
Manufacturing wages 20,000
Prime cost 74,000
Overheads
Rent 15,400
Electricity 12,600
Depreciation 3,000
31,000
Manufacturing costs 105,000
Opening work in progress 10,000
Closing work in progress (6,000)
The cost of goods made is transferred to the statement of comprehensive income.

Illustration: Statement of comprehensive income to show transfer of cost of goods made.
Rs. Rs.
Sales revenue 500,000
Less cost of goods sold
Opening inventory of finished goods 25,000
Cost of goods manufactured(109,000 x 125%) 136,250
,161,250
Closing inventory of finished goods (10,000)
Gross profit
88,000
Net profit for the period 260,750

7
CHAPTER
IAS 16: Property, plant
and equipment
Contents
1 Revaluation
2 Disclosure requirements

1 REVALUATION
Section overview
 Revaluation and the entity’s accounting policy

 Accounting for revaluation
 Changing the carrying amount of an asset
 Depreciation of a revalued asset
 Realisation of the revaluation surplus
 The frequency of revaluations
1.1 Revaluation and the entity’s accounting policy

Property, plant and equipment is recognised at cost when it is first acquired.
IAS 16 allows a business to choose one of two measurement models as its accounting policy for
property, plant and equipment after acquisition. The same model should be applied to all assets
in the same class.
The two measurement models for property, plant and equipment after acquisition are:
 cost model (i.e. cost less accumulated depreciation); and
 revaluation model (i.e. revalued amount less accumulated depreciation since the most
recent revaluation).
For example, a company’s policy might be to value all its motor vehicles at cost, but to apply the
revaluation model to all its land and buildings.
Revaluation model – Issues
The following accounting issues have to be addressed when using the revaluation model:
Issue
1 What happens to the other side of the entry when the carrying amount of an asset is
changed as a result of a revaluation adjustment?
An asset value may increase or decrease.
What happens in each case?
2 How the carrying amount of the asset being revalued is changed? The carrying amount is
located in two accounts (cost and accumulated depreciation) and it is the net amount that
must be changed so how is this done?
3 How often should the revaluation take place?
1.2 Accounting for revaluation

When a non-current asset is revalued, its ‘carrying amount’ in the statement of financial position
is adjusted from carrying amount to its fair value (normally current market value) at the date of
the revaluation.
Asset carried at cost revalued upwards
An increase in value is credited to other comprehensive income and accumulated in equity under
the heading of revaluation surplus.

Chapter 7: IAS 16: Property, plant and equipment
Example: Upward revaluation

Land was purchased for Rs.100 million on the first day of the 2019 accounting period.
The business applies the IAS 16 revaluation model to the measurement of land after initial
recognition.
The land was revalued to Rs.130 million at the end of the first year of ownership.
Other comprehensive Statement of
Land
income comprehensive income
------------------ Rs. in million ------------------
At start 100  
Adjustment 30 30 Cr The surplus is
taken to other
comprehensive
31/12/19 130 30 Cr income
Double entry:
Debit Credit
Land 30 m
Revaluation surplus 30 m
Extract from the statement of financial position as at 31/12/19

ASSETS
Non-current assets
Property, plant and equipment 130 m
EQUITY AND LIABILITIES
Revaluation surplus 30 m
Asset carried at cost revalued downwards

A decrease in value is debited as an expense to the statement of comprehensive income.
Example: Downward revaluation
Land was purchased for Rs.100 million on the first day of the 2019 accounting period.
recognition.
The land was revalued to Rs.90 million at the end of the first year of ownership.
Other comprehensive Statement of
Land
income comprehensive income
------------------- Rs. in million ------------------
Adjustment (10) 10Dr
31/12/19 90
Double entry:
Debit Credit
Statement of comprehensive income 10 m
Land 10 m
Asset carried at a revaluation deficit is revalued upwards

An asset might be carried at an amount lower than its original cost as a result of being revalued
downwards. If the asset is later revalued upwards, the revaluation increase is recognised in the
statement of comprehensive income to the extent of the previously recognised expense. That
part of any increase above the previously recognised expense is recognised in the usual way,
directly in other comprehensive income.

Asset carried at a revaluation surplus revalued downwards

An asset might be carried at an amount higher than its original cost as a result of being revalued
upwards. If the asset is later revalued downwards, the revaluation decrease is recognised in
other comprehensive income to the extent of the previously recognised surplus. That part of any
decrease above the previously recognised surplus is recognised in the statement of
comprehensive income the usual way.
Example: Downward revaluation

A business purchased a plot of land on the first day of the 2015 accounting period.
recognition. The business has a policy of revaluing land annually.
The initial amount recognised and the year end values are shown below:
Rs.
Measurement on initial recognition 100
Valuation as at:
31 December 2015 130
31 December 2017 95
The double entries are as follows

As at 31 December 2015 Debit Credit
Land (130 – 100) 30

Land (110 – 130) 20
The fall in value reverses a previously recognised surplus. It is recognised in OCI to the
extent that it is covered by the surplus.

Statement of comprehensive income 5
Land (95 – 110) 15
The fall in value in part reverses a previously recognised surplus. It is recognised in OCI to
the extent that it is covered by the surplus. This reduces the revaluation surplus to zero.
Any amount not covered by the surplus is recognised as an expense in the statement of
comprehensive income.

Land (116 – 95) 21
Statement of comprehensive income 5
A rise in value that reverses a previously recognised expense is recognised in the statement
of comprehensive income to the extent that it reverses the expense. Any amount above this
is recognised in other comprehensive income.

Example (continued) – Overview

Other Statement of
comprehensive comprehensive
Land income income
Double entry 30 30 Cr
31/12/15 130
b/f 130
Adjustment (20) 20Dr 
31/12/16 110
b/f 110
Adjustment (15) 10Dr 5Dr
31/12/17 95
b/f 95
Adjustment 21 16Cr 5Cr
31/12/18 116
1.3 Changing the carrying amount of a revalued asset

In the previous example land was revalued. Land is not depreciated so the carrying amount of
land is represented in a single account. This made it easy to change:
The carrying amount of depreciable assets is the net of balances on two separate accounts. The
double entry to revalue the asset must take this into account.
A simple approach (and one that accords with IAS 16) is as follows:
 Step 1: Transfer the accumulated depreciation to the asset account. The result of this is
that the balance on the asset account is now the carrying amount of the asset and the
accumulated depreciation account in respect of this asset is zero.
 Step 2: Change the balance on the asset account to the revalued amount.
Example:
A building owned by a company is carried at Rs.8,900,000 (Cost of Rs.9m less accumulated
depreciation of Rs.100,000. The company’s policy is to apply the revaluation model to all its land
and buildings.
A current valuation of this building is now Rs.9.6 million.
Step 1 Rs. (000) Rs. (000)
Accumulated depreciation 100
Asset 100
Step 2
Asset (Rs.9.6m – Rs.8.9m) 700
Alternatively this could be done with a single journal

Asset (Rs.9.6m – Rs.9m) 600

Example:
An office building was purchased four years ago for Rs.3 million.
The building has been depreciated by Rs.100,000.
It is now re-valued to Rs.4 million. Show the book-keeping entries to record the revaluation.
Answer
Building account
Rs. Rs.
Opening balance b/f 3,000,000 Accumulated depreciation 100,000
Revaluation account 1,100,000 Closing balance c/f 4,000,000
4,100,000 4,100,000
Opening balance b/f 4,000,000
Accumulated depreciation of building account

Rs. Rs.
Building account 100,000 Opening balance b/f 100,000
Revaluation surplus
Rs. Rs.
Revaluation account 1,100,000
Practice question 4
A company owns a building which was purchased three years ago for Rs.1 million. The
building has been depreciated by Rs.60,000.
It is now to be revalued to Rs.2 million. Show the book-keeping entries to record the
revaluation.
1.4 Depreciation of a revalued asset

After a non-current asset has been revalued, depreciation charges are based on the new
valuation.
Example:
An asset was purchased three years ago, at the beginning of Year 1, for Rs.100,000.
Its expected useful life was six years and its expected residual value was Rs.10,000.
It has now been revalued to Rs.120,000. Its remaining useful life is now estimated to be three
years and its estimated residual value is now Rs.15,000.
The straight-line method of depreciation is used.
Required
(a) What is the transfer to the revaluation surplus at the end of Year 3?
(b) What is the annual depreciation charge in Year 4?
(c) What is the carrying amount of the asset at the end of Year 4?

Answer
(a) Annual depreciation originally (for Years 1 – 3)
= Rs.(100,000 – 10,000)/6 years = Rs.15,000.
Rs.
Cost 100,000
Less: Accumulated depreciation at the time of
revaluation (= 3 years x Rs.15,000) (45,000)
Carrying amount at the time of the revaluation 55,000
Re-valued amount of the asset 120,000
Transfer to the revaluation surplus 65,000
(b) Revised annual depreciation = Rs.(120,000 – 15,000)/3 years = Rs.35,000.
(c) The annual depreciation charge in Year 4 will therefore be Rs.35,000.
Rs.
Re-valued amount 120,000
Less: depreciation charge in Year 4 (35,000)
Carrying amount at the end of Year 4 85,000
1.5 Realisation of the revaluation surplus

All assets eventually disappear from the statement of financial position either by becoming fully
depreciated or because the company sells them.
If nothing were done this would mean that there was a revaluation surplus on the face of the
statement of financial position that related to an asset that was no longer owned. IAS 16 allows
(but does not require) the transfer of a revaluation surplus to retained earnings when the asset to
which it relates is derecognised (realised).
This might happen over several years as the asset is depreciated or at a point in time when the
asset is sold.
Revalued assets being depreciated
Revaluation of an asset causes an increase in the annual depreciation charge. The difference is
known as excess depreciation:
Excess depreciation is the difference between:
 the depreciation charge on the re-valued amount of the asset, and
 depreciation that would have been charged on historical cost.
Each year a business might make a transfer from the revaluation surplus to the retained profits
equal to the amount of the excess depreciation.
Illustration:
Debit Credit
Revaluation surplus X
Retained earnings X

Revalued assets being sold

When a revalued asset is sold the business might transfer the balance on the revaluation surplus
in respect of the asset into retained earnings. The journal entry would be the same as above.
Example:
An asset was purchased two years ago at the beginning of Year 1 for Rs.600,000. It had an
expected life of 10 years and nil residual value.
Annual depreciation is Rs.60,000 (= Rs.600,000/10 years) in the first two years.
At the end of Year 2 the carrying value of the asset -Rs.480,000.
After two years it is revalued to Rs.640,000.
Double entry: Revaluation
Debit Credit
Asset (Rs.640,000 – Rs.600,000) 40,000
Accumulated depreciation 120,000
Other comprehensive income 160,000
Each year the business is allowed to make a transfer between the revaluation surplus and retained
profits:
Double entry: Transfer
Debit Credit
Revaluation surplus (160,000/8) 20,000
Retained profits 20,000
1.6 The frequency of revaluations

When the revaluation model is applied to the measurement of property, plant and equipment, the
frequency of revaluations should depend on the volatility in the value of the assets concerned.
When the value of assets is subject to significant changes (high volatility), annual revaluations
may be necessary.
Practice Question 1
Depreciation calculation for revalued asset

ABC Ltd has a Factory that is revalued to Rs.250,000 in the fourth year of the acquisition of the
Factory. Original cost of the building as Rs.150,000 with estimated useful life of 10 years. The
company depreciates the factory on straight-line basis.
Required
1. Revaluation surplus amount
2. Depreciation charge for the period
3. Excess depreciation to be transferred
Practice Question 2
An asset was purchased four years ago at the beginning of Year 1 for Rs.1,000,000. It had an
expected life of 10 years and nil residual value.
Annual depreciation is Rs.100,000 (Rs.1,000,000/10 years) in the first four years.
At the end of Year 4 the carrying value of the asset - Rs.600,000.
After two years it is re-valued to Rs. 1,200,000.
Calculate the amount to be posted in the revaluation surplus?

2 DISCLOSURE REQUIREMENTS OF IAS 16

Section overview
 Disclosure requirements of IAS 16
2.1 Disclosure requirements of IAS 16

IAS 16 Property, plant and equipment requires the following disclosures in the notes to the
financial statements, for each major class of property, plant and equipment.
 The measurement bases used (cost or revaluation model)
 The depreciation methods used
 The useful lives or depreciation rates used
 Gross carrying amounts and the accumulated depreciation at the beginning and at the end
of the period
 A reconciliation between the opening and closing values for gross carrying amounts and
accumulated depreciation, showing:
 additions during the year
 disposals during the year
 depreciation charge for the year
 assets classified as held for sale in accordance with IFRS 5
 acquisitions of assets through business combinations
 impairment losses
 the net exchange differences
 the effect of revaluations.
The following is an example of how a simple table for tangible non-current assets may be
presented in a note to the financial statements.
An entity must also disclose:
 the existence and amounts of restrictions on title, and property, plant and equipment
pledged as security for liabilities;
 the amount of expenditures recognised in the carrying amount of an item of property, plant
and equipment in the course of its construction;
 the amount of contractual commitments for the acquisition of property, plant and
equipment; and
 if it is not disclosed separately in the statement of comprehensive income, the amount of
compensation from third parties for items of property, plant and equipment that were
impaired, lost or given up that is included in profit or loss.
Illustration:
Plant and
Property equipment Total
Cost Rs. m Rs. m Rs. m
At the start of the year 7,200 2,100 9,300
Additions 920 340 1,260
Disposals (260) (170) (430)
At the end of the year 7,860 2,270 10,130

Accumulated depreciation
At the start of the year 800 1,100 1,900
Depreciation expense 120 250 370
Accumulated depreciation on disposals (55) (130) (185)
At the end of the year 865 1,220 2,085
Carrying amount
At the start of the year 6,400 1,000 7,400
At the end of the year 6,995 1,050 8,045
Disclosures for assets stated at revalued amounts

When items of property, plant and equipment are stated at revalued amounts the following must
be disclosed:
 the effective date of the revaluation;
 whether an independent valuer was involved;
 the methods and significant assumptions applied in estimating the items’ fair values
 the extent to which the items’ fair values were determined directly by reference to
observable prices in an active market or recent market transactions on arm’s length terms
or were estimated using other valuation techniques
 for each revalued class of property, plant and equipment, the carrying amount that would
have been recognised had the assets been carried under the cost model; and
 the revaluation surplus, indicating the change for the period and any restrictions on the
distribution of the balance to shareholders.
Additional disclosures encouraged by IAS 16
IAS 16 encourages disclosure of the following information as users of financial statements might
find it to be useful.
 the carrying amount of temporarily idle property, plant and equipment;
 the gross carrying amount of any fully depreciated property, plant and equipment that is
still in use;
 the carrying amount of property, plant and equipment retired from active use and held for
disposal; and
 when the cost model is used, the fair value of property, plant and equipx`ment when this is
materially different from the carrying amount.
Practice Question 3
Following information has been extracted from the financial statements of Newton Pharma for
the year ended 30 June 2018
Rupees
Manufacturing Unit 650,000
Accumulated depreciation 170,000
Carrying amount 480,000
Revaluation surplus 20,000

The Company provides depreciation on vehicles @ 10% per annum on straight line method.
Additional information
1. On 30 June 2018, a tablet pressing machine which was acquired at a cost of Rs. 50,000, in
exchange for another machine in January 2016, was revalued. The revalued amount was
60,000.
2. The Sealing machine, imported from Japan at a cost of 100,000 in July 2016, is annually
revalued by the Company. On June 30, 2018 the machine was devalued to 60,000. The
revaluation surplus shows 20,000 balance in respect of revaluation of the machine.
Make relevant ledgers for the year ended 30 June 2018.


Solution 1
1. Revaluation surplus amount

To calculate this we need to know the carrying amount of asset at the time of revaluation which
is cost less accumulated depreciation of five years. Depreciation for four years is:
= 150,000 / 10 = 15,000 x 4 = Rs.60,000
Carrying amount is therefore Rs.90,000 (150,000 – 60,000)
As the factory was revalued to Rs.250,000, therefore, the revaluation surplus amount is
Rs.100,000 (250,000 – 150,000)
2. Depreciation charge for the period
Divide the revalued amount over the remaining useful life to get depreciation charge for the
year:
= 250,000 / 6 = Rs.41,667
3. Excess depreciation
Depreciation on revalued amount = Rs.41,667
Depreciation on original cost = Rs.15,000
The difference is Rs.26,667 (41,667 – 15,000) and this amount will be transferred from
revaluation surplus to retained earnings account if entity chose to do so. The journal entry will
be:
(Dr) Revaluation surplus a/c = Rs.26,667
(Cr) Retained earnings a/c = Rs.26,667
Solution 2
Double entry: Revaluation

Debit Credit
Asset (Rs.1,200,000 – Rs.1,000,000) 200
Revaluation surplus 600
Each year the business is allowed to make a transfer between the revaluation surplus and retained
profits:
Double entry: Transfer
Debit Credit
Revaluation surplus (600/6) 100
Retained profits 100

Solution 3
Manufacturing Unit Account
Rs. Rs.
Opening balance b/f 650,000 Accumulated depreciation 170,000
Revaluation surplus 10,000 Closing balance c/f ,000
470,000 470,000
Accumulated depreciation of Manufacturing Unit account

Rs. Rs.
Manufacturing unit account 170,000 Opening balance b/f 170,000
Revaluation surplus
Rs. Rs.
Reversal of revaluation 20,000 Opening balance 20,000
surplus – Sealing machine
Closing balance c/f 10,000 Revaluation-tablet pressing 10,000
machine


Certificate in accounting and Finance
8
CHAPTER
Non-current assets: sundry standards
Contents
1 IAS 20: Accounting for government grants and disclosure of
government assistance
2 IAS 23: Borrowing costs
3 IAS 40: Investment property

1 IAS 20: ACCOUNTING FOR GOVERNMENT GRANTS AND DISCLOSURE OF

GOVERNMENT ASSISTANCE
Section overview
 Introduction and definitions

 Accounting treatment of government grants
 Repayment of government grants
 Government assistance
 Disclosure requirements
1.1 Introduction and definitions

In many countries the government provides financial assistance to industry. The most common
form of such assistance is a grant of cash from local or national government.
Definitions
Government assistance is action by government designed to provide an economic benefit specific
to an entity or range of entities qualifying under certain criteria. Government assistance does not
include benefits provided only indirectly through action affecting general trading conditions, such
as the provision of infrastructure in development areas or the imposition of trading constraints on
competitors.
Government grants are assistance by government in the form of transfers of resources to an
entity in return for past or future compliance with certain conditions relating to the operating
activities of the entity. They exclude those forms of government assistance which cannot
reasonably have a value placed upon them and transactions with government which cannot be
distinguished from the normal trading transactions of the entity.
IAS 20 Accounting for Government Grants and Disclosure of Government Assistance identifies
two types of government grants:
 grants related to assets, or
 grants related to income.
Definitions
Grants related to assets are government grants whose primary condition is that an entity
qualifying for them should purchase, construct or otherwise acquire long-term assets. Subsidiary
conditions may also be attached restricting the type or location of the assets or the periods during
which they are to be acquired or held.
Grants related to income are government grants other than those related to assets.
Government grants are sometimes called by other names such as subsidies, subventions, or
premiums.
1.2 Accounting treatment of government grants

IAS 20 states that grants should not be recognised until there is reasonable assurance that:
 the entity will comply with any conditions attaching to the grant, and
 the grant will be received.
Once these recognition criteria are met, the grants should be recognised in profit or loss over the
periods necessary to match them with their related costs.

Chapter 8: Non-current assets: sundry standards
Neither type of grant should be credited directly to shareholders’ interests in the statement of
financial position. They must be reported on a systematic basis through the statement of profit or
loss (profit or loss).
Grants related to income
For grants related to income, IAS 20 states that an ‘income approach’ should be used, and the
grant should be taken to income over the periods necessary to match the grant with the costs
that the grant is intended to compensate.
IAS 20 allows two methods of doing this:
 Method 1. Include the grant for the period as ‘other income’ for inclusion in profit or loss
for the period
 Method 2. Deduct the grant for the period from the related expense.
Example: Grant related to income

A company receives a cash grant of Rs. 30,000 on 31 December Year 0.
The grant is towards the cost of training young apprentices, and the training programme is
expected to last for 18 months from 1 January Year 1.
Actual costs of the training were Rs. 50,000 in Year 1 and Rs. 25,000 in Year 2.
The grant would be accounted for as follows:
At 31 December Year 0 the grant would be recognised as a liability and presented in the
statement of financial position split between current and non-current amounts. Rs. 20,000 (12
months/18 months Rs. 30,000) is current and would be recognised in profit for Year 1.The
balance is non-current.
At the end of year 1 there would be a current balance of Rs. 10,000 (being the non-current
balance at the end of Year 0 reclassified as current) in the statement of financial position. This
would be recognised in profit in Year 2.
Extracts from the financial statements are as follows:
Statement of financial position (extracts)
31 31 31
December December December
Year 0 Year 1 Year 2
Current liabilities
Deferred income 20,000 10,000 
Non-current liabilities
Deferred income 10,000  
Statement of profit or loss (extracts)
Method 1
Training costs (50,000) (25,000)
Government grant received 20,000 10,000
Method 2
Training costs (50,000 – 20,000) 30,000
Training costs (25,000 – 10,000) 15,000

Grants related to assets

For grants related to assets, IAS 20 allows two methods of doing this:
 Method 1. Deduct the grant from the cost of the related asset. The asset is included in the
statement of financial position at cost minus the grant. Depreciate the net amount over the
useful life of the asset.
 Method 2. Treat the grant as deferred income and recognise it as income on a systematic
basis over the useful life of the asset.
Both methods achieve the same effective result.
Example: Grant related to an asset

A company receives a government grant of Rs. 400,000 towards the cost of an asset with a cost
of Rs. 1,000,000.
The asset has an estimated useful life of 10 years and no residual value.
The amounts could be reflected in the financial statements prepared at the end of Year 1 in
accordance with IAS 20 in the following ways:
Method 1:
Statement of financial position (extract)
Property, plant and equipment Rs.
Cost (1,000,000 – 400,000) 600,000
Included in statement of profit or loss (extract) Rs.
Depreciation charge (Rs. 600,000/10 years) 60,000
Method 2:
Statement of financial position (extract)
Cost 1,000,000
Current liabilities
Deferred income 40,000
At the end of year 1 there would be Rs. 360,000 of the grant left to recognise in profit in
the future at Rs. 40,000 per annum. Rs. 40,000 would be recognised in the next year and
is therefore current. The balance is non-current
Included in statement of profit or loss (extract) Rs.
Expense: Depreciation charge (Rs. 1,000,000/10 years) (100,000)
Income: Government grant (Rs. 400,000/10 years) 40,000

Practice question 1
On January Year 1 Entity O purchased a non-current asset with a cost of Rs. 500,000 and
received a grant of Rs. 100,000 in relation to that asset.
The asset is being depreciated on a straight-line basis over five years.
Required
Show how the asset and the grant would be reflected in the financial statements at the end
of the first year under both methods of accounting for the grant allowed by IAS 20.
Grants as compensation for expenses or losses

A government grant may be awarded for the purpose of giving immediate financial support to an
entity rather than as an incentive to undertake specific expenditures.
The circumstances under which the grant is made may warrant immediate recognition of the
grant in profit or loss in the period in which the entity qualifies to receive it with disclosure to
ensure that its effect is clearly understood.
A government grant may become receivable by an entity as compensation for expenses or
losses incurred in a previous period. Such a grant is recognised in profit or loss of the period in
which it becomes receivable, with disclosure to ensure that its effect is clearly understood.
1.3 Repayment of government grants

A government grant might become repayable by the entity (e.g. when the entity fails to meet the
underlying conditions for the grant).
When a government grant becomes repayable it is accounted for as a change in accounting
estimate (IAS 8: Accounting policies, changes in accounting estimates and errors).
Repayment of a grant related to income
Repayment of a grant related to income is applied in the first instance against any unamortised
deferred credit recognised in respect of the grant. If the repayment exceeds any such deferred
credit any excess is recognised immediately in profit or loss.
Example: Repayment of grant related to income

On 1 January Year 1 X Limited received a cash grant of Rs. 500,000 towards the cost of
employing an environmental impact analyst on a new project for a 5 year period.
The grant is repayable in full if the project is not completed.
The analyst was employed and the project commenced from the 1 January Year 1.
On 1 January Year 3 the project was abandoned and the grant became repayable in full.
The grant and its subsequent repayment is accounted for as follows:
Year 1 Debit Credit
Cash 500,000
Statement of profit or loss
(reduction of employment cost) 100,000
Year 2 Debit Credit
Statement of profit or loss
(reduction of employment cost) 100,000

Example: Repayment of grant related to income (continued)

The double entry to reflect the repayment is as follows
Debit Credit
Statement of profit or loss 200,000
Cash 500,000
Repayment of a grant related to an asset

Accounting for a repayment of a grant related to an asset depends on how the grant was
accounted for originally.
If the grant was accounted for as reduction of the carrying amount of the related asset, its
repayment is recognised by increasing the carrying amount of the asset.
If the grant was accounted for as deferred income, its repayment is recognised by reducing the
deferred income balance by the amount repayable.
The cumulative additional depreciation that would have been recognised in profit or loss to date
in the absence of the grant must be recognised immediately in profit or loss.
Also note that the circumstances giving rise to repayment of the grant might indicate the possible
impairment of the new carrying amount of the asset.
1.4 Government assistance

The definition of government grants (see earlier) excludes:
 certain forms of government assistance which cannot reasonably have a value placed
upon them (e.g. free advice and the provision of guarantees); and
 transactions with government which cannot be distinguished from the normal trading
transactions of the entity (e.g. a government procurement policy that is responsible for a
portion of the entity’s sales).
There is no specified accounting treatment for either of these. However, the significance of the
benefit may require disclosure of the nature, extent and duration of the assistance in order to
prevent the financial statements being misleading.
1.5 Disclosure requirements

IAS 20 requires the following disclosures in the notes to the financial statements:
 the accounting policy adopted for government grants, including the method of presentation
in the financial statements
 the nature and extent of government grants recognised in the financial statements and an
indication of other forms of government assistance from which the entity has directly
benefitted.
 unfulfilled conditions and other contingencies attaching to government assistance (if this
assistance has been recognised in the financial statements).
Government assistance may be significant so that disclosure of the nature, extent and duration of
the assistance is necessary in order that the financial statements may not be misleading.

2 IAS 23: BORROWING COSTS
Section overview
 Introduction
 Borrowing costs eligible for capitalisation
 Period of capitalisation
 Disclosures
2.1 Introduction
A company might incur significant interest costs if it has to raise a loan to finance the purchase or
construction of an asset. IAS 23: Borrowing costs defines borrowing costs and sets guidance on
the circumstances under which they are to be capitalised as part of the cost of qualifying assets.
Definition: Borrowing costs

Borrowing costs are interest and other costs that an entity incurs in connection with the borrowing
of funds.
Definition: Qualifying asset

A qualifying asset is an asset that necessarily takes a substantial period of time to get ready for
its intended use or sale.
Any of the following may be qualifying assets depending on circumstances:

 inventories;
 items of property, plant and equipment;
 intangible assets.
The following are not qualifying assets:
 inventories that are manufactured, or otherwise produced, over a short period of time, are
not qualifying assets
 assets that are ready for their intended use or sale when acquired.
 Qualifying assets are usually self-constructed non-current assets.
2.2 Borrowing costs eligible for capitalisation

Borrowing costs that are directly attributable to the acquisition, construction or production of a
qualifying asset must be capitalised as part of the cost of that asset. All other borrowing costs are
recognised as an expense in the period in which they are incurred.
Borrowing costs that are directly attributable to the acquisition, construction or production of a
qualifying asset are those that would have been avoided if the expenditure on the qualifying
asset had not been made.
This includes the costs associated with specific loans taken to fund the production or purchase of
an asset and general borrowings. General borrowings are included because if an asset was not
being constructed it stands to reason that there would have been a lower need for cash.

Funds specifically borrowed to obtain a qualifying asset

When a specific loan is taken in order to obtain a qualifying asset the borrowing costs eligible for
capitalisation are the actual borrowing costs incurred on that borrowing during the period less any
investment income on the temporary investment of those borrowings.
Example: Specific borrowings

On 1 January 2016 Okara Engineering issued a bond to raise Rs. 25,000,000 to fund a capital
project which will take three years to complete.
Amounts not yet needed for the project are invested on a temporary basis.
During the year to 31 December 2016, Okara Engineering spent Rs. 9,000,000 on the project.
The cost of servicing the bond was Rs. 1,250,000 during this period and the company was able to
earn Rs. 780,000 through the temporary reinvestment of the amount borrowed.
The amounts recognised as capital work in progress in the period was:
Rs.
Costs incurred (labour, material, overhead etc.) 9,000,000
Interest capitalised:
Actual interest cost 1,250,000
Less: return on temporary investment (780,000)
470,000
Additions to capital work in progress 9,470,000
General funds used for the purpose of obtaining a qualifying asset.

When general borrowings are used the amount of borrowing costs eligible for capitalisation is
obtained by applying a capitalisation rate to the expenditures on that asset.
The capitalisation rate is the weighted average of the borrowing costs applicable to the
borrowings that are outstanding during the period except for borrowings made specifically for the
purpose of obtaining a qualifying asset.
The amount of borrowing costs capitalised cannot exceed the amount of borrowing costs it
incurred during a period.
Example: General borrowings: Capitalisation rate

Sahiwal Construction has three sources of borrowing:
Average loan in the year Interest expense incurred in
(Rs.) the year (Rs.)
7 year loan 8,000,000 800,000
10 year loan 10,000,000 900,000
Bank overdraft 5,000,000 900,000
The 7 year loan has been specifically raised to fund the building of a qualifying asset.
A suitable capitalisation rate for other projects is found as follows:
Average loan in the year Interest expense incurred in
(Rs.) the year (Rs.)
10 year loan 10,000,000 900,000
Bank overdraft 5,000,000 900,000
15,000,000 1,800,000
Capitalisation rate = 1,800,000/15,000,000 100 = 12%

Alternatively:
Rate on 10 year loan = 900,000/10,000,000 100 = 9%
Rate on bank overdraft = 900,000/5,000,000 100 = 18%
Weighted average: 9% 10,000,000/15,000,000 + 18% 5,000,000/15,000,000
6% + 6% = 12%
The capitalisation rate is applied from the time expenditure on the asset is incurred.
Example: General borrowings: Capitalisation rate

Continuing the example above, Sahiwal Construction has incurred the following expenditure on a
project funded from general borrowings for year ended 31 December 2016.
Date incurred: Amount (Rs.)
31st March 1,000,000
31st July 1,200,000
30th October 800,000
The amount capitalised in respect of capital work in progress during 2016 is as follows:
Rs.
31st March  Expenditure 1,000,000
Interest (1,000,000  12% 9/12) 90,000
31st July  Expenditure 1,200,000
Interest (1,200,000  12% 5/12) 60,000
30th October  Expenditure 800,000
Interest (800,000  12% 2/12) 16,000
3,166,000
2.3 Period of capitalisation

Commencement of capitalisation
Capitalisation of borrowing costs should start only when:
 expenditures for the asset are being incurred; and
 borrowing costs are being incurred, and
 activities necessary to prepare the asset have started.

Suspension of capitalisation
Capitalisation of borrowing costs should be suspended if development of the asset is suspended
for an extended period of time.
Cessation of capitalisation
Capitalisation of borrowing costs should cease when the asset is substantially complete. The
costs that have already been capitalised remain as a part of the asset’s cost, but no additional
borrowing costs may be capitalised.
Example: Commencement and suspension of capitalisation

Company A borrowed Rs. 9,000 @ 15% per annum to fund a project on 1st Jan 2015.
The following expenditures were made on the project during the year ending 31 December 2016
Date: 1st March 2016: Rs. 2,500
Date: 1st Oct 2016: Rs. 4,200
Work on the project was suspended during the month of August and resumed in September.
The IAS 23 rules apply as follows:
The total interest cost of the borrowing is:
Rs. 9,000  15%  10/12 = 1,125
The project commenced on 1st March resulting in a period of 10 months up to the year end.
However, interest cannot be capitalised during the period of suspension. Therefore, interest is
capitalised only for 9 months.
The borrowing is specific to the project so interest on whole amount (principal) is capitalised in
the amount of:
9,000  15%  9/12 = 1,012.5
The double entry to reflect the above is as follows:
Debit Credit
Asset in the course of construction 1,012.5
Statement of profit or loss (finance costs) 112.5
Cash/interest liability 1,125
2.4 Disclosures
IAS 23 requires disclosure of the following:
 the amount of borrowing costs capitalised during the period; and
 the capitalisation rate used to determine the amount of borrowing costs eligible for
capitalisation.

3 IAS 40: INVESTMENT PROPERTY
Section overview
 Definitions
 Accounting treatment of investment property
 Why investment properties are treated differently from other properties
 Transfers and disposals of investment property
 Disclosure requirements
3.1 Definitions
IAS 40: Investment Property, defines and sets out the rules on accounting for investment
properties.
Definition: Investment property

An investment property is property (land or a building, part of a building or both) held to earn
rentals or for capital appreciation or both.
Investment property differs from other property, which is:
 used in the production or supply of goods, or for administrative purposes (which is covered
by IAS 16; Property, plant and equipment); or
 held for sale in the ordinary course of business (which is covered by IAS 2: Inventories).
Examples of investment property
The following are examples of investment property:
 land held for long-term capital appreciation rather than for short-term sale in the ordinary
course of business.
 land held for a currently undetermined future use. (If an entity has not determined that it
will use the land as owner-occupied property or for short-term sale in the ordinary course
of business),
 property that is being constructed or developed for future use as investment property.
Not investment property
The following are examples of items that are not investment property:
 property intended for sale in the ordinary course of business;
 owner-occupied property including (among other things),
i. property held for future use as owner-occupied property,
ii. property held for future development and subsequent use as owner-occupied property,
iii. property occupied by employees (whether or not the employees pay rent at market
rates) and
iv. owner-occupied property awaiting disposal;
Partly occupied buildings
An entity might use part of a property for the production or supply of goods or services or for
administrative purposes and hold another part of the same property to earn rentals or for capital
appreciation. In other words, part of a property might be owner occupied and part held as an
investment. The two parts are accounted for separately if they could be sold separately (or
leased out separately under a finance lease).

If this is not the case, the property is investment property only if an insignificant portion is held for
use in the production or supply of goods or services or administrative purpose.
3.2 Accounting treatment of investment property

The recognition criteria for investment property are the same as for property, plant and
equipment under IAS 16. An owned investment property should be recognised as an asset only
when:
 it is probable that future economic benefits associated with the property will flow to the
entity; and
 the cost of the property can be measured reliably.
Measurement at recognition
Owned investment property should be measured initially at cost plus any directly attributable
expenditure (e.g. legal fees, property transfer taxes and other transaction costs) incurred to
acquire the property.
The cost of an investment property is not increased by:
 start-up costs (unless necessary to bring the property to the condition necessary for it to be
capable of operating in the manner intended by management);
 operating losses incurred before the investment property achieves the planned level of
occupancy; or
 abnormal waste incurred in constructing or developing the property.
Measurement after recognition
After initial recognition an entity may choose as its accounting policy:
 the fair value model; or
 the cost model.
The chosen policy must be applied to all the investment property of the entity.
Once a policy has been chosen it cannot be changed unless the change will result in a more
appropriate presentation. IAS 40 states that a change from the fair value model to the cost model
is unlikely to result in a more appropriate presentation.
Fair value model for investment property
Definition: Fair value

Fair value is the price that would be received to sell an asset or paid to transfer a liability in an
orderly transaction between market participants at the measurement date.
Under the fair value model the entity should:
 revalue all its investment property to ‘fair value’ (open market value) at the end of each
financial year; and
 recognise any resulting gain or loss in profit or loss for the period.
The property would not be depreciated.
This is different to the revaluation model of IAS 16, where gains are reported as other
comprehensive income and accumulated as a revaluation surplus.
If an entity’s policy is to measure investment properties at fair value but its fair value cannot be
measured reliably such investment property shall be measured at cost for example an investment
property under construction. However, if the entity expects the fair value of the investment
property under construction to be reliably measured when construction is complete it shall
measure that investment property under construction at cost until either its fair value becomes
reliably measured or construction is completed (whichever is earlier).

If it is not possible to arrive at a reliable fair value figure then the cost model should be adopted
for that property using the cost model in accordance with IAS 16 for owned assets or IFRS 16 for
investment property held by a lessee as a right-of-use asset. This is an exception to the rule that
all investment property must be valued under either one model or the other.
Cost model for investment property
The cost model follows the provisions of IAS 16. The property is measured at cost less
accumulated depreciation (related to the non-land element) and less impairment loss if any.
Example: Accounting for investment property

On 1 January Year 1 Entity P purchased a building for its investment potential. The building cost
Rs. 1 million with transaction costs of Rs. 10,000.
The depreciable amount of the building component of the property at this date was Rs. 300,000.
The property has a useful life of 50 years.
At the end of Year 1 the property’s fair value had risen to Rs. 1.3 million.
The amounts which would be included in the financial statements of Entity P at 31 December
Year 1, under the cost model are as follows:
Cost model
The property will be included in the statement of financial position as follows:
Rs.
Cost (1,000,000 + 10,000) 1,010,000
Accumulated depreciation (300,000 ÷ 50 years) (6,000)
Carrying amount 1,004,000
The statement of profit or loss will include depreciation of Rs. 6,000.
The amounts which would be included in the financial statements of Entity P at 31 December
Year 1, under the fair value model are as follows:
Fair value model
The property will be included in the statement of financial position at its fair value of Rs.
1,300,000.
The statement of profit or loss will include a gain of Rs. 290,000 (Rs. 1,300,000 – Rs. 1,010,000)
in respect of the fair value adjustment.
3.3 Why investment properties are treated differently from other properties
Most properties are held to be used directly or indirectly in the entity’s business. For example, a
factory, plant and equipment which is used to produce goods for sale. The property is being
consumed and it is appropriate to depreciate it over its useful life.
An investment property is held primarily because it is expected to increase in value over time
(capital appreciation) or it is held to earn rentals. It generates economic benefits for the entity
because it might earn regular stream of income in the form of rentals or might be sold at a profit.
An investment property also differs from owner-occupied properties (IAS 16) because it
generates cash flows that are largely independently of other assets held by an entity.
The most relevant information about an investment property is its fair value (the amount for which
it could be sold). Depreciation is largely irrelevant. Therefore it is appropriate to re-measure an
investment property to fair value each year and to recognise gains and losses in profit or loss for
the period.

3.4 Transfers and disposals of investment property

If a property is transferred into or out of this category it must be reclassified as an investment
property or as no longer being an investment property. A transfer of investment property can only
be made where there is a change in use (when the property meets or ceases to meet, the
definition of investment property) as illustrated below.
Circumstance for
Transfer from/to Deemed transfer value
a change in use
Commencement Transfer from investment Fair value at the date of change of use
of or development property to owner-occupied becomes the deemed cost for future
with a view to property accounting purposes
owner-occupation
End of owner- Transfer from owner- Where investment properties are
occupation occupied property to measured at fair value, revalue in
investment property accordance with IAS 16 prior to the
transfer
Commencement Transfer from investment Fair value at the date of change of use
of development property to inventories becomes the deemed cost for future
with a view to sale accounting purposes
Inception of an Transfer from inventories to Fair value at the date of the transfer, and
operating lease to investment property any difference compared to previous
another party carrying amount is recognised in profit or
loss
Gain or loss on disposal

Gains or losses on disposals of investment properties are included in profit or loss in the period in
which the disposal occurs.
Example: Disposal of investment property
The investment property in the previous example was sold early in Year 2 for Rs. 1,550,000,
Selling costs were Rs. 50,000.
The amount that would be included in the statement of profit or loss for Year 2 in respect of this
disposal under the cost model is as follows:
Cost model Rs.
Sale value 1,550,000
Selling costs (50,000)
Net disposal proceeds 1,500,000
Minus: Carrying amount (1,004,000)
The amount that would be included in the statement of profit or loss for Year 2 in respect of this
disposal under the fair value model is as follows:
(Fair value model Rs.
Sale value 1,550,000
Selling costs (50,000)
Net disposal proceeds 1,500,000
Minus: Carrying amount (1,300,000)

3.5 Disclosure requirements

The following disclosures are required by IAS 40 in the notes to the accounts.
Disclosure requirements applicable to both the fair value model and the cost model
 whether the fair value model or the cost model is used
 the methods and assumptions applied in arriving at fair values
 the extent to which the fair value of investment property was based on a valuation by a
qualified, independent valuer with relevant, recent experience
 amounts recognised as income or expense in the statement of profit or loss for:
 rental income from investment property
 operating expenses in relation to investment property
 details of any restrictions on the ability to realise investment property or any restrictions on
the remittance of income or disposal proceeds
 the existence of any contractual obligation to purchase, construct or develop investment
property or for repairs, maintenance or enhancements.
Disclosure requirements applicable to the fair value model only
There must be a reconciliation, in a note to the financial statements, between opening and
closing values for investment property, showing:
 additions during the year
 assets classified as held for sale in accordance with IFRS 5
 net gains or losses from fair value adjustments
 acquisitions through business combinations
This reconciliation should show separately any amounts in respect of investment properties
included at cost because their fair values cannot be estimated reliably.
For investment properties included at cost because fair values cannot be estimated reliably, the
following should also be disclosed:
 a description of the property
 an explanation as to why fair values cannot be determined reliably
 if possible, the range within which the property’s fair value is likely to lie.
Disclosure requirements applicable to the cost model only
 the depreciation methods used
 the useful lives or depreciation rates used
 gross carrying amounts and accumulated depreciation at the beginning and at the end of
the period
 A reconciliation between opening and closing values showing:
 Companies Act, 2017additions
 depreciation
 assets classified as held for sale in accordance with IFRS 5
 acquisitions through business combinations
 impairment losses
 transfers
When the cost model is used, the fair value of investment property should also be disclosed. If
the fair value cannot be estimated reliably, the same additional disclosures should be made as
under the fair value model.


Solution 1
The amounts could be reflected in the financial statements prepared at the end of Year 1 in accordance
with IAS 20 in the following ways:
Method 1:
Statement of financial position

Cost (500,000 – 100,000) 400,000
Included in statement of profit or loss Rs.

Depreciation charge (Rs.400,000/5 years) 80,000
Method 2:
Statement of financial position
Cost 500,000
Current liabilities
At the end of year 1 there would be Rs. 80,000 of the grant left to recognise in profit
in the future at Rs. 20,000 per annum. Rs. 20,000 would be recognised in the next
year and is therefore current. The balance is non-current.
Included in statement of profit or loss Rs.
Expense: Depreciation charge (Rs. 500,000/5 years) (100,000)
Income: Government grant (Rs. 100,000/5 years) 20,000

9
CHAPTER
IAS 36: Impairment of assets
Contents
1 Impairment of assets

1 IMPAIRMENT OF ASSETS
Section overview
 Objective and scope of IAS 36

 Identifying impairment or possible impairment
 Measuring recoverable amount
 Accounting for impairment
 Summary of the approach
1.1 Objective and scope of IAS 36

An asset is said to be impaired when its recoverable amount is less than its carrying amount in
the statement of financial position. From time to time an asset may have a carrying value that is
greater than its fair value but this is not necessarily impairment as the situation might change in
the future as the reporting date approaches.
The objective of IAS 36 Impairment of assets is to ensure that assets are ‘carried’ (valued) in
the financial statements at no more than their recoverable amount.
Scope of IAS 36
IAS 36 applies to accounting for impairment of all assets except the following:
 inventories (IAS 2: Inventories);
 assets arising from contracts with customers that are recognised in accordance with IFRS
15: Revenue from contracts with customers.
 investment property that is measured at fair value (IAS 40:
The requirements of IAS 36 also do not apply to IFRSs like IAS 12, IAS 27, IAS 28, IAS 38, IAS
41, IFRS 4, IFRS 5, IFRS 10, IFRS 11, which are out of syllabus at this level.
Recoverable amount of assets
Definitions
The recoverable amount of an asset is defined as the higher of its fair value minus costs of
disposal, and its value in use.
Fair value is the price that would be received to sell an asset or paid to transfer a liability in an
orderly transaction between market participants at the measurement date.
Value in use is the present value of future cash flows from using an asset, including its eventual
disposal.
Impairment loss is the amount by which the carrying amount of an asset (or a cash-generating
unit) exceeds its recoverable amount.
Stages in accounting for an impairment loss

There are various stages in accounting for an impairment loss:
Stage 1: Establish whether there is an indication of impairment.
Stage 2: If so, assess the recoverable amount.
Stage 3: Write down the affected asset (by the amount of the impairment) to its recoverable
amount.
Each of these stages will be considered in turn.

Chapter 9: IAS 36: Impairment of assets
1.2 Identifying impairment or possible impairment

An entity must carry out an impairment review when there is evidence or an indication that
impairment may have occurred. At the end of each reporting period, an entity should assess
whether there is any indication that impairment might have occurred. If such an indication exists,
the entity must estimate the recoverable amount of the asset, in order to establish whether
impairment has occurred and if so, the amount of the impairment.
Indicators of impairment
The following are given by IAS 36 as possible indicators of impairment. These may be
indicators outside the entity itself (external indicators), such as market factors and changes in the
market. Alternatively, they may be internal indicators relating to the actual condition of the asset
or the conditions of the entity’s business operations.
When assessing whether there is an indication of impairment, IAS 36 requires that, at a
minimum, the following sources are considered:
External sources Internal sources

An unexpected decline in the asset’s market Evidence that the asset is damaged or no
value. longer of use to the entity.
Significant changes in technology, markets, There are plans to discontinue or restructure
economic factors or laws and regulations that the operation for which the asset is currently
have an adverse effect on the company. used.
An increase in interest rates, affecting the There is a reduction in the asset’s expected
value in use of the asset. remaining useful life.
The company’s net assets have a higher There is evidence that the entity’s expected
carrying value than the company’s market performance is worse than expected.
capitalisation (which suggests that the assets
are over-valued in the statement of financial
position).
Internal indicators for impairment are generally refers to items under control of management
while external indicators are outside the control of management.
If there is an indication that an asset is impaired then it is tested for impairment. This involves the
calculating the recoverable amount of the item in question and comparing this to its carrying
amount.
1.3 Measuring recoverable amount

It has been explained that recoverable amount is the higher of an asset’s:
 fair value less costs of disposal; and
 its value in use.
If either of these amounts is higher than the carrying value of the asset, there has been no
impairment.
IAS 36 sets out the requirements for measuring ‘fair value less costs of disposal’ and ‘value in
use’.
Measuring fair value less costs of disposal
Fair value of an asset at a particular date is normally its current market value. If no active market
exists, it may be possible to estimate the amount that the entity could obtain from the disposal.

Direct selling costs normally include legal costs, taxes and costs necessary to bring the asset into
a condition to be sold. However, redundancy and similar costs (for example, where a business is
reorganised following the disposal of an asset) are not direct selling costs.
Calculating value in use
Value in use represents the present value of the expected future cash flows from use of the
asset, discounted at a suitable discount rate or cost of capital.
The following elements should be reflected in the calculation of an asset’s value in use:
 An estimate of the future cash flows the entity expects to derive from the asset
 Expectations about possible variations in the amount or timing of those future cash flows
 The time value of money (represented by the current market risk-free rate of interest)
 The price for bearing the uncertainty inherent in the asset

 Other factors that market participants would reflect in pricing the future cash flows the entity
expects to derive from the asset.
Estimates of future cash flows should be based on reasonable and supportable assumptions that
represent management’s best estimate of the economic conditions that will exist over the
remaining useful life of the asset.
Estimates of future cash flows must include:
 cash inflows from the continuing use of the asset;
 cash outflows that will be necessarily incurred to generate the cash inflows from continuing
use of the asset; and
 net disposal proceeds at the end of the asset’s useful life.
Estimates of future cash flows must not include:
 cash inflows or outflows from financing activities; or
 income tax receipts or payments.
Also note that future cash flows are estimated for the asset in its current condition. Therefore,
any estimate of future cash flows should not include estimated future cash flows that are
expected to arise from:
 a future restructuring to which an entity is not yet committed; or
 improving or enhancing the asset’s performance.
The discount rate must be a pre-tax rate that reflects current market assessments of:
 the time value of money; and
 the risks specific to the asset for which the future cash flow estimates have not been
adjusted.
However, both the expected future cash flows and the discount rate might be adjusted to allow
for uncertainty about the future – such as the business risk associated with the asset and
expectations of possible variations in the amount or timing of expected future cash benefits from
using the asset.

Example: Measurement of recoverable amount

A company has a machine in its statement of financial position at a carrying amount of
Rs.300,000.
The machine is used to manufacture the company’s best-selling product range, but the entry of a
new competitor to the market has severely affected sales.
As a result, the company believes that the future sales of the product over the next three years
will be only Rs.150,000, Rs.100,000 and Rs.50,000. The asset will then be sold for Rs.25,000.
An offer has been received to buy the machine immediately for Rs.240,000, but the company
would have to pay shipping costs of Rs.5,000.The risk-free market rate of interest is 10%.
Market changes indicate that the asset may be impaired and so the recoverable amount for the
asset must be calculated.
Fair value less costs of disposal Rs.
Fair value 240,000
Costs of disposal (5,000)
235,000
Year Cash flow (Rs.000) Discount factor Present value
1 150,000 1/1.1 136,364
2 100,000 1/1.12 82,645
3 50,000 + 25,000 1/1.13 56,349
Value in use 275,358
The recoverable amount is the higher of Rs.235,000 and Rs.275,358, i.e. Rs.275,358.
The asset must be valued at the lower of carrying value and recoverable amount.
The asset has a carrying value of Rs.300,000, which is higher than the recoverable amount
from using the asset.
It must therefore be written down to the recoverable amount, and an impairment of
Rs.24,642 (Rs.300,000 – Rs.275,358) must be recognised.
1.4 Accounting for impairment

The impairment loss is normally recognised immediately in profit or loss.

Rs.300,000.
The machine has been tested for impairment and found to have recoverable amount of
Rs.275,358 meaning that the company must recognise an impairment loss of Rs.24,642.
This is accounted for as follows:
Debit Credit
Accumulated impairment loss 24,642
(Property, plant and equipment would be
presented net of the balance on this
account on the face of the statement of
financial position).

Practice question 1
On 1 January Year 1 Entity Q purchased for Rs.240,000 a machine with an estimated useful
life of 20 years and an estimated zero residual value.
Depreciation is on a straight-line basis.
On 1 January Year 4 an impairment review showed the machine’s recoverable amount to be
Rs.100,000 and its remaining useful life to be 10 years.
Calculate:
a) The carrying amount of the machine on 31 December Year 3 (immediately before the
impairment).
b) The impairment loss recognised in the year to 31 December Year 4.
c) The depreciation charge in the year to 31 December Year 4.c)
However, an impairment loss recognised in respect of an asset carried at a previously

recognised revaluation surplus is recognised in other comprehensive income to the extent that it
is covered by that surplus. Thus it is treated in the same way as a downward revaluation,
reducing the revaluation reserve balance relating to that asset.
Impairment not covered by a previously recognised surplus on the same asset is recognised in
profit or loss.

Rs.300,000 including a previously recognised surplus of Rs.20,000.
The machine has been tested for impairment and found to have recoverable amount of
Rs.275,358 meaning that the company must recognise an impairment loss of Rs.24,642.
This is accounted for as follows:
Debit Credit
Other comprehensive income 20,000
Following the recognition of the impairment, the future depreciation of the asset must be based
on the revised carrying amount, minus the residual value, over the remaining useful life.
Practice question 2
On 1 January Year 1 Entity Q purchased for Rs.240,000 a machine with an estimated useful
life of 20 years and an estimated zero residual value.
Depreciation is on a straight-line basis.
The asset had been re-valued on 1 January Year 3 to Rs.250,000, but with no change in
useful life at that date.
On 1 January Year 4 an impairment review showed the machine’s recoverable amount to be
Rs.100,000 and its remaining useful life to be 10 years.

Calculate:
a) The carrying amount of the machine on 31 December Year 2 and hence the revaluation
surplus arising on 1 January Year 3.
b) The carrying amount of the machine on 31 December Year 3 (immediately before the
impairment).
c) The impairment loss recognised in the year to 31 December Year 4.
d) The depreciation charge in the year to 31 December Year 4.
1.5 Summary of the approach

Impairment of an asset should be identified and accounted for as follows:
(1) At the end of each reporting period, the entity should assess whether there are any
indications that an asset may be impaired.
(2) If there are such indications, the entity should estimate the asset’s recoverable amount.
(3) When the recoverable amount is less than the carrying value of the asset, the entity should
reduce the asset’s carrying value to its recoverable amount. The amount by which the
value of the asset is written down is an impairment loss.
(4) This impairment loss is recognised as a loss for the period.
(5) However, if the impairment loss relates to an asset that has previously been re-valued
upwards, it is first offset against any remaining revaluation surplus for that asset. When
this happens it is reported as other comprehensive income for the period (a negative
value) and not charged against profit.
(6) Depreciation charges for the impaired asset in future periods should be adjusted to
allocate the asset’s revised carrying amount, minus any residual value, over its remaining
useful life (revised if necessary).


Solution 1
On 31 December Year 3 the machine was stated at the following amount:
a) Carrying amount of the machine on 31 December Year 3 Rs
Cost 240,000
Accumulated depreciation (3 × (240,000 ÷ 20 years)) (36,000)
b) Impairment loss at the beginning of Year 4 of Rs.104,000 (Rs.204,000 – Rs.100,000).

This is charged to profit or loss.
c) Depreciation charge in Year 4 of Rs.10,000 (= Rs.100,000 ÷ 10). The depreciation

charge is based on the recoverable amount of the asset.
Solution 2
a) Carrying amount on Rs.
Cost 240,000
Accumulated depreciation at 1 January Year 3
(2 years × (240,000 ÷ 20)) (24,000)
Valuation at 1 January Year 3 250,000
Revaluation surplus 34,000
b) When the asset is revalued on 1 January Year 3, depreciation is charged on the

revalued amount over its remaining expected useful life.
On 31 December Year 3 the machine was therefore stated at:
Rs.
Valuation at 1 January (re-valued amount) 250,000
Accumulated depreciation in Year 3 (= Rs.250,000 ÷ 18)) (13,889)
Note: The depreciation charge of Rs.13,889 is made up of Rs.12,000 (being that part
of the charge that relates to the original historical cost) and Rs.1,889 being the
incremental depreciation.
Rs.1,889 would be transferred from the revaluation surplus into retained earnings.
c) On 1 January Year 4 the impairment review shows an impairment loss of Rs.136,111

(Rs.236,111 – Rs.100,000).
An impairment loss of Rs.32,111 (Rs.34,000 Rs.1,889) will be taken to other
comprehensive income (reducing the revaluation surplus for the asset to zero).
The remaining impairment loss of Rs.104,000 (Rs.136,111 Rs.34,000) is recognised
in the statement of profit or loss for Year 4.
d) Year 4 depreciation charge is Rs.10,000 (Rs.100,000 ÷ 10 years).

10
CHAPTER
IFRS 15: Revenue from contracts
with customers
Contents
1 IFRS 15: Revenue from contracts with customers
2 IFRS 15: The five step model
3 Other aspects of IFRS 15
4 Examinable Examples of IFRS 15

1 IFRS 15: REVENUE FROM CONTRACTS WITH CUSTOMERS
Section overview
 Introduction
 Core principle and the five step model
1.1 Introduction
The IASB issued IFRS 15: Revenue from contracts with customers in May 2014.
IFRS 15 is the end product of a major joint project between the IASB and the US Financial
Accounting Standards Board and replaces IAS 18, IAS 11, IFRIC 13, IFRIC 15, IFRIC 18 and
SIC 31.
IFRS 15 will have an impact on all entities that enter into contracts with customers with few
exceptions. Entities will need to reassess their revenue recognition policies and may need to
revise them. The timing and amount of revenue recognised may not change for simple contracts
for a single deliverable but will change for more complex arrangements involving more than one
deliverable.
This standard is effective for annual accounting periods beginning on or after 1 January 2017 but
earlier application is allowed.
Summary
IFRS 15:
 establishes a new control-based revenue recognition model;
 changes the basis for deciding whether revenue is recognised at a point in time or over
time;
 provides new and more detailed guidance on specific topics; and
 improves disclosures about revenue.
1.2 Core principle and the five step model

IFRS 15 is based on a core principle that requires an entity to recognise revenue:
 in a manner that depicts the transfer of goods or services to customers
 at an amount that reflects the consideration the entity expects to be entitled to in exchange
for those goods or services.
Applying this core principle involves following a five step model as follows:
 Step 1: Identify the contract(s) with the customer
 Step 2: Identify the separate performance obligations
 Step 3: Determine the transaction price
 Step 4: Allocate the transaction price
 Step 5: Recognise revenue when or as an entity satisfies performance obligations
Definitions
Revenue is income arising in the course of an entity’s ordinary activities.
A customer is a party that has contracted with an entity to obtain goods or services that are an
output of the entity’s ordinary activities.

Chapter 10: IFRS 15: Revenue from contracts with customers
2 IFRS 15: THE FIVE STEP MODEL
Section overview
 Step 1: Identify the contract(s) with a customer

 Step 2: Identify the separate performance obligations in the contract
 Step 3: Determine the transaction price
 Step 4: Allocate the transaction price to the performance obligations
 Step 5: Recognise revenue when or as an entity satisfies performance obligations
2.1 Step 1: Identify the contract(s) with a customer

The first step in IFRS 15 is to identify the contract. This may be written, oral, or implied by an
entity’s customary business practices.
Definition
A contract is an agreement between two or more parties that creates enforceable rights and
obligations.
The general IFRS 15 model applies only when or if:

 the parties have approved the contract;
 the entity can identify each party’s rights;
 the entity can identify the payment terms for the goods and services to be transferred; and
 the contract has commercial substance (i.e. the risk, timing or amount of the entity’s future
cash flows is expected to change as a result of the contract); and
 it is probable the entity will collect the consideration.
If a customer contract does not meet these criteria, revenue is recognised only when either:
 the entity’s performance is complete and substantially all of the consideration in the
arrangement has been collected and is non-refundable; or
 the contract has been terminated and the consideration received is non-refundable.
Example:
Mr. Owais agreed on March 1, 2017 to sell 5 cutting machines to Axiom Enterprises. Due to some
deficiency in drafting the agreement each party’s rights cannot be identified. On March 31, 2017
Mr. Owais delivered the goods and these were accepted by Axiom Enterprises. After 10 days of
delivery i.e. April 10, 2017 Axiom Enterprises made the full payment and the payment is non-
refundable.
When should Owais record the revenue?
Answer
Mr. Owais cannot identify each party’s rights so revenue recognition should be delayed until the
entity’s (Owais) performance is complete and substantially all of the consideration (cash) in the
arrangement has been collected and is non-refundable.
Therefore, Mr. Owais should record the revenue on April 10, 2017, as it is the date on which
performance is complete and non-refundable payment is received.
A contract does not exist if each party has an enforceable right to terminate a wholly
unperformed contract without compensating the other party.

Example:
A shopkeeper agreed to deliver 10 computers to Waqas Enterprises within 3 months. As per the
agreement shopkeeper can cancel the contract any time before delivering the computers. In case
of cancellation, shopkeeper is not required to pay any penalty to Waqas Enterprises.
Does the contract exist?
Answer
A contract does not exist if each party (either buyer or seller) has an enforceable right to
terminate a wholly unperformed contract without compensating the other party.
As shopkeeper can cancel contract without compensating Waqas Enterprises so contract does
not exist.
Combination of contracts
An entity must combine two or more contracts entered into at or near the same time with the
same customer (or related parties of the customer) and treat them as a single contract if one or
more of the following conditions are present:
 the contracts are negotiated as a package with a single commercial objective;
 the amount of consideration to be paid in one contract depends on the price or
performance of the other contract; or
 the goods or services promised in the contracts (or some goods or services promised in
the contracts) are a single performance obligation.
Illustration:
Adil Ltd. enters into 2 separate agreements with customer X.
1. Agreement 1: Deliver 10,000 bricks for Rs. 100,000
2. Agreement 2: Build a boundary wall for Rs. 20,000
The two agreements should be combined and considered as a one agreement because contracts
are negotiated with a single commercial objective of building a wall. The price of two agreements
is interdependent. Adil Ltd. is probably charging high price for bricks to compensate for the
discounted price for building the wall.
2.2 Step 2: Identify the separate performance obligations in the contract

Performance obligations are normally specified in the contract but could also include promises
implied by an entity’s customary business practices, published policies or specific statements that
create a valid customer expectation that goods or services will be transferred under the contract.
Definition
A performance obligation is a promise in a contract with a customer to transfer to the customer
either:
a. a good or service (or a bundle of goods or services) that is distinct; or
b. a series of distinct goods or services that are substantially the same and that have the
same pattern of transfer to the customer.
At the inception of a contract the entity must assess the goods or services promised in a contract
with a customer and must identify as a performance obligation each promise to transfer to the
customer either:
 a good or service (or a bundle of goods or services) that is distinct; or
 a series of distinct goods or services that are substantially the same and that have the
same pattern of transfer to the customer (described by reference to promises satisfied over
time, and progress to completion assessment)

Example:
Pico Ltd. (PL) sells 10 washing machines for Rs. 20,000 each to a Retailer Co. (RC). PL also provides
the following free of cost:
• Free service and maintenance for 3 years
• 10 kg of washing powder every month for the next 18 months
• A discount voucher for a 50% discount if next purchase is made in the next 6 months.
Required:
How many performance obligations are in the contract?
Answer
There are 4 separate performance obligations as all of the goods and services are distinct
because the RC can benefit from the good and service on its own and the PC’s promise to
transfer the good or service is separately identifiable from other promises in the contract:
Following are the separate performance obligations:
1. Delivery of washing machines (point in time)
2. Service and maintenance over 3 years (over time)
3. 10 kg washing powder over the next 18 months (over time)
4. Discount voucher (point in time)
A good or service is distinct if both of the following criteria are met:

 the customer can benefit from the good or service either on its own or together with other
resources that are readily available to the customer; and
 the entity’s promise to transfer the good or service is separately identifiable from other
promises in the contract.
If a good or service is regularly sold separately, this would indicate that customers generally can
benefit from the good/service on its own or in conjunction with other available resources.
If a promised good or service is not distinct, an entity must combine that good or service with
other promised goods or services until it identifies a bundle of goods or services that is distinct. In
some cases, this would result in the entity accounting for all the goods or services promised in a
contract as a single performance obligation
Example: Promised goods and services

Goods produced by an entity for sale
Resale of goods purchased by an entity
Resale of rights to goods or services purchased by an entity
Performing a contractually agreed-upon task for a customer
Standing ready to provide goods or services
Providing a service of arranging for another party to transfer goods or services to the customer
Granting rights to goods or services to be provided in the future that a customer can resell
Constructing, manufacturing or developing an asset on behalf of a customer
Granting licences
Granting options to purchase additional goods/services
When (or as) a performance obligation is satisfied, an entity will recognise as revenue the
amount of the transaction price (excluding estimates of variable consideration that are
constrained) allocated to that performance obligation (step 5))
There are two issues to address:
 The amount of the transaction price, including any constraints (step 3))
 The allocation of that price to POs (step 4)

2.3 Step 3: Determine the transaction price

Definition
The transaction price is the amount of consideration an entity expects to be entitled to in exchange
for the goods or services promised under a contract, excluding any amounts collected on behalf
of third parties (for example, sales taxes).
An entity must consider the terms of the contract and its customary practices in determining the
transaction price.
The transaction price assumes transfers to the customer as promised in accordance with the
existing contract and that the contract will not be cancelled, renewed or modified.
The transaction price is not adjusted for effects of the customer’s credit risk, but is adjusted if the
entity (e.g. based on its customary business practices) has created a valid expectation that it will
enforce its rights for only a portion of the contract price.
An entity must consider the effects of all the following factors when determining the transaction
price:
 variable consideration;
 the constraint on variable consideration;
 time value of money;
 non-cash consideration;
 consideration payable to the customer.
Example:
Tayyab Co. enters into a contract to build an oil rig for Rs. 100,000
If the oil rig is not completed on time there will be a Rs. 20,000 penalty
Tayyab Co. has built similar oil rigs before and there is 90% chance that the oil rig will be completed
on time
What is the transaction price?
Answer
Two possible outcomes:
Rs. 100,000 if completed on time
Rs. 80,000 if not completed on time
The “most likely amount” method better predicts the amount of consideration
Therefore, transaction price is Rs. 100,000 as there is 90% chance that the oil rig will be
completed on time.
2.4 Step 4: Allocate the transaction price to the performance obligations

The entity allocates a contract’s transaction price to each separate performance obligation within
that contract on a relative stand-alone selling price basis at contract inception.
Definition
A stand-alone selling price is the price at which an entity would sell a promised good or service
separately to a customer.
IFRS 15 suggests, but does not require, the following three methods as suitable for estimating
the stand-alone selling price:
 adjusted market assessment approach
 expected cost plus margin approach
 residual approach.

2.5 Step 5: Recognise revenue when or as an entity satisfies performance obligations

Revenue is recognised when or as the promised goods or services are transferred to a customer.
 A transfer occurs when the customer obtains control of the good or service.
 A customer obtains control of an asset (good or service) when it can direct the use of and
obtain substantially all the remaining benefits from it. Control includes the ability to prevent
other entities from directing the use of and obtaining the benefits from an asset. Indicators
of control include:
 The entity has a present right to payment for the asset
 The customer has legal title
 The customer has physical possession (exceptions for bill and hold, consignment
sales and repos)
 The customer has the significant risks and rewards of ownership of the asset
 The customer has accepted the asset
 The benefits of an asset are the potential cash flows that can be obtained directly or
indirectly from the asset in many ways.
When goods or services are transferred continuously, a revenue recognition method that best
depicts the entity’s performance should be applied (updated as circumstances change).
Example:
On 1 November 2017, Shahid receives an order from a customer for 30 computer as well as 12
months of technical support for computers. Shahid delivers the computers (and transfers its legal
title) to the customer on the same day. The customer paid Rs.25,000 upfront. The computer sells
for Rs.20,000 and the technical support sells for Rs.5,000.
How revenue should be recorded for year ended December 31, 2017.
Answer
Below is how the 5 steps would be applied to this contract:
Step 1 - Identify the contract
There is a contract between Shahid and its customer for the provision of goods (computers) and
services (technical support services)
Step 2 – Identify the separate performance obligations within a contract
There are two performance obligations (promises) within the contract:
1. The supply of a computer
2. The provision of technical support services over a year
Step 3 – Determine the transaction price
The total transaction price is Rs.25,000 per computer.
Step 4 –Allocate the transaction price to the performance obligations in the contract
No need for any allocation as the transaction price and stand-alone price (market price) is same.
Step 5 – Recognise revenue when (or as) a performance obligation is satisfied.
Computer (Point in time)
Control over the computer has been passed to the customer so the full revenue of Rs. 20,000 for
30 computers (i.e. Rs.600,000) should be recognized immediately.
Technical support services (Over time)
The technical support is provided over time (12 months), so revenue from this should be
recognized over time. For the year ended 31 December 2017, revenue of Rs. 25,000 (Rs.5,000 x
30 x 2/12) should be recognised from the provision of technical support services.
Acceptable methods include:
 Output methods: units produced, units delivered, contract milestones or surveys of work
performed; or
 Input methods: costs incurred, labour hours expended, machine hours used.

3 OTHER ASPECTS OF IFRS 15
Section overview
 Contract costs
 Presentation
3.1 Contract costs

Costs might be incurred in obtaining a contract and in fulfilling that contract.
Incremental costs of obtaining a contract
The incremental costs of obtaining a contract with a customer are recognised as an asset if the
entity expects to recover those costs.
The incremental costs of obtaining a contract are those costs that would not have been incurred
if the contract had not been obtained.
Costs to obtain a contract that would have been incurred regardless of whether the contract was
obtained are expensed as incurred (unless they can be recovered from the customer regardless
of whether the contract is obtained).
Example: Incremental costs of obtaining a contract

X Limited wins a competitive bid to provide consulting services to a new customer.
X Limited incurred the following costs to obtain the contract:
Rs.
Commissions to sales employees for winning the contract 10,000
External legal fees for due diligence 15,000
Travel costs to deliver proposal 25,000
Total costs incurred 50,000
Analysis
The commission to sales employees is incremental to obtaining the contract and should be
capitalised as a contract asset.
The external legal fees and the travelling cost are not incremental to obtaining the contract because
they have been incurred regardless of whether X Limited obtained the contract or not.
An entity may recognise the incremental costs of obtaining a contract as an expense when
incurred if the amortisation period of the asset that the entity otherwise would have recognised is
one year or less.
Costs to fulfil a contract
Costs incurred in fulfilling a contract might be within the scope of another standard (for example,
IAS 2: Inventories, IAS 16: Property, Plant and Equipment or IAS 38: Intangible Assets). If this is
not the case, the costs are recognised as an asset only if they meet all of the following criteria:
 the costs relate directly to a contract or to an anticipated contract that the entity can
specifically identify;
 the costs generate or enhance resources of the entity that will be used in satisfying (or in
continuing to satisfy) performance obligations in the future; and
 the costs are expected to be recovered.

Costs that relate directly to a contract might include:

 direct labour and direct materials;
 allocations of costs that relate directly to the contract or to contract activities;
 costs that are explicitly chargeable to the customer under the contract; and
 other costs that are incurred only because an entity entered into the contract (e.g.
payments to subcontractors).
The following costs must be recognised as expenses when incurred:
 general and administrative costs (unless those costs are explicitly chargeable to the
customer under the contract);
 costs of wasted materials, labour or other resources to fulfil the contract that were not
reflected in the price of the contract;
 costs that relate to satisfied performance obligations (or partially satisfied performance
obligations) in the contract (i.e. costs that relate to past performance).
Amortisation and impairment
An asset for contract costs recognised in accordance with this standard must be amortised on a
systematic basis consistent with the transfer to the customer of the goods or services to which
the asset relates.
The amortisation must be updated to reflect a significant change in the entity’s expected timing of
transfer to the customer of the goods or services to which the asset relates.
An impairment loss must be recognised in profit or loss to the extent that the carrying amount of
an asset recognised exceeds:
 the remaining amount of consideration that the entity expects to receive in exchange for
the goods or services to which the asset relates; less
 the costs that relate directly to providing those goods or services and that have not been
recognised as expenses.
When the impairment conditions no longer exist or have improved a reversal of the impairment
loss is recognised. This will reinstate the asset but the increased carrying amount of the asset
must not exceed the amount that would have been determined (net of amortisation) if no
impairment loss had been recognised previously.
Example: Amortisation of contract costs

X Limited wins a 5 year contract to provide a service to a customer.
The contract contains a single performance obligation satisfied over time.
X Limited recognises revenue on a time basis
Costs incurred by the end of year 1 and forecast future costs are as follows:
Rs.
Costs to date 10,000
Estimate of future costs 18,000
Total expected costs 28,000
Analysis
Costs must be recognised in the P&L on the same basis as that used to recognise revenue.
X Limited recognises revenue on a time basis, therefore 1/5 of the total expected cost should be
recognised = Rs. 5,600 per annum.


X Limited wins a 5 year contract to provide a service to a customer.
The contract is renewable for subsequent one-year periods.
The average customer term is seven years.
The contract contains a single performance obligation satisfied over time.
X Limited recognises revenue on a time basis.
Rs.
Analysis
X Limited recognises revenue on a time basis. The asset relates to the services transferred to the
customer during the contract term of five years and X Limited anticipates that the contract will be
renewed for two subsequent one-year periods.
Therefore 1/7 of the total expected cost should be recognised = Rs. 4,000 per annum.

X Limited wins a contract to build an asset for a customer. It is anticipated that the asset will take
2 years to complete
The contract contains a single performance obligation. Progress to completion is measured on an
output basis.
At the end of year 1 the assets is 60% complete.
Rs.
Analysis
Therefore 60% of the total expected cost should be recognised (Rs. 16,800) at the end of year 1.
3.2 Presentation
This section explains how contracts are presented in the statement of financial position. In order
to do this it explains the double entries that might result from the recognition of revenue. The
double entries depend on circumstance.
An unconditional right to consideration is presented as a receivable.
The accounting treatment to record the transfer of goods for cash or for an unconditional promise
to be paid consideration is straightforward.

Illustration: Possible double entries on recognition of revenue
Debit Credit
Cash X
Receivable X
Revenue X
Example: Double entry – Unconditional right to consideration

1 January 20X8
X Limited enters into a contract to transfer Products A and B to Y Limited in exchange for Rs. 1,000.
Product A is to be delivered on 28 February.
Product B is to be delivered on 31 March.
The promises to transfer Products A and B are identified as separate performance obligations.
Rs.400 is allocated to Product A and Rs.600 to Product B.
X Limited recognises revenue and recognises its unconditional right to the consideration when
control of each product transfers to Y Limited.
The following entries would be required to reflect the progress of the contract).
Contract progress
28 February: X Limited transfers Product A to Y Limited.
At 28 February Dr (Rs.) Cr (Rs.)
Receivables 400
Revenue 400
31 March: X Limited transfers Product B to Y Limited
31 March
Receivables 600
Revenue 600
In other cases, a contract is presented as a contract asset or a contract liability depending on the
relationship between the entity’s performance and the customer’s payment.
Contract assets
A supplier might transfer goods or services to a customer before the customer pays
consideration or before payment is due. In this case the contract is presented as a contract asset
(excluding any amounts presented as a receivable).
A contract asset is a supplier’s right to consideration in exchange for goods or services that it has
transferred to a customer. A contract asset is reclassified as a receivable when the supplier’s
right to consideration becomes unconditional.

Example: Double entry – Recognition of a contract asset

1 January 20X8
Revenue is recognised when control of each product transfers to Y Plc.
Payment for the delivery of Product A is conditional on the delivery of Product B. (i.e. the
consideration of Rs. 1,000 is due only after X Limited has transferred both Products A and B to Y
Limited). This means that X Limited does not have a right to consideration that is unconditional (a
receivable) until both Products A and B are transferred to Y Limited.
The following entries would be required to reflect the progress of the contract
Contract progress
The following accounting entries would be necessary:
28 February: X Limited transfers Product A to Y Limited
X Plc does not have an unconditional right to receive the Rs.400 so the amount is recognised as a
contract asset.
Contract asset 400
Revenue 400

X Limited now has an unconditional right to receive the full Rs. 1,000. The Rs.400 previously
recognised as a contract asset is reclassified as a receivable and the Rs.600 for the transfer of
product B is also recognised as receivable.
31 March Dr (Rs.) Cr (Rs.)
Receivable 1,000
Contract asset 400
Revenue 600
Contract liabilities
A contract might require payment in advance or allow the supplier a right to an amount of
consideration that is unconditional (i.e. a receivable), before it transfers a good or service to the
customer.
In these cases, the supplier presents the contract as a contract liability when the payment is
made or the payment is due (whichever is earlier).
The contract liability is a supplier’s obligation to transfer goods or services to a customer for
which it has received consideration (an amount of consideration is due) from the customer.

Example: Double entry – Recognition of a contract liability

1 January 20X8
X Limited can invoice this full amount on 31 January.
Revenue is recognised when control of each product transfers to Y Limited.
The following entries would be required to reflect the progress of the contract
Contract progress
The following accounting entries would be necessary:
At 31 January Dr (Rs.) Cr (Rs.)
Receivable 1,000
Contract liability 1,000
28 February: X Limited transfers Product A to Y Limited
Contract liability 400
Revenue 400
31 March Dr (Rs.) Cr (Rs.)
Contract liability 600
Revenue 600

4 EXAMINABLE EXAMPLES OF IFRS 15 REVENUE FROM CONTRACTS WITH

CUSTOMERS
IFRS 15 is accompanied with examples that illustrate how an entity applies some of the requirements to
particular aspects of contract with a customer. Out of the said examples the following are relevant to
learning outcomes of CAF 5- Financial accounting and reporting I:
CONTRACT MODIFICATIONS
Example 5: Modification of a contract for goods
IE19 An entity promises to sell 120 products to a customer for CU12,000 (CU100 per product).
The products are transferred to the customer over a six-month period. The entity transfers
control of each product at a point in time. After the entity has transferred control of 60
products to the customer, the contract is modified to require the delivery of an additional
30 products (a total of 150 identical products) to the customer. The additional 30 products
were not included in the initial contract.
Case A—Additional products for a price that reflects the stand-alone selling price
IE20 When the contract is modified, the price of the contract modification for the additional 30
products is an additional CU2,850 or CU95 per product. The pricing for the additional
products reflects the stand-alone selling price of the products at the time of the contract
modification and the additional products are distinct (in accordance with paragraph 27 of
IFRS 15) from the original products.
IE21 In accordance with paragraph 20 of IFRS 15, the contract modification for the additional
30 products is, in effect, a new and separate contract for future products that does not
affect the accounting for the existing contract. The entity recognises revenue of CU100 per
product for the 120 products in the original contract and CU95 per product for the 30
products in the new contract.
Case B—Additional products for a price that does not reflect the stand-alone selling price
IE22 During the process of negotiating the purchase of an additional 30 products, the parties
initially agree on a price of CU80 per product. However, the customer discovers that the
initial 60 products transferred to the customer contained minor defects that were unique
to those delivered products. The entity promises a partial credit of CU15 per product to
compensate the customer for the poor quality of those products. The entity and the
customer agree to incorporate the credit of CU900 (CU15 credit × 60 products) into the
price that the entity charges for the additional 30 products. Consequently, the contract
modification specifies that the price of the additional 30 products is CU1,500 or CU50 per
product. That price comprises the agreed-upon price for the additional 30 products of
CU2,400, or CU80 per product, less the credit of CU900.
IE23 At the time of modification, the entity recognises the CU900 as a reduction of the
transaction price and, therefore, as a reduction of revenue for the initial 60 products
transferred. In accounting for the sale of the additional 30 products, the entity determines
that the negotiated price of CU80 per product does not reflect the stand-alone selling price
of the additional products. Consequently, the contract modification does not meet the
conditions in paragraph 20 of IFRS 15 to be accounted for as a separate contract. Because
the remaining products to be delivered are distinct from those already transferred, the
entity applies the requirements in paragraph 21(a) of IFRS 15 and accounts for the
modification as a termination of the original contract and the creation of a new contract.
IE24 Consequently, the amount recognised as revenue for each of the remainingproducts is a
blended price of CU93.33 {[(CU100 × 60 products not yet transferred under the original
contract) + (CU80 × 30 products to be transferred under the contract modification)] ÷ 90
remaining products}.

Example 13—Customer simultaneously receives and consumes the benefits

IE67 An entity enters into a contract to provide monthly payroll processing services to a
customer for one year.
IE68 The promised payroll processing services are accounted for as a single performance
obligation in accordance with paragraph 22(b) of IFRS 15. The performance obligation is
satisfied over time in accordance with paragraph 35(a) of IFRS 15 because the customer
simultaneously receives and consumes the benefits of the entity’s performance in
processing each payroll transaction as and when each transaction is processed. The fact
that another entity would not need to re-perform payroll processing services for the service
that the entity has provided to date also demonstrates that the customer simultaneously
receives and consumes the benefits of the entity’s performance as the entity performs.
(The entity disregards any practical limitations on transferring the remaining performance
obligation, including setup activities that would need to be undertaken by another entity.)
The entity recognises revenue over time by measuring its progress towards complete
satisfaction of that performance obligation in accordance with paragraphs 39–45 and
B14–B19 of IFRS 15.
Example 17—Assessing whether a performance obligation is satisfied at a point in time or over time
IE81 An entity is developing a multi-unit residential complex. A customer enters into a binding
sales contract with the entity for a specified unit that is under construction. Each unit has
a similar floor plan and is of a similar size, but other attributes of the units are different
(for example, the location of the unit within the complex).
Case A—Entity does not have an enforceable right to payment for performance completed to date
IE82 The customer pays a deposit upon entering into the contract and the deposit is refundable
only if the entity fails to complete construction of the unit in accordance with the contract.
The remainder of the contract price is payable on completion of the contract when the
customer obtains physical possession of the unit. If the customer defaults on the contract
before completion of the unit, the entity only has the right to retain the deposit.
IE83 At contract inception, the entity applies paragraph 35(c) of IFRS 15 to determine whether
its promise to construct and transfer the unit to the customer is a performance obligation
satisfied over time. The entity determines that it does not have an enforceable right to
payment for performance completed to date because, until construction of the unit is
complete, the entity only has a right to the deposit paid by the customer. Because the entity
does not have a right to payment for work completed to date, the entity’s performance
obligation is not a performance obligation satisfied over time in accordance with paragraph
35(c) of IFRS 15. Instead, the entity accounts for the sale of the unit as a performance
obligation satisfied at a point in time in accordance with paragraph 38 of IFRS 15.
Case B—Entity has an enforceable right to payment for performance completed to date
IE84 The customer pays a non-refundable deposit upon entering into the contract and will make
progress payments during construction of the unit. The contract has substantive terms that
preclude the entity from being able to direct the unit to another customer. In addition, the
customer does not have the right to terminate the contract unless the entity fails to perform
as promised. If the customer defaults on its obligations by failing to make the promised
progress payments as and when they are due, the entity would have a right to all of the
consideration promised in the contract if it completes the construction of the unit. The
courts have previously upheld similar rights that entitle developers to require the customer
to perform, subject to the entity meeting its obligations under the contract.
IE85 At contract inception, the entity applies paragraph 35(c) of IFRS 15 to determine whether
its promise to construct and transfer the unit to the customer is a performance obligation
satisfied over time. The entity determines that the asset (unit) created by the entity’s
performance does not have an alternative use to the entity because the contract precludes
the entity from transferring the specified unit to another customer. The entity does not
consider the possibility of a contract termination in assessing whether the entity is able to
direct the asset to another customer.

Example 17 (continued)
IE86 The entity also has a right to payment for performance completed to date in accordance
with paragraphs 37 and B9–B13 of IFRS 15. This is because if the customer were to default
on its obligations, the entity would have an enforceable right to all of the consideration
promised under the contract if it continues to perform as promised.
IE87 Therefore, the terms of the contract and the practices in the legal jurisdiction indicate that
there is a right to payment for performance completed to date. Consequently, the criteria
in paragraph 35(c) of IFRS 15 are met and the entity has a performance obligation that it
satisfies over time. To recognise revenue for that performance obligation satisfied over
time, the entity measures its progress towards complete satisfaction of its performance
obligation in accordance with paragraphs 39–45 and B14–B19 of IFRS 15.
IE88 In the construction of a multi-unit residential complex, the entity may have many contracts
with individual customers for the construction of individual units within the complex. The
entity would account for each contract separately. However, depending on the nature of
the construction, the entity’s performance in undertaking the initial construction works (ie
the foundation and the basic structure), as well as the construction of common areas, may
need to be reflected when measuring its progress towards complete satisfaction of its
performance obligations in each contract.
Case C—Entity has an enforceable right to payment for performance completed to date
IE89 The same facts as in Case B apply to Case C, except that in the event of a default by the
customer, either the entity can require the customer to perform as required under the
contract or the entity can cancel the contract in exchange for the asset under construction
and an entitlement to a penalty of a proportion of the contract price.
IE90 Notwithstanding that the entity could cancel the contract (in which case the customer’s
obligation to the entity would be limited to transferring control of the partially completed
asset to the entity and paying the penalty prescribed), the entity has a right to payment for
performance completed to date because the entity could also choose to enforce its rights
to full payment under the contract. The fact that the entity may choose to cancel the
contract in the event the customer defaults on its obligations would not affect that
assessment (see paragraph B11 of IFRS 15), provided that the entity’s rights to require the
customer to continue to perform as required under the contract (ie pay the promised
consideration) are enforceable.
Example 18—Measuring progress when making goods or services available

IE92 An entity, an owner and manager of health clubs, enters into a contract with a customer
for one year of access to any of its health clubs. The customer has unlimited use of the
health clubs and promises to pay CU100 per month.
IE93 The entity determines that its promise to the customer is to provide a service of making
the health clubs available for the customer to use as and when the customer wishes. This
is because the extent to which the customer uses the health clubs does not affect the
amount of the remaining goods and services to which the customer is entitled. The entity
concludes that the customer simultaneously receives and consumes the benefits of the
entity’s performance as it performs by making the health clubs available. Consequently,
the entity’s performance obligation is satisfied over time in accordance with paragraph
35(a) of IFRS 15.
IE94 The entity also determines that the customer benefits from the entity’s service of making
the health clubs available evenly throughout the year. (That is, the customer benefits from
having the health clubs available, regardless of whether the customer uses it or not.)
Consequently, the entity concludes that the best measure of progress towards complete
satisfaction of the performance obligation over time is a time-based measure and it
recognises revenue on a straight-line basis throughout the year at CU100 per month.

Example 20—Penalty gives rise to variable consideration

IE102 An entity enters into a contract with a customer to build an asset for CU1 million. In
addition, the terms of the contract include a penalty of CU100,000 if the construction is
not completed within three months of a date specified in the contract.
IE103 The entity concludes that the consideration promised in the contract includes a fixed
amount of CU900,000 and a variable amount of CU100,000 (arising from the penalty).
IE104 The entity estimates the variable consideration in accordance with paragraphs 50–54 of
IFRS 15 and considers the requirements in paragraphs 56–58 of IFRS 15 on constraining
estimates of variable consideration.
Example 22—Right of return

IE110 An entity enters into 100 contracts with customers. Each contract includes the sale of one
product for CU100 (100 total products × CU100 = CU10,000 total consideration). Cash is
received when control of a product transfers. The entity’s customary business practice is to
allow a customer to return any unused product within 30 days and receive a full refund.
The entity’s cost of each product is CU60.
IE111 The entity applies the requirements in IFRS 15 to the portfolio of 100 contracts because it
reasonably expects that, in accordance with paragraph 4, the effects on the financial
statements from applying these requirements to the portfolio would not differ materially
from applying the requirements to the individual contracts within the portfolio.
IE112 Because the contract allows a customer to return the products, the consideration received
from the customer is variable. To estimate the variable consideration to which the entity
will be entitled, the entity decides to use the expected value method (see paragraph 53(a)
of IFRS 15) because it is the method that the entity expects to better predict the amount
of consideration to which it will be entitled. Using the expected value method, the entity
estimates that 97 products will not be returned.
IE113 The entity also considers the requirements in paragraphs 56–58 of IFRS 15 on constraining
estimates of variable consideration to determine whether the estimated amount of
variable consideration of CU9,700 (CU100 × 97 products not expected to be returned) can
be included in the transaction price. The entity considers the factors in paragraph 57 of
IFRS 15 and determines that although the returns are outside the entity’s influence, it has
significant experience in estimating returns for this product and customer class. In
addition, the uncertainty will be resolved within a short time frame (ie the 30-day return
period). Thus, the entity concludes that it is highly probable that a significant reversal in
the cumulative amount of revenue recognised (ie CU9,700) will not occur as the uncertainty
is resolved (ie over the return period).
IE114 The entity estimates that the costs of recovering the products will be immaterial and
expects that the returned products can be resold at a profit.
IE115 Upon transfer of control of the 100 products, the entity does not recognize revenue for the
three products that it expects to be returned. Consequently, in accordance with paragraphs
55 and B21 of IFRS 15, the entity recognises the following:
(a) revenue of CU9,700 (CU100 × 97 products not expected to be returned);
(b) a refund liability of CU300 (CU100 refund × 3 products expected to be returned);
and
(c) an asset of CU180 (CU60 × 3 products for its right to recover products from
customers on settling the refund liability).

Example 24—Volume discount incentive

IE124 An entity enters into a contract with a customer on 1 January 20X8 to sell Product A for
CU100 per unit. If the customer purchases more than 1,000 units of Product A in a calendar
year, the contract specifies that the price per unit is retrospectively reduced to CU90 per
unit. Consequently, the consideration in the contract is variable.
IE125 For the first quarter ended 31 March 20X8, the entity sells 75 units of Product A to the
customer. The entity estimates that the customer’s purchases will not exceed the 1,000-
unit threshold required for the volume discount in the calendar year.
IE126 The entity considers the requirements in paragraphs 56–58 of IFRS 15 on constraining
estimates of variable consideration, including the factors in paragraph 57 of IFRS 15. The
entity determines that it has significant experience with this product and with the
purchasing pattern of the entity. Thus, the entity concludes that it is highly probable that a
significant reversal in the cumulative amount of revenue recognised (ie CU100 per unit)
will not occur when the uncertainty is resolved (ie when the total amount of purchases is
known). Consequently, the entity recognises revenue of CU7,500 (75 units × CU100 per
unit) for the quarter ended 31 March 20X8.
IE127 In May 20X8, the entity’s customer acquires another company and in the second quarter
ended 30 June 20X8 the entity sells an additional 500 units of Product A to the customer.
In the light of the new fact, the entity estimates that the customer’s purchases will exceed
the 1,000-unit threshold for the calendar year and therefore it will be required to
retrospectively reduce the price per unit to CU90.
IE128 Consequently, the entity recognises revenue of CU44,250 for the quarter ended 30 June
20X8. That amount is calculated from CU45,000 for the sale of 500 units (500 units ×
CU90 per unit) less the change in transaction price of CU750 (75 units × CU10 price
reduction) for the reduction of revenue relating to units sold for the quarter ended 31 March
20X8 (see paragraphs 87 and 88 of IFRS 15).
Example 26—Significant financing component and right of return
IE135 An entity sells a product to a customer for CU121 that is payable 24 months after delivery.
The customer obtains control of the product at contract inception. The contract permits the
customer to return the product within 90 days. The product is new and the entity has no
relevant historical evidence of product returns or other available market evidence.
IE136 The cash selling price of the product is CU100, which represents the amount that the
customer would pay upon delivery for the same product sold under otherwise identical
terms and conditions as at contract inception. The entity’s cost of the product is CU80.
IE137 The entity does not recognise revenue when control of the product transfers to the
customer. This is because the existence of the right of return and the lack of relevant
historical evidence means that the entity cannot conclude that it is highly probable that a
significant reversal in the amount of cumulative revenue recognised will not occur in
accordance with paragraphs 56–58 of IFRS 15. Consequently, revenue is recognised after
three months when the right of return lapses.
IE138 The contract includes a significant financing component, in accordance with paragraphs
60–62 of IFRS 15. This is evident from the difference between the amount of promised
consideration of CU121 and the cash selling price of CU100 at the date that the goods are
transferred to the customer.
IE139 The contract includes an implicit interest rate of 10 per cent (ie the interest rate that over
24 months discounts the promised consideration of CU121 to the cash selling price of
CU100). The entity evaluates the rate and concludes that it is commensurate with the rate
that would be reflected in a separate financing transaction between the entity and its
customer at contract inception. The following journal entries illustrate how the entity
accounts for this contract in accordance with paragraphs B20–B27 of IFRS 15.

(a) When the product is transferred to the customer, in accordance with paragraph B21
of IFRS 15:
Asset for right to recover product to be Returned CU80(a)
Inventory CU80
(a) This example does not consider expected costs to recover the asset.
(b) During the three-month right of return period, no interest is recognized in

accordance with paragraph 65 of IFRS 15 because no contract asset or
receivable has been recognised.
(c) When the right of return lapses (the product is not returned):
Receivable CU100(a)
Revenue CU100
Cost of sales CU80
Asset for product to be returned CU80
(a) The receivable recognised would be measured in accordance with IFRS 9. This example
assumes there is no material difference between the fair value of the receivable at
contract inception and the fair value of the receivable when it is recognised at the time
the right of return lapses. In addition, this example does not consider the impairment
accounting for the receivable.
IE140 Until the entity receives the cash payment from the customer, interest revenue would be
recognised in accordance with IFRS 9. In determining the effective interest rate in
accordance with IFRS 9, the entity would consider the remaining contractual term.
Example 29—Advance payment and assessment of discount rate

IE148 An entity enters into a contract with a customer to sell an asset. Control of the asset will
transfer to the customer in two years (ie the performance obligation will be satisfied at a
point in time). The contract includes two alternative payment options: payment of CU5,000
in two years when the customer obtains control of the asset or payment of CU4,000 when
the contract is signed. The customer elects to pay CU4,000 when the contract is signed.
IE149 The entity concludes that the contract contains a significant financing component because
of the length of time between when the customer pays for the asset and when the entity
transfers the asset to the customer, as well as the prevailing interest rates in the market.
IE150 The interest rate implicit in the transaction is 11.8 per cent, which is the interest rate
necessary to make the two alternative payment options economically equivalent. However,
the entity determines that, in accordance with paragraph 64 of IFRS 15, the rate that
should be used in adjusting the promised consideration is six per cent, which is the entity’s
incremental borrowing rate.
IE151 The following journal entries illustrate how the entity would account for the significant
financing component:
(a) recognise a contract liability for the CU4,000 payment received at contract inception:
Cash CU4,000
Contract liability CU4,000

(b) during the two years from contract inception until the transfer of the asset, the entity
adjusts the promised amount of consideration (in accordance with paragraph 65 of
IFRS 15) and accretes the contract liability by recognising interest on CU4,000 at six
per cent for two years:
Interest expense CU494(a)
Contract liability CU494
CU494 = CU4,000 contract liability × (6 per cent interest per year for two years).
(c) recognise revenue for the transfer of the asset:

Revenue CU4,494
Example 31—Entitlement to non-cash consideration

IE156 An entity enters into a contract with a customer to provide a weekly service for one year.
The contract is signed on 1 January 20X1 and work begins immediately. The entity
concludes that the service is a single performance obligation in accordance with paragraph
22(b) of IFRS 15. This is because the entity is providing a series of distinct services that are
substantially the same and have the same pattern of transfer (the services transfer to the
customer over time and use the same method to measure progress—that is, a time-based
measure of progress).
IE157 In exchange for the service, the customer promises 100 shares of its common stock per
week of service (a total of 5,200 shares for the contract). The terms in the contract require
that the shares must be paid upon the successful completion of each week of service.
IE158 The entity measures its progress towards complete satisfaction of the performance
obligation as each week of service is complete. To determine the transaction price (and
the amount of revenue to be recognised), the entity measures the fair value of 100 shares
that are received upon completion of each weekly service. The entity does not reflect any
subsequent changes in the fair value of the shares received (or receivable) in revenue.
Example 32—Consideration payable to a customer

IE160 An entity that manufactures consumer goods enters into a one-year contract to sell goods
to a customer that is a large global chain of retail stores. The customer commits to buy at
least CU15 million of products during the year. The contract also requires the entity to make
a non-refundable payment of CU1.5 million to the customer at the inception of the contract.
The CU1.5 million payment will compensate the customer for the changes it needs to make
to its shelving to accommodate the entity’s products.
IE161 The entity considers the requirements in paragraphs 70–72 of IFRS 15 and concludes that
the payment to the customer is not in exchange for a distinct good or service that transfers
to the entity. This is because the entity does not obtain control of any rights to the
customer’s shelves. Consequently, the entity determines that, in accordance with
paragraph 70 of IFRS 15, the CU1.5 million payment is a reduction of the transaction price.
IE162 The entity applies the requirements in paragraph 72 of IFRS 15 and concludes that the
consideration payable is accounted for as a reduction in the transaction price when the
entity recognises revenue for the transfer of the goods. Consequently, as the entity
transfers goods to the customer, the entity reduces the transaction price for each good by
10 per cent (CU1.5 million ÷ CU15 million). Therefore, in the first month in which the entity
transfers goods to the customer, the entity recognises revenue of CU1.8 million (CU2.0
million invoiced amount less CU0.2 million of consideration payable to the customer).
changes in the fair value of the shares received (or receivable) in revenue.

Example 33—Allocation methodology

IE164 An entity enters into a contract with a customer to sell Products A, B and C in exchange for
CU100. The entity will satisfy the performance obligations for each of the products at
different points in time. The entity regularly sells Product A separately and therefore the
stand-alone selling price is directly observable. The stand-alone selling prices of Products
B and C are not directly observable.
IE165 Because the stand-alone selling prices for Products B and C are not directly observable, the
entity must estimate them. To estimate the stand-alone selling prices, the entity uses the
adjusted market assessment approach for Product B and the expected cost plus a margin
approach for Product C. In making those estimates, the entity maximises the use of
observable inputs (in accordance with paragraph 78 of IFRS 15). The entity estimates the
stand-alone selling prices as follows:
Product Stand-alone Method CU

selling price
Product A 50 Directly observable (see paragraph 77 of IFRS 15)
Product B 25 Adjusted market assessment approach (see
paragraph 79(a) of FRS15)
Product C 75 Expected cost plus a margin approach (see paragraph
79(b) of IFRS 15)
Total 150
IE166 The customer receives a discount for purchasing the bundle of goods because the sum of
the stand-alone selling prices (CU150) exceeds the promised consideration (CU100). The
entity considers whether it has observable evidence about the performance obligation to
which the entire discount belongs (in accordance with paragraph 82 of IFRS 15) and
concludes that it does not. Consequently, in accordance with paragraphs 76 and 81 of IFRS
15, the discount is allocated proportionately across Products A, B and C. The discount, and
therefore the transaction price, is allocated as follows:
Product Allocated transaction price
CU
Product A 33 (CU50 ÷ CU150 × CU100)
Product B 17 (CU25 ÷ CU150 × CU100)
Product C 50 (CU75 ÷ CU150 × CU100)
-----
Total 100
Example 34—Allocating a discount

IE167 An entity regularly sells Products A, B and C individually, thereby establishing the following
stand-alone selling prices:
Product Stand-alone selling price
CU
Product A 40
Product B 55
Product C 45
-----
Total 140
IE168 In addition, the entity regularly sells Products B and C together for CU60.
Case A—Allocating a discount to one or more performance obligations

IE169 The entity enters into a contract with a customer to sell Products A, B and C in exchange
for CU100. The entity will satisfy the performance obligations for each of the products at
different points in time.
IE170 The contract includes a discount of CU40 on the overall transaction, which would be
allocated proportionately to all three performance obligations when allocating the
transaction price using the relative stand-alone selling price method (in accordance with
paragraph 81 of IFRS 15). However, because the entity regularly sells Products B and C
together for CU60 and Product A for CU40, it has evidence that the entire discount should
be allocated to the promises to transfer Products B and C in accordance with paragraph
82 of IFRS 15.
IE171 If the entity transfers control of Products B and C at the same point in time, then the entity
could, as a practical matter, account for the transfer of those products as a single
performance obligation. That is, the entity could allocate CU60 of the transaction price to
the single performance obligation and recognise revenue of CU60 when Products B and C
simultaneously transfer to the customer.
IE172 If the contract requires the entity to transfer control of Products B and C at different points
in time, then the allocated amount of CU60 is individually allocated to the promises to
transfer Product B (stand-alone selling price of CU55) and Product C (stand-alone selling
price of CU45) as follows:
Product Allocated transaction price
CU
Product B 33 (CU55 ÷ CU100 total stand-alone selling price × CU60)
Product C 27 (CU45 ÷ CU100 total stand-alone selling price × CU60)
Total 60
Case B—Residual approach is appropriate
IE173 The entity enters into a contract with a customer to sell Products A, B and C as described
in Case A. The contract also includes a promise to transfer Product D. Total consideration
in the contract is CU130. The stand-alone selling price for Product D is highly variable (see
paragraph 79(c) of IFRS 15) because the entity sells Product D to different customers for
a broad range of amounts (CU15–CU45). Consequently, the entity decides to estimate the
stand-alone selling price of Product D using the residual approach.
IE174 Before estimating the stand-alone selling price of Product D using the residual approach,
the entity determines whether any discount should be allocated to the other performance
obligations in the contract in accordance with paragraphs 82 and 83 of IFRS 15.
IE175 As in Case A, because the entity regularly sells Products B and C together for CU60 and
Product A for CU40, it has observable evidence that CU100 should be allocated to those
three products and a CU40 discount should be allocated to the promises to transfer
Products B and C in accordance with paragraph 82 of
IFRS 15 Using the residual approach, the entity estimates the stand-alone selling price of Product
D to be CU30 as follows:
Stand-alone
Product selling
Price Method
CU
Product A 40 Directly observable (see paragraph 77 of IFRS 15)
Products B
and C 60 Directly observable with discount (see paragraph 82 of IFRS 15)
Product D 30 Residual approach (see paragraph 79(c) of IFRS 15)
Total 130

IE176 The entity observes that the resulting CU30 allocated to Product D is within the range of its
observable selling prices (CU15–CU45). Therefore, the resulting allocation (see above
table) is consistent with the allocation objective in paragraph 73 of IFRS 15 and the
requirements in paragraph 78 of IFRS 15.
Case C—Residual approach is inappropriate

IE177 The same facts as in Case B apply to Case C except the transaction price is CU105 instead
of CU130. Consequently, the application of the residual approach would result in a stand-
alone selling price of CU5 for Product D (CU105 transaction price less CU100 allocated to
Products A, B and C). The entity concludes that CU5 would not faithfully depict the amount
of consideration to which the entity expects to be entitled in exchange for satisfying its
performance obligation to transfer Product D, because CU5 does not approximate the
stand-alone selling price of Product D, which ranges from CU15–CU45. Consequently, the
entity reviews its observable data, including sales and margin reports, to estimate the
stand-alone selling price of Product D using another suitable method. The entity allocates
the transaction price of CU105 to Products A, B, C and D using the relative stand-alone
selling prices of those products in accordance with paragraphs 73–80 of IFRS 15.
Example 36—Incremental costs of obtaining a contract

IE189 An entity, a provider of consulting services, wins a competitive bid to provide consulting
services to a new customer. The entity incurred the following costs to obtain the contract:
CU
External legal fees for due diligence 15,000
Travel costs to deliver proposal 25,000
Commissions to sales employees 10,000
Total costs incurred 50,000
IE190 In accordance with paragraph 91 of IFRS 15, the entity recognises an asset for the
CU10,000 incremental costs of obtaining the contract arising from the commissions to
sales employees because the entity expects to recover those costs through future fees for
the consulting services. The entity also pays discretionary annual bonuses to sales
supervisors based on annual sales targets, overall profitability of the entity and individual
performance evaluations. In accordance with paragraph 91 of IFRS 15, the entity does not
recognise an asset for the bonuses paid to sales supervisors because the bonuses are not
incremental to obtaining a contract. The amounts are discretionary and are based on other
factors, including the profitability of the entity and the individuals’ performance. The
bonuses are not directly attributable to identifiable contracts.
IE191 The entity observes that the external legal fees and travel costs would have been incurred
regardless of whether the contract was obtained. Therefore, in accordance with paragraph
93 of IFRS 15, those costs are recognised as expenses when incurred, unless they are
within the scope of another Standard, in which case, the relevant provisions of that
Standard apply.
Example 38—Contract liability and receivable

Case A—Cancellable contract
IE198 On 1 January 20X9, an entity enters into a cancellable contract to transfer a product to a
customer on 31 March 20X9. The contract requires the customer to pay consideration of
CU1,000 in advance on 31 January 20X9. The customer pays the consideration on 1 March
20X9. The entity transfers the product on 31 March 20X9. The following journal entries
illustrate how the entity accounts for the contract:

(a) The entity receives cash of CU1,000 on 1 March 20X9 (cash is received in advance of
performance):
Cash CU1,000
(b) The entity satisfies the performance obligation on 31 March 20X9:
Revenue CU1,000
Case B—Non-cancellable contract
IE199 The same facts as in Case A apply to Case B except that the contract is non-cancellable.
The following journal entries illustrate how the entity accounts for the contract:
(a) The amount of consideration is due on 31 January 20X9 (which is when the entity
recognises a receivable because it has an unconditional right to consideration):
Receivable CU1,000
(b) The entity receives the cash on 1 March 20X9:
Cash CU1,000
Receivable CU1,0003
(c) The entity satisfies the performance obligation on 31 March 20X9:
Revenue CU1,000
IE200 If the entity issued the invoice before 31 January 20X9 (the due date of the consideration),
the entity would not present the receivable and the contract liability on a gross basis in the
statement of financial position because the entity does not yet have a right to consideration
that is unconditional.
Example 39—Contract asset recognised for the entity’s performance

IE201 On 1 January 20X8, an entity enters into a contract to transfer Products A and B to a
customer in exchange for CU1,000. The contract requires Product A to be delivered first
and states that payment for the delivery of Product A is conditional on the delivery of
Product B. In other words, the consideration of CU1,000 is due only after the entity has
transferred both Products A and B to the customer. Consequently, the entity does not have
a right to consideration that is unconditional (a receivable) until both Products A and B are
transferred to the customer.
IE202 The entity identifies the promises to transfer Products A and B as performance obligations
and allocates CU400 to the performance obligation to transfer Product A and CU600 to
the performance obligation to transfer Product B on the basis of their relative stand-alone
selling prices. The entity recognises revenue for each respective performance obligation
when control of the product transfers to the customer.
IE203 The entity satisfies the performance obligation to transfer Product A:
Contract asset CU400
Revenue CU400
IE204 The entity satisfies the performance obligation to transfer Product B and to recognise the
unconditional right to consideration:
Receivable CU1,000
Contract asset CU400
Revenue CU600

Example 40—Receivable recognised for the entity’s performance

IE205 An entity enters into a contract with a customer on 1 January 20X9 to transfer products to
the customer for CU150 per product. If the customer purchases more than 1 million
products in a calendar year, the contract indicates that the price per unit is retrospectively
reduced to CU125 per product.
IE206 Consideration is due when control of the products transfer to the customer. Therefore, the
entity has an unconditional right to consideration (ie a receivable) for CU150 per product
until the retrospective price reduction applies (ie after 1 million products are shipped).
IE207 In determining the transaction price, the entity concludes at contract inception that the
customer will meet the 1 million products threshold and therefore estimates that the
transaction price is CU125 per product. Consequently, upon the first shipment to the
customer of 100 products the entity recognises the following:
Receivable CU15,000(a)
Revenue CU12,500(b)
Refund liability (contract liability) CU2,500
(a) CU150 per product × 100 products.

(b) CU125 transaction price per product × 100 products.
IE208 The refund liability (see paragraph 55 of IFRS 15) represents a refund of CU25 per product,
which is expected to be provided to the customer for the volume-based rebate (ie the
difference between the CU150 price stated in the contract that the entity has an
unconditional right to receive and the CU125 estimated transaction price).
Example 49—Option that provides the customer with a material right (discount voucher)
IE250 An entity enters into a contract for the sale of Product A for CU100. As part of the contract,
the entity gives the customer a 40 per cent discount voucher for any future purchases up
to CU100 in the next 30 days. The entity intends to offer a 10 per cent discount on all sales
during the next 30 days as part of a seasonal promotion. The 10 per cent discount cannot
be used in addition to the 40 per cent discount voucher.
IE251 Because all customers will receive a 10 per cent discount on purchases during the next 30
days, the only discount that provides the customer with a material right is the discount that
is incremental to that 10 per cent (ie the additional 30 per cent discount). The entity
accounts for the promise to provide the incremental discount as a performance obligation
in the contract for the sale of Product A.
IE252 To estimate the stand-alone selling price of the discount voucher in accordance with
paragraph B42 of IFRS 15, the entity estimates an 80 per cent likelihood that a customer
will redeem the voucher and that a customer will, on average, purchase CU50 of additional
products. Consequently, the entity’s estimated stand-alone selling price of the discount
voucher is CU12 (CU50 average purchase price of additional products × 30 per cent
incremental discount × 80 per cent likelihood of exercising the option). The stand-alone
selling prices of Product A and the discount voucher and the resulting allocation of the
CU100 transaction price are as follows:
Performance Obligation Stand-alone selling price

CU
Product A 100
Discount voucher 12
Total 112

Allocated transaction price
Product A 89 (CU100 ÷ CU112 × CU100
Discount voucher 11 (CU12 ÷ CU112 × CU100)
Total 100
IE253 The entity allocates CU89 to Product A and recognises revenue for Product A when control
transfers. The entity allocates CU11 to the discount voucher and recognises revenue for the
voucher when the customer redeems it for goods or services or when it expires.
Example 52—Customer loyalty programme

IE267 An entity has a customer loyalty programme that rewards a customer with one customer
loyalty point for every CU10 of purchases. Each point is redeemable for a CU1 discount on
any future purchases of the entity’s products. During a reporting period, customers
purchase products for CU100,000 and earn 10,000 points that are redeemable for future
purchases. The consideration is fixed and the stand-alone selling price of the purchased
products is CU100,000. The entity expects 9,500 points to be redeemed. The entity
estimates a stand-alone selling price of CU0.95 per point (totalling CU9,500) on the basis
of the likelihood of redemption in accordance with paragraph B42 of IFRS 15.
IE268 The points provide a material right to customers that they would not receive without
entering into a contract. Consequently, the entity concludes that the promise to provide
points to the customer is a performance obligation. The entity allocates the transaction
price (CU100,000) to the product and the points on a relative stand-alone selling price basis
as follows:
CU
Product 91,324
[CU100,000 × (CU100,000 stand-alone selling price ÷ CU109,500)]
Points 8,676
[CU100,000 × (CU9,500 stand-alone selling price ÷ CU109,500)]
IE269 At the end of the first reporting period, 4,500 points have been redeemed and the entity
continues to expect 9,500 points to be redeemed in total. The entity recognises revenue
for the loyalty points of CU4,110 [(4,500 points ÷ 9,500 points) × CU8,676] and recognises
a contract liability of CU4,566 (CU8,676 – CU4,110) for the unredeemed points at the end
of the first reporting period.
IE270 At the end of the second reporting period, 8,500 points have been redeemed cumulatively.
The entity updates its estimate of the points that will be redeemed and now expects that
9,700 points will be redeemed. The entity recognises revenue for the loyalty points of
CU3,493 {[(8,500 total points redeemed ÷ 9,700 total points expected to be redeemed) ×
CU8,676 initial allocation] – CU4,110 recognised in the first reporting period}. The contract
liability balance is CU1,073 (CU8,676 initial allocation – CU7,603 of cumulative revenue
recognised).

Example 63—Bill-and-hold arrangement

IE323 An entity enters into a contract with a customer on 1 January 20X8 for the sale of a
machine and spare parts. The manufacturing lead time for the machine and spare parts is
two years.
IE324 Upon completion of manufacturing, the entity demonstrates that the machine and spare
parts meet the agreed-upon specifications in the contract. The promises to transfer the
machine and spare parts are distinct and result in two performance obligations that each
will be satisfied at a point in time. On 31 December 20X9, the customer pays for the
machine and spare parts, but only takes physical possession of the machine. Although the
customer inspects and accepts the spare parts, the customer requests that the spare parts
be stored at the entity’s warehouse because of its close proximity to the customer’s factory.
The customer has legal title to the spare parts and the parts can be identified as belonging
to the customer. Furthermore, the entity stores the spare parts in a separate section of its
warehouse and the parts are ready for immediate shipment at the customer’s request. The
entity expects to hold the spare parts for two to four years and the entity does not have the
ability to use the spare parts or direct them to another customer.
IE325 The entity identifies the promise to provide custodial services as a performance obligation
because it is a service provided to the customer and it is distinct from the machine and
spare parts. Consequently, the entity accounts for three performance obligations in the
contract (the promises to provide the machine, the spare parts and the custodial services).
The transaction price is allocated to the three performance obligations and revenue is
recognised when (or as) control transfers to the customer.
IE326 Control of the machine transfers to the customer on 31 December 20X9 when the
customer takes physical possession. The entity assesses the indicators in paragraph 38 of
IFRS 15 to determine the point in time at which control of the spare parts transfers to the
customer, noting that the entity has received payment, the customer has legal title to the
spare parts and the customer has inspected and accepted the spare parts. In addition, the
entity concludes that all of the criteria in paragraph B81 of IFRS 15 are met, which is
necessary for the entity to recognise revenue in a bill-and-hold arrangement. The entity
recognises revenue for the spare parts on 31 December 20X9 when control transfers to
the customer.
IE327 The performance obligation to provide custodial services is satisfied over time as the
services are provided. The entity considers whether the payment terms include a significant
financing component in accordance with paragraphs 60–65 of IFRS 15.


11
CHAPTER
Interpretation
of financial statements
Contents
1 Purpose of financial ratio analysis
2 Return on capital, profitability and asset turnover
3 Working capital efficiency ratios
4 Liquidity ratios
5 Debt ratios
6 Financial Statement Analysis
7. Limitations of financial statements and ratio analysis

1 PURPOSE OF FINANCIAL RATIO ANALYSIS

Section overview
 Obtaining information from the financial statements: financial ratios

 Uses of ratios
 Categories of financial ratios
 Users of the financial statements and their information needs
1.1 Obtaining information from the financial statements: financial ratios

Financial statements are used to make decisions. They are used by shareholders and investors,
and also by lenders, as well as by management. The financial statements contain a large number
of figures, but the figures themselves do not necessarily have much meaning to a user of the
financial statements. However, the figures can be analysed and interpreted by calculating
financial ratios.
Financial ratios can help the user of the financial statements to assess:
 the financial position of the entity, and
 its financial performance
1.2 Uses of ratios

Financial ratio analysis helps a business in a number of ways. The importance and advantages
of financial ratios are given below:
 Ratios help in analyzing the performance trends over a long period of time.
 They also help a business to compare the financial results to those of competitors.
 Ratios assist the management in decision making.
 They also point out problem and weak areas along with the strength areas.
 Ratios help to develop relationships between different financial statement items.
 Ratios have the advantage of controlling for differences in size. For example, two
businesses may be quite different in size but can be compared in terms of profitability,
liquidity, etc., by the use of ratios.
1.3 Categories of financial ratios

The main financial ratios can be classified as:
 financial performance: return on capital, profitability and use of assets
 working capital ‘turnover’ ratios
 liquidity ratios
 debt ratios
 investor ratios
1.4 Users of the financial statements and their information needs

The IASB Conceptual Framework identifies several groups of people who may use financial
statements:
 investors and potential investors
 lenders

Chapter 11: Interpretation of financial statements
 employees
 suppliers
 customers
 government and government agencies
 the general public and
 the management
All these groups are interested in financial performance, financial position and cash flows, but
some users are mainly interested in performance and profitability, while others may be more
interested in liquidity and gearing or other matters.
For example:
 A private investor needs to know whether to continue to hold shares or to sell them. He or
she will tend to be most interested in profitability ratios (such as gross and net profit margin
and return on capital employed) and investor ratios (such as earnings per share, dividend
cover and price earnings ratio).
 A potential acquirer needs information about an entity’s profitability and probably also
information about whether or not the entity is managed efficiently. The acquirer’s
management is likely to focus on profit margins, return on capital employed, asset turnover
and working capital ratios.
 Employees are interested in fair wages: adequate fringe benefits and bonus linked with
productivity/profitability. Ratio analysis provides them adequate information regarding
efficiency and profitability of the entity.
 A bank that has been approached to lend money to an entity needs to know whether it will
receive interest payments when these are due and whether the money that it lends will
eventually be repaid. A bank manager will normally be most interested in cash flows and
liquidity ratios (current ratio, acid test ratio) gearing and interest cover. A potential lender
will also be interested in predicting future performance as without sales there will be no
cash.
 The management do financial forecasting, planning (of a future based on the past and
present) and controlling (budgets) as a decision maker.
An examination question might ask you to interpret an entity’s financial statements for the benefit
of specific people or groups of people. Therefore your analysis should focus on the needs of the
user. What do they need to know? What are they interested in? What decision do they need to
make?

2 RETURN ON CAPITAL, PROFITABILITY AND ASSET TURNOVER

Section overview
 Return on capital employed

 Return on shareholder capital (equity)
 Return on assets
 Analysing return: profitability and asset utilisation
 Profit/sales ratio (and cost/sales ratios)
 Sales/capital employed ratio
 Percentage annual growth in sales
2.1 Return on capital employed

Profit-making companies should try to make a profit that is large enough in relation to the amount
of money or capital invested in the business. The most important profitability ratio is probably
return on capital employed (ROCE) or return on investment (ROI).
For a single company:
Formula:
Profit before interest and taxation X 100%
ROCE = (Share capital and reserves + long-term debt capital + preference
share capital)
The capital employed is the share capital and reserves, plus long-term debt capital such as bank
loans, bonds and loan stock.
Where possible, use the average capital employed during the year. This is usually the average of
the capital employed at the beginning of the year and end of the year.
A higher ROCE indicates more efficient use of capital. ROCE should be higher than the
company’s capital cost; otherwise it indicates that the company is not employing its capital
effectively and is not generating shareholder value.
Example:
Sting Company achieved the following results in Year 1.
1 January Year 1 31 December Year 1
Rs. Rs.
Share capital 200,000 200,000
Share premium 100,000 100,000
Retained earnings 500,000 600,000
Bank loans 200,000 500,000
Rs.
Income tax expense 65,000
–––––––
–––––––
Interest charges on bank loans were Rs.30,000. Dividend payments to shareholders were
Rs.45,000. Sales during the year were Rs.5,800,000.
Required
Calculate the return on capital employed for Year 1.

Answer
Capital employed at the beginning of the year = Rs.1,000,000.
Capital employed at the end of the year = Rs.1,400,000.
Average capital employed = [Rs.1,000,000 + Rs.1,400,000]/2 = Rs.1,200,000.
Profit before interest and taxation = Rs.210,000 + Rs.30,000 = Rs.240,000.
240,000
ROCE =  100% = 20%
1,200,000
Comment:
The 20% return on the capital employed indicates a return of Rs.20 on every 100 rupees invested
into the business. The ratio shows how efficiently the entity’s long term funds are being employed.
The investors are interested to invest in the company that has a higher ROCE than the other
available option(s). Besides the company’s return should always be higher than the cost at which
the funds were acquired. For example if a company borrows at 15% and achieves a return of only
10%, that says they are actually losing money.
ROCE is a useful measure of comparing profitability across competing entities based on the
amount of capital they use. It becomes more useful when the comparison is between capital-
intensive entities. Moreover, for a single company, the ROCE trend over the years is a significant
performance indicator. Generally speaking, the investors are more inclined to invest in the
companies that have stable and rising ROCE figures as compared to those where the ROCE is
volatile and inconsistent.
Example
Calculate the return on capital employed of Company A and B operating in the similar lines of
business for the year ender 31st December 2016. Comment on the profitability of both the
companies.
Company A Company B
Rs. Rs.
Profit before Interest and 539,900 2,616,100
Taxation
Capital employed 3,659,000 12,193,400
Solution:
Company A
539,900
ROCE =  100% = 14.8%
3,659,000
Company B
2,616,100
ROCE =  100% = 21.5%
12,193,400
Comment:
Based on the given figures, Company B appears to be utilising its capital better than Company A.
Company B can reinvest a greater portion of its profits back into the business operations to the
benefit of the shareholders. While we see that Company B’s ROCE is higher than that of Company
A yet there is not a lot to be attained from using data from one angle and at a single point of time.
Greater insight can be achieved if trends over time are analysed. As Company B though is
performing better than A yet it might have been facing a constant decline in the ROCE that may
point to a loss of competitive advantage.

2.2 Return on shareholder capital (equity)

Return on shareholder capital (ROSC), or return on equity, measures the return on investment
that the shareholders of the company have made. This ratio normally uses the values of the
shareholders’ investment as shown in the statement of financial position (rather than market
values of the shares).
Formula:
Profit after taxation and preference dividend
ROSC = X 100%
Share capital and reserves
The average value of shareholder capital should be used if possible. This is the average of the
shareholder capital at the beginning and the end of the year.
Profit after tax is used as the most suitable measure of return for the shareholders, since this is a
measure of earnings (available for payment as dividends or for reinvestment in the business).
Example:
Using the figures in the previous example:
Shareholders’ capital at the beginning of the year = Rs.200,000 + Rs.100,000 + Rs.500,000 =
Rs.800,000.
Shareholders’ capital at the end of the year= Rs.200,000 + Rs.100,000 + Rs.600,000
= Rs.900,000.
Average shareholders’ capital employed = [Rs.800,000 + Rs.900,000]/2 = Rs.850,000.
145,000
ROSC =  100% = 17.06%
850,000
Comment:
The ROSC measures the ability of the entity to generate profits from the investments made by its
shareholders. The figure above shows a percentage of 17.06% meaning that the entity generates
a return of Rs.17 for every 100 rupees invested by the shareholder into the business. ROSC is the
indicator of effective management of equity financing.
2.3 Return on assets
Formula:
Profit before interest and taxation

ROA = X 100%
Assets
The normal convention is to use ‘total assets’ which includes both current and non-current
assets. However, other variations are sometimes used such as non-current assets only.
The return on assets ratio is a profitability ratio and measures the return produced by the total
assets. It helps both, the management and the investors, to know how well the entity can convert
its investment in assets into profits. The figures of ROA depend highly on the industry and hence
can vary substantially. This suggests that when ROA has to be used as a comparative measure
then the best practice is to compare it against a company’s previous ROA figures or the ROA of a
company in the similar business line.

Example:
A company’s chartered accountant is calculating ROA for the year 2016. The year end figures of
total non- current assets and total current assets are Rs.882,900 and Rs.360,000 respectively.
The net profit for the year was Rs.685,000
Required:
Calculate company’s ROA for the year 2016 using
(a) Total assets
(b) Non-current assets
Solution:
(a) Calculating ROA using total assets
685,000
ROA =  100% = 55%
1,242,900
(b) Calculating ROA using non-current assets
685,000
ROA =  100% = 77.6%
882,900
Comment:
This means that on average every single rupee invested in business’s assets generated 55 paisas
in profit.
If taken from the perspective of non-current assets only, they contribute to the
extent of 77.6%. That says for every 100 rupees invested in the non-current assets around 78
rupees are generated in profit.
The analysis would be more useful and meaningful when compared with the entity’s own
performance over the years and against the figures of the firm(s) competing in the similar
industry.
2.4 Analysing return: profitability and asset utilisation

The size of the return on capital employed, or the size of the return on shareholders’ capital,
depends on two factors:
 the profitability of the goods or services that the entity has sold
 the volume of sales that the entity has achieved with the capital and assets it has
employed: this is known as asset utilisation or asset turnover.
2.5 Profit/sales ratio (and cost/sales ratios)

The profit/sales ratio is the ratio of the profit that has been achieved for every Rs.1 of sales.
Formula:
Profit
X 100%
Profit/sales ratio =
Sales
Profit/sales ratios are commonly used by management to assess financial performance, and a
variety of different figures for profit might be used.

The definition of profit can be any of the following:

 Profit before interest and tax
 Gross profit (= Sales minus the Cost of sales)
 Net profit (= Profit after tax)
It is important to be consistent in the definition of profit, when comparing performance from one
year to the next.
The gross profit ratio is often useful for comparisons between companies in the same industry, or
for comparison with an industry average.
It is also useful to compare the net profit ratio with the gross profit ratio. A high gross profit ratio
and a low net profit ratio indicate high overhead costs for administrative expenses and selling
and distribution costs.
Example:
Using the figures in the previous example, profit/sales ratios can be calculated as follows:
 If profit is defined as profit before interest and tax, the profit/sales ratio =
Rs.240,000/Rs.5,800,000 = 0.0414 = 4.14%
 If profit is defined as profit after interest and tax, the profit/sales ratio =
Rs.145,000/Rs.5,800,000 = 0.025 = 2.5%
Comment:
The figure suggests that Rs.4.14 are earned on every 100 rupees of sales before interest and tax
are deducted. After the deduction this figure becomes Rs.2.5 in the given scenario.
The profit to sales ratios show the percentage of sales that is left over after the business has paid
all its expenses. The ratio helps to determine how effectively a company’s sales are converted into
net income. Again the figures have to be compared with the industry averages and over the years
for the same company to arrive at a more meaningful conclusion.
Example: Gross Profit margin

Using the given figures compute the gross profit ratio of A to Zee ltd and discuss its significance.
Gross Profit Rs.235,000
Net Sales Rs.910,000
235,000
GP Margin =  100% = 26%
910,000
Comment:
The rounded off figure of GP margin is 26% that implies the company may reduce the selling price
of its products up to around 26% without incurring any loss. The GP ratio is an important ratio as it
evaluates the operational performance of the entity. Gross profit is an important figure for the
business, it should be sufficient enough to cover all the expenses and provide for the profit to the
investors.
In general, a higher ratio is a better ratio. The profitability of the business can be measured by
comparing it with the competing entities in the similar industry and with the past trend for the same
company. A consistent growth over the years indicates a sustainable continuous improvement in
the business’s processes and practices.

It is also useful to monitor the ratio of different types of cost to sales. The following ratios can be
useful to highlight an unexpected change in a period or to indicate a difference between the
company and another in a similar industry:
 Ratio of (Cost of sales/Sales) × 100%
 Ratio of (Administration costs/Sales) × 100%
 Ratio of (Selling and distribution costs/Sales) × 100%
Example: Costs to sales ratios

Following figures have been extracted from the Income Statement of Alpha ltd. Calculate the cost
of goods sales ratio, administration costs ratio and Selling and distribution costs ratio.
Rs.
Net Sales 650,000
Solution:
Cost of sales ratio
422,500
=  100% = 65%
650,000
Administration costs ratio
26,000
=  100% = 4%
650,000
Selling and distribution costs ratio
39,000
=  100% = 6%
650,000
Comment:
Costs ratios represent what extent of sales is an individual expense or a group of expenses. The
lower the ratio the better is the profitability status of the organisation. Care must be taken in
dealing with the variable expenses as they vary with the change in the sales volume. This ratio
doesn’t normally change significantly with the rise or decline in the sales volume. Whereas the
ratios for fixed expenses change significantly with the increase or decrease in the sales volume.
In the given scenario the cost of sales/sales ratio states that every 65 rupees out of 100 rupees of
sales represent cost of sales. These are the direct costs that vary with the level of sales.
Looking at the other two ratios we find that in this particular period every 4 rupees out of every 100
rupees of sales were spent on the administration costs and 6 rupees were expensed on selling and
distribution costs.
These ratios help the management in controlling and estimating future expenses.

2.6 Sales/capital employed ratio

The sales/capital employed ratio is also called the ‘asset turnover ratio’. It measures the amount
of sales achieved during the period for each Rs.1 of investment in assets.
Formula:
Sales
Asset turnover ratio = (Share capital and reserves + long-term debt capital + preference
shares)
It is measured as ‘x times a year’.

The sales/capital employed ratio is also a ratio of sales to (assets – current liabilities). This is
because capital employed = total assets minus liabilities excluding long-term debt.
Example:
Using the figures in the previous example, the asset turnover ratio = Rs.5,800,000/Rs.1,200,000
= 4.83 times.
Note that:
ROCE = Profit/sales ratio × Asset turnover ratio
(where profit is defined as profit before interest and taxation).
Using the figures in the previous example:
ROCE = Profit/sales × Sales/capital employed
240,000 240,000 5,800,000
= ×
1,200,000 5,800,000 1,200,000
20% = 4.14% × 4.83 times

Comment:
The Sales/Capital employed ratio measures how efficiently an organisation’s assets generate
revenues. The figure in the solution says that every single rupee of the capital employed in the
business is generating revenue of Rs.4.83. It must also be taken into account that the age of a
company’s assets can heavily impact hence result in different asset turnover ratios for similar
companies. For example a company having older assets with lower book values might have a
higher asset turnover ratio than the one with the similar revenues but newer, higher net book
value assets.
A constantly declining assets turnover ratio or a lower ratio as compared to the industry averages
might indicate towards the issues related to the excess production capacity, poor inventory
management, sloppy collection methods etc. The higher the ratio the better it is considered yet
capital investment for purchasing assets in anticipation of future growth or sale of existing
unnecessary assets for an anticipated decline in future can suddenly and may be artificially
change the company’s assets turnover ratio. Besides companies in the capital-intensive industries
tend to have a lower assets turnover ratio than the ones operating with fewer assets. Therefore for
a more meaningful analysis, the companies should be compared within the same industry.
2.7 Percentage annual growth in sales

It can be useful to measure the annual growth (or decline) in sales, measured as a
percentage of sales in the previous year.
For example, if sales in the year just ended were Rs.5,800,000 and sales in the previous
year were Rs.5,500,000, the annual growth in sales has been (Rs.300,000/Rs.5,500,000) ×
100% = 5.45%.

3 WORKING CAPITAL EFFICIENCY RATIOS

Section overview
 Purpose of working capital efficiency ratios

 Average time to collect (receivables days or days sales outstanding)
 Average time for holding inventory
 Average time to pay suppliers
 Cash operating cycle/working capital cycle
 Turnover (multiples) ratios
3.1 Purpose of working capital efficiency ratios

Working capital efficiency ratios measure the efficiency with which the entity has managed its
receivables, inventory and trade payables. The ratios are usually measured in terms of an
average number of days.
The working capital ratios are a useful measure of whether the entity has too much or too little
invested in working capital.
Excessive investment in working capital is indicated by a long cash cycle (a long working
capital cycle) that appears to be getting even longer. When too much is invested in working
capital, the return on capital employed and ROSC will be lower than they should be.
Under-investment in working capital is an indication of possible liquidity difficulties. When
working capital is low in comparison with the industry average, this might indicate that current
assets are being financed to an excessive extent by current liabilities, particularly trade payables
and a bank overdraft.
(The cash cycle, also called the operating cycle and the working capital cycle, is explained later).
3.2 Average time to collect (receivables days or days sales outstanding)

This ratio estimates the time that it takes on average to collect the payment from customers after
the sale has been made. It could be described as the average credit period allowed to customers
or the ‘average collection period’.
Formula:
Trade receivables
Average days to collect = Sales X 365 days
Trade receivables should be the average value of receivables during the year. This is the
average of the receivables at the beginning of the year and the receivables at the end of the
year.
However, the value for receivables at the end of the year is also commonly used.
Sales are usually taken as total sales for the year. However, if sales are analysed into credit
sales and cash sales, it is probably more appropriate to use the figure for credit sales only.
The average time to collect money from credit customers should not be too long. A long average
time to collect suggests inefficient collection of amounts due from receivables.

3.3 Average time for holding inventory

This ratio is an estimate of the average time that inventory is held before it is used or sold.
Formula:
Inventory
Inventory holding period = Cost of sales X 365 days
In theory, inventory should be the average value of inventory during the year. This is the average
of the inventory at the beginning of the year and the inventory at the end of the year.
However, the value for inventory at the end of the year is also commonly used, particularly in
examinations.
3.4 Average time to pay suppliers

The average time to pay suppliers may be calculated as follows:
Formula:
Trade payables
X 365 days
Average time to pay =
Cost of purchases
Trade payables should be the average value of trade payables during the year. This is the
average of the trade payables at the beginning of the year and the trade payables at the end of
the year.
However, the value for trade payables at the end of the year is also commonly used. When the
cost of purchases is not available, the cost of sales should be used instead. This figure is
obtained from the profit and loss information in the statement of profit or loss and other
comprehensive income.
Example:
The following information is available for The Brush Company for Year 1.
1 January Year 1 31 December Year 1

Rs. Rs.
Inventory 300,000 360,000
Sales in Year 1 totalled Rs.3,000,000 and the cost of sales was Rs.1,800,000.
Required
Calculate the working capital turnover ratios.
Answer
Average inventory = [Rs.300,000 + Rs.360,000]/2 = Rs.330,000
Average trade receivables = [Rs.400,000 + Rs.470,000]/2 = Rs.435,000
Average trade payables = [Rs.150,000 + Rs.180,000]/2 = Rs.165,000.
Turnover ratios
Average days to collect = [435,000/3,000,000] × 365 days = 52.9 days
Inventory turnover period = [330,000/1,800,000] × 365 days = 66.9 days
Average time to pay = [165,000/1,800,000] × 365 days = 33.5 days.

Comment:
The relationship among the three ratios given above is quite critical. The sale of inventory generates
receivables, that when collected are used to settle creditors and the cycle goes on. The firm’s ability
to get the cycle repeated continuously depends heavily on the entity’s short-term liquidity and the
cash generating ability. In the given scenario the firm is responsible to settle its payables at least
around 19 days before it receives payments from its customers. The working capital need then
would be financed through some bank operating line and that would bring a cost which in turn
would reduce the profitability of the organisation. The credit policy therefore needs to get revised
and improved and sloppy collections to be gotten rid of. Also the agreement with the supplier might
be refreshed for the purpose of extending the credit period.
3.5 Cash operating cycle/working capital cycle

The cash operating cycle or working capital cycle is the average time of one cycle of business
operations:
 from the time that suppliers are paid for the resources they supply
 to the time that cash is received from customers for the goods (or services) that the entity
makes (or provides) with those resources and then sells.
A cash cycle or operating cycle is measured as follows. Figures are included for the purpose of
illustration:
Days Days
Inventory turnover A 40.2
Average days to collect B 88.2
–––––
128.4
Average time to pay (C) (33.5)
––––––––– –––––
Cash cycle/operating cycle A+B–C 94.9
––––––––– –––––
The working capital ratios and the length of the cash cycle should be monitored over time. The
cycle should not be allowed to become unreasonable in length, with a risk of over-investment or
under-investment in working capital.
A positive working capital cycle balances incoming and outgoing payments to minimise net
working capital and maximise free cash flow. For example, a company that pays its suppliers in
30 days but takes 60 days to collect its receivables has a working capital cycle of 30 days. This
30 day cycle usually needs to be funded through a bank operating line, and the interest on this
financing is a carrying cost that reduces the company's profitability.
Growing businesses require cash, and being able to free up cash by shortening the working
capital cycle is the most inexpensive way to grow. Sophisticated buyers review closely a target's
working capital cycle because it provides them with an idea of the management's effectiveness at
managing their balance sheet and generating free cash flow.
3.6 Turnover (multiples) ratios

Inventory turnover
Formula:
Cost of sales
times
Inventory turnover =
Average inventory

Receivables (debtor) turnover
Formula:
Credit sales
times
Receivables turnover =
Average trade receivables
Payables (creditor) turnover
Formula:
Credit purchases
times
Payables turnover =
Average trade payables

4 LIQUIDITY RATIOS
Section overview
 The meaning of liquidity

 Current ratio
 Quick ratio or acid test ratio
4.1 The meaning of liquidity

Liquidity means having cash or access to cash readily available to meet obligations to make
payments.
For the purpose of ratio analysis, liquidity is measured on the assumption that the only sources of
cash available are:
 cash in hand or in the bank, plus
 current assets that will soon be converted into cash during the normal cycle of trade.
It is also assumed that the only immediate payment obligations faced by the entity are its current
liabilities.
There are two ratios for measuring liquidity:
 current ratio
 quick ratio, also called the acid test ratio.
The more suitable ratio for use depends on whether inventory is considered a liquid asset that
will soon be used or sold, and converted into cash from sales.
4.2 Current ratio

The current ratio is the ratio of current assets to current liabilities.
Formula:
Current assets
Current ratio = Current liabilities
The amounts of current assets and current liabilities in the statement of financial position at the
end of the year may be used. It is not necessary to use average values for the year.
It is sometimes suggested that there is an ‘ideal’ current ratio of 2.0 times (2:1).
However, this is not necessarily true and in some industries, much lower current ratios are
normal. It is important to assess the liquidity ratios by considering:
 changes in the ratio over time
 the liquidity ratios of other companies in the same period
 the industry average ratios.

Liquidity should be monitored by looking at changes in the ratio over time.
Example:
The following information is available for X ltd. for Year 1. Calculate the current ratio and interpret
it.
Current Assets Rs.1,100,000
Current Liabilities Rs.400,000
Solution
1,100,000
Current Ratio = = 2.75 times
400,000
Comment
A current ratio of 2:1 or higher is considered satisfactory for most of the entities yet the analysts
should be very careful at interpreting it. A simple calculation of current ratio might not disclose the
exact liquidity position of the company. A deeper analysis into the individual items of current assets
and liabilities would add value to the results. A higher current ratio might not indicate the ability to
pay off the entity’s current obligations efficiently as a huge portion of current assets may comprise
of needless, obsolete and/or slow moving inventory items.
4.3 Quick ratio or acid test ratio

The quick ratio or acid test ratio is the ratio of current assets excluding inventory to current
liabilities. Inventory is excluded from current assets on the assumption that it is not a very liquid
item.
Formula:
Current assets excluding inventory
Quick ratio =
Current liabilities
The amounts of current assets and current liabilities in the statement of financial position at the
end of the year may be used. It is not necessary to use average values for the year.
This ratio is a better measurement of liquidity than the current ratio when inventory turnover times
are very slow, and inventory is not a liquid asset.
It is sometimes suggested that there is an ‘ideal’ quick ratio of 1.0 times (1:1).
However, this is not necessarily true and in some industries, much lower quick ratios are normal.
As indicated earlier, it is important to assess liquidity by looking at changes in the ratio over time,
and comparisons with other companies and the industry norm.
Example:
Kashif’s Clothing Store has applied for a loan to remodel the shop front. The bank has asked him
for a detailed balance sheet, so it can compute the quick ratio. Kashif's balance sheet includes the
following figures:
Cash: Rs.20,000
Accounts Receivable: Rs.10,000
Inventory: Rs.5,000
Stock Investments: Rs.2,000
Prepaid taxes: Rs.500
Current Liabilities: Rs.30,000

Example: (continued)
The bank can compute Kashif's quick ratio like this.
Solution
20,000  10,000  2,000

Quick Ratio = = 1.07 times
30,000
Comment
The Quick ratio of Kashif’s Clothing store turns out to be 1.07 times that says Kashif can pay off
all his current liabilities with liquid assets and can still have some quick assets left over. The Acid-
test ratio gives a more rigorous assessment of the company’s ability to pay off its current liabilities
as it considers only highly liquid assets. Had it been below 1 it would have represented the company
as an overly leveraged company that is struggling to; maintain or increase sales, settling its
creditors quickly, or/and collecting receivables on time.

5 DEBT RATIOS
Section overview
 Gearing (debt to equity) ratio
Debt ratios are used to assess whether the total debts of the entity are within control and are not
excessive.
5.1 Gearing (debt to equity) ratio

Gearing, also called leverage, measures the total long-term debt of a company as a percentage
of either:
 the equity capital in the company, or
 the total capital of the company
Formula:
Long-term debt
Gearing = Share capital and reserves X 100%
Alternatively:
Formula:
Long-term debt
Gearing = Share capital and reserves + Long-term debt X 100%
It is usually appropriate to use the figures from the statement of financial position at the end of
the year. However, a gearing ratio can also be calculated from average values for the year.
When there are redeemable preference shares it is usual to include them within debt capital. This
is because redeemable preference shares behave more like a long-term loan or bond with fixed
annual interest followed by future redemption.
Irredeemable preference shares behave more like Equity (as they are never redeemed) and
should therefore be treated as equity.
A company is said to be high-geared or highly-leveraged when its debt capital exceeds its
share capital and reserves. This means that a company is high-geared when the gearing ratio is
above either 50% or 100%, depending on which method is used to calculate the ratio.
A company is said to be low-geared when the amount of its debt capital is less than its share
capital and reserves. This means that a company is low-geared when the gearing ratio is less
than either 50% or 100%, depending on which method is used to calculate the ratio.
A high level of gearing may indicate the following:
 The entity has a high level of debt, which means that it might be difficult for the entity to
borrow more when it needs to raise new capital.
 High gearing can indicate a risk that the entity will be unable to meet its payment
obligations to lenders, when these obligations are due for payment.
The gearing ratio can be used to monitor changes in the amount of debt of a company over time.
It can also be used to make comparisons with the gearing levels of other, similar companies, to
judge whether the company has too much debt, or perhaps too little, in its capital structure.

6 FINANCIAL STATEMENTS ANALYSIS

Section overview
 Overview
 Horizontal analysis
 Vertical analysis
6.1 Overview
Financial statement analysis is the process of analyzing a company's past, current and projected
performance for decision-making purposes
Financial statement analysis allows analysts to identify trends by comparing ratios across
multiple periods and statement types to allow analysts to measure liquidity, profitability,
company-wide efficiency, and cash flow.
Financial statement analysis is of the following types:
 Horizontal analysis
 Vertical analysis
 Ratio analysis(already explained in above sections)
6.2 Horizontal analysis

Horizontal analysis is used to compare historical data, such as ratios, or line items, over a
number of accounting periods.
Financial analysts and investors need to identify trends and growth patterns in the company’s
performance over a number of years, a year-end balance sheet or income statement is not
enough to evaluate whether the company is operating efficiently and profitably.
Horizontal analysis also makes it easier to compare growth rates and profitability among different
companies.
The following is the formula for horizontal analysis:
Amount in comparison year – Amount in base year x 100

Base year
The following figure is an example of how to prepare a horizontal analysis for two years.
Carnations Ltd
Profit & Loss Account
For the year ended December 31, 2018
%age change
2015 2014
from 2014 to 2015
Rs. in millions
Sales 86,320 75,200 14.79
Cost of Sales (44,618) (40,900) 9.09
Gross Profit 41,702 34,300 21.58
Distribution costs (19,597) (15,380) 27.42
Administrative expenses (2,339) (2,053) 13.93

%age change
2015 2014
from 2014 to 2015
Rs. in millions
Other operating expenses (1,322) (1,052) 25.67
Other income 1,488 1,000 48.80
19,932 16,815 18.54
Finance cost (343) (300) 14.33
Profit before taxation 19,589 16,515 18.61
6.3 Vertical analysis

In vertical analysis each category of accounts on the balance sheet is shown as a percentage of
the total account.
Line items on an income statement can be stated as a percentage of gross sales, while line items
on a balance sheet can be stated as a percentage of total assets or liabilities. This analysis of
income statements gives the company a heads up if cost of goods sold or any other expense
appears to be too high when compared to sales and allows the management to identify the
reasons and take action to fix the problem(s).
Carnations Ltd
Statement of Financial Position
2015 2014
Rs. in millions
Assets
Non-Current Assets
Property, plant & equipment 15,000 42.33% 12,000 32.71%
Intangibles 500 1.41% 600 1.64%
Long term investments 120 0.34% 100 0.27%
Long term loans 200 0.56% 150 0.41%
Long term deposits and
prepayments 70 0.20% 180 0.49%
15,890 44.84% 13,030 35.51%
Current Assets
Stores and spares 650 1.83% 585 1.59%
Stock in trade 6,000 16.93% 5,500 14.99%
Trade debts 2500 7.05% 1200 3.27%
Loans and advances 800 2.26% 300 0.82%
Short term deposits and 750 900
2.12%
prepayments 2.45%
Other receivables 350 0.99% 175 0.48%
Cash and bank balances 8,500 23.98% 15,000 40.88%
19,550 55.16% 23,660 64.49%
Total assets 35,440 36,690

2015 2014
Rs. in millions
Equity and liabilities
Share capital and reserves
Share capital 1,000 2.82% 1,000 2.73%
Reserves 2,950 8.32% 7,095 19.34%
Liabilities
Staff retirement benefits 290 0.82% 295 0.80%
Current liabilities
Trade and other payables 30,000 84.65% 27,500 74.95%
Provisions 1200 3.39% 800 2.18%
Total current liabilities 31,200 88.04% 28,300 77.13%
Total liabilities 31,490 88.85% 28,595 77.94%
Total equity and liabilities 35,440 36,690
Carnations Ltd
Profit & Loss Account
2015 2014
Rs. in millions
Sales 86,320 100% 75,200 100%
Cost of Sales (44,618) 51.69% (40,900) 54.39%
Gross Profit 41,702 48.31% 34,300 45.61%
Distribution costs (19,597) 22.70% (15,380) 20.45%
Administrative expenses (2,339) 2.71% (2,053) 2.73%
Other operating expenses (1,322) 1.53% (1,052) 1.40%
Other income 1,488 1.72% 1,000 1.33%
19,932 23.09% 16,815 22.36%
Finance cost (343) 0.40% (300) 0.40%
Profit before taxation 19,589 22.69% 16,515 21.96%

7 LIMITATIONS OF FINANCIAL STATEMENTS AND RATIO ANALYSIS

Section overview
 Limitations of financial statements and ratio analysis
7.1 Limitations of financial statements and ratio analysis

Financial statement are time and cost producing. Ratio analysis can be used to compare
information taken from the financial statements to gain an analytical understanding of the results,
financial position and cash flows of a business. This analysis is a useful tool, especially for an
outsider such as a supplier, lender or an investor. However, there are a number of limitations of
ratio analysis which are given below:
Historical
All of the information used in ratio analysis is derived from actual historical results. This does not
mean that the same results will carry forward into the future. However, you can use ratio analysis
on pro forma information and compare it to historical results for consistency.
Historical versus current cost
The information on the income statement is stated in current costs (or close to it), whereas many
elements of the balance sheet are stated at historical cost (which could vary substantially from
current costs). This disparity can result in unusual ratio results.
Inflationary effect
If the rate of inflation has changed in any of the periods under review, this can mean that the
numbers are not comparable across periods. For example, if the inflation rate was 100% in one
year, sales would appear to have doubled over the preceding year, when in fact sales did not
change at all.
Aggregation
The information in a financial statement line item that you are using for a ratio analysis may have
been aggregated differently in the past, so that running the ratio analysis on a trend line does not
compare the same information through the entire trend period.
Accounting policies and estimates
Different companies in a similar industry may have different policies for recording the
same accounting transaction. This means that comparing the ratio results of different companies
may be like comparing apples and oranges. For example, one company might use reducing
balance method while another company uses straight-line depreciation.
Business conditions
You need to place ratio analysis in the context of the general business environment. For
example, 60 days of sales outstanding for receivables might be considered poor in a period of
rapidly growing sales, but might be excellent during an economic contraction when customers
are in severe financial condition and unable to pay their bills.
Interpretation
It can be quite difficult to ascertain the reason for the results of a ratio. For example, an acid test
ratio of 2:1 might appear to be excellent, until you realize that the company just sold a large
amount of its stock to bolster its cash position. A more detailed analysis might reveal that the acid
test ratio will only temporarily be at that level, and will probably decline in the near future.
Company strategy
It can be difficult to interpret a ratio analysis comparison between two companies that are
pursuing different strategies. For example, one company may be following a low-cost strategy,
and so is willing to accept a lower gross margin in exchange for more market share. Conversely,
a company in the same industry is focusing on a high customer service strategy where its prices
are higher and gross margins are higher, but it will never attain the revenue levels of the first
company.
In short, ratio analysis has a variety of limitations that can restrict its usefulness. However, as
long as you are aware of these problems and use alternative and supplemental methods to
collect and interpret information, ratio analysis is still useful.

I
Index
Cash
a from disposal of P, P & E
paid for purchase of P, P & E
56
49
paid for purchase of investment 57
Accounting for
received from sale of investment 57
Government grants and disclosure of
from new share issues 59
grant assistance 152
from new loans/repay loans 60
Impairment 171
operating cycles 215
Revaluation 138
Control 107
management 104
Cost
Accounting treatment of investment
accounting 108
Property 162
accounting cycle 110
Accumulated fund 71
behaviour graphs 123
Administration costs 117
behaviour 122
Assets 10
classification 115
Accrual based figures 29
and management accounting 109
Accounting equation 85
unit 113
Allowance for doubtful debts 36
structures 92
Analysing returns 209
Current ratio 217
Average time to collect 213
customer 176
To pay suppliers 214
contract 177
For holding inventories 214
cash flows
Acid test ratio 218
from financing activities 25, 59
from investing activities 24, 49
c from operating activities

changes in
23, 28, 43
inventory 37
Changing the carrying amount of an asset 141 trade and other receivables 47
Carrying amount 164 changes in
Cash trade payables 38
equivalents 22

Comparison of financial accounting and cost Gearing ratio 220

and management 109
Calculation of opening capital 87
i
d IAS 1: Presentation of Financial
Statements 10, 13
Data and information 104 IAS 7: statement of cash flows 19
Depreciable amount 163,164 IAS 16: Property, Plant & Equipment 137
Depreciation of a revalued asset 142 IFRS 15: Revenue from contracts with
Direct customer 176
Cost 127 Five step model 176
expenses 128 Identifying missing balances 86
labour 128 Incomplete records
materials 127 dealing with 84
Disposal of property, plant and equipment 56 meaning 84
Disclosure requirements Indirect costs (overheads) 129
For IAS 16: P, P & E 145 Indirect method 27
Assets stated at revalued amounts 146 Cash flow from operating activities 28
Debt ratios 220 adjustments for working capital 34
Donations 77 Investing activities 34, 49
Dividends payments to equity
share holders 60
l
e Labour costs 116
Lack of detail 40
Equity 5 Life membership fees 68
Liquidity ratios 217
f
m
Finance costs 117
Financing activities 25,59 Management accounting 108
Fixed & variable costs 122 Manufacturing accounts 119
Full cost 130 Material costs 116
Financing of a sole proprietor or partnership 62 marketing costs (selling and administrative) 117
Financial ratio analysis 204 Measurement
Frequency of revaluations 144 after initial recognition (P, P & E) 162
Memorandum cash and bank account 91
Memorandum control accounts 84
g Missing inventory figure 94
Gain or loss on disposal

of property, plant and equipment 56
of non current asset 28

Index
revalued assets
n being sold
being depreciated
144
143
receipt & payment account 66
Non-production costs 117
reporting profit 199
Nature of incomplete records 84
return on
Non-cash items 28
capital employed 206
Not for profit organizations 66
shareholder capital (equity) 208
assets 208
o
Opening capital (calculation of) 87
s
Operating cash flows 26
Selling and distribution costs 117
Overheads (Indirect costs) 129
Semi-variable cost 124
Operating activities 23
Special funds 73
Stepped cost 125
p Statement of
Financial position 73
Cash flows 21
Percentage annual growth in sales 212 Subscription account 69
Performance obligations 178 Surplus from
Period costs 133 Running an operation 72
Planning 107 Running an event 72
Prime cost 119 Sales/capital employed ratio 212
Profit before taxation 28
Profit/sales ratio 209
Product costs
Production and non-production costs
133
116
t
Profit and cash flow 21
Transaction price 180
Purpose of management information 106
Types of organizations 112
Turnover ratio 214
q
Qualities of good information 105
u
Quick ratio or acid test ratio 218
Useful life
Unit costs 114
r Uses of ratios 204

Usefulness of classifying costs by function 116
Revaluation model 138

Revaluation of property,
plant and equipment 138
v
Revenue 176
Variable cost 122
realisation of the revaluation surplus 143

w
Working capital 34
adjustments 34
efficiency ratios 213
cycle 215
write-off of subscription 70

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© Emile Woolf International i The Institute of Chartered Accountants of Pakistan

© Emile Woolf International, February 2019

© Emile Woolf International ii The Institute of Chartered Accountants of Pakistan

1 Accounting and Reporting Concepts 1

2 IAS 1: Preparation of Financial Statements 9

3 IAS 7: Statement of cash flows 19

4 Income and expenditure account 65

5 Preparation of accounts from incomplete records 83

6 Introduction to Cost of production 103

7 IAS 16: Property, plant and equipment 137

8 Non-Current Assets: Sundry standards 151

9 IAS 36: Impairment of assets 167

10 IFRS 15: Revenue from contracts with customers 175

11 Interpretation of financial statements 203

© Emile Woolf International iii The Institute of Chartered Accountants of Pakistan

© Emile Woolf International iv The Institute of Chartered Accountants of Pakistan

© Emile Woolf International 1 The Institute of Chartered Accountants of Pakistan

1 THE CONCEPTUAL FRAMEWORK OF IASB

 Overview of the Conceptual Framework of IASB

1.1 Overview of the Conceptual Framework of IASB

1.2 Recognition of elements of the financial statements

© Emile Woolf International 2 The Institute of Chartered Accountants of Pakistan

© Emile Woolf International 3 The Institute of Chartered Accountants of Pakistan

1.3 Measurements of elements of financial statements

© Emile Woolf International 4 The Institute of Chartered Accountants of Pakistan

1.4 Concepts of Capital and Capital maintenance

Formula: Accounting equation

© Emile Woolf International 5 The Institute of Chartered Accountants of Pakistan

Change in equity = Closing equity  Opening equity

Increase in equity = Profit + capital introduced  distributions

Profit = Increase in equity  capital introduced + distributions

Illustration: Adjustment to maintain opening equity

Statement of profit or loss X

Physical capital maintenance

© Emile Woolf International 6 The Institute of Chartered Accountants of Pakistan

The following example should help you to understand this.

Example: Capital maintenance concepts

Statement of financial position Rs. Rs. Rs.

Commentary on the example

© Emile Woolf International 7 The Institute of Chartered Accountants of Pakistan

© Emile Woolf International 8 The Institute of Chartered Accountants of Pakistan

IAS 1: Preparation of financial

© Emile Woolf International 9 The Institute of Chartered Accountants of Pakistan

1 STATEMENT OF CHANGES IN EQUITY (SOCIE)

1.2 IAS 1 Preparation of Financial Statements

1.3 Purpose and Importance

© Emile Woolf International 10 The Institute of Chartered Accountants of Pakistan

1.4 The contents of a statement of changes in equity

Transactions with owners

Total comprehensive income

© Emile Woolf International 11 The Institute of Chartered Accountants of Pakistan

Authorized Share Capital

© Emile Woolf International 12 The Institute of Chartered Accountants of Pakistan

Profit after taxation 300,000

Transfer to general reserve (50,000)

Retained earnings for the year 150,000

Retained earnings b/f 500,000

Retained earnings c/f 650,000

Requirements of IAS 1, Presentation of Financial Statements

© Emile Woolf International 13 The Institute of Chartered Accountants of Pakistan

Effect of Changes in Accounting Policies

Effect of Correction of Prior Period Error