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Welcome to your ExPress notes 3
1. Financial statements 4
2. Objectives of financial reporting 10
3. Sources of financial information 13
4. Double entry bookkeeping: the debits and cred-its 18
5. Tangible non-current assets 20
6. Intangible non-current assets 24
7. Inventory and purchases 26
8. Receivables and payables 29
9. Bank reconciliations 33
10. Long term finance 35
11. Accruals and prepayments 37
12. Provisions and contingencies 39
13. Sales tax 41
14. Trial balances and correction of errors 43
15. Suspense accounts 47
16. Incomplete records 48
17. Limited companies 50
18. Statements of cash flow 52
19. Consolidated financial statements 55
20. Events after reporting date, errors and esti-mates 62
21. Interpretation of financial statements 63

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 The ExP Group

Hello
Thank you for downloading a copy of these ExPress notes and I hope you
find them useful for your studies.
We provide these ExPress notes free of charge to individual students
Steve Crossman as part of our CSR initiatives. The notes are designed to help students
assimilate and understand the most important areas for the exam as
quickly as possible.
A word of warning though in that they have not been designed to cover
everything in the syllabus so you should only use these notes for either
an overview of the key areas before you start your main studies or as part
of your final revision in the run up to your exams.
Importantly though, we want you to be successful in your exams so good
luck with your studies and please do let us know how you get on.
All the best,
Steve

About The Group

We were born with one passion, with one aim,
with one desire. To use technology the way it
should be used. To use technology to open up
education, and in particular financial education,
to whoever needs it regardless of their income,
wealth, race, sex, religion or location.
We wanted to use technology to empower
individuals to develop themselves through
financial expertise, organisations to improve
their performance through enhanced human
capital and ultimately communities and families
to benefit as a result.
We’re on target and since our birth we have
had the privilege of working with and learning
from inspirational individuals and organisations
from all 4 corners of the world in countries as
varied as the UK in the north, Singapore in the
east, South Africa in the south and the Cayman
Islands in the west.
We’re only part way through our journey but
we’re doing better than we expected. The best
is yet to come though,
Education + Technology = Ethical Empowerment.

Thank you for being part of our story.

Disclaimer : © 2019 The ExP Group. Individuals may reproduce this material if it is for their own private study use only. Written permission needs to be obtained
in advance if you are planning on using them on a training course you’re delivering. Reproduction by any means for any other purpose is prohibited. These
materials are for educational purposes only and so are necessarily simplified and summarised. Always obtain expert advice on any specific issue. Refer to our
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full terms and conditions of use. No liability for damage arising from use of these notes will be accepted by the ExP Group.
The Big Picture
Financial statements (more colloquially called accounts) are a crucial part of managing a business and
reporting to shareholders. A set of financial statements will need to be produced at least annually for
presentation to external stakeholders, but generally much more frequently for management control
within the business.

Frequent and accurate financial statements can add a great deal to the efficient running of a business.

A set of financial statements is produced periodically (often once a year for smaller businesses but as
frequently as the users want them). A full set of financial statements for a limited company comprises a
number of statements:

• A statement of financial position, referred to by some people as a balance sheet. This lists
all the assets and liabilities of the business plus the equity of the business (which explains where
the assets and liabilities came from). The statement of financial position is a snapshot of the
assets and liabilities of a business at a moment in time.

• A statement of profit or loss and other comprehensive income. This shows all the gains
and losses that the business has experienced in the period. The statement of comprehensive
income is a record of what happened over a period to the net assets of a business.

• A statement of cash flows, which shows where the cash and short-term assets very similar to
cash came from and went do during the period. Income isn’t always the same as cash, as we’ll
see later.

• Notes to the financial statements, which give further detail to readers who want to know
more than the summary story.

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Statement of financial position of Sole Trader X at 30 June 20x1

ASSETS $ $

Non-current assets

License to operate 10,000

Land and buildings 35,000

Office equipment 20,000

Motor vehicles 30,000

Fixtures and fittings 10,000

105,000

Current assets

Inventory 20,000

Trade receivables 13,000

Less: allowance for doubtful receivables (1,000)

12,000

Prepayments 4,000

Cash at bank 3,000

Cash in hand 2,000

Total assets 146,000

EQUITY AND LIABILITIES

Capital

Initial capital introduced 30,000

Total cumulative comprehensive income at 1 July 20x0 85,700

Less: Cumulative withdrawals at 1 July 20x0 (24,000)

Total equity at 1 July 20x0 91,700

Total comprehensive income in the current period 16,000

Withdrawals in the current year (8,000)

Total equity at 30 July 20x1 99,700

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Non-current liabilities

Bank loans 32,000

Current liabilities

Bank overdraft 3,300

Trade payables 8,000

Accruals 3,000

Total liabilities 46,300

Total equity and liabilities 146,000

Principal features of the statement of financial position:

• It balances, with the total assets equaling equity (i.e. owner’s interest) plus liabilities

• Each section is conventionally written in terms of increasing liquidity

• Non-current assets and liabilities are ones that are expected to remain on the SOFP next year.
Current assets and liabilities are expected to be used up or paid within the coming year.

A SOFP may be rearranged into a number of ways. As above shows:

Total assets = Equity + total liabilities.

Equally validly therefore:

Total assets – total liabilities = Equity

Given that equity = capital + cumulative profit – cumulative withdrawals, then the equation could be
written in any number of ways such as:

Total assets – total liabilities = Capital + cumulative profit – cumulative withdrawals

Or

Cumulative profit = Total assets – total liabilities – capital + cumulative withdrawals.

This is sometimes called the “accounting equation” and often comes up in the FA exam. The task is to
drop in the figures that you know and find the missing figure, whatever it might be.

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Statement of profit or loss and other comprehensive income for the year ended 30 June
20x1

$ $

Sales revenue 154,000

Cost of sales (100,000)

Gross profit 54,000

Distribution costs (11,000)

Admin and selling expenses (22,000)

Operating profit 21,000

Less: Finance costs (1,000)

Profit before tax 10,000

Tax (2,000)

Profit for the year 8,000

Other comprehensive income:

Revaluation gain on property 2,000

Total comprehensive income in the period 10,000

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

Unusual items

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

Key Knowledge - Elements of financial statements

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

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Elements of the statement of financial position:

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

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

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

Elements of the statement of comprehensive income:

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

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

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

Key Knowledge - Relationship between the statements: the

business equation
An increase in net assets of a business will come from a mixture of these sources:

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

This is sometimes called the accounting equation or the business equation. It can be summarised:

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

Page 8
This is also a frequent exam question, with some figures given and the others having to be deduced.

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

Separate accounting entity

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

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

Sole trader Limited company

Number of investors 1 (the sole trader!) Can be between 1

and an unlimited
large number

Must produce Yes Yes

accounts for the tax
authority

Must produce No Yes

accounts to file with
the commercial
register

Business name Normally just the Must end Ltd (if

name of the owner private limited
“trading as” the company) or plc (if
name of the business public limited
company)
Can offer shares to No Yes, if a plc. No if
the public? Ltd.

Equity part of the Initial capital Share capital

SOFP Cumulative profit Reserves:
Cumulative (revaluation reserve,
withdrawals retained earnings,
etc).

Page 9
 Objectives of
financial reporting

The Big Picture

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

For financial information to be useful, it must exhibit a number of characteristics.

Qualitative Our definition

characteristic

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

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

Accruals A key concept. It means recording transactions in the period

when they happened; not necessarily when the cash was
settled. It also means matching costs and associated revenues.

Consistency Items should be reported the same way between periods, so

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

Materiality Materiality means large enough to influence the user’s opinion

on the financial statements. Immaterial information should not
be disclosed, as it’s a distraction. Material information must be
presented accurately and fairly.

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 Relevance Irrelevant information is a distraction and should not be
presented.

Reliability Information is useless if it’s not considered to be reliable. E.g.

an external valuation of property is more reliable than a biased
director’s valuation.

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

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

Neutrality Unbiased – neither excessively optimistic nor excessively

prudent.

Prudence Conservatism. This is no longer a core concept in IFRS

accounting, but broadly losses should be recognised more
readily than gains.

Completeness All information that needs to be presented in order to give a full

picture has been presented.

Comparability Financial statements this period should be presented using

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

Understandability Information should be presented in a way that users can

understand. Excessive complication reduces usefulness.

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

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

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

• It can give out of date asset valuations for long-lived assets

• This can result in an unrealistically low depreciation charge
• Profit trends can be misleading (e.g. a profit growth of 10% per year isn’t so impressive as it first
seems if inflation is 12% per year!)
• Where there’s significant inflation and inventory is held for a long time, profit can be reported
simply by matching today’s revenues with yesterday’s costs.

Key Knowledge - Regulation of financial reporting

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

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

There are a number of bodies that you need to be aware. Their roles are given below.

IFRS Foundation The Foundation is made up of trustees, who appoint

the members of the bodies below.

IASB: International Accounting The IASB issues International Financial Reporting

Standards Board Standards and the IFRS for SMEs. It employs a
permanent staff to draft new accounting standards
and amendments considered necessary to extant
accounting standards.

IFRS Advisory Council This is made up of a cross section of advisors from

different user groups. It advises the IASB on the
IASB’s work programme.

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

Page 12
 Sources of financial
information

The Big Picture

The accounting system must naturally be fed with raw source data. This data is then analysed,
categorised and recorded in the accounting system itself, which may be a fully manual (paper based)
system or may be maintained using software. Both use the same system of double entry bookkeeping
that we will see later on.

You should be able to define the following:

Document Purpose Often feeds the

Quotation To give a potential customer an
indication of what a product or service
would be likely to cost. It may be a
binding quote or just an indicative
quote.
Sales order To record an order from a customer.
Submitting a booking form for an ExP
online course for example is a sales
order that ExP will then process.
Purchase order To record an order placed with a
supplier. It may require pre-
authorisation to be valid.
Goods received To record that an order for inventory
note for resale has been received. It will
normally only be produced once the
goods have been inspected at the point
of delivery to ensure that they are
correct in description and quality.
Goods To record that an order from a
despatched note customer has been sent out.
accounting information
on....
Nowhere. At this stage,
there has been no
transaction to record; it’s
still at the state of being a
prospective transaction.
Sales (revenue).
Purchases, normally of
inventory for resale.
Purchases of inventory for
resale and payables.
Sales (revenue) and
possibly also inventory
management, depending on
how the accounting system
is set up.

Page 13
 Invoice A request for payment from a supplier. Payables.
Sent by the supplier to the customer.
Statement A summary of transactions recorded by Does not generally instigate
a supplier with a customer, including any recording of a
amounts received from the customer. transaction, since all
Sent by the supplier to the customer. transactions on the
statement will have been
recorded when goods were
ordered. But useful for
cross-checking our records
with the supplier’s records.
Credit note Acknowledgement from a supplier that Payables.
the customer has overpaid and is
entitled either to a refund or free
goods/ services in the future.
Debit note To cancel a credit note that previously Receivables.
existed, e.g. if goods were ordered,
paid for and then returned there would
initially be a credit note. The refund
made would be accompanied with a
debit note.
Remittance Normally included with an invoice. A Receivables.
advice document that is included with the
payment (e.g. if paid by cheque) with
details that will allow the recipient of
the funds to match the payment to the
customer’s account.
Receipt Issued by the supplier for goods, to Receivables, payables and
acknowledge payment of a debt. purchases.

Key Knowledge - Data sources / data capture

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

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

Key Knowledge – Books of original entry

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

Page 14
The most commonly used books of original entry are:

Book of Used to record data on: Data typically used to

original entry: feed:

Cash in book Cash received into the business bank All sorts of things! Anything
account. that may generate cash for
the business.

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

Petty cash book Cash in and out of the balance of cash Typically, small expenses
held in notes and coins by the business (e.g. Friday cakes for staff!)
(normally small). This is often controlled and sundry income.
using the imprest system (see later).

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

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

Journal book Anything not covered by any of the other Often, this is the book
books of original entry. maintained by the
accountant, in which “period
13” adjustments like
depreciation and bad debts
are recorded.

Key Knowledge – Computerised systems

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

Advantages of using a computerised system include:

• Back ups can be made easily

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

Page 15
Disadvantages of a computerised system include:

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

Key Knowledge – Journal book

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

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

Key Knowledge – Credit control and memorandum

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

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

Key Knowledge – Controlling petty cash – the imprest

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

The cash box has a pre-set limit of maximum cash that it ever contains, e.g. $1,000

• Before any cash is taken out of the cash box (which should be guarded by a very diligent and
ideally slightly frightening person), the person claiming the cash must provide a receipt and
complete an expense voucher.
• As an expense record is submitted, the same amount of cash is taken out of the box.

Page 16
 • Under no circumstances is anybody ever allowed to take money out of the tin without completing
a petty cash voucher.

The result of this is that at any point in time, the sum of cash plus the expense vouchers will always
equal the pre-set limit of $1,000. When cash reaches a low level, more cash is withdrawn from the bank
to replenish the sum up to the $1,000 limit. The expense vouchers are then exchanged for the
replenishment cash.

These movements in petty cash can then be summarised in a petty cash book each period, which will
look like this:

PETTY CASH BOOK

Reason for cash movement

Staff
Cash in/ From food &
Date out Voucher # bank drink Travel Stationery Other

01/03/20X1 1,000.00 Opening balance

03/03/20X1 (21.12) 332; Supermarket (21.12)

12/03/20X1 (20.00) 333; Taxi for MD (20.00)

23/03/20X1 (430.00) 334; Stationery shop (430.00)

335; Flowers for new

25/03/20X1 (32.00) baby (32.00)

27/03/20X1 (43.12) 336; Supermarket (43.12)

31/03/20X1 453.76 Subtotal

31/03/20X1 546.24 Replenish 546.24

1,000.00 Subtotals 546.24 (64.24) (20.00) (430.00) (32.00)

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

Page 17
 Double entry
bookkeeping: the
debits and credits

The Big Picture

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

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

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

Key Knowledge – So why debits and credits?

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

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

Page 18
You may have encountered the words debit and credit in the context of your bank statement. This
brings danger, since the bank statement is a record from their own records. This means that it’s upside
down. This can cause confusion, so it’s best for the moment if you try to unlearn everything you’ve ever
come to think of debits and credits as being. The truth is the opposite way round to the way that lay
people use the terms.

Key Knowledge – Building up the rules

Here are the core concepts that you need to be happy with:

• An asset, or an increase in an asset, is a debit.

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

So you may have started to think “debits good, credits bad” or even the other way round. That’s not
the way to look at it. Neither is good or bad. A debit can be an asset, but it can also be an expense.
So it’s not correct to think of one being good and the other bad. It’s simpler than that.

Here’s a table to summarise the rules. Review this and then try to produce it yourself, using the logic of
explaining movements in net assets and things being opposites (e.g. a liability is a credit because an
asset is a debit).

It will take a while to become familiar with this system, just the way that it takes a while to become
familiar with riding a bicycle. Don’t panic – it comes and don’t feel pressured to rush it. There’s not
much intrinsically to actually understand here – it’s just a task and a system that becomes really easy
with repetition.

Debits mean Credits mean

What happens to net assets:

An increase in assets A decrease in assets

A decrease in liabilities An increase in liabilities

And the reason for that increase in net assets:

An item of expenditure An item of income

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

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 Tangible
non-current assets

The Big Picture

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

Key Knowledge – Capital and revenue expenditure

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

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

Key Knowledge – Acquisition of a non-current asset

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

Key Knowledge – Depreciation

All assets, with the sole exception of freehold land, wear out over time. This means that the total cost
of ownership of the asset must be matched to the revenue stream that the asset generates, or supports.
This is done by making an allowance for depreciation and charging depreciation.

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The aim of depreciation is to match the cost of using the asset to the income stream that it generates.
It is not aimed at anything else such as showing the asset at its current market value in the SOFP.

The depreciation method chosen for an asset should be the method that most closely matches the cost
of the asset to the pattern of revenue that it generates.

The SOFP will show the asset at its net book value (NBV). NBV is original cost less cumulative allowance
for depreciation.

Method Annual depreciation Example where suitable

Straight line
Reducing balance (also
known as diminishing
balance)
Machine hour method
calculated as
(Cost – estimated residual
value)/ expected useful life.
NBV at start of the period x
annual depreciation %
(Cost – estimated residual
value) x (Machine hours this
period/ estimated total
useable hours)
estimate of revenue
generated
Office furniture, or anything
that does not produce
materially greater income
when it’s new. This is the
most commonly used
method of depreciation.
Motor vehicles used by a taxi
company. Older cars
generate less net revenue as
they break down more than
new cars and require more
maintenance.
Where an item of machinery
has an estimated maximum
useful life.

Ledger accounting

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

Dr Depreciation expense (SOCI) $x

Cr Allowance for depreciation (SOFP) $x

Key Knowledge – Disposal

When an asset is eventually disposed, it will generally be sold for some cash. This means that a new
asset will be recognised in the SOFP (the cash) and another will be derecognised (the NBV of the asset).

A gain or loss will arise on this simultaneous recognition and derecognition.

If sales proceeds > NBV then a profit on disposal will be recognised

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If sales proceeds < NBV then a loss on disposal will be recognised.

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

Key Knowledge – Revaluation

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

Key Knowledge – Depreciation of revalued asset

A revalued asset will still need to be depreciated. The depreciation charged must be on the higher,
revalued amount (a revaluation downwards is an impairment, which is unlikely to feature in the FR
exam).

Depreciation expense and allowance for depreciation will therefore increase.

www.theexpgroup.com/students/acca

Page 22
Key Knowledge – Disposal of revalued asset
On disposal of a revalued asset, a gain or loss will arise as normal. The gain or loss will be the
difference between the new revalued amount and the net book value immediately prior to the
revaluation.

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

Key Knowledge – Disclosure of non-current assets

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

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 Intangible
non-current assets

The Big Picture

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

Key Knowledge – Research and development costs

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

Most research and development fails to produce a commercially viable product. It is also difficult to
patent (i.e. restrict commercial use of) knowledge until it has reached a relatively advanced stage.

Research costs are costs incurred in the early stages of a development project. It is defined in IAS 38 as
is original and planned investigation undertaken with the prospect of gaining new scientific or technical
knowledge and understanding. The key issue here is that it is not reasonably certain that expenditure
will generate a viable income stream in the future.

The accounting treatment required for research costs is to write them off immediately in profit or loss.

Key Knowledge – Development costs

Development is defined in IAS 38 as “the application of research findings or other knowledge to a plan
or design for the production of new or substantially improved materials, devices, products, processes,
systems or services before the start of commercial production or use”.

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The accounting treatment of development costs is to recognise them as an intangible non-current asset
if they meet the criteria that suggest that they will be likely to generate a profitable income stream in
the future and can be reliably separately identified using the mnemonic RAT PIE:

• Resources are adequate to complete the project

• Ability to complete
• Technically feasible
• Probable economic benefit (i.e. expected to be profitable)
• Intend to complete the project
• Expenditure on the project can be separately recorded.

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

Key Knowledge – Write-off period

Intangible assets are written off over the period during which they generate benefits. As with tangible
non-current assets, the aim is to match the pattern of cost to the pattern of benefit that the intangible
asset generates.

Development projects such as drugs patents tend to generate their greatest revenues in the early years
of their commercial life. For this reason, amortisation is often chosen to be by the reducing balance
method of amortisation rather than straight line.

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 Inventory and
purchases

The Big Picture

For most businesses, inventory will be a very short lived asset, which is expected to be sold (or possibly
thrown away or stolen!) by the end of the accounting period.

When inventory is purchased, it creates an asset, since the inventory is expected to give an inflow of
benefit to the entity and the entity controls it. Strictly speaking therefore, the correct accounting
treatment for inventory would be, using illustrative numbers:

Step 1: Inventory is purchased:

Dr Inventory asset (SOFP) $10,000

Cr Cash/ payables $10,000

Step 2: Inventory is sold:

Dr Cost of sales (SOCI) $12

Cr Inventory asset (SOFP) $12

For a retailer, this could create practical problems, since each time an item of inventory is sold it would
be necessary to identify the historical cost of that specific item of inventory and charge it to cost of sales
(step 2 above). If the retailer deals with fast moving consumer goods, or perishable goods, then only a
very small proportion of inventory purchased during the year would remain in inventory at the year end.
In practical terms, journal step 2 above could be repeated many thousands of times as each individual
sale happened.

To simplify matters, most accounting systems (and all accounting systems that you can expect to
encounter in the FR exam) take the shortcut of writing inventory purchases off immediately to cost of
sales in the SOCI, thus:

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Single step: Inventory is purchased and treated as an expense:

Dr Cost of sales (purchases expense) $10,000

Cr Cash/ payables $10,000

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

Dr Inventory asset (SOFP) $800

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

At the start of the next period, this inventory asset is then treated as an expense, since it’s expected
that it will be used up (e.g. by being sold or scrapped) by the end of that period and so becoming an
expense of that period:

Dr Cost of sales (opening inventory) (SOCI)$800

Cr Inventory asset (SOFP) $800

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

Opening inventory 0 Expense in SOCI

Add: Purchases in the period 10,000 Expense in SOCI

Less: Closing inventory (800) Reduction in expense in SOCI

Cost of sales made 9,200

Key Knowledge – Valuing inventory

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

• Cost paid to the supplier

• Irrecoverable taxes (e.g. import duties)
• Costs of delivery inwards (sometimes called carriage inwards).

Where inventory is work-in-progress in a manufacturing process it will also include fair costs of
conversion (e.g. labour costs, production overhead costs).

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Recoverable sales taxes, non-production administrative costs and one-off costs that do not add anything
to the inventory’s value (e.g. costs of delivery to the wrong location and cost of bringing to the right
location) would be excluded from cost of sales, since they are unnecessary to bringing the inventory to
saleable condition.

By writing inventory off immediately to cost of sales, it is possible to keep inventory outside the
accounting system. This simplifies matters considerably. However, it does mean that at the end of each
period, inventory must be physically counted and valued, in order to make the necessary adjustments to
lift unsold inventory out of cost of sales.

Maximum value: lower of cost and NRV

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

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

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

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 Receivables and
payables

The Big Picture

We have already looked at how credit sales are often made to encourage sales. The problem with
extending credit is that not all receivables will pay. This means that some will become irrecoverable.
Before being written off as irrecoverable, some will also look like they may not pay (perhaps by being a
month overdue for payment). These are doubtful debts.

Remember that an asset is a resource that is expected to give an inflow of benefits. Logically therefore
if a receivable is not expected to pay, it cannot be shown as an asset. The SOFP of the receivables
cannot exceed the neutral estimate of how much cash is actually expected to be received.

Key Knowledge – Irrecoverable debts

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

Dr Irrecoverable debts expense $x

Cr Receivables $x

Key Knowledge – Recovery of debts written off

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

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Dr Bank $800

Cr Receivables $800

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

Dr Receivables $800

Cr Irrecoverable debt expense $800.

There is no attempt to change the previous year’s figures, which include an expense for the write off of
the debt, since this was a fair estimate at the time. There will be an expense recorded for the write off
in the year when it was written off and a credit to profit or loss when the cash was received.

Depending on how the initial cash receipt has been recorded, it may be possible to simplify the above
two journals, because there is a debit and credit of the same amount to receivables, thus:

Dr Bank $800

Cr Irrecoverable debt expense $800.

Key Knowledge – Doubtful debts

It is likely that some receivables will not pay, even if they have not yet been written off. The business
will continue to chase the receivables for full payment and may eventually even sue for the full balance.
The amount cannot be written out of debtors, as credit control will need the records of the debt in full to
know how much to chase for payment.

However, if it’s estimated that there is a 20% chance that a debt will not pay, it would fail to give a true
and fair view on the face of the SOFP to show the full amount as an asset. The solution is to create an
allowance account, which reduces the value of net receivables on the face of the SOFP without
corrupting the records of the actual debtor balance that will be needed to try to obtain payment.

Creating, or increasing, an allowance will reduce net assets. This therefore creates an expense. The
allowance account itself is a SOFP account, so just like assets and liabilities it will remain on the balance
sheet until it is removed.

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Key Knowledge – Control account reconciliations

It is possible that an accounting system will maintain memorandum ledgers with individual customer
balances outside the main accounting system. This creates duplication of effort and record keeping, but
provides a check on accuracy of the figures. The receivables account in the double entry system is often
called the “control account”, since it contains only summary figures of lots of transactions, rather than
lots of detail of individual transactions. It may alternatively be called the general ledger, or nominal
ledger. The memorandum ledger cards are confusing sometimes referred to as the “ledgers”.

The double entry system will be kept as simple as possible, with as few figures posted to the ledger
accounts (T accounts) as possible, since the fewer transactions there are, the less the chance of error
and the less information to seek through in order to find errors when they occur. For this reason, the
ledger accounts are normally updated using the totals from the sales day book and cash receipts book,
rather than details of individual sales.

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Key Knowledge – Other common items with receivables
Interest on overdue debts

If a sale agreement with a customer provides for a right to charge penalty interest on an overdue debt,
this will increase the amount receivable. Increasing a receivable increases net assets, which therefore
generates a source of income. It will normally be recorded as:

Dr Receivables $x

Cr Sundry income (or perhaps finance income) $x

Discounts

There are two types of discount that you may encounter: trade discounts and settlement discounts.
Trade discounts are those given to customers at the point of sale, perhaps because the customer buys
in large volumes or is a member of staff. These discounts are not subject to any uncertainty at the time
of sale – it is known for sure that the customer will never pay the list price of the goods or services.

The accounting is therefore very simple: they are simply ignored. The sale is recorded at the amount
net of the trade discount.

Settlement discounts

A settlement discount is an incentive for customers to pay you earlier than they otherwise naturally
would. For example, a discount of 5% may be offered on the invoice sent to customers if payment is
received within seven days of the invoice being sent. If payment is not received within that period, the
offer of the discount lapses.

Settlement discounts are uncertain at the point of sale. The actual amount of the debt is gross of the
settlement discount, i.e. before its deduction, since this is the amount that the customer will eventually
be chased for if they don’t pay early.

If the settlement discount is allowed to the customer, this is similar to the treatment of irrecoverable
debts. It is simply a debt that we are voluntarily choosing to write off as partially irrecoverable because
of the cash flow advantage of receiving the cash quickly. Settlement discounts are sometimes also
called cash discounts for this reason.

The terminology can be confusing here.

Discounts allowed are settlement discounts that we allow to customers. They are therefore partial
write off of debts receivable by us. They are therefore an expense in our books.

Discounts received are settlement discounts that our suppliers allow to us. They are therefore partial
forgiveness of debts that we owe to other people. They are therefore a source of income in our books.

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 Bank reconciliations

The Big Picture

The cash book will record payments in and out of the bank account. Banks, of course, provide bank
statements that record all the transactions that they have recorded in the same bank account. This
independent record keeping is a powerful check on the accuracy of a business’s accounting records.

In a small company scenario, it is likely that each transaction on the bank statements will be manually
compared to the transactions on the cash book, ticking off matching transactions. This will then leave
only items that don’t agree. In larger businesses that use a computerised accounting system, it is likely
that the bank’s transactions will be downloaded in a raw data file (such as a .csv file) and will then be
run through the accounting software. The accounting software will then match transactions and run off
a report of differences.

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

Reasons for differences

between bank
account and cash book

Errors/ omissions Timing differences

(require correction) (no action needed)

Errors/ omissions by
the company itself

Errors/omissions
by the bank

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

Typical errors/ omissions made by the company:

• Misposting of amounts, e.g. recording a cash payment of $45 as $54

• Omission of cash payments or receipts
• Omission of standing orders processed by the bank (i.e. automatic payments of non-variable
amounts)
• Omission of “direct debit” payments processed by the bank (i.e. automatic payments of variable
amounts)
• Omission of bank charges
• Processing errors, e.g. miscasting manually maintained accounts.

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

• Incorrect charges
• Processing payments or receipts incorrectly.

Typical timing differences:

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

A warning about terminology!

A bank statement will record positive deposits with the

bank as a credit, where the cash book will record them
as debit. Both are correct, as a debit is an asset. If the
bank holds some of your money, that means that the
bank owes you money – i.e. you are a liability of the
bank. So the bank statements will list your balance as a
credit. Bank statements are run off from the records of
the bank, not of the client. Hence, our debit correctly
equals their credit and vice versa.

Page 34
 Long term finance

The Big Picture

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

Key Knowledge – Long term debt

Debt is a liability, meaning it’s an obligation of the business. Long-term debt may be funds raised from
banks, or from other investors who buy loan notes (also called bonds, securities or commercial paper).
Debt generally incurs an interest charge and may be redeemable (meaning repayable) over a period of
time, on a fixed date or exceptionally irredeemable debt. The last category simply therefore pays
interest into perpetuity without ever repaying the loan principle. It is only ever issued by governments,
and then only rarely. Loan notes are often tradable, meaning that the original buyer can get their cash
back before redemption by selling the loan note to somebody else for its market value on that day.

Any loan principal due for repayment within the current year is a current liability; any debt due for
repayment after more than one year is a non-current liability.

On the issue of a loan, the cash received will be credited to a loan liability account. No liability is
recorded for expected future interest, as the obligation to pay interest only arises as time passes.

Key Knowledge – Equity

Equity is the residual interest of all assets after deducting all liabilities. For a sole trader, equity is simply
termed proprietor’s interest. In a partnership, it is the sum of each partner’s capital account and each

Page 35
partner’s current account. In the case of a company, IFRS and national regulation often require a
greater analysis of each component of equity.

Equity in total is often termed shareholders’ interest or shareholders’ funds.

In a large limited liability company, equity may comprise the sum of the following:

• Ordinary share capital

• Preference share capital
• Reserves:
o Share premium account
o Revaluation reserves
o Other reserves
o Retained earnings
Companies are required to present a note in their financial statements that reconcile each component of
equity at the start of the year to the end of the year. This is another expression of the accounting
equation and business equation from chapter 1.

Page 36
 Accruals and
prepayments

The Big Picture

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

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

Accruals Prepayments

Where an expense has been incurred, but
it’s not yet been paid. Often, an invoice
hasn’t yet been received, so an estimate of
expense incurred by the year-end will need
to be made. This means there is a liability at
the period end.
Where an amount has been paid in advance,
but that cash payment gives a right to
receive benefits beyond the current period
end. This means that there is an asset at
the period end, since there is a right to
receive future benefits.

Examples:
• Estimated water and electricity used
• Estimated telephone charges for a
traditional landline telephone at a
month end.
Examples:
• Insurance paid in advance for a
year’s insurance cover.
• Prepaid balances on pay-as-you-go
mobile telephones.

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Key Knowledge – Accounting treatment at the year end
Accruals Prepayments

Estimate the cost of goods or services used
by the year end but not invoiced. This might
be done using typical levels of usage, or done
after the period end using invoices that came
in after the period end, but before the
accounts are prepared.
Calculate the amount of the prepayment
from cash paid before the year-end.
Determining the amount of the prepayment
will normally be easier than estimating the
amount of an accrual, since there is an actual
cash payment before the period end to base
the calculation on.

Recognise this as a liability, since there is an
obligation to pay this charge. Recognising
the liability reduces net assets, so generates
an associated expense:
Dr Expense in SOCI (e.g. electricity) $x
Cr Accruals in SOFP (liability) $x
Recognise the asset (the right to receive
future benefits) at the period end. Doing this
increases net assets so generates a source of
income. In reality, this source of income will
be a reduction in the expense recognised so
far from posting cash payments from the
cash book to expenses.
Dr Prepayment in SOFP (asset) $x
Cr Expense in SOCI (e.g. insurance) $x

Key Knowledge – treatment in the following period

In the following period, it’s reasonable to assume at the start of the period that the prepayment asset
will be used up (e.g. the benefit of insurance received) or the liability will be settled by payment of cash.
It’s therefore normal at the start of the year to anticipate this by reversing the accrual liability or
prepayment asset through profit. This is often done at the beginning of the following period, but it
could be done at the end of the period in some companies. It’s a manual adjustment through the
journal book, so it can be done anytime that the company likes. It must be done, however, as
otherwise redundant assets and liabilities will be shown on the SOFP forever!

Accruals Prepayments

Recognise the discharge of the liability in the
following period. This increases net assets, so
creates a credit to expenses. This means that
as cash is paid the following period, not all of it
will be recognised as an expense in that period,
since an amount equivalent to the opening
accrual will already have been reported as an
expense the previous year. Reversing the
accrual removes any chance of accidental
double recognition of the expense.
Dr Accruals in SOFP (liability) $x
Cr Expense in SOCI (e.g. electricity) $x
Recognise the consumption of the asset in the
following period. This derecognises the asset
that no longer exists. Derecognising the asset
reduces net assets, so generates an expense.
This will be an expense in period 2 of the cash
payment not recognised as an expense in
period 1.
Dr Expense in SOCI (e.g. insurance) $x
Cr Prepayment in SOFP (asset) $x

Page 38
 Provisions and
contingencies

The Big Picture

A liability is defined in IFRS as being:

• An obligation at the period end (i.e. something that is impossible to avoid – not just an intention
to do something), and

• Where an outflow of benefit is expected to arise from that obligation, and

• A reliable (which in practice means meaningful) estimate of the outflow can be made.

A provision is simply a liability of uncertain timing or amount. Accruals may be a form of provision, if
there is no firm data on which to base the estimate of the amount expected to be paid.

A provision is valued at the neutral best estimate of what the business expects to pay to settle the
obligation. For a one-off liability (e.g. lawsuit) this will be the single most probable outcome. For a
recurring series of similar liabilities (e.g. lots of goods sold under warranty) it will be the weighted
average of outcomes.

Contingent liabilities

A contingent liability exists in one of two situations, which are either:

It is believed that there is probably no obligating event (<50% probability) but the chances of there
being an obligating event are more than remote (>5% probability), or

An obligation probably exists, but it is so difficult to obtain an estimate of what the outflow is likely to be
that any estimate would be no more reliable than zero. This second situation is very rare.

Contingent liabilities are disclosed in the notes to the financial statements but are not shown with any
value on the SOFP.

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Contingent assets

A contingent asset is one where it is uncertain if the asset (i.e. right to something) even exists.
Examples are insurance claims where it’s uncertain if the item being claimed for is covered by the policy
at all or a lottery ticket before the lottery draw.

Contingent assets are not shown as assets in the SOFP, nor disclosed in the notes to the financial
statements.

Movement in provisions

A provision is a liability. As with any item on the SOFP, it will remain on the SOFP until it is removed. If
a provision is increased during the period, the effect will be to reduce profit and net assets:

Dr Expense (e.g. for legal costs) $ Increase in provision

Cr Provision $ Increase in provision

The provision is categorised on the SOFP within current liabilities or non-current liabilities, depending
upon whether it is expected to be settled within 12 months of the reporting date or longer.

If a provision is no longer needed, it will be reversed. This will reduce the profit effect of the cash
payment in the period.

Page 40
 Sales taxes

The Big Picture

Sales taxes, such as Value Added Tax (“VAT”) are a common feature of business. The rules vary
considerably between countries, but typically businesses are required to register for sales tax if their
expected turnover exceeds a certain limit.

Businesses that are not registered for sales tax simply record purchases and sales at whatever cash they
pay or receive.

Businesses that must register for sales tax have an additional complication in their accounting system.
In order to comply with the law, they must very accurately maintain records of sales taxes that they
have been required to charge on their sales (their “output tax”) and the tax that they have paid on their
purchases of goods and services (their “input tax”).

As people who are not registered for sales tax, we may often be unaware of what sales taxes we are
suffering, though receipts will normally provide a breakdown of the amount inclusive of the sales tax
(“gross”), the amount of the sales tax itself and thus the amount excluding the sales tax (“net”).

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

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

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

Page 41
Ledger accounting

Purchases and payables would be recorded as:

Dr Purchases (SOCI, so net) $135,000

Cr Cash/ payables (SOFP, so gross) $162,000

= > Dr Sales tax control account (SOFP) $27,000

The sales tax control at any point will show the amount due to or from the tax authority for sales taxes.

Sales and receivables would be recorded as:

Cr Sales revenue (SOCI, so net) $178,000

Dr Cash/ receivables (SOFP, so gross) $213,600

= > Cr Sales tax control account (SOFP) $35,600

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

Recoverable or irrecoverable?

Some items will include sales taxes that under local law are not recoverable, as a matter of public policy.
These might include business entertaining expenses or sales tax on cars. In the UK for example, sales
tax on vans is recoverable for a registered business, but sales tax on purchase of a company car is not.

If an item includes irrecoverable sales tax, it is included within the recognised value of the asset or
expense.

Page 42
 Trial balances and
correction of errors

The Big Picture

The following is a list of all the balances on the accounts of a sole trader at the end of a period. This is
a preliminary trial balance.

Dr Cr

Cash 16,140

Capital 15,000

Purchases 3,000

Payables 2,040

Sales income 4,140

Staff costs 50

Non-current assets 540

Telephone 60

Receivables 1,240

Withdrawals 150

Totals 21,180 21,180

The fact that the total debits equal the total of the credits gives us a considerable amount of comfort
that the bookkeeping has been done accurately.

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If the total debits does not equal total credits, it implies that errors have been made in the recording of
transactions, the adding up of the T accounts or the extraction of balances from the T accounts into the
trial balance itself.

It does not mean that no errors have taken place. These types of errors will not be picked up in a trial
balance:

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

• Compensating errors – two errors happening to cancel each other out

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

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

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Overview of stages in preparation of financial statements

Record transactions using

books of original entry

Periodically total books of

original entry and post
totals to ledger accounts

Total ledgers and produce

preliminary trial balance

Use journal book for

corrections and
"period 13" adjustments
❶

Final trial balance

Reset income and

expenditure accounts to
Produce financial
zero by transferring
statements
balacnes to profit and loss
account

Transfer profit and loss T

account to equity

Opening trial balance for

next period

Page 45
Key Knowledge – Correction of errors
As professional accountants, much time is spent dealing with correcting errors from draft records
prepared by less experienced people. Knowing how to correct errors is therefore a critical skill for a
chartered certified accountant.

The easiest approach to take is to take three steps and resist the temptation to try to simplify them, as
rushing into a simplification normally results in further complication and a poor trail for another person
to review the work that you’ve done. So the approach to take is:

1. Work out what has been done to record a transaction and write down the journal that has been
recorded, no matter how crazy it might be.
2. Work out what the journal entry should have been.
3. Compare the results from steps 1 and 2 to work out a correcting journal.

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 Suspense accounts

The Big Picture

We saw in previous chapters that if all is working well with an accounting system, the total of the debits
will equal the total of the credits when a trial balance is presented.

Errors may occur that will result in total debits not being equal to total credits. This may arise in many
situations, including:

• One sided journal (e.g. Dr Cash $100 only)

• Posting both sides of a journal on the debit or credit side (e.g. Dr Receivables $80, Dr Sales $80)
• Recording different amounts on the debit and credit sides (e.g. Dr Payables $230, Cr Cash $320).

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

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

Deliberate creation of suspense accounts

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

Page 47
 Incomplete records

The Big Picture

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

The key techniques to answer exam questions on this are:

• Cost structures of mark-up and margin

• Use of T accounts to find missing figures
• Use of the accounting equation/ business equation to find missing figures such as profit (this was
covered in chapter 1).

Key Knowledge – Margin and mark-up

There is a terminology distinction here that is important:

Mark-up means that you start with the cost of a sale, then add the mark-up % to determine sales price.

Margin means that you start with the sales price, of which a specified % will be gross profit.

Mark-up Margin

Sales revenue 120% Sales revenue 100%

Cost of sales 100% Cost of sales 80%

Gross profit 20% Gross profit 20%

Page 48
Withdrawal of inventory for own use

In a smaller business, a proprietor is likely to withdraw inventory for his/ her own use. This is a
withdrawal from the business.

The purchase of inventory will have been written off to purchases, within cost of sales. However, if the
inventory is taken by the proprietor, it has not been sold. A common accounting treatment and the one
to use in any exam question is therefore to remove it from cost of sales (at cost) and debit to
withdrawals.

Page 49
 Limited companies

The Big Picture

Separate legal identity

A sole trader is a different entity to his/ her business as far as accountants are concerned, but not as far
as the law is concerned. The business debts of a sole trader are indistinguishable from that person’s
general debts in the event that the business goes insolvent. A sole trader, or traditional unlimited
partnership, is a risky form of enterprise as if it goes bankrupt, the trustee in bankruptcy can seek to
recover personal assets to make up the shortfall.

This can be a different story with a company, since a company has a legal identity of its own, being an
artificial legal person.

Note that limited liability does not mean that the liability of the company to its creditors is
limited! It means that the liability of the members to the company is limited. This is developed in
greater detail in the ACCA Law paper, LW.

Taxation

With a sole trader, taxation expense does not appear in the SOCI. This is because the sole trader’s tax
liability depends on lots of other things, such as any other sources of income that they may have or tax
deductible personal expenses. The business is not the complete story of the owner’s wealth, so the tax
liability of that person from business earnings cannot be known.

With a company, the tax position is known, since the company itself will have a liability for corporate
income tax. This means that it is possible to make an estimate of what tax will be due on profit for the
period. This tax:

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

Page 50
Key Knowledge – Equity
The equity section of the SOFP of a limited company will look different to that of a sole trader. This was
outlined in chapter 10. Companies are regulated in law by what dividend they can pay and which
reserves dividends can be paid from. Basically, dividends can only be paid out of retained earnings.
Retained earnings are the cumulative of recognised profit (not total comprehensive income) less
cumulative dividends paid.

Other comprehensive income (e.g. revaluation gains) are transferred to revaluation reserve. See the
statement of changes in equity in chapter 10 for an example of this.

Component of What it is Distributable?

equity

Ordinary share Records the nominal value of the shares issued to No

capital date. Ordinary shares generally have only a
discretionary dividend and come with voting rights.

Preference share Records the nominal value of preference shares No

capital issued to date. Preference shares normally carry a
fixed dividend but have no voting rights.

Share premium Records the excess over nominal value of No

account consideration received on the issue of shares.

Revaluation reserve Records cumulative revaluation gains on profit No

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

Retained earnings Records cumulative recognised profit, less Yes

cumulative dividends received.

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

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

Page 51
 Statement of cash
flows

The Big Picture

Purpose of a statement of cash flows

In addition to information about profit and other comprehensive income, it is useful to provide investors
with analysed information about cash flows. This gives the following benefits:

Understandability - Smaller investors in particular are likely to find cash flows easier to understand than
total comprehensive income.

Business valuation – a common method of valuing businesses is to work out the net present value of
cash flows. This is covered in detail in other ACCA papers.

Predicting liquidity problems – when companies run out of cash, they are often in serious trouble and
may go out of business. If a business is reporting profits but not collecting cash (e.g. by making sales
on excessively generous credit terms) then this needs to be made clear to readers.

Key Knowledge – What is cash?

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

Cash and cash equivalents include notes, coins and demand deposits at a bank.

Cash and cash equivalents will exclude shares in other companies and long-dated bonds.

If a company uses cash to buy a cash equivalent, it will not be reported in the statement of cash flows
as a cash movement.

Page 52
If a company uses cash or cash equivalents to buy shares, it will be reported in the statement of cash
flows as a cash outflow on investing activities.

Profit vs. cash flow

We have seen already that there are many items within a statement of comprehensive income that do
not represent a movement of cash.

The method used by most companies to present a statement of cash flows reconciles operating profit
(earnings before interest and taxation) to cash generated from operations (i.e. cash flow from core
operations, before buying or selling non-current assets or raising new finance).

If a transaction or journal adjustment affects earnings before interest and tax, but does not affect cash
from operations, then it is a difference. That difference will be part of the reconciliation.

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Page 53
Key Knowledge – Direct method or indirect method
The cash generated from operations may be presented under IAS 1 using two alternative presentations,
both of which reach the same figure, but by different means.

The direct method is shorter in presentation but often longer to calculate the figures in an exam.

Finding cash flows using double entry

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

Technique to use

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

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

Page 54
 Consolidated
financial statements

The Big Picture

There are three possible levels of investment that one company may have in another:

Type of investment Level of influence Accounting treatment in

group financial
statements

Available for sale asset (i.e. Little or none Historical cost or market
trade investment) value

Associate Significant influence, “Equity accounting”, which is

normally by holding between a simplified form of
20% and 50% of the voting consolidation.
shares

Subsidiary Control, normally by holding Line-by-line consolidation of

>50% of the voting shares all items under parent’s
control, plus goodwill and
non-controlling interests.

Subsidiary
Companies often trade through a group of companies. This might be due to acquisition of other pre-
existing companies or by setting up separate legal entities to ring-fence business risks.

Legally, each company exists separately and must produce separate (“individual” or “entity”) financial
statements.

Page 55
Investors in the parent company, however, will be interested to see all the assets, liabilities and profits
that their company has controlled. This is achieved by the process of consolidation, which presents the
financial statements of all entities under the parent company’s control as if it were one single entity.

Investors

Parent

Group
Subsidiary

Consolidation is the process of replacing the single figure for “investment in subsidiary” in the individual
financial statements of the parent with more useful information about what assets, liabilities, income and
expenditure the parent company controls via its investment, i.e.:

Net assets in the subsidiary’s financial

statements (i.e. equity or capital plus
reserves) at the acquisition date.

Consideration transferred to buy

subsidiary (as shown in the Non-controlling interests’ share of the
parent company’s individual net assets of the subsidiary.
accounts)

Goodwill arising on acquisition

(premium paid to acquire the
subsidiary).

Consolidation is basically a double entry to derecognise the carrying value of the investment (Cr
Investment in subsidiary) and recognise the individual assets (Dr PP&E, etc), the liabilities (Cr Payables,
etc), the non-controlling interest (CR NCI) and recognise goodwill as a balancing, residual, item
(normally DR Goodwill).

Page 56
Key definitions - What group accounting is trying to do
Subsidiary Any entity that is controlled by another entity, normally by having more
than 50% of the voting power, though there is no minimum
shareholding.

Parent The entity at the top of the group structure, controls the subsidiaries
and has a significant interest in associates.

Associate A company in which the parent has significant influence, but not control
nor joint control (as with a joint venture).

Control The power to control the financial and operating policies of another
entity, so as to obtain benefit from its activities.

Significant influence The power to participate in the financial and operating policies of
another entity, so as to obtain benefit from its activities.

Equity Equity is defined in the Framework document as assets less liabilities.

By definition, this is the same as capital and reserves of any company
at any date in time. In group accounting, we very frequently use the
capital + reserves = net assets. For example, this is used to work out
the net assets on the date of acquiring control of a company (as part of
the goodwill working) and to work out post-acquisition growth in a
subsidiary’s assets (i.e. post-acquisition profit).

Group reserves The cumulative gains made under the control of the parent. The
parent company’s reserves, plus the post-acquisition retained gains of
all subsidiaries, joint ventures and associates.

Non-controlling Formerly called minority interest. The share of the net assets and
interest gains of a subsidiary that is not owned by the parent.

Goodwill The premium paid by the parent to acquire its interest in a subsidiary or
associate.

The mechanics of consolidation

The best approach to consolidation is to use a set of standard workings.

(W1) Establish the group structure

Date of acquisition 80% This indicates that P owns 80% of the ordinary shares
of S and when they were acquired.

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(W2) Goodwill

IFRS 3 Revised introduced an accounting policy choice when accounting for goodwill on acquisition. It
can either be calculated on a full ("fair value") basis or a proportionate ("net") basis. Only full goodwill
method is relevant for F3 examination.

Purchase consideration paid by parent (i.e. fair value paid by parent) X

NCI value at acquisition X
Fair value of net assets at acquisition (X)
___
Goodwill X

(W3) Group reserves

Retained earnings Other reserves

Parent X X
Sub (% × post-acq reserves) X X
–––– ––––
X X
–––– ––––

(W4) Non-controlling interests

NCI value at acquisition X

NCI value of post acquisition reserves X

___
NCI value at reporting date X

Fair Values
To ensure that an accurate figure is calculated for goodwill:

• the consideration paid for a subsidiary must be accounted for at fair value
• the subsidiary’s identifiable assets and liabilities acquired must be accounted for at their fair values.

Calculation of cost of investment

The cost of acquisition includes the following elements:

• cash paid
• fair value of any other consideration i.e. share exchange.

Share exchange

Often the parent company will issue shares in its own company in return for the shares acquired in the
subsidiary. The share price at acquisition should be used to record the cost of the shares at fair value.

Page 58
Fair value of net assets of subsidiary

At acquisition, the parent recognises in the group accounts the identifiable assets acquired and liabilities
assumed of the subsidiary. They are to be measured at their fair value as at the date of acquisition.

Adjustments will be required to subsidiary’s accounts if the carrying values do not reflect fair value. Most
common adjustment in the exam will relate to land and buildings and it will ignore depreciation.

Intra-group trading
P and S may trade with each. If this is done on a credit basis one company will have a receivable and
the other a payable at the year end. These amounts must be cancelled on consolidation, since only
assets and liabilities outside the group will appear on consolidated statement of financial position.

If inter-company trading is done at a profit it should be eliminated on consolidation for all items traded
and still held in inventory at the year end.

Adjustments for unrealised profit in inventory

The following steps should be considered when adjusting for unrealised profits:

(1) Determine the value of intra-group purchases still held in inventory at year end.
(2) Use markup or margin to calculate the profit earned by the selling company.
(3) Always make the adjustments in the books of the seller.

Mid- year acquisition

If the subsidiary is acquired part way into the year, the net assets at the date of acquisition must be
determined. Unless otherwise stated, the calculation is based on the assumption that subsidiary’s profits
accrue evenly over the year.

Page 59
Key Knowledge – Principles of consolidated statement
of comprehensive income
The principles used to prepare the group statement of financial position are equally applicable when
preparing group income statement and summarised below:

Group statement of Group income Comment

financial position statement

Cross casting Basic rule: all assets and
liabilities are fully cross
cast
Intercompany Inter-company current
items account balances are
excluded.
Same principle applies
for intercompany loans
Basic rule: all Subsidiary results
income and need to be time
expenses are fully apportioned if it
cross cast was acquired part
way into the year.
Inter-company
sales and
purchases are
excluded.
Same principles
apply with inter-
company
interest.

Provision for For all unsold The PURP The extra

unrealized inventory at year end consolidation expense in
at a transfer price adjustment will respect of PURP
profit between group reduce profits. is included in
companies. The PURP COS.
will reduce both
inventory and equity.

If the subsidiary is the If the subsidiary

seller the NCI is is the seller the
charged NCI is charged

NCI The NCI in the The NCI in the By showing the

subsidiary’s net assets
will reflect fair value
adjustments on assets
and PURPs (where the
subsidiary is the
seller).
subsidiary’s profit profit of the
will reflect fair subsidiary that is
value attributable to
adjustments, and NCI, the group
PURPs (where SOCI can show
the subsidiary is as a balancing
the seller) and. figure the total
group profit that
are attributable
to equity holders.

Page 60
Key Knowledge – Associate

IAS 28 Investments in Associates defines an associate as an entity over which the investor has
significant influence and that is neither a subsidiary nor an interest in joint venture.

Significant influence is the power to participate in the financial and operating policy decisions of the
investee but is not control or joint control over those policies.

Significant influence is assumed with a shareholding of 20% to 50%, but other factors may be taken
into account, such as:

• Representation on the investee’s board of directors

• Evidence that the investee company is used to accepting the investor as having significant
influence

• Whether the investee is part of the supply chain of the investor

• Sharing key personnel

• Sharing key information.

Under these circumstances the parent cannot consolidate each item of the investee’s assets, liabilities,
income and gains, since the parent does not have control of them.

Equity accounting is a method of accounting whereby the investment is initially recorded at cost and
adjusted thereafter for the post-acquisition change in the investor’s share of net assets of the
associate.

Consolidated statement of financial position will include one line within non-current assets
“investment in associate” that will reflect group share of the assets and liabilities of the associate.

Consolidated income statement will include one line “share of profits from associates” that reflects
group share of the associate’s profit after tax.

Note: in order to equity account, the parent company must already be producing consolidated financial
statements (i.e. it must already have at least one subsidiary).

Trading with the associate

The associate is considered to be outside the group and therefore only unrealised profit in inventory and
dividends are adjusted for.

Page 61
 Events after
reporting date,
errors and estimates

The Big Picture

Events after the reporting date are ones that happen between the financial year end and when the
financial statements are authorised for issue.

All material events after the reporting date must be disclosed and explained in the notes to the financial
statements.

An adjusting event is one that gives further information on conditions that existed at the reporting date.
The figures in the financial statements are amended to incorporate the latest available information.

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

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

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

• Issue of new shares

• Declaration of a dividend after the reporting date.

Page 62
 Interpretation of
financial statements

The Big Picture

Financial statements on their own are of limited use and therefore in order to gain additional useful
information from them ratio analysis is used.

For FA exam purposes being able to calculate a series of ratios and explain their interrelationship is a
must.

Interpretation
of financial
statements

Liquidity and
Profitability Gearing Investor ratios
efficiency

Profitability

Typical ratios to measure relative profitability include:

Gross margin Gross profit

Revenue

Page 63
 Net margin Profit before interest and
tax
Revenue

Return on capital Profit before interest and

employed (ROCE) tax
Equity + interest bearing
debt

Asset turnover Revenue

Equity + interest bearing
debt

Liquidity and efficiency

If a business runs out of cash and cannot refinance in a hurry, it goes out of business. It’s possible for
companies to focus excessively on profitability at the expense of liquidity management.

Current ratio Current assets

Current liabilities

Quick ratio (“Acid test”). Current assets, except

inventory
Current liabilities

Inventory days Average inventory x 365

Purchases/COS

Receivables collection Average receivables x 365

period Credit sales

Payables payment period Average payables x 365

Credit purchases

Gearing

This is of considerable topical relevance at the moment, as many companies are criticized for having taken
on excessive amounts of debt, which they felt were cheap at the time. However, this has provided a high
amount of interest to pay off as revenues have fallen.

Debt/ equity Interest bearing debt

Capital + reserves

Page 64
 Interest cover Profit before interest and
tax
Interest expense

Investor ratios

These largely give an indication of the risk to investors of putting money into the company, i.e. what is
the chance that the money may not come back to them?

As the greater the risk of investing in a business, the greater the return investors will want, it is important
to look at profitability ratios against the backdrop of investor returns as well.

Dividend cover Profit before ordinary

dividend
Ordinary dividend

Dividend yield Dividend

Market price of shares

Price/ earnings ratio Market price of shares

Earnings per share

Page 65
Page 66