UCL School of Management

Accounting for Business

MSIN0004

Lecture 4: Financial Frameworks III

2022-2023
Learning Outcomes
By the end of this lecture, you will……
— have seen further application of the core principles when
recording transactions and constructing financial statements
— Considered specific issues associated with the preparation of
Core Financial Statements:
▪ Revenue recognition
▪ Inventory valuation
▪ Bad Debts, allowances for trade receivables
▪ Depreciation, revaluations
Recognition of revenue and profit
measurement
Basic criteria that must be met before revenue is recognised:

The amount of revenue can be (new) IFRS

measured reliably
15 applied
from 1
It is probable that the economic
benefits will be received January 2018

Additional criterion is to be applied where the revenue comes from the

sale of goods:

Ownership and control of the items

should pass to the buyer
IFRS 15
5 steps in detail, but here is a core step:

An entity can recognize revenue when performance

obligations have been settled, a performance obligation has
been settled when the customer has received all the benefits
associated with the performance obligation, and is able to use
and enjoy the asset to his or her own discretion.

4
Tesco…
• In 2014-15…Overstated its profits by £263m.
• But not all of this just related to 2014-15…!
• In 2015 it recorded a £6.3bn loss!
• Aggressive Accounting…
• ‘the accelerated recognition of commercial income and delayed accrual
of costs’
• …judgment required in accounting for the commercial income
(revenue) deals and the risk of manipulation of these balances...
• Pressures of financial targets, market share competition and healthy
looking results.

5
Current Assets
Held for sale or consumption during
the business’s operating cycle

Expected to be sold/consumed
within the next year

Held principally for trading/operations

They are cash or near

equivalents to cash
Inventory valuation…it’s all about timing

▪ FIFO: First In First Out

▪ assumes that the first items
▪ placed in inventory are the first sold

▪ LIFO: Last In First Out

▪ assumes that the last items placed in inventory are the first sold
during an accounting year

▪ AVCO: Average Cost

▪ determines the value of ending inventory and cost of sales on the
basis of average cost of units available for sale
Current Assets - Inventory
Assume the transactions in the latest financial period for a
fictitious business are:

• Buy one table for £50 cash

• Buy another identical table for £60 cash
• Sell one for £100 on account

What is…
a) the impact on cash
b) the profit or loss
c) the remaining value of the table unsold

8
9
Inventory Valuation
LIFO is NOT permitted under IFRS and USA uses its own accounting standards

Cash Impact Income FIFO LIFO AVCO

Impact £ £ £
In: Sales Value The approach
the business
Out: Less
selects is the
Cash Flow: Cost of Sales ACCOUNTING
Profit POLICY for
inventory
valuation
Closing Stock at
cost

With Closing Inventory valued at lower of cost and net realisable value
Inventory Valuation
Lower of Cost and Net Realisable
Value
Assume the cost of inventory (based on FIFO) at the end of a financial
period for a fictitious business is £60

Unfortunately the roof of the store room has developed a leak and the
inventory has deteriorated because of water damage

The inventory could now only be sold for £10, which is less
than its cost value. The inventory is reduced…
WRITTEN DOWN… by £50 to £10
and shown on the Balance Sheet at that £10 value.
10
Marks & Spencer
 Rolls-Royce
Inventories
Inventories and work in progress are valued at the lower of
cost and net realisable value on a first-in, first-out basis.

Cost comprises direct materials and, where applicable,

direct labour costs and those overheads, including
depreciation of property, plant and equipment, that have
been incurred in bringing the inventories to their present
location and condition. Net realisable value represents the
estimated selling prices less all estimated costs of
completion and costs to be incurred in marketing, selling
and distribution.
SAMSUNG
Louis Vuitton
15

Exxon Mobil
Inventories: Crude oil, products and merchandise inventories are
carried at the lower of current market value or cost (generally
determined under the last-in, first-out method – LIFO).

Inventory costs include expenditures and other charges (including

depreciation) directly and indirectly incurred in bringing the inventory to
its existing condition and location.

Selling expenses and general and administrative expenses are

reported as period costs and excluded from inventory cost. Inventories
of materials and supplies are valued at cost or less.

LIFO is NOT permitted under UK law and IFRS

Accounts Receivable:
Bad debts written off
Reduce trade receivables Accounts must
show a
Increase expenses ‘True and Fair’
view
Example
• Customers owe, in total: £100,000
• One customer, owing £10,000, goes bankrupt
• The debt is written off:
Trade Receivables reduced by £10,000 (Credit)
Income Statement reduced by £10,000 (Debit)
16
 Account Receivable: Allowance for
Doubtful debts
There is a risk that the customer will not pay.
The risk of non-payment is dealt with by reducing the reported value
of the asset by an estimate for doubtful debts.
This usually referred to as an allowance for doubtful debts.
Sometimes referred to as a provision for bad debt/doubtful debts.
On the Assets section we can create an allowance (provision for bad
debt) column which is a sub-division that affects the Receivables
column.
Gross Receivables Also known as an
Allowance for trade
receivables

17
Example
• Per the previous example the business was owed £100,000 and is
now owed £90,000 having had to write off a large bad debt of
£10,000 – it is worried about further bad and doubtful debts.
• It decides to create an allowance for Bad/doubtful Debts, equivalent
to 10% of year end trade receivables

➢ An allowance for trade receivables (TR) sub-account is created

and receives a Credit entry of £9,000
➢ Income Statement reduced by £9,000 (Debit)

On the period end balance sheet under Current Assets, the

presentation is: Gross Trade Receivables £90,000
less allowance (provision) (£ 9,000)
Net Trade Receivables £ 81,000
Adjustment of Provision
• The same business was owed £90,000 at the start of the next financial
period, but assume is now owed £100,000 at the end.
• The Allowance for TR is currently showing £9,000.
• If 10% is the allowance, then the allowance should be £10,000 (10% x
£100,000) and must be increased from £9,000 by £1,000 to £10,000.

The Allowance for TR Account receives a Credit entry of £1,000

Matching expense shown on the Income Statement £1,000 (Debit)

On the period end balance sheet under Current Assets, the presentation is:
Gross Trade Receivables £100,000
less allowance (provision) (£10,000)
Net Trade Receivables £ 90,000
19
Ongoing Adjustment
The % allowance selected by the business selects is the ACCOUNTING POLICY for bad debts
…….. it may change if circumstances change
• The same business was owed £100,000 at the start of the next financial period, but is
now owed £80,000 at the end.
• The Allowance for TR is currently showing £10,000.
• If 10% is the provision, the provision should be £8,000 (10% x £80,000) and must be
decreased from £10,000 by £2,000 to £8,000.

The Allowance for TR Account receives a Debit entry of £2,000

Income Statement increased by £2,000 (Credit)

On the period end balance sheet under Current Assets, the presentation
is: Gross Trade Receivables £80,000
less allowance (provision) (£8,000)
Net Trade Receivables £ 72,000
20
Non-current Assets
Non-current (fixed or long-term) assets

Held for a period of time (usually more than one year)

and used in the process of generating profits

Not for sale in ordinary course of business (but may be

sold if the circumstances are appropriate).

21
Classification by Categories of
Non-current assets
• Tangible non-current (fixed/long-term) assets – such as
property, equipment, machinery, vehicles

• Intangible non-current (fixed/long-term) assets – with no

physical substance, such as Patents, Trade marks,
Development costs, Goodwill

• Investments held long term (often other businesses)

22
Depreciation
• Non-current assets are gradually used up in providing goods and
services over time.
• Purpose of accounting depreciation is to spread the cost of a non-
current asset over its expected useful life and charge an
appropriate portion to the Income Statements of the periods
benefiting from the use of that asset.
• Thus Accounting Depreciation is a method of allocating cost
as an expense.
• The net book value NBV (carrying amount) derived is not intended
to represent the asset’s market value merely the value in the books
of account based on the remaining unconsumed cost of the non-
current asset.
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Profit measurement and
Depreciation
To calculate a depreciation charge for a
period, four factors have to be considered:

The cost (or fair value) of the asset

Meant to be
reviewed
annually.
The useful life of the asset

Residual/Scrap value (disposal value)

Depreciation methods
Depreciation Methods
• Accounting Depreciation is a method of allocating cost.
• Achieves a matching of costs against the related revenues.
• There are many methods of depreciation
• Probably the two most commonly used are:
• Straight-line method
• Reducing balance (aka double declining balance).

And also…
• Sum of year’s digits
• Units of production
And others!
25
Calculating annual depreciation
Cost (fair value)
less Many organizations
do not deduct
Residual value
equals
residual value when
calculating reducing
Depreciable amount/base balance method.

The actual procedure is

Year 1 Year 2 Year 3 Year 4
and so on stated in the
Depreciation Depreciation Depreciation Depreciation DEPRECIATION
ACCOUNTING
POLICY.

Asset life (Number of years)

 First saw this in

Straight Line method TT & Co in

Seminar #2

Cost – Residual/scrap value (if any) = depreciable base

Depreciable base divided by number years*
Thus the Annual straight line depreciation
charge is obtained

*you can also express this as a % where you consume the amount (100%)
over a number of years, you would charge a % each year.

For example 10 years useful life = 100/10 = 10% each year; 2 years
=100/2 = 50% each year; 4 years = 100/4 = 25% each year and so on.

27
NBV over Time: Straight-Line Method
80
If cost is £80,000, and useful life
Carrying amount (£000)

is 4 years, annual straight line

60 depreciation is £20,000 each
year.
40
Net Book value (carrying
amount) at end of year 1 is
20
£60,000, at end of year 2 is
£40,000, at end of year 3 is
0 1 2 3 4 £20,000, at end of year 4 is £0.
Asset life
(years)
Reducing Balance Method
There is a formula… BUT we can also use another
way to calculate the reducing balance approach…

Step 1: calculate the straight line annual % (so 5 years

= 20%, 4 years = 25%, 10 years = 10%),

Step 2: Double that % to produce the fixed % to be

applied under reducing balance on an annual basis.

Usual to NOT deduct any residual/scrap value

29
Reducing Balance depreciation
STEP 1: Using Straight Line = 100%
Depreciation rate Useful Life
(%)

STEP 2: Double-Declining = 2x Straight Line

Balance rate Depreciation rate
(%)

STEP 3: Depreciation Expense = Double-Declining X NBV

Balance rate
NBV over Time: Reducing Balance Method
If cost is £80,000, and useful life is 4 years, and, imagine, fixed annual % is 50%
reducing-balance depreciation is:

80
Carrying amount (£000)

Year 1 dpn: £80,000 x 50% = £40,000

NBV £80,000-£40,000 = £40,000.
60
Year 2 dpn: £40,000 x 50% = £20,000
NBV £80,000 – £60,000 = £20,000.
40
Year 3 dpn: £20,000 x 50% = £10,000
NBV £80,000 - £70,000 = £10,000.
20

Year 4 dpn £10,000 x 50% = £5,000

NBV £80,000 - £75,000 = £5,000.
0 1 2 3 4
Asset life (years)
Summary of example
As before…..cost is £80,000 useful life is 4yrs
To calculate % rate…(100/4 = 25% x 2 = 50%)
Year NBV at start Annual Depreciation NBV at end of
of year % rate charge year

1 £80,000 50% £40,000 £40,000

2 £40,000 50% £20,000 £20,000

3 £20,000 50% £10,000 £10,000

4 £10,000 50% £5,000 £5,000

For Reducing balance method, always use the NBV at the start of
the period to charge your annual % rate upon.

32
Value at end of Useful life
• Under straight-line, the value at the end of the useful
life is zero.
• Under reducing-balance, there will always be an end We first met the
book value. idea of this in
Seminar #1 with
• In either case, when disposed of, the book value is set Joe Conday’s part
exchange.
against any sale value received, and a profit or loss on
disposal arises.
• If the asset in the current example is sold for £10,000…

33
 Dr/Cr for the disposal of NCA: Example

➢ Let’s buy equipment for £11,000 which will last for 5 years.
➢ Use Reducing Balance depreciation.
✓ What is the NBV of the equipment after 1 year?
➢ After 1 year, let’s sell the equipment for £5,000.
✓ How much profit or loss on disposal of the fixed asset do we
make?
ASSETS EQUITY
Equipment
CASH At Cost Acc. Depreciation Income Statement
+ - + - + - - +
Dr Cr Dr Cr Dr Cr Dr Cr
11,000 11,000 4,400 4,400

5,000 11,000 4,400 1,600

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Current Liabilities
Bank finance
— Overdraft, repayable on demand
— Shown as a current liability on the balance sheet

Trade payables/creditors
— Usually with set conditions for repayment, e.g., within 30 days,
within 60 days.
— May charge interest on overdue amounts.
— Problem of large organisations delaying payment to small
suppliers. Companies are required to explain their policy in
paying suppliers who have given credit.
35
Provisions
▪ A provision is a present obligation as a result of a past
event, whereby:

i. It is probable that settlement of the obligation will lead

to a future outflow of company resources
ii. The amount or timing of future outflow is uncertain
iii. A reliable estimate of the amount of the obligation is
feasible

(IAS 37 Provisions, Contingent Liabilities and Contingent Assets)

36
Liabilities continued…
Some liabilities may not exist formally.

• There may be a potential claim against the company

but there is some doubt about the validity and/or
outcome.
• In such cases, companies may be conservative and
prudent and create a liability called a provision.

37
38

Mis-selling of Payment Protection Insurance (PPI)

About 34m PPI policies have been sold since 2001, with almost £14bn (in
2013) set aside by the banks and building societies in compensation.

The financial industry has already incurred a bill for more than £26bn in
compensation and administration costs from the scandal…

Proposals to set a 2018 deadline for people to claim compensation. More

than 10 million customers have already received compensation.

Backdrop in March 2013…

▪ Lloyds Group made the biggest provision putting aside £6.7bn
▪ HSBC added £199m to its provision, increasing the total to £1.5bn
▪ Santander put aside £538m…but hasn’t increased its provision since
2011.
▪ Nationwide put aside £173m
▪ RBS put aside £2.2bn
▪ Barclays made provisions of £2.6bn
39
Contingent liability
A contingent liability refers to
1. A possible obligation that arises from past events
and whose existence will be confirmed only by the
occurrence or non-occurrence of one or more
uncertain future events not wholly within the control
of the company, or
2. A present obligation that is not recognised
because the future expenditure is not probable or
the obligation cannot be measured with sufficient
reliability
NOT recognised in the statement of financial position (balance
sheet), but disclosed in the notes to the financial statements.
40
Decision tree - Recognising a provision
Source: IAS 37 – Provisions, Contingent Liabilities and Contingent Assets
Post-Lecture #4
1. Check Moodle for the completed slide deck version of
this session.
2. Revisit what you need to.
3. Check Moodle Post-Lecture 4 area for the pre-seminar
task to complete and bring with you to Thursday’s
seminar #3.
4. You NEED to read. So far, you should have read
Chapters 1, 2 and 3.
5. Now add to this: Chapter 7 pp244 – 253.