FR – Preparation of financial

statements
Contents
Preparation of Single Entity Financial Statements - Part 1 .................................................... 2
Preparation of Single Entity Financial Statements - Part 2 .................................................... 7
IAS 7 Statement of Cash Flows - Module 1 .......................................................................... 13
INTRODUCTION ................................................................................................................ 13
ADVANTAGES AND DISADVANTAGES OF CASH FLOW STATEMENT ................................ 14
IAS 7 - Module 2 ................................................................................................................... 15
CASH FLOWS FROM OPERATING ACTIVITIES - DIRECT METHOD ..................................... 15
IAS 7 - Module 3 ................................................................................................................... 17
CASH FLOWS FROM OPERATING ACTIVITIES - INDIRECT METHOD: ................................ 17
IAS 7 - Module 4 ................................................................................................................... 19
CASH FLOWS FROM INVESTING ACTIVITIES ..................................................................... 19
IAS 7 - Module 5 ................................................................................................................... 21
CASH FLOWS FROM FINANCING ACTIVITIES: ................................................................... 21

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Preparation of Single Entity Financial Statements - Part 1
The single entity financial statements include the following:

 Statement of financial position

 Statement of profit and loss and other comprehensive income

 Statement of changes in equity

 Statement of cash flows

The questions on the preparation of single entity financial statements typically contain a
trial balance, which is a list of all accounts, and the notes containing a number of
adjustments. The financial statements have to be prepared by taking the balances from the
trial balance and adjusting them to arrive at the final values.

2
Example 1

The following trial balance relates to Clarion as at 31 March 2015: $000 $000
Equity shares of $1 each (note (i)) 30,000
Retained earnings – 1 April 2014 8,600
Other component of equity – share premium (note (i)) 5,000
8% loan notes (note (ii)) 20,000
Plant and equipment at cost (note (iii)) 77,000
Accumulated depreciation plant and equipment – 1 April 2014 19,000
Investments through profit or loss – value at 1 April 2014 (note (iv)) 6,000
Inventory at 31 March 2015 11,700
Trade receivables 18,500
Bank 3,900
Deferred tax (note (v)) 2,700
Trade payables 9,400
Environmental provision (note (iii)) 4,000
Revenue 132,000
Cost of sales 88,300
Administrative expenses 8,000
Distribution costs 7,400
Loan note interest paid 800
Suspense account (note (ii)) 5,800
Bank interest 300
Dividends paid 3,900
Investment income (note (iv)) 500
Current tax (note (v)) 400
231,600 231,600

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The following notes are also relevant:

(i) The equity shares and share premium balances in the trial balance above
include a fully subscribed 1 for 5 rights issue at $1·60 per share which was made
by Clarion on 1 October 2014.

(ii) On 31 March 2015, one quarter of the 8% loan notes were redeemed at par and
six months’ outstanding loan interest was paid. The suspense account
represents the double entry corresponding to the cash payment for the capital
redemption and the outstanding interest.

(iii) Included in property, plant and equipment is a major item of plant acquired on
1 April 2014.

The item had a cash cost $14 million, however, the plant will cause environmental damage
which will have to be rectified when it is dismantled at the end of its five-year life. The
present value (discounting at 8%) on 1 April 2014 of the rectification is $4 million. The
environmental provision has been correctly accounted for, however, no finance cost has yet
been charged on the provision.

No depreciation has yet been charged on plant and equipment which should be charged to
cost of

sales on a straight-line basis over a five-year life. No plant is more than four years old.

(iv) The investments through profit or loss are those held at 31 March 2015 (after
the sale below). They are carried at their fair value as at 1 April 2014, however,
they had a fair value of $6·5 million on 31 March 2015. During the year an
investment which had a carrying amount of $1·4 million was sold for $1·6
million. Investment income in the trial balance above includes the profit on the
sale of the investment and dividends received during the year.

(v) A provision for current tax for the year ended 31 March 2015 of $3·5 million is
required. The balance on current tax in the trial balance above represents the
under/over provision of the tax liability for the year ended 31 March 2014. At
31 March 2015, the tax base of Clarion’s net assets was $12 million less than
their carrying amounts. The income tax rate of Clarion is 25%.

4
Required:

(a) Prepare the statement of profit or loss for Clarion for the year ended 31 March 2015.

Solution:

Clarion – Statement of profit or loss for the year ended 31 March 2015

$’000
Revenue 132,000
Cost of sales (W1) -103,700
Gross profit 28,300
Distribution costs -7,400
Administrative expenses -8,000
Profit from operations 12,900
Finance costs (W2) -2,220
Investment income (W3) 1,000
––––––
Profit before tax 11,680
Income tax expense (W4) -3,400
Profit for the year 8,280

W1 – Cost of sales

Depreciation = $77,000 x 20%

Depreciation = $15,400

Cost of sales = $88,300 + 15,400

Cost of sales = $103,700

W2 – Finance cost
Loan interest = $800

Suspense account balance = $5,800

Loan notes balance = $20,000 x 25% = $5,000

Remaining finance costs = $800

Bank interest = $300

Environmental provision unwinding = $4,000 x 8% = $320

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Total finance cost = $800 + $800 + $300 + $320
Total finance cost = $2,220

W3 – Investment income

Investment income = $500 + ($6,500 - $6,000)

Investment income = $1,000

W4 – Income tax expense

Tax liability = Current tax – Overprovision

Tax liability = $3,500 - $400

Tax liability = $3,100

Increase in deferred tax = Temporary differences x Tax rate

Deferred tax = $12,000 x 25% = $3,000

Increase in deferred tax = $3,000 - $2,700

Increase in deferred tax = $300

Total tax = $3,400

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Preparation of Single Entity Financial Statements - Part 2
The single entity financial statements include the following:

 Statement of financial position

 Statement of profit and loss and other comprehensive income

 Statement of changes in equity

 Statement of cash flows

The questions on the preparation of single entity financial statements typically contain a
trial balance, which is a list of all accounts, and the notes containing a number of
adjustments. The financial statements have to be prepared by taking the balances from the
trial balance and adjusting them to arrive at the final values.

7
Example 1

The following trial balance relates to Clarion as at 31 March 2015: $1000 $1000
Equity shares of $1 each (note (i)) 30,000
Retained earnings – 1 April 2014 8,600
Other component of equity – share premium (note (i)) 5,000
8% loan notes (note (ii)) 20,000
Plant and equipment at cost (note (iii)) 77,000
Accumulated depreciation plant and equipment – 1 April 2014 19,000
Investments through profit or loss – value at 1 April 2014 (note (iv)) 6,000
Inventory at 31 March 2015 11,700
Trade receivables 18,500
Bank 3,900
Deferred tax (note (v)) 2,700
Trade payables 9,400
Environmental provision (note (iii)) 4,000
Revenue 132,000
Cost of sales 88,300
Administrative expenses 8,000
Distribution costs 7,400
Loan note interest paid 800
Suspense account (note (ii)) 5,800
Bank interest 300
Dividends paid 3,900
Investment income (note (iv)) 500
Current tax (note (v)) 400
231,600 231,600

The following notes are also relevant:

(i) The equity shares and share premium balances in the trial balance above
include a fully subscribed 1 for 5 rights issue at $1·60 per share which was made
by Clarion on 1 October 2014.

(ii) On 31 March 2015, one quarter of the 8% loan notes were redeemed at par and
six months’ outstanding loan interest was paid. The suspense account
represents the double entry corresponding to the cash payment for the capital
redemption and the outstanding interest.

(iii) Included in property, plant and equipment is a major item of plant acquired on
1 April 2014.

8
The item had a cash cost $14 million, however, the plant will cause environmental damage
which will have to be rectified when it is dismantled at the end of its five-year life. The
present value (discounting at 8%) on 1 April 2014 of the rectification is $4 million. The
environmental provision has been correctly accounted for, however, no finance cost has yet
been charged on the provision.

No depreciation has yet been charged on plant and equipment which should be charged to
cost of

sales on a straight-line basis over a five-year life. No plant is more than four years old.

(iv) The investments through profit or loss are those held at 31 March 2015 (after
the sale below). They are carried at their fair value as at 1 April 2014, however,
they had a fair value of $6·5 million on 31 March 2015. During the year an
investment which had a carrying amount of $1·4 million was sold for $1·6
million. Investment income in the trial balance above includes the profit on the
sale of the investment and dividends received during the year.

(v) A provision for current tax for the year ended 31 March 2015 of $3·5 million is
required. The balance on current tax in the trial balance above represents the
under/over provision of the tax liability for the year ended 31 March 2014. At
31 March 2015, the tax base of Clarion’s net assets was $12 million less than
their carrying amounts. The income tax rate of Clarion is 25%.

Required:

(a) Prepare the statement of profit or loss for Clarion for the year ended 31
March 2015.

(b) Prepare the statement of changes in equity for Clarion for the year ended 31
March 2015.

(c) Prepare the statement of financial position for Clarion as at 31 March 2015.

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Solution:

Clarion – Statement of profit or loss for the year ended 31 March 2015
$’000
Revenue 132,000
Cost of sales (W1) -103,700
Gross profit 28,300
Distribution costs -7,400
Administrative expenses -8,000
Profit from operations 12,900
Finance costs (W2) -2,220
Investment income (W3) 1,000
––––––
Profit before tax 11,680
Income tax expense (W4) -3,400
Profit for the year 8,280
Clarion – Statement of changes in equity for the year ended 31 March 2015

Share capital Share premium Retained earnings Total equity

$’000 $’000 $’000 $’000
Balance at 1 April 2014 25,000 2,000 8,600 35,600
Rights issue (W5) 5,000 3,000 8,000
Dividends paid (3,900) (3,900)
Profit for the year 8,280 8,280

Balance at 31 March 2015 30,000 5,000 12,980 47,980

Clarion – Statement of financial position as at 31 March 2015

Assets $’000 $’000
Non-current assets
Property, plant and equipment (77,000 – 19,000– 15,400) 42,600
Investments through profit or loss 6,500
Current assets Inventory 49,100
11,700
Trade receivables 18,500
Cash at bank 3,900 34,100

Total assets
83,200

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Equity and liabilities Equity
Equity shares of $1 each
30,000
Share premium 5,000
Retained earnings 12,980
Non-current liabilities 8% loan notes 47,980
15,000
Deferred tax 3,000
Environmental provision (4,000 + 320) 4,320 22,320

Current liabilities Trade payables

9,400
Current tax payable 3,500 12,900

Total equity and liabilities

83,200

W1 – Cost of sales

Depreciation = $77,000 x 20%

Depreciation = $15,400

Cost of sales = $88,300 + 15,400

Cost of sales = $103,700

W2 – Finance cost
Loan interest = $800

Suspense account balance = $5,800

Loan notes balance = $200,000 x 25% = $5,000

Remaining finance costs = $800

Bank interest = $300

Environmental provision unwinding = $4,000 x 8% = $320

Total finance cost = $800 + $800 + $300 + $320

Total finance cost = $2,220

W3 – Investment income

Investment income = $500 + ($6,500 - $6,000)

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Investment income = $1,000

W4 – Income tax expense

Tax liability = Current tax – Overprovision

Tax liability = $3,500 - $400

Tax liability = $3,100

Increase in deferred tax = Temporary differences x Tax rate

Deferred tax = $12,000 x 25% = $3,000

Increase in deferred tax = $3,000 - $2,700

Increase in deferred tax = $300

Total tax = $3,400

W5 – Rights issue

No. of new shares = 25,000 / 5

No. of new shares = 5,000

Share capital = $1 x 5,000

Share capital = $5,000

Share premium = $0.60 x 5,000

Share premium = $3,000

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IAS 7 Statement of Cash Flows - Module 1
INTRODUCTION

Objective of IAS 7: To provide users of financial statements with a basis to assess an entity’s
potential to generate cash, as well as its cash needs.

This objective is achieved by requiring preparers of financial statements to present historical

changes in cash and cash equivalents in a statement which classifies cash flows during the
period into those associated with:

1. Operating activities;

2. Investing activities; and

3. Financing activities.

Specific cash flows should be allocated to one of these three categories in a manner which
reflects the business of the reporting entity.

Note: A single transaction may comprise elements of cash flows which are classified
differently (e.g., repayment of the loan principal must be shown under cash flows from
financing activities, whereas the interest portion may be reported as an operating or
financing cash flow).

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

Remember: The statement of cash flows excludes any movements between cash on hand,
demand deposits, and cash equivalents, treating these as a component of the company’s
cash management activities rather than as part of its operating, investing or financing
operations.

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ADVANTAGES AND DISADVANTAGES OF CASH FLOW STATEMENT

The statement of cash flows presents the following advantages compared to the income
statement:

 A company’s potential to generate cash flows is more important than its ability to
generate earnings;

 The statement of cash flows may be used to assess the quality of profits generated, to
see what proportion of those profits actually turns into cash; and

 The statement of cash flows is much less prone to manipulation or subjective

judgement, and is not easily affected by accounting policy choices made by the
reporting entity.

On the other hand, the statement of cash flows has the following drawbacks:

 The information which it contains is historic and its use for forecasting or projection
purposes requires judgement and appropriate adjustments; and

 Short-term cash generation in some periods may have to be sacrificed if the company
grows, so a positive cash flow balance may not always be a sign of good management.

Some of the questions which ought to be asked when evaluating a company’s statement of
cash flows are:

 Are there signs of overtrading (e.g., a combination of high earnings but low cash flows
from operating activities, significant increases in inventories, receivables, and
payables)?

 Is cash from operating activities sufficient to sustain interest and dividend payments?

 Is the company selling non-current assets to maintain liquidity?

 Is the company issuing shares, taking on fresh loans or repaying them?

 Are investments in non-current assets sufficient to maintain operating capacity? This

may be assessed by comparing purchases of non-current assets with the level of
depreciation:

Purchases of non-current
assets >Depreciation Company is expanding
charge 
Purchases of non-current
assets <Depreciation The company’s non-current asset base is diminishing
charge 

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IAS 7 - Module 2
CASH FLOWS FROM OPERATING ACTIVITIES - DIRECT METHOD

Operating activities are defined as the principal revenue-producing activities of the entity
and also include all other activities which are not classified as investing or financing.

Information on cash flows from operating activities provides a critical indicator of the extent
to which a company is able to generate cash flows, which should allow it to make
investments with the aim of maintaining or even increasing its operating capacity, service its
debts, and pay dividends to shareholders.

Moreover, information about the components of historical operating cash flows may assist
analysts in the process of forecasting future operating cash flows, especially when used in
conjunction with other financial statements' information.

The standard provides the following typical examples of cash flows from operating activities:

 Cash receipts from the sale of goods and the rendering of services;

 Cash receipts from royalties, fees, commissions and other revenue;

 Cash payments to suppliers for goods and services;

 Cash payments to employees;

 Cash payments or refunds of income taxes, unless they can be specifically identified
with financing or investing activities; and

 Specific examples of cash flows which relate to the operations of insurance companies
and the holders of some derivatives contracts.

As you know, cash flows from operating activities may be reported using the direct or
indirect methods.

Under the direct method, major classes of gross cash receipts and gross cash payments are
presented. In fact, IAS 7 encourages preparers of financial statements to apply the direct
approach, on the grounds that it provides information which is more useful in making
projections of future performance than is the case if the indirect method is used.

The information about those major categories of gross cash receipts and payments may be
derived either: 1) From the cash records of the company; or

2) By adjusting items recognised in the income statement, such as sales or cost of goods
sold, for the following:

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 a) Changes in the balance of inventories, receivables, and payables:

Cash inflow/outflow from changes in Receivables = Opening balance + Credit sales - Closing
balance

Cash inflow/outflow from changes in Inventory = Closing balance + Cost of sales - Opening
balance Cash inflow/outflow from changes in Payables = Opening balance + Purchases -
Closing balance

b) Other non-cash items; and

c) Those items whose cash effect should be included under investing or financing
activities.

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IAS 7 - Module 3
CASH FLOWS FROM OPERATING ACTIVITIES - INDIRECT METHOD:

The indirect method arrives at exactly the same value for net cash flows from operating
activities as under the direct approach but does so by working back from amounts reported
in the income statement. This is typically achieved by adjusting reported profit or loss for
the effect of:

 Changes in inventories, as well as trade receivables and payables during the period;
 Non-cash items such as depreciation, provisions, deferred taxes, unrealised foreign
currency gains and losses, and undistributed profits of associates;
 All other items for which the cash effects are classified under investing or financing cash
flows.

To utilise the indirect method, we need to start with the reported net income. Then, we will
apply a series of standardised adjustments, with the goal of arriving at the net cash flow
from operating activities:

Description $’000
Profit before tax (net profit) X
Adjustments
Finance cost X
Investment income (X)
Depreciation charge X
Loss/(profit) on disposal of NCA X/(X)
(Increase)/decrease in inventory (X)/X
(Increase)/decrease in trade receivables (X)/X
Increase/(decrease) in trade payables X/(X)
Net cash flow from operating activities AAA

Each of the adjustments posted to net income under the indirect method has the aim of
either:

 Eliminating the impact of a non-cash item, such as depreciation;

 Eliminating the effect of a transaction which should be reported under a different
heading, as was the case with the gain on disposal of the fixed asset;
 Adjusting the level of an item of income or expense to its true cash amount.

17
You should remember the direction of the adjustments which need to be made to net
income to take account of the changes to trade receivables, inventory and trade payables:

Rules for adjustments

Trade
receivables  Balance decrease = Add  Balance increase = Less

Inventory
 Balance decrease = Add  Balance increase = Less

Trade payables
 Balance
Less
decrease =
 Balance increase = Add

 Rising trade receivables are associated with customers not paying, hence the negative
adjustment, whereas falling receivables are typically associated with the receipt of cash
which fits in with the positive sign of the adjustment;
 An increase in the inventory balance may be associated with cash being spent, whereas
a fall, would generally be interpreted as having a positive impact on cash flow;
 An increase in trade payables may be associated with the company taking longer to pay
its suppliers, giving rise to a cash saving and thus necessitating a positive adjustment,
whereas the opposite would be true if payables are falling.

18
IAS 7 - Module 4
CASH FLOWS FROM INVESTING ACTIVITIES

IAS 7 defines investing activities as the acquisition and disposal of long-term assets and
other investments not included in cash and cash equivalents (e.g., the purchase or sale of a
long-term bond).

The standard provides the following examples of cash flows from investing activities:

 Payments to acquire, and receipts from the sale of, property, plant and equipment,
intangibles and other long-terms assets (e.g., items of investment property).

 Payments to acquire, and receipts from the sale of, equity and debt instruments of
other entities (e.g., the cash used to buy shares in other companies, invest in their
bonds, or extend loans to them, providing that such instruments do not meet the
definition of a cash equivalent).

 Payments for and receipts from derivative contracts (e.g., forwards, futures, options,
and swaps, under the condition that these contracts are not held for trading purposes).

Cash flows from investing activities

Purchase of NCA (X)
Proceeds from sale of NCA X
Interest received X
Dividends received X
Net cash flow from investing activities X

Remember: Only those cash outflows which result in the recognition of an asset in the
statement of financial position are eligible for inclusion under investing activities.
Accordingly, an expenditure that is recognised in P&L as it is incurred, for example,
maintenance expenses in relation to items of property, plant and equipment, cannot be
classified as investing cash flows.

The standard notes that:

 Interest and dividends paid may be classified under either operating or financing
activities; whereas

 Interest and dividends received may be included in either operating or investing cash
flows.

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From an analytical perspective, the requirement to show, separately from other cash flows,
those cash flows which are associated with investing, allows readers of financial statements
to make important judgements with regard to:

 Whether the company is making sufficient investments in non-current assets, so as to

maintain its future revenue-generating potential; and

 Whether it is not resorting to asset disposals to generate funds, so as to fill the cash gap
left by inefficient operations and the need to repay providers of external financing.

20
IAS 7 - Module 5
CASH FLOWS FROM FINANCING ACTIVITIES:

IAS 7 defines financing activities as those activities which result in changes in the size and
composition of the contributed equity and borrowings of the company.

Typical examples of cash flows which ought to be classified under financing are:

 Proceeds from issuing shares or other equity instruments (e.g., warrants);

 Payments to owners to acquire or redeem the entity’s shares (e.g., as part of share buy-
back transactions);
 Proceeds from issuing, and outflows to repay, debentures, that is unsecured debt
instruments, loans, notes, bonds and other short or long-term borrowings;
 Payments by a lessee for the reduction of the outstanding liability relating to a finance
lease.

As you remember, IAS 7 allows preparers of financial statements a choice with regard to which
segment of the statement of cash flows to use to present interest and dividend payments.
These may be classified under either operating or financing activities.

The standard also requires the total amount of interest paid during a reporting period, to be
disclosed in the statement of cash flows, irrespective of whether it has been expensed to profit
or loss or capitalised in accordance with IAS 23 Borrowing costs.

21