CHAPTER 1

PARTNERSHIP ACCOUNTS
Objective

After studying this chapter the student should be able to prepare partnership accounts and
be able to account for changes in a partnership such as:

(a) When a partner leaves, dies or retires

(b) When a new partner enters the partnership
(c) When existing partners change their profit sharing ratio
(d) Amalgamation of partnership
(e) Conversion of partnership to limited companies

1 THE BASIC PRINCIPLES OF PARTNERSHIP ACCOUNTING

1.1 Accounting changes

The main bookkeeping changes introduced by partnerships compared to sole

trader are:

(a) The income statement has a separate section called the appropriation
account, which shows how the net profit is divided among the
partners.
(b) The capital employed in the business is usually divided into Partners’
capital and current accounts, the balances on which are shown
separately in the balance sheet.

1.2 Appropriation account

This account is credited with the net profit brought forward from the profit and
loss account section, and on the debit side shows the division of that profit
between the partners. This division is normally in respect of the three factors of
production which the partners bring into the partnership

(a) Capital for which they receive interest on capital

(b) Labour for which they may be credited with salary.
(c) Risk-taking – for which they are credited with a share of the residual
profits

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 Example

Using the following information complete the appropriation account

A B
Fixed capitals K6m K4m
Salaries allowed K1.5m K0.5m
Profit sharing ratios 2 1
Interest on capitals allowed at rate of 10%
Net profit available for appropriation K2.1m

Solution
A and B Appropriation Account
K’000 K’000
Current account Net profit b/d 2,100
Interest on capitals Current accounts
A 600 Share of loss
B 400 A 600
1,000 B 300
Salaries 900
A 1,500
B 500
2,000 ____
3,000 3,000

All partners’ entitlements (in the form of interest, salaries, profit shares etc) must
be dealt with through the appropriation account and NEVER charged in the profit
and loss account section in arriving at the net profit.

The appropriation account may also be constructed in the form of a statement.

Using the data in the example:
Total A B
K’000 K’000 K’000
Interest on capital 1,000 600 400
Salary 2,000 1,500 500
Share of profit/(loss) (900) (600) (300)
Total 2,100 1,500 600

1.3 Interest on drawings

A partnership agreement may contain a provision for a notional interest charge on

the drawings by each partner. The interest charges are merely a negative profit
share – they are a means by which total profits are allocated between the partners.
The reason for an interest on drawings provision is that those partners who draw
more cash than their colleagues in the early part of an accounting period should
suffer a cost or penalty.

1.4 Capital and current accounts

2
 It is usual to divide the proprietors’ capital employed between their capital and
current accounts. The basis of the division is that capital accounts represent net
assets which the partners intend to retain in the business, while current accounts
represent net assets which they consider they can withdraw. This division is a
matter for agreement between the partners in the partnership deed unless
otherwise directed, the following are posted

(a) to capital accounts

(i) Goodwill adjustments

(ii) Profits or losses arising on the revaluation of fixed assets
(iii) Capital sums introduced by partners

(b) to Current accounts

(i) Interest on capital

(ii) Partners’ salaries
(iii) Profit shares
(iv) Drawings
(v) Adjustments relating to profits
(vi) Interest on drawings

1.5 The provision of the Partnership Act

The essence of a partnership is the mutual agreement of the partners. The

Partnership Act 1890 allows partners wide powers in determining their
relationships with each other. Partnership agreements may be written or oral,
although the former are preferable in order to prevent misunderstanding or
disputes. However, in the absence of a specific agreement, section 24 of the Act
lays down the following rules:

(i) Partners’ capitals to be contributed equally.

(ii) No partner is entitled to interest on capital.
(iii) No partner is entitled to a salary.
(iv) Profits and losses, both of capital and revenue nature are to be shared
equally.
(v) Any loan made to the business by a partner is to carry interest at the rate of
5%

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1.6 Example
You are provided with the following information regarding the partnership
of Meleki, Kayuma and Besa.

(a) The trial balance at 31 December 20X5

Dr Cr
K’000 K’000
Sales 50,000
Inventory at 1 January 20X5 6’000
Purchases 29,250
Carriage inwards 250
Carriage outwards 400
Payables (Creditors) 4,000
Cash at bank 3,900
Current accounts:
Meleki 900
Kayuma 750
Besa 1,350
Capital accounts:
Meleki 2,000
Kayuma 5,000
Besa 6,000
Drawings:
Meleki 2,000
Kayuma 3,000
Besa 5,000
Sundry expenses 2,800
Receivables (Debtors) 13,000
Shop fittings:
Cost 8,000
Accumulated Depreciation ______ _1,600
73,600 73,600

(b) Closing inventory is valued for accounts purposes at K5.5m.

(c) Depreciation of K800, 000 is to be provided on the shop fittings.

(d) The profit sharing arrangements are as follows:

(i) Interest on capital is to be provided at a rate of 10 % per annum

(ii) Meleki and Besa are to receive salaries of K3m and K4m per
annum respectively.

(iii) The balance of profits or loss is to be divided between Meleki,

Kayuma and Besa in the ratio of 3:8:4.

You are required to prepare final accounts together with current accounts of the
partners.

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1.7 Solution

Meleki, Kayuma and Besa

Income statement for the year ended 31 December 20X5

K’000 K’000
Sales 50,000
Inventory at 1.1.20X5 6,000
Purchases 29,250
Carriage inwards 250
35,500
Less: Inventory at 31.12.20X5 5,500
30,000

Gross profit 20,000

Sundry expenses 2,800
Carriage outwards 400
Depreciation 800
4,000
Net Profit 16,000
P & L Appropriations (Allocated to):
Meleki 4,900
Kayuma 4,500
Besa 6,600
16,000

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 Balance sheet as at 31 December 20X5

Cost Acc Dep’n Net

K’000 K’000 K’000
Non – current assets:
Shop fittings 8,000 2,400 5,600
Current assets
Inventory 31.12.20X6 5,500
Receivables 13,000
Cash 3,900
22,400
28,000
Capital and liabilities
Capital accounts
Meleki 4,000
Kayuma 5,000
Besa 6,000
15,000
Current accounts
Meleki 3,800
Kayuma 2,250
Besa 2,950
9,000
Current liabilities
Payables 4,000
28,000

Partners’ current accounts

Meleki Kayuma Besa Meleki Kayuma Besa

K’000 K’000 K’000 K’000 K’000 K’000
20X5 20X5
Drawings 2,000 3,000 5,000 1 Jan. Balance
31 Dec Balance b/d 3,800 2,250 2,950 b/d 900 750 1,350
P&L approp 4,900 4,500 6,600
5,800 5,250 7,950 5,800 5,250 7,950
20X6
Balance b/d 3,800 2,250 2,950

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2 ADMISSION AND RETIREMENT OF PARTNERS.

2.1 ADMISSION OF A PARTNER

When a prospective partner is due to be admitted to partnership, the old partners

will wish to ensure that they receive their full entitlements to partnership profits
to date of change of the partnership composition, so will the new partner
not wish to bear any losses incurred during the period prior to admission.

Accounting Treatment

The partnership assets including goodwill will have to be revalued and new values
introduced and possibly eliminated later from the partnership books.

Example
A and B, sharing profits 1:1, decide to admit C into partnership at 1 January 2004,
and subsequently to share profits in the ratio A 4 : B 3 : C 3

Balance sheet at 1 January 2004 before revaluation

Cost Dep’n NBV
K’000 K’000 K’000
Non current assets
Freehold property 5,000 - 5,000
Plant and machinery 1,300 200 1,100
6,300 200 6,100
Current assets:
Inventory 4,000
Receivables 3,000
Less: Provision 100
2,900
Cash 3,000
9,900
16,000
Capital and liabilities
Partners’ capital accounts
A 8,000
B 6,000
14,000
Current liabilities
Trade account payables 2,000
16,000
The following valuations have been agreed between A, B and C:

K’000
Freehold property 8,000
Goodwill (To remain in the books)
5,000

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 Plant and machinery 900
Inventory 3,600
Receivables 2,700
Payables At book value
C is to introduce cash capital of K2,000,000
Required

Prepare the necessary ledger accounts in the books of the partnership to reflect the
above arrangements.

Solution

Revaluation account
K’000 K’000
Losses on revaluation and Profits on revaluation:
revaluation expenses: Freehold 3,000
Plant and machinery Goodwill 5,000
depreciation 200
Inventory 400
Bad debt provision 200
Profit on revaluation:
A (1) 3,600
B (1) 3,600
7,200
8,000 8,000

Partners’ capital accounts

A B C A B C
K’000 K’000 K’000 K’000 K’000 K’000
Balance c/d 11,600 9,600 2,000 Balances b/d 8,000 6,000
Revaluation
Profit 3,600 3,600
Cash introduced 2,000
11600 9,600 2,000 11,600 9,600 2,000

Note: in effect this case, where effect has been given to a full revaluation, any
cash introduced by C is credited to his capital account.

The balance sheet after revaluation would appear as follows:

Cost Dep’n NBV

K’000 K’000 K’000
Non-current assets
Goodwill 5,000 5,000
Freehold property 8,000 - 8,000
Plant and machinery 1,300 400 900
14,300 400 13,900
Current assets

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 Inventory 3,600
Receivables 3,000
Less: Provision 300
2,700
Cash 5,000
11,300
25,200
Capital and liabilities
Partners Capital accounts:
A 11,600
B 9,600
C 2,000
Current liabilities
Trade account payables 2,000
25,200

3 RETIREMENT OR DEATH OF A PARTNER

Changes in partnership composition require a new partnership agreement. Legally

the old partnership is dissolved and new partnership created. However it is more
realistic from accounting point of view to make appropriate adjustments in the
books rather than to close them off and start afresh.

Accounting treatment

The exiting partner’s share of partnership assets must be calculated and

transferred to him or his personal representatives. Assets will have to be revalued
and goodwill taken into account.

Example

B, H and S have been in partnership for many years. B retired from the
partnership on 1 July. At 30 June the summarized balance sheet showed the
following position:
K’000 K’000
Sundry assets 27,296
Partners’ accounts
Capital accounts:
B 12,000
H 8,000
S 3,000
Current account:
B 1,735
H 2,064
S 497
27,296

Note: It is assumed that the current account balances reflect profit shares and
drawings up to 30 June. At that date the balances on B’s capital account and

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 currents (K13,735) should be transferred to a loan account and regarded as a
liability of the partnership. A balance sheet at 1 July would then appear as
follows:
K’000
Sundry assets 27,296
Less: Loan account – B 13,735
Net assets 13,561

Partners’ accounts
Capital accounts: H 8,000
S 3,000
Current account: H 2,067
S 497
13,561
B is now a creditor of the partnership as he is no longer a partner

4 GOODWILL
Definition
There are many definitions of goodwill, most generally accepted is:

Goodwill is the difference between the value of a business as a whole and the fair
value of it separable net assets.
Other definitions include:

i) Excess of the price paid for a business over the market value of its
individual assets and liabilities.

ii) The value of the business community’s attitude towards the firm

Sources of goodwill

Goodwill may arise from a large number of sources.

Example:

i) Quality of goods

ii) Reputation of owners

iii) Advantageous patents or trade marks

iv) Site monopoly or advantage

When goodwill occurs in partnership it gives rise to two problems:

i) That of Valuation according to the rules agreed between partners

ii) That of recording the goodwill, when change such as admission,

retirement, or death of partner is taking place.

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 Valuation of goodwill

There are several methods in practice used to quantify the value of goodwill. Most
of the methods are arbitrary, and adopted by the custom of the trade or profession.
In all cases the method of valuation must be agreed upon by the partners.

Some of the methods that may be used are:

a) A given number of years purchase of the gross income – this is rather

arbitrary as the gross income does not necessarily give any
indication of the profitability of a business. This method is
frequently used by professional practices e.g.,
accountants, solicitors, etc.

b) A given number of years purchase of the average annual profits – the

average past profits being taken as a rough guide to future

maintainable profits. This again can be arbitrary as it pays no attention to

the trend of those past profits.

c) The excess of the value of the business on a going-concern basis over the
value of the net tangible assets – this is probably the most
satisfactory method as goodwill is really only the balancing
figure between the price a purchaser would pay for the whole
business, and the value of the net tangible assets acquired.

d) A given number of year’s purchase of the average weighted annual profits

– this method takes into account the trend of profits by attaching
greater importance to recent results. It is computed as follows:

Sum of annual profits x Weighted factors

Sum of the weights

Example

There are two firms, A & B which have made profits as follows:
A B
K’000 K’000
Profits in year 1 30,000 10,000
Profits in year 2 20,000 20,000
Profits in year 3 10,000 30,000
60,000 60,000

What are the annual weighted average profits applying a factor of 3 to the
most recent year, 2 to year 2 and 1 to year 1?

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 Solution

In both case the average profits are K60m = K20m.

3
By applying weighting factors the average weighted profits can be calculated:
A B
K’000 Wt factor K’000 K’000 Wt factor K’000
Year 1 30,000 x 1 = 30,000 10,000 x 1 = 10,000

Year 2 20,000 x 2 = 40,000 20,000 x 2 = 40,000

Year 3 10,000 x 3 = 30,000 30,000 x 3 = 90,000
6 100,000 6 140,000

Weighted average K100m = K16.667m K140m = K23.333m

6 6

On this basis B’s goodwill is clearly more valuable as its profits are rising, while
those of A are falling.

Elimination of goodwill

When goodwill has been determined or arisen, the partners must decide what to
do with it. There three main ways to treat goodwill.

a) Retain goodwill in the accounts indefinitely as an intangible asset on the

basis that the total goodwill of a business tends to increase rather
decrease and so write off is unnecessary.

b) Write off goodwill over a period of years on the basis that goodwill has a
limited life and is a cost to be offset against future profits.

c) Write off goodwill immediately on the grounds of prudence. Since

goodwill is written off it never appears in the balance sheet.

5 AMALGAMATION OR MERGER OF TWO SOLE TRADERS

AMALGAMATION meaning:

Sole traders amalgamating (joining) to form a partnership,

or
Sole trader amalgamating with existing partnership,
or
Two partnership amalgamating to form a new partnership

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 Accounting treatment:

Similar to admission of partner. There are three basic steps for amalgamation.

Step 1

Each trader will record their capital profit or loss accruing to him at the date of the
merger. Values will be placed on the tangible net assets and goodwill of each
trader’s business, the values being incorporated into traders’ books by use of
revaluation account. Balancing figure in the revaluation account will be
transferred to traders’ capital accounts.

Step 2

Any assets not being taken over by the partnership are removed from traders’
books by transferring the book value of the assets to the debit of the trader’s
capital account.

Step 3

The separate books can now be merged at agreed values. The partnership assets
will be the sum of the assets of the two sole traders and each person’s capital
account will be their opening balance of capital in the partnership.

Note

If goodwill is not to appear as an asset in the balance sheet, the combined amounts
needs to be written off against each partner’s capital account in new profit sharing
ratio.

Example
A and B, trading as AB & Co. and sharing profits and losses 1:1, agree to
amalgamate their partnership with the firm of CD & Co, whose partners C and D
share profits 4:1 respectively, to form X & Co.
The Balance sheets of the two firms at that date of amalgamation were as follows:

AB CD
K’000 K’000
Non-Current assets
Land 10,000
Plant and Machinery 4,000 7,000
Motor vehicles (partners) 3,000
17,000 7,000
Current assets
Inventory 4,000 3,000
Trade accounts receivables 2,000 1,000
Cash at bank 2,000 4,000
25,000 15,000

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Capital and liabilities
Loan from F 2,000
Current liabilities
Trade account payables 5,000 6,000
Capital accounts:
A 7,000
B 8,000
C 3,000
D 3,000
Current accounts:
A 2,000
B 1,000
C 2,000
D 1,000
Total capital and liabilities 25,000 15,000

X & Co was to take over all the assets and liabilities of the partnerships except:

(a) F’s loan for which A agreed to take over responsibility;

(b) A and B were to take over their own cars valued at K1, 000,000

(c) The cash of the new firm was to be K3, 000,000 transferred from the old
firms.

The following were the agreed values placed on the assets of the old firms:

AB CD
K’000 K’000
Goodwill 9,000 3,000
Land 14,000
Plant and Machinery 3,000 6,000
Inventory 4,000 2,000
Trade accounts receivables 2,000 1,000

Trade account payables were taken over at their book value.

Profit sharing ratios in the new firm was to be 2:2:1:1 between A: B: C: D and
capital accounts were to be in the same ratio, with no initial balances on current
accounts. The new firm was to commence with capital of K24m.

Goodwill was not to appear in the new firm’s balance sheet.

You are required

(a) to prepare the balance sheet of X & Co immediately following the

amalgamation:

(b) to prepare the closing entries in the books of AB & Co and CD & Co.

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Solution
(a) X & Co Balance Sheet after amalgamation
K’000 K’000

Non-current assets:
Land 14,000
Plant and Machinery 9,000
23,000
Current assets:
Inventory 6,000
Trade accounts Receivables 3,000
Cash 3,000
12,000
35,000
Capital and liabilities
Capital account:
A (2) 8,000
B (2) 8,000
C (1) 4,000
D (1) 4,000
Current liabilities
Trade account payables 11,000
Total capital and liabilities 35,000

(b) Books of AB & Co

Revaluation account
K’000 K’000
Plant and Machinery
- loss 1,000 Goodwill – profit 9,000
Motor vehicles – loss 1,000 Land – profit 4,000
Partner’s accounts-
Profit on revaluation:
A 5,500
B 5,500
11,000
13,000 13,000

Motor vehicles account

K’000 K’000
Balance b/d 3,000 Partners accounts:
A 1,000

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 B 1,000
Revaluation loss 1,000
3,000 3,000

Plant and Machinery account

K’000 K’000
Balance b/d 4,000 Revaluation loss 1,000
Transferred to new firm 3,000
4,000 4,000

Land account
K’000 K’000
Balance b/d 10,000 Transferred to new firm 14,000
Revaluation profit 4,000
14,000 14,000

Partners’ accounts
A B A B
K’000 K’000 K’000 K’000
Motor vehicles 1,000 1,000 Balances b/d:
Balances c/d to Capital accounts 7,000 8,000
New firm 12,000 12,000 Current accounts 2,000 1,000
Cash adjustment F’s loan 2,000 -
In new firm Profit on revaluation 5,500 5,500
(missing figure) 3,500 1,500
16,500 14,500 16,500
14,500

Books of CD & Co

Revaluation account
K’000 K’000
Plant and Machinery- loss 1,000 Goodwill – profit 3,000
Inventory – loss 1,000
Partners’ accounts –
Profit on revaluation:
C (4) 800
D (1) 200
1,000
3,000 3,000

Partners’ accounts
C D C D
K’000 K’000 K’000 K’000
Balances c/d to Balances b/d
New firm 6,000 6,000 Capital accounts 3,000 3,000
Current accounts 2,000 1,000

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 Profit on revaluation 800 200
Cash adjustment in
New firm (missing
_ Figure) 200 1,800
6,000 6,000 6,000 6,000

WORKINGS
Books of new firm
Partners’ capital accounts
A B C D A B C D
K’000 K’000 K’000 K000 K’000 K’000 K’000 K,000
Goodwill written Balance b/d
off in new profit from old firm
sharing ratio 4,000 4,000 2,000 2,000 (missing
Balance c/d figure) 12,000 12,000 6,000 6,000
Per balance sheet
(total capital K24m) 8,000 8,000 4,000 4,000
12,000 12,000 6,000 6,000 12,000 12,000 6,000 6,000

Cash account
K’000 K’000
Balance b/d from books of :
AB & Co 2,000 A’s account 3,500
CD & Co 4,000 B’s account 1,500
C’s account 200 Balance c/d per balance sheet 3,000
D’s account 1,800
8,000 8, 000

6 DISSOLUTION OF PARTNERSHIP

6.1 Reasons for dissolution.

 Possible reasons for dissolution include:

 Death or retirement of a partner
 Disagreement among the partners
 Continuing trading losses
 Completion of the purpose for which the partnership was formed

Whatever the reason, accounting treatment is the same.

6.2 Objective of dissolution

The objective is to dispose of the partnership assets, pay off the liabilities and
distribute the balance to the partners according to their entitlements.

6.3 Procedure

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a) All assets (except cash) and liabilities are transferred to realization account
at their book value.
b) Each partner’s current account is cleared to his capital. The distinction
between the two is irrelevant at this stage.
c) As assets are sold, liabilities settled, double entry is made between the
Realisation account and the cash account. Any realization expenses
are debited to realization account. If partners take over assets,
this fact is recorded in their accounts by crediting the
realization account with assets taken over.
d) When all assets are disposed off and all liabilities met, the balance on
realisation is transferred to partners’ accounts in their profit
sharing ratios.

e) Finally total amount due to the partners should equal the cash balance. The
cash is distributed to partners and the partnership is over.

Example

Mwamba, Banda and Chanda share profits 4:3:3. They agree to dissolve their
partnership at the end of the financial year, when the balance appeared as follows:

K’000 K’000
Fixed assets, at cost less depreciation:
Freehold 4,000
Plant and Machinery 1,500
Motor vehicles (three cars) 1,600
7,100
Current assets:
Stock 5,000
Debtors 2,500
Cash 1,500
9,000
Current liabilities 2,100
6,900
Loan account – Mulenga (2,000)
12,000
Partners’ accounts:
Mwamba Banda Chanda
K’000 K’000 K’000
Capital 4,000 3,000 2,000 9,000
Current 1,500 1,000 500 3,000

5,500 4,000 2,500 12,000

The following are sold for cash:
K’000
Freehold, for 8,000
Plant and Machinery, for 1,300
Stock, for 4,300
13,600

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 The creditors are settled for K2m
Chanda takes over the debtors at an agreed value of K2.2m.
Mwamba takes over Mulenga’s loan at its book value.
Mwamba, Banda and Chanda take over the cars at the following valuations:
Mwamba K600,000
Banda K800,000
Chanda K400,000
Realisation expenses are K200,000

Required

Prepare the ledger accounts to close the partnership books.

Solution
Realisation account (outline)
Dr CR
Book value of assets x Sale or disposal proceeds:
Realisation expenses x (i) cash sales x
Balance of Profits shared (ii) Partners’ accounts - assets
In Profit Sharing Ratio x taken over x

Realisation account
K’000 K’000
Freehold account 4,000 Cash – sale proceeds 13,600
Plant and Machinery a/c 1,500 Discount received on
Motor vehicles a/c 1,600 on creditors 100
Stock a/c 5,000 Partners’ accounts – assets
Debtors a/c 2,500 taken over:
Cash – realisation expenses 200 Chanda debtors 2,000
Partners’ accounts - Mwamba motor car 600
Profit on realisation: Banda motor car 800
Mwamba 40% 1,160 Chanda motor car 400
Banda 30% 870
Chanda 30% 870
2,900
17,700 17,700

Partners’ accounts
M B C M B C
K’000 K’000 K’000 K’000 K’000 K’000
Debtors taken Balance b/d:
Over 2,000 Capital accounts 4,000 3,000 2,000
Motor cars Current accounts 1,500 1,000 500
Taken over 600 800 400 Mulenga’s loan a/c 2,000
Cash to Realisation
Settle 8,060 4,070 770 a/c – profit 1,160 870 870
8,660 4,870 3,370 8,660 4,870 3,370

Creditors’ account
K’000 K’000

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 Cash 2,000 Balance b/d 2,100
Realisation a/c -
Discount received
On settlement 100 _____
2,100 2,100_
Mulenga’s loan account
K’000 K’000
Mwamba’s partner a/c 2000 Balance b/d. 2,000

Cash account
K’000 K’000
Balance b/d 1,500 Creditors 2,000
Sale proceeds to realisation Realisation expenses 200
Account: Partners accounts to
Freehold 8,000 Settle:
Plant & Mwamba 8,060
Machinery 1,300 Banda 4,070
Stock 4,300 Chanda 770
13,600
15,100 15,100

7 CONVERSION OF PARTNERSHIP TO A LIMITED COMPANY

A partnership will often be converted into a limited when the business becomes
quite large.

7.1 Closing off a set of partnership books on sale or conversion

to limited company.
This exercise is very similar to dissolution except that:

a) Most of the assets are sold to one buyer and this might include
some or all of the cash;
b) The assets are not sold for cash alone but a mix of shares,
debentures and/ or cash.

Accounting is for two basic operations:

The sale of the assets to the company

use a realization account
Dr New Company account
Cr Realisation Account
With the purchase consideration

When the company pays the purchase consideration

Dr Cash
Shares in new company (at issue value)
Cr New company account
- this is merely the discharge of a debt.

The distribution of the purchase consideration between the partners:

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 Transfer shares and debentures to partners in the agreed proportions.
Dr Partners’ accounts
Cr Shares in new company (at issue value)
Debentures in new company (at issue value)

(ii) Finally transfer cash in or out to close down the

partnership books

7.2 Opening appropriate accounts in the company’s records

The company will place values on the assets it acquires. If the purchase
consideration exceeds value of the net tangible assets, the surplus will be treated
as goodwill because it represents the premium paid to acquire those assets. If the
reverse is the case (ie, negative goodwill) the amounts will be credited to a non-
distributable reserve.

The accounting treatment centres around a personal account for the vendor ie, the
old partnership and again comprises two basic operations:

(a) The purchase of the assets:

Dr Sundry assets at agreed

Cr Vendor (partnership) account

(b) The discharge of purchase consideration:

Dr Vendor (partnership) account with elements of purchase

consideration
Cr Share capital, share premium, debentures, cash, etc.

Any balance on the vendor’s account is then transferred to goodwill or

capital reserve

7.3 Preparing final accounts covering the year in which sale or conversion takes
place.

A and B trade as partners sharing profits 3 : 2 and decide to sell their business to
X Ltd which agree to pay K16m in the form of :
5,000 K1, 000 shares at a premium of K200
6,000 K1, 000 8% debentures issued at K900,
Cash of K4.6m
X Ltd is to acquire all the assets of the partnership with exception of the cash
and the two motor vehicles which A and B are to take over at values of K900,000
and K600,000 respectively.

A and B agree that their accounts are to be settled so that:

(a) they take the ordinary shares in X Ltd in profit sharing ratio;
(b) the debentures are to be taken in the ratio of their capital accounts;
(c) balance settled by cash transfer.

21
 Balance sheet of A and B at date of take-over
Cost Dep’n NPV
K’000 K’000 K’000
Non Current assets
Freehold property 4,000 4,000
Fixtures and fittings 1,000 500 500
Motor vehicles 2,500 500 2,000
7,500 1,000 6,500
Current assets
Inventory 4,000
Receivables 2,100
Less: Provision 100
2,000
Cash 1,000
7,000
Total assets 13,500

Capital and liabilities

Capital accounts
A 6,000
B 3,000
9,000
Current accounts
A 1,500
B 1,500
3,000
Current liabilities
Payables 1,500
13,500

You are required:

(a) to show the ledger accounts reflecting the above transactions in the books
of A and B

(b) to show the journal entries in the books of X Ltd to reflect the take-over
assuming that the partnership assets are taken over at book value
with the exception of the freehold which is to be valued at K7m and
the receivables at K1.8m;

(c) to construct the opening balance sheet of X Ltd.

7.4 Solution

Number in brackets refer to sequence of entries.

(a) Books of A and B

22
 Realisation account
K’000 K’000
(1) Freehold property 4,000 (2) Payables 1,500

(1) Fixtures and fittings 500 (3) X Ltd account

(1) Motor vehicles 2,000 monetary value of
(1) Inventory 4,000 purchase consideration:
(1) Receivables 2,000 shares
Partners accounts- 5000 at K1200 6,000
Profit on sale: Debentures
(5) A (3) 3,900 6,000 at 900 5,400
(5) B (2) 2,600 Cash 4,600
6,500 16,000
Partners’ accounts
- motor vehicles
taken over:
(4) A 900
(4) B 600
1,500
19,000 19,000

Partners’ accounts
A B A B
K’000 K’000 K’000 K’000

(4) Realisation account Balances b/d:

Motor vehicles Capital accounts 6,000 3,000
taken over 900 600 Current accounts 1,500 1,500
X Ltd account- 7,500 4,500
discharge of (5) Realisation
purchase account – profit
consideration: on sale 3,900 2,600
(6) Shares 3 : 2 3,600 2,400
(6) Debentures 2 : 1 3,600 1,800
(8) Cash 3,300 2,300

11,400 7,100 11,400 7,100

Cash account
K’000 K’000
Balance b/d 1,000 Final settlement to close
(7) X Ltd 4,600 down books:
(8) A 3,300
(8) B 2,300
5,600 5,600

New company’s account – X Ltd

K’000 K’000
(3) Realisation account - Discharge of purchase

23
 Monetary value of consideration to
Purchase consideration 16,000 partners’ accounts:
(6) Shares in X Ltd 6,000
(6) Debentures in X Ltd 5,400
(7) Cash 4,600
16,000 16,000

(b) X Ltd Journal

K’000 K’000
Freehold property 7,000
Fixtures and fittings 500
Inventory 4,000
Receivables 2,100
Bad debt provision 300
Payables 1,500
A and B Partnership accounts 16,000

Goodwill – balancing figure 4,200

17,800 17,800

Purchase of K11.8m specific net assets from A and B for K16m, giving
rise to K4.2m goodwill.

A and B partnership account 16,000

Debenture discount 600
Ordinary share capital 5,000
Share premium account 1,000
8% debentures 6,000
Cash – bank overdraft 4,600
16,600 16,600

Discharge of purchase consideration, being:

- 5,000 ordinary K1,000 shares issued at a premium of K200 per share
- 6,000 K1,000 8% debentures issued at K900
- K4.6m in cash

Note: that the ‘goodwill’ arising in the new limited company’s accounts is simply
the excess of the purchase consideration over the fair values placed on the net
tangible assets taken over. This should be contrasted with the ‘profit on
realisation’ in the partnership books, which is the surplus of the sale proceeds
over the book values of the assets sold. The two figures will thus not necessarily
be the same.

(c) X Ltd opening balance sheet

K’000 K’000 K’000
Non-current assets
Goodwill 4,200
Freehold property at valuation 7,000
Fixtures and fittings at valuation 500
11,700

24
 Current assets
Inventory 4,000
Receivables 2,100
Less: Provision 300
1,800
5,800
17,500
Capital and liabilities
Capital and reserves
Ordinary shares of K1,000, fully paid 5,000
Share premium account 1,000
Less: Debenture discount written off 600
400
8% Debentures 6,000
Current liabilities
Payables account 1,500
Bank overdraft 4,600
6,100
17,500

Note: that partner A now owns 60% of the company’s shares and partner B
owns 40%. They are effectively still acting as a partnership but through the
medium of a company.
7.5 Books carried on without a break

The above example of X Ltd assume that the partnership books are closed off,
and new books are opened up for the company. In practice very often the old
books are carried on without a break and amended at the end of the accounting
period to reflect the conversion into a company. In this situation the necessary
adjusting entries can be made through the partners’ accounts since they represent
the net assets of the partnership at the existing book values. Hence:

(a) Any assets or liabilities not taken over must be written out of the books by
transfer to the partner concerned ie,
(i) Assets not taken over:
Dr Partners account
Cr Asset account
Thus reducing both the balance due to the partner and the net
assets taken over.

(ii) Liabilities not taken over:

Dr Liability account
Cr Partner’s account
Thus extinguishing the liability and increasing the net assets taken
over.

(b) The remaining assets (including goodwill) and liabilities must be

increased or reduced to their agreed take-over values. The profit or
loss arising will be credited or debited to the partners’ accounts in

25
profit sharing ratio. A revaluation account may be used for this purpose if
several adjustments are required.

(c) Open up accounts for each element of the purchase consideration and
debit each partner’s share to his partners account.

(d) Any balance remaining on the partner’s accounts will be settled by cash
transfers into or out of the business.

(e) A company cannot distribute profits made prior to the date of its
incorporation. Consequently any pre-incorporation profits should
be transferred to a non-distributable reserve or used to write down any
goodwill arising on take-over.

7.6 Trade account receivables and trade account payables not taken over

Often the purchaser of business will not take over the existing receivables and
payables (for tax reasons). He may however agree to collect the debts and pay off
the liabilities on behalf of the vendor, so that the existing purchase and sales
ledgers are carried on. The transactions affecting the vendor are recorded by
means of suspense accounts. The necessary entries would be made as follows:

Receivables
(a) Debts to be collected Dr Receivables account
Cr Receivables suspense account

(b) Cash collected Dr Cash

Cr Receivables account

(c) Bad debts incurred or

discounts allowed Dr Receivables suspense account
Cr Receivables account

(d) Amount due to vendor Dr Receivables suspense account

Cr Vendor’s account
Payables

(a) Payables to be paid Dr Payables suspense account

Cr Payables account
(b) Cash paid Dr Payables account
Cr Cash

(c) Discounts received Dr Payables account

Cr Payables suspense account

(d) Amount due from vendor Dr Vendor’s account

Cr Payables suspense account.

26
Example

When taking over the business of Sameta & co, Sameta Ltd agreed to collect the
receivables of K7.7m and pay off the payables of K5.6m on behalf of the former
partners. The debts were collected subject to a bad debt of K320,000 and discount
allowed of K150,000 and out of the proceeds the payables were paid subject to
discount received of K95,000.
Record the entries in the books of the company to show the final amount payable
to the partners.

Solution
Receivables account
K’000 K’000
Receivables suspense a/c 7,700 Cash (balancing fig.) 7,230
Receivables suspense a/c:
Bad debt 320
Discount allowed 150
7,700 7,700

Receivables suspense account

K,000 K’000
Receivables a/c:
Bad Debt 320 Receivables a/c 7,700
Discount allowed 150
Vendor’s a/c (balancing fig.) 7,230 ------
7,700 7,700

Vendors account
K’000 K’000
Payables suspense a/c 5,505 Receivables suspense a/c 7,230
Balance c/d 1,725 _____
7,230 7,230

Payables account
K’000 K’000
Cash (balancing fig.) 5,505 Payables suspense a/c 5,600
Payables suspense a/c:
- discount received 95 _____
5,600 5,600

Payables suspense account

K’000 K’000
Payables a/c 5,600 Payables a/c:
- discount received 95
_____ Vendor’s account 5,505
5,600 5,600

27
 The balance remaining on the vendor’s account represents the final amount
payable to the partners.

Note: for balance sheet purposes any balances on the suspense accounts will cancel out
with the corresponding balances on the receivables’ and payables’ accounts.

Chapter 2

IAS 1: PRESENTATION OF PUBLISHED FINANCIAL STATEMENTS

Learning outcomes:

On completing this chapter, you should be able to prepare financial statements with
appropriate note’s for publication.

Learning aims:
The learning aims of this part of the syllabus are that students should be able to prepare
statutory accounts in appropriate form for a single company.

Introduction:

This chapter looks at how to prepare final accounts of a company. You will have
prepared financial statements at early stages of your studies. We are therefore going to
build on what you already know.

The focus of the preparation of financial statements at this level is on company’s

accounts (that is limited and public limited companies) that are prepared in a form
suitable for publication. To ensure that they conform to the relevant companies Act 1994
(Zambian), international accounting standard board (IASB) prescribed formats for the
financial statements.

This chapter firstly looks at the general requirements for published financial statements
and then considers in detailed the formats for the Income statement and balance sheet,
what items should be shown on the face of the income statement and balance sheet, what
items should be shown in the notes to the income statement and balance sheet.
Finally some extracts of the formats for the income statement and balance sheet are
given.

You are encouraged to read accounts for same companies registered on the Lusaka stock
exchange to get a detailed insight of the variety of financial statements that are prepared
in Zambia.

28
Published accounts questions require knowledge of formats and disclosure requirements.
Do not attempt to learn these formats and requirement by note. Become familiar with this
material by practicing on as many practical questions as you can.

Scope.

Applies to all general-purpose financial statements based on International Financial

Reporting Standards.
General purpose financial statements are those intended to serve users who do not have
the authority to demand financial reports tailored for their own needs.

Objective of Financial Statements

The objective of general-purpose financial statements is to provide information about the

financial position, financial performance, and cash flows of an entity that is useful to a
wide range of users in making economic decisions. To meet that objective, financial
statements provide information about an entity's:

 Assets
 Liabilities
 Equity
 Income and expenses, including gains and losses
 Other changes in equity
 Cash flows

That information, along with other information in the notes, assists users of financial
statements in predicting the entity's future cash flows and, in particular, their timing and
certainty. The users of financial statements are:

 Management
 Employees
 Trade unions
 Loan providers
 Banks
 Governments
 Suppliers and creditors
 Customers
 The local community
 Etc.

Why are financial statements prepared?

Financial statements are prepared and published at regular intervals to satisfy the
information needs of many user groups like the ones stated above.
For instance:

(a) Investors are the providers of risk capital

 Information is required to help make a decision about buying or selling
shares.

29
  Investors must have information about the level of dividends, past, present
and future.
 Investors need information to know whether the management has been
running the company efficiently.
(b) Employee’s need information about the security of employment and future
prospects for jobs in the company, and to help in bargaining for new wages.
(c) Lenders need information to help them decide whether to lend to the company or
not.
(d) Suppliers will need to know whether the company is a good payer.
(e) Government interest in a company may be one of creditor or customer as well as
being concerned on compliance with laws, taxes etc.

From this you will note that the financial statements prepared have to meet the needs of
each user group mentioned above and other groups that we have not mentioned.

For the financial statement to meet all the needs, as mentioned above it should have some
components that will help to deliver the information that user’s want from the financial
statement.

Components of Financial Statements

A complete set of financial statements should include:

 A balance sheet,
 Income statement,
 A statement of changes in equity showing either:
o All changes in equity, or
o Changes in equity other than those arising from transactions with equity
holders Acting in their capacity as equity holders;
 Cash flow statement, and
 Notes, comprising a summary of accounting policies and other explanatory notes.

Reports that are presented outside of the financial statements -- including financial
reviews by management, environmental reports, and value added statements -- are
outside the scope of international financial reporting standards (IFRS’s). But they do add
more information that is why they are included in many published accounts. But the
standard (IAS 1) requires those mentioned above.

Before we go in more details on how to prepare the accounts we need to look at some
rules that we need to observe as we prepare the financial statements. The following are
some points to take into account:

(a) Fair Presentation and Compliance with IFRS’s

The financial statements must "present fairly" the financial position, financial
performance and cash flows of an entity. Fair presentation requires the faithful
representation of the effects of transactions, other events, and conditions in accordance
with the definitions and recognition criteria for assets, liabilities, income and expenses set
out in the Framework. The application of IFRS’s, with additional disclosure where
necessary, is presumed to result in financial statements that achieve a fair presentation.

30
IAS 1 requires that an entity whose financial statements comply with IFRS’s make an
explicit and unreserved statement of such compliance in the notes. Financial statements
shall not be described as complying with IFRS’s unless they comply with all the
requirements of IFRS’s.
Inappropriate accounting policies are not rectified either by disclosure of the accounting
policies used or by notes or explanatory material.
IAS 1 acknowledges that, in extremely rare circumstances, management may conclude
that compliance with an IFRS requirement would be so misleading that it would conflict
with the objective of financial statements set out in the Framework. In such a case, the
entity is required to depart from the IFRS requirement, with detailed disclosure of the
nature, reasons, and impact of the departure.

(b) Going Concern

An entity preparing IFRS financial statements is presumed to be a going concern. If
management has significant concerns about the entity's ability to continue as a going
concern, the uncertainties must be disclosed. If management concludes that the entity is
not a going concern, the financial statements should not be prepared on a going concern
basis, in which case IAS 1 requires a series of disclosures.

(c) Accrual Basis of Accounting

IAS 1 requires that an entity prepare its financial statements, except for cash flow
information, using the accrual basis of accounting.

(d) Consistency of Presentation

The presentation and classification of items in the financial statements shall be retained
from one period to the next unless a change is justified either by a change in
circumstances or a requirement of a new IFRS.

(e) Materiality and Aggregation

Each material class of similar items must be presented separately in the financial
statements. Dissimilar items may be aggregated only if they are individually immaterial.

(f) Offsetting
Assets and liabilities, and income and expenses, may not be offset unless required or
permitted by a Standard or law (companies Act).

(g) Comparative Information

IAS 1 requires that comparative information shall be disclosed in respect of the previous
period for all amounts reported in the financial statements, both on the face of financial
statements and notes, unless another Standard requires otherwise.
If comparative amounts are changed or reclassified, various disclosures are required.

Having looked at some of the rules that we need to observe as we prepare the accounts,
the standard goes on to look at what the financial statements should contain.
The standard list the following items:

(a) The financial statements. The financial statement means the following items:
- Income statement
- Balance sheet

31
 - Cash flow
- Notes to the income statement and balance sheet.

(b) The standard says that the financial statements should be clearly identified and
distinguished from other information in the same published document. The other
information may include the value added statement, the tread analysis for the past 10
years, etc.
(c) What this means is that the income statement should have a heading that this is the
income statement like wise the balance sheet, etc.
It also means that we should include the name of the reporting enterprise or other form
of identification. Whether the financial statement covers’s one enterprise or groups of
enterprises.
(d) The date or period covered
(e) The presentation currency (Kwacha , United States Dollar, etc)
(f) The level of precision (thousands, millions, etc.)

Reporting Period
There is a presumption that financial statements will be prepared at least annually, that is
every year. If the annual reporting period changes and financial statements are prepared
for a different period, the enterprise must disclose the reason for the change and a
warning about problems of comparability.

Timeliness

The financial statement should be given within a reasonable time after the balance sheet
date. Other wise the user will get outdated information. The standard states that
enterprises should be able to produce financial statements within 6 months from the
balance sheet date, or local legislation may imposes specific deadlines for instance, in
Zambia, S164 (1)(a)(b)(c) of companies Act Chapter 388 of the laws of Zambia:

“The directors of a company shall after the end of each financial year of the company but
not later than twenty one days before the annual general meeting, or if no annual general
meeting within three months after the end of the financial year cause to produce the profit
and loss accounts and balance sheet.”1

Balance Sheet
The standard then looks at the details. We begin by looking at the balance sheet and the
income statement and the finally the cash flow statement.

An entity must normally present a classified balance sheet, separating current and
noncurrent assets and liabilities. Only if a presentation based on liquidity provides
information that is reliable and more relevant may the current / non-current split be
omitted. In either case, if an asset (liability) category commingles amounts that will be
received (settled) after 12 months with assets (liabilities) that will be received (settled)
within 12 months, note disclosure is required that separates the longer-term amounts from
the 12-month amounts.

1
S164 (1)(a)(b)(c) of companies Act Chapter 388 of the laws of Zambia

32
Current assets: are cash; cash equivalent; assets held for collection, sale, or consumption
within the enterprise's normal operating cycle; or assets held for trading within the next
12 months. All other assets are non-current.

Noncurrent assets: include tangible, intangible operating assets and finance assets of a
long nature

Current liabilities: are those to be settled within the enterprise's normal operating cycle
or due within 12 months, or those held for trading, or those for which the entity does not
have an unconditional right to defer payment beyond 12 months. Other liabilities are non-
current.

Noncurrent liabilities: Is debt due more than 12 months from the balance sheet date.
Long-term debt expected to be refinanced under an existing loan facility is non-current,
even if due within 12 months.

If a liability has become payable on demand because an entity has breached an

undertaking under a long-term loan agreement on or before the balance sheet date, the
liability is current, even if the lender has agreed, after the balance sheet date and before
the authorisation of the financial statements for issue, not to demand payment as a
consequence of the breach. However, the liability is classified as non-current if the lender
agreed by the balance sheet date to provide a period of grace ending at least 12 months
after the balance sheet date, within which the entity can rectify the breach and during
which the lender cannot demand immediate repayment.

IAS 1 say’s ‘an entity must normally present a classified balance sheet, separating current
and non-current assets and liabilities’

The standard then goes on to look at what should be shown on the face of the balance
sheet.
Minimum items on the face of the balance sheet are:
(a) Property, plant and equipment;
(b) Investment property;
(c) Intangible assets;
(d) Financial assets (excluding amounts shown under (e), (h) and (i));
(e) Investments accounted for using the equity method
(f) Biological assets;
(g) Inventories;
(h) Trade and other receivables;
(i) Cash and cash equivalents;
(j) Trade and other payables;
(k) Provisions;
(l) Financial liabilities (excluding amounts shown under (j) and (k));
(m) Liabilities and assets for current tax, as defined in IAS 12;
(n) Deferred tax liabilities and deferred tax assets, as defined in IAS 12;
(o) Minority interest, presented within equity; and
(p) Issued capital and reserves attributable to equity holders of the parent.

Additional line items may be needed to fairly present the entity's financial position.

33
IAS 1 does not prescribe the format of the balance sheet. Assets can be presented current
then non-current, or vice versa, and liabilities and equity can be presented current then
non-current then equity, or vice versa. A net asset presentation (assets minus liabilities) is
allowed. The long-term financing approach used in UK and elsewhere (fixed assets +
current assets - short-term payables = long-term debt plus equity) is also acceptable.

Regarding issued share capital and reserves, the following disclosures are required:

 Numbers of shares authorised, issued and fully paid, and issued but not fully
paid
 Par value
 Reconciliation of shares outstanding at the beginning and the end of the
period
 Description of rights, preferences, and restrictions
 Treasury shares, including shares held by subsidiaries and associates
 Shares reserved for issuance under options and contracts
 A description of the nature and purpose of each reserve within owners'
equity

The suggested format of the balance sheets.

MWAPE BANDA LIMITED

BALANCE SHEET AS AT 31ST DECEMBER 2004

2004 2003
K’000 K’000 K’000 K’000
Assets.
Non current assets
Property plant & equipment X X
Goodwill X X
Manufacturing licenses X X
Investments in associated companies X X
Other financial assets X X
X X
Current assets
Inventories X X
Trade & other receivables X X
Prepayments X X
Cash & cash equivalents X X
X X
Total assets X X
Equity and liabilities

34
Capital & reserves
Issued capital X X
Reserves X X
Accumulated profits/losses X X
X X
Minority interest X X
X X

Non current liabilities

Interest bearing borrowings X X

Deferred tax X X
Retirement benefit obligation X X
X X
Current liabilities

Trade and other payables X X

Short term borrowing X X
Current portion of interest
Bearing borrowing X X
Warranty provision X X
X X
Total equity & liabilities X X

Income Statement
IAS 1, is now using "profit or loss" rather than "net profit or loss" as the descriptive term
for the bottom line of the income statement.

All items of income and expense recognised in a period must be included in profit or loss
unless a Standard or an Interpretation requires otherwise. Minimum items on the face of
the income statement should include:
(a) Revenue.
(b) Finance costs.
(c) Share of the profit or loss of associates and joint ventures accounted for using the
equity method.
(d) A single amount comprising the total of (i) the post-tax profit or loss of discontinued
operations and (ii) the post-tax gain or loss recognised on the disposal of the assets or
disposal group(s) constituting the discontinued operation and;
(e) Tax expense and,
(f) Profit or loss.

The following items must also be disclosed on the face of the income statement as
allocations of profit or loss for the period:
(a) Profit or loss attributable to minority interest; and
(b) Profit or loss attributable to equity holders of the parent.

Additional line items may be needed to fairly present the enterprise's results of
operations.
No items may be presented on the face of the income statement or in the notes as
"extraordinary items".

35
Certain items must be disclosed either on the face of the income statement or in the notes,
if material, including:

(a) Write-downs of inventories to net realisable value or of property, plant and equipment
to recoverable amount, as well as reversals of such write-downs;
(b) Restructurings of the activities of an entity and reversals of any provisions for the
costs of restructuring;
(c) Disposals of items of property, plant and equipment;
(d) Disposals of investments;
(e) Discontinuing operations;
(f) Litigation settlements; and
(g) Other reversals of provisions.

Expenses should be analysed either by nature (raw materials, staffing costs, depreciation,
etc.) or by function (cost of sales, selling, administrative, etc.) either on the face of the
income statement or in the notes. If an enterprise categorises by function, additional
information on the nature of expenses (at a minimum depreciation, amortisation, and staff
costs) must be disclosed.

MWAPE BANDA LIMITED

INCOME STATEMENT FOR THE YEAR ENDED 31ST DECEMBER 2004

By Function.

2004 2003
K’000 K’000
Revenue X X
Cost of sales (X) (X)
Gross profit X X
Other operating income X X
Distribution costs (X) (X)
Administrative expenses (X) (X)
Other operating expenses (X) (X)
Profit from operation X X
Finance cost (X) (X)
Income from associate X X
Profit before tax X X
Income tax expenses (X) (X)
Profit after tax X X
Minority interest (X) (X)
Net profit from ordinary Activities X X
Net profit for the period X X

By function of expenses or cost of sale, method classifies expenses according to their

functions part of the cost of sales, distribution or administration Activities. This
presentation often provides more relevant information to users than the classification by
nature but the allocation of costs to function can be arbitrary and involves considerable
judgment.

36
By nature method, expenses are aggregated in the income statement according to their
nature. For example deprecation, purchases of materials, transport costs, wages and
salaries, advertising cost etc. and are not reallocated amongst various functions within the
company. This method is simple to apply in many smaller companies because no
allocation of operating expenses between functional classifications is necessary.

By nature
MWAPE BANDA LIMITED
INCOME STATEMENT FOR THE YEAR ENDED 31ST DECEMBER 2004

2004 2003
K’000 K’000
Revenue X X
Other operating income X X
Changes in inventories of finished
Goods and work in progress (X) (X)
Work performed by the enterprise and
capitalized X X
Raw material and consumables used (X) (X)
Staff costs (X) (X)
Other operating expenses (X) (X)
Profit from operating X X
Finance costs (X) (X)
Income from associates X X
Profit before tax X X
Income tax expenses (X) (X)
Profit after tax X X
Minority interest (X) (X)
Net profit or loss from ordinary
Activities X X
Net profit for the period. X X

Statement of Changes in Equity

IAS 1 requires an entity to present a statement of changes in equity as a separate
component of the financial statements. The statement must show:
(a) Profit or loss for the period;
(b) Each item of income and expense for the period that is recognised directly in equity,
and the total of those items;
(c) Total income and expense for the period (calculated as the sum of (a) and (b)),
showing separately the total amounts attributable to equity holders of the parent and to
minority interest; and

37
(d) For each component of equity, the effects of changes in accounting policies and
corrections of errors recognised in accordance with IAS 8.

The following amounts may also be presented on the face of the statement of changes in
equity, or they may be presented in the notes:
(a) Capital transactions with owners;
(b) The balance of accumulated profits at the beginning and at the end of the period, and
the movements for the period; and
(c) A reconciliation between the carrying amount of each class of equity capital, share
premium and each reserve at the beginning and at the end of the period, disclosing each
movement.

MWAPE BANDA LIMITED

STATEMENT OF CHANGES IN EQUITY FOR THE YEAR ENDED 31 ST
DECEMBER 2004

Statement of changes in equity

Share Share Revaluatio Accumulate
  Total
capital premium n reserve d profit
  K’000 K’000 K’000 K’000 K’000
Balance from previous period X X X X X
Changes in accounting policy
                  (X) (X)
– prior year adjustment*
Restated balance X X X X X
           
Deficit on revaluation of
    (X)   (X)
properties
Surplus on revaluation of
    X   X
investments
           
Net gains and losses not
recognised in the income     (X)   (X)
statement
           
Net profit for the period       X X
           
Dividends paid       (X) (X)
Issue of share capital X X             X
Balance at end of period X X X X X

* The change in accounting policy is treated as a prior year adjustment. This is the
treatment required in IAS 8 if the change is to be applied retrospectively (in other words,
as if the new policy had always been in use). A change can also be applied prospectively
(applied only to transactions after the change, with no adjustment to the opening balance

38
of retained earnings). A fundamental error affecting prior periods would also normally be
treated as a prior period adjustment as shown here.

A statement of recognised gains and losses

The alternative method of presenting the information about changes in equity is to
include only some of the information in the statement itself and the rest of the
information in a note to the accounts.

If this second presentation is adopted, the reconciliation of opening and closing balances
of share capital, reserves, and accumulated profit included in the statement of changes in
equity would be shown in the notes to the financial statements.

MWAPE BANDA LIMITED

STATEMENT OF RECOGNIZED GAIN AND LOSSES
FOR THE YEAR ENDED 31ST DECEMBER 2004

2004 2003
K’000 K’000
Surplus/deficit on revaluation of
Properties X X
Surplus /deficit on revaluation of
Investment X X
Exchange difference on transaction
of financial statement for foreign
entities (X) (X)

Net gain not recognized in the Income

Statement X X
Net profit for the period X X
Total recognized gain and loss X X
Effect of changes in accounting policy (X)

Notes to the Financial Statements

The notes must:
 Present information about the basis of preparation of the financial
statements and the specific accounting policies used.
 Disclose any information required by IFRS’s that is not presented on
the face of the balance sheet, income statement, statement of changes
in equity, or cash flow statement; and provide additional information
that is not presented on the face of the balance sheet, income
statement, statement of changes in equity, or cash flow statement that
is deemed relevant to an understanding of any of them.

Notes should be cross-referenced from the face of the financial statements to the relevant
note. IAS 1 suggests that the notes should normally be presented in the following order:
 A statement of compliance with IFRS’s,

39
  A summary of significant accounting policies applied, including,
 The measurement basis (or bases) used in preparing the financial
statements; and
 The other accounting policies used that are relevant to an
understanding of the
 Financial Statements.
 Supporting information for items presented on the face of the balance
sheet,
 Income statement, statement of changes in equity, and cash flow
statement, in the order in which each statement and each line item
is presented.

Other disclosures, including:

Contingent liabilities and unrecognised contractual commitments; and Non-financial
disclosures, such as the entity's financial risk management objectives and policies.

Disclosure of judgments. New in the 2003 revision to IAS 1, an entity must disclose, in
the summary of significant accounting policies or other notes, the judgments, apart from
those involving estimations, that management has made in the process of applying the
entity's accounting policies that have the most significant effect on the amounts
recognised in the financial statements.

Examples cited in IAS 1, include management's judgments in determining:

 Whether financial assets are held-to-maturity investments

 When substantially all the significant risks and rewards of ownership of
financial assets and leased assets are transferred to other entities;
 Whether, in substance, particular sales of goods are financing arrangements
and therefore do not give rise to revenue; and
 Whether the substance of the relationship between the entity and a special
purpose entity indicates that the special purpose entity is controlled by the
entity.

Disclosure of key sources of estimation uncertainty . Also new in the 2003 revision to
IAS 1, an entity must disclose, in the notes, information about the key assumptions
concerning the future, and other key sources of estimation uncertainty at the balance
sheet date, that have a significant risk of causing a material adjustment to the carrying
amounts of assets and liabilities within the next financial year. These disclosures do not
involve disclosing budgets or forecasts.

The following, other notes IAS 1 require disclosures if not disclosed elsewhere in
information published within the financial statements:

 Domicile of the enterprise;

 Country of incorporation;
 Address of registered office or principal place of business;
 Description of the enterprise's operations and principal Activities;

40
  Name of its parent and the ultimate parent if it is part of a group.

Disclosures about Dividends

The following must be disclosed either on the face of the income statement or the
statement of changes in equity or in the notes:

 The amount of dividends recognised as distributions to equity holders

during the
period, and the related amount per share.

The following must be disclosed in the notes:

 The amount of dividends proposed or declared before the financial
statements were authorised for issue but not recognised as a distribution
to equity holders during the period, and the related amount per share; and
the amount of any cumulative preference dividends not recognised.

Future developments with IAS 1

August 2005 Amendments Capital Disclosures

As part of its project to develop IFRS 7 Financial Instruments: Disclosures, the IASB
concluded also to amend IAS 1 to add requirements for disclosures of:
 The entity's objectives, policies and processes for managing capital;
 Quantitative data about what the entity regards as capital whether the
entity has complied with any capital requirements; and if it has not
complied, the consequences of such non-compliance.

These disclosure requirements apply to all entities, effective for annual periods beginning
on or after 1 January 2007, with earlier application encouraged. Illustrative examples are
provided as guidance.

Cash Flow Statement

IAS 1 requires entities to include a cash flow statement as part of the financial statement
but IAS 7 sets out the detailed requirements for this statement. Cash flow statement will
be dealt with in the next chapter.

Example
The trial balance of Zula Ltd, a limited liability company, at 31 May 2006 was as
follows: Dr Cr
Km Km
Revenue 3,500
Discounts received 80
Discounts allowed 70
Bank balance 147
Buildings at cost 1,040
Buildings, accumulated depreciation, 1 June 2005 160

41
Plant at cost 1,200
Plant, accumulated depreciation, 1 June 2005 400
Land at cost 345
Purchases 2,170
Returns inwards 15
Returns outwards 17
Heating and lighting 270
Administrative expenses 60
Trade payables 1,030
Trade receivables 700
Carriage inwards 105
Wages and salaries 250
10% Loan notes 580
General reserve 35
Allowance for doubtful debts, at 1 June 2005 30
Director’s remuneration 60
Retained earnings at 1 June 2005 115
K1 Ordinary shares 800
Inventory at 1 June 2005 515
Share premium account 200
–––––– ––––––
6,947 6,947

Additional information as at 31 May 2006

(i) Closing inventory has been counted and is valued at K560 million.
(ii) There are wages and salaries to be paid of K42 million.
(iii) Loan note interest has not been paid during the year.
(iv) The allowance for doubtful debts is to be increased to K40 million
(v) Plant is depreciated at 25% per annum using the reducing balance method. The
entire charge is to be allocated to cost of sales.
(vi) Buildings are depreciated at 5% per annum on their original cost, allocated 25%
to cost of sales, 50% to distribution costs and 25% to administrative expenses.
(vii) No dividends have been paid or declared.
(viii) The directors have agreed a transfer of K35 million to the general reserve from
profits for the period.
(ix) Tax has been calculated as K70 million for the year.
(x) The expenses listed below should be apportioned as indicated:
(xi)
Cost of Distribution Administrative
Sales Costs Expenses
Discounts allowed
and received – – 100%
Heating and lighting 40% 20% 40%
Wages and salaries 50% 25% 25%

Required:
(a) Prepare, for external use, the following financial statements for Zula Ltd in
accordance with IAS 1 Presentation of Financial Statements:

42
 (i) The income statement for the year ended 31 May 2006; and
(ii) The balance sheet as at 31 May 2006
(Notes to the financial statements are not required)

How you should answer the questions.

Start with the income statement the layout either by nature or by function.
You should be able to distinguish between notes to the accounts and the workings.
You should not enter the detailed items of income and expenses, you should
summarise them.

Example by function.
Zula Limited
Income statement for the year ended 31st May 2006

K ‘ Millions K ‘ Millions
Notes
Revenue 3,485
Cost of sales (2,680)
Gross Profits 805

Less: Expenses
Distribution costs 153
Administration expenses 314
467
Profits from operations 338
Less
Finance Costs (58)
Profit before tax 280
Less
Tax Expenses (70)
Net profit for the period 210

Zula Limited:
Statement of changes in equity for the year ended 31st May 2006

General Retained Share Share

Reserves Profits Premium Capital

K ‘ Millions K ‘ Millions K ‘ Millions K ‘ millions
Opening Balance
1/06/2005 35 115 200 800
Add:
Current year profits - 210 - -
Transfer from profits 35 - - -

43
 Total 70 325 200 800
Less:
Transfer to G. Reserves - (35) - -

Dividends paid - - - -

Closing Balance 31/05/06 70 290 200 800

Zula Limited
Balance sheet as at 31st May 2006
K ‘ Millions K ‘ Millions
Notes

Non Current Assets

Building, Land and Plant 1,773

Current Assets
Inventory 560
Trade receivables 660
Bank 147
1,367
Total Assets 3,140

Equity and liabilities

Equity and reserves

Share capital 800
Share premium 200
General reserves 70
Retained profits 290
Total Equity and Reserves 1,360

Non-current liabilities
10% loan note 580

Current liabilities
Trade payables 1,030

44
 Accruals 42
Tax 70
Interest on loan 58
1,200
Total equity and liabilities 3,140
Workings:

Workings 1
Cost of Distribution Administration
Sales Costs Expenses
K ‘ Millions K ‘ Millions K ‘ Millions

Purchases 2,170 - -
Return outwards (17) - -
Heating &
Lighting 108 54 108
Administrative
Expenses - - 60
Carriage
Inwards 105 - -
Wages &
Salaries (WK 1) 146 73 73
Directors
Remunerations - - 60
Inventory 1/6/05 515 - -
Inventory 31/5/06 (560) - -
Allowance
for debts - - 10
Depreciation:
Plant 200 - -
Building 13 26 13
Discounts recv’d - - (80)
Discounts allowed - - 70
-----
2,680 153 314

Working 2: Wages and salaries

K ‘ Millions
As per the trial balance 250
Add
Wages owing 42
Total 292

It is this amount that is allocated to the 3 departments, that is cost of sale

(K292, 000,000 x 50%), Distribution costs and Administration Expenses
(K292, 000,000 x 25% each)

Working 3: Depreciation for the buildings

45
K1, 040,000,000 x 5% = K52, 000,000. This amount is given to:
K ‘ Millions
Cost of sales 13
Distribution cost 26
Administration expenses 13

Workings 4: Revenue: K 3,500,000,000 – K15, 000,000 = K3, 485,000,000

Workings 4: Assets schedule

Buildings Land Plant Total

Cost/ MV K ‘ Millions K ‘ Millions K ‘ Millions K ‘ Millions
Opening Balance 1,040 345 1,200 2,585
Add:
Revaluations
Purchase - - - -
Total 1,040 345 1,200 2,585
Less:
Adjustments - - - -
Disposals - - - -
Closing Balance
31/05/06 1,040 345 1,200 2,585

Depreciation
Opening Balance 160 - 400 560
Add:
Current year
charge 52 - 200 252
Total 212 - 600 812
Less:
Adjustments - - - -
Disposals - - - -
Closing balance
31/05/06 212 - 600 812

Net book values:

46
Closing Balance
As at 31/05/06 828 345 600 1,773
Closing Balance
As at 31/05/05 880 345 800 2,025

Example by nature.
Zula limited
Income statement for the year ended 31st May 2006

K ‘ Millions

Revenue 3,485
Other operating income 80
Changes in inventories of finished
Goods and work in progress 45
Work performed by the enterprise and
Capitalized -
Raw material and consumables used (2,258)
Staff costs (352)
Depreciation costs (252)
Other operating expenses (410)
Profit from operating 338
Finance costs (58)
Income from associates -
Profit before tax 280
Income tax expenses (70)
Profit after tax 210
Minority interest -
Net profit or loss from ordinary
Activities -
Net profit for the period. 210

Regarding the balance sheet it will be the some as under the by function type.

47
Workings
Workings 1: Changes in inventories of finished Goods and work in progress
K ‘ Millions
Opening inventory 1/6/05 (515)
Closing inventory 31/05/06 560
45

Workings 2: Raw materials & consumables used

K ‘ Millions
Carriage inwards 105
Purchases 2,170
Less return (17)
2,153
2,258
Workings 3: Staff costs
K ‘ Millions
Directors remuneration 60
Wages & salaries 250
Accrued wages & salaries 42
292
352
Workings 4: depreciation
K ‘ Millions
Plant 200
Building 52
252
Workings 5: Other operating costs
K ‘ Millions
Discount allowed 70
Heat and lighting 270
Administration expenses 60
Allowance for doubtful debts 10
410

CHAPTER 3

CASH FLOW STATEMENT - IAS 7

The notion of cash flows and funds flows has been included in accounting standards for
more than two decades. For example in the UK SSAP 10 (1976), source and application
of funds statement, was an early attempt by standard setters to provide a link between the
balance sheet at the start of the accounting period, the profit and loss account for the
period and the balance sheet at the end of the period.

It has been argued that profit does not always give a useful or meaningful picture of the
operations of the company. For instance:

48
  Shareholders believe that if a company makes a profit then this is the amount,
which it could afford to pay as dividend.
 Employees might believe that if a company makes a profit it can afford to pay
higher wages.
 Survival of a business entity depends not so much on profit but on its ability to
pay debts when they fall due.
 You will note that a company’s performance and prospects depends not so much
on profits but on liquidity.
The greatest advantage of cash flow statement is that it provides information that is in
additional to that in the rest of the accounts. It also describes the cash flow of an
organisation by activity. For instance:
 Assessing the current liquidity of a business,
 Providing additional information on the business activities,
 Providing an overview of the major sources of cash inflows and out
flows from the business,
 A guide to estimate future cash flows,
 Determining cash flows generated from trading as opposed to other
sources of finance.

Objective
The objective of the IAS 7 is to ensure that the reporting entity reports on their cash
generation and cash absorption for a period, by highlighting the significant components
of cash flows, in a way that facilitates comparison, and that it provides information that
assists in the assessment of their liquidity, solvency and financial adaptability.
Historical cash flow statement information is often used as an indicator of the amount,
timing and certainty of future cash flows. It is also useful in checking the accuracy of past
assessments of future cash flows and in examining the relationship between profitability
and net cash flow and the impact of changing prices.
IAS 7 requires enterprises to present a cash flow statement as part of their financial
statement.

Definitions:

Cash: comprises cash on hand and demand deposits

Cash equivalents: are short-term highly liquid investments that are readily convertible to
known amounts of cash and which are subjects to an insignificant risk of change in value.
Cash flows are in flows (money coming into the company like Trade receivables paying
you) and outflows (money going out like payment to buy a car) of cash and cash
equivalents
Operating activities: are the principal revenue producing activities of the enterprises and
other activities that are not investing or financing activities
Investing activities: are the acquisition and disposal of long term assets and other
investments not included in cash equivalents
Financing activities: are activities that result in changes in the size and composition of
the equity capital and borrowing of the enterprise.

Presentation of cash flow statement

The standard list the main heading of the cash flow statement, which all companies have
to follow when preparing the cash flow statement. The main headings are:

49
Operating activities: operating profits with adjustments for depreciation or non cash
items, profits and losses on sale of non current assets, and interest paid, together with
working capital changes, that are increase or decrease in inventories, receivables and
payables. It also includes outflows as interest paid, dividends paid, and tax paid.
Investing activities: purchase of non-current asset and proceeds on sales of such assets.
Financing activities: proceeds on the issue of shares and loan notes and the redemption
of certain classes of shares and loan notes.

Enterprises should report cash flows from operating activities using either:
As with FRS 1 in the UK, IAS 7 recommends two formats:
 Direct method,
 Indirect method.

Research suggests that the vast majority of published report use the indirect method. You
can also see this in Zambia; all the published accounts are in indirect method.

Examples of layout of the cash flow statement

Direct method.
This shows operating cash receipts and payments, that is cash receipts from customers,
cash payments to suppliers and payments for services and other expenses, and on behalf
of employees, aggregating to the cash flow from operating activities.

MMS Limited.
Cash flow statement for the year ended 31st December 2004
K ‘ Millions K ‘ Millions
Cash flow from operating Activities:
Cash receipts from customers X
Cash paid to suppliers and employees (X)
Cash generated from operations X
Interest paid (X)
Income taxes paid (X)
Cash flow before extraordinary items X
Proceeds from earthquake disaster
Settlement X

Net cash operating Activities X/(X)

Cash flow from investing Activities

Purchase of property plant and equipment (X)
Proceeds from sale of equipment X
Interest received X
Dividend received X

Net cash used in investing Activities X/(X)

Cash flow from financing Activities

Proceeds from issuance of share capital X
Proceeds from long term borrowing X
Dividends paid (X)

50
Net cash used in financing Activities. X/(X)

Net increase in cash and cash equivalent X/(X)

Cash and cash equivalent at beginning of

Period (note) X/(X)
Cash and cash equivalent at end of
Period (note) X/(X)

Indirect method.
This starts with the operating profits and adjusting for non-cash changes, and debits and
credits, changes in working capital, interest paid and tax paid to reconcile it to the net
cash from operating activities.

MMS Limited.
Cash flow statement for the year ended 31st December 2004

K ‘ Millions K ‘ Millions

Cash flow from operating Activities:

Net profit before interest, taxation and

Extraordinary items X
Adjustment for:
Depreciation X
Investment income (X)
Operating profit before working
Capital changes X
Increase in trade and other receivables X
Decrease in inventories X
Decrease in trade payables (X)
Cash generated from operation X
Interest paid (X)
Income taxes paid (X)
Cash flow before extraordinary items X
Proceeds from earthquake disaster
Settlement X

Net cash operating Activities X/(X)

Cash flow from investing Activities

51
Purchase of property plant and equipment (X)
Proceeds from sale of equipment X
Interest received X
Dividend received X

Net cash used in investing Activities X/(X)

Cash flow from financing Activities

Proceeds from issuance of share capital X
Proceeds from long term borrowing X
Dividends paid (X)

Net cash used in financing Activities. X/(X)

Net increase in cash and cash equivalent X/(X)

Cash and cash equivalent at beginning of

Period (note) X/(X)
Cash and cash equivalent at end of
Period (note) X/(X)

The following notes to accompany the cash flow statement, whether the indirect or direct
method is used.

Cash and cash equivalent

2004 2003
K ‘ Millions K ‘ Millions

Cash on hand and balances

With banks X X
Short term investments X X
Cash and cash equivalents X X

Exceptional and extraordinary items are to be shown under the appropriate standard
headings according to the nature of each item.

The advantages of the cash flow statement are:

 Survival in business depends on the ability to generate cash, which the cash
flow
 Cash flow Statements aim to attain by showing how much the company was
able to generate and use in its operation.
 Cash flow statement reporting satisfies the needs of all users better,
 Cash flow statement is easier to prepare than profit and loss accounts,
 It is easier to audit Cash Flow Statements as compared to Accrual
Accounting based statements.

52
Interpretation of cash flow statements

Cash flow statements should help an external user to evaluate the effect of financial
management decisions taken during the year. However, the user will then need to decide
whether these cash movements are normal in relation to past movements and comparable
industry information or abnormal and require further analysis.
Over time a business needs to generate positive cash flows from its operating Activities,
otherwise it is unlikely to survive. Indeed, a business must generate sufficient cash from
its operations to reward the various stakeholders e.g., shareholders, and lenders. An
expanding company might have negative operating cash flow as it builds up the level of
its inventory, and debtors in line with the increased turnover. However, an increase in
working capital without an increase in turnover might indicate operational inefficiencies
and will lead to liquidity problems.
The user of a cash flow statement can also identify the impact of a business’s
performance in managing working capital. Changes in working capital on operating cash
flow can be analysed together with working capital ratios such as the inventory holding
period, the Trade receivables’ payment period and the Trade payables payment period.
Another useful ratio to monitor a business’s investment in working capital over time (and
against other businesses) is that of working capital/sales. This ratio shows how much
capital is required to finance operations in addition to the capital required to finance fixed
assets.

Cash flow examination questions

If you are required to prepare a cash flow statement in an examination, you will usually
be given the following information:
 A income statement for the period;
 A balance sheet at the beginning and end of the period;
 Some notes to the financial statements.

Before you start any computational work, ensure you read the question thoroughly. Then
begin by drafting out the main headings of the statement. The statement should be drafted
in accordance with IAS 7.
You should now complete the statement starting with the straightforward calculations
e.g., increase/decrease in cash figure, before moving on to the more complex figures.
Don’t forget to include the cash and cash equivalent statements; these are always worth
some marks.
You should be able to complete the question within the time available, however, don’t
worry if the statement doesn’t balance. Quickly compute the difference to see if the
figure suggests the cause of the error. However, do not waste too much time trying to
identify mistakes. It’s better to move on to the next question and come back at the end of
the examination if there is time.

Conclusion

53
Cash flow statements provide important information for external users of the financial
statements on how well the business is managing its cash. The long-term survival of a
business depends on its ability to successfully manage its cash.

The example will illustrate how to prepare the cash flow statement in accordance with
IAS 7.

An illustration 1
The following information has been extracted from the draft financial statements of
ZamCop Ltd, a limited liability Company.

ZamCop Ltd
Balance Sheets as at 31 May
2006 2005
K ‘ Millions K ‘ Millions K ‘ Millions K ‘ Millions

Non-current assets 4,600 2,700

Current assets
Inventory 580 500
Trade receivables 360 230
Bank 0 940 170 900
–––– ––––––– –––– –––––––
Total assets 5,540 3,600
––––––– –––––––

Equity and liabilities

Capital and reserves
Ordinary share capital 3,500 2,370
Share premium 300 150
Retained earnings 1,052 470
––––––– –––––––
4,852 2,990
Non-current liabilities
10% Loan note
(Redeemable 31 May 2006) 100

Current liabilities
Trade payables 450 365
Taxation 180 145
Bank overdraft 58 688 0 510
–––– ––––––– –––– –––––––
Total equity and liabilities 5,540 3,600
––––––– –––––––

Additional Information:
(i) The income statement for the year ended 31 May 2006 shows the following:
K ‘ Millions

54
Operating profit 1,042
Interest payable (10)
––––––
Profit before taxation 1,032
Taxation (180)
––––––
Profit for financial year 852
––––––
(ii) During the year dividends paid were K270, 000,000.
(iii) Profit before taxation had been arrived at after charging K700, 000,000 for
depreciation on non-current assets.
(iv) During the year non-current assets with a net book value of K200, 000,000 were sold
for K180, 000,000.

Required:
(a) Prepare a cash flow statement for ZamCop Ltd for the year ended 31 May 2006 in
accordance with IAS 7 ‘Cash Flow Statements’, using the indirect method.
(b) Comment on the financial position of ZamCop Ltd as shown by the cash flow
statement you have prepared.
(c) Briefly state some of the ways in which companies could manipulate their year-end
cash position.

Solution to illustration 1

Prepared in accordance with IAS7

ZamCop Ltd
Cash flow statement for the year ended 31 May 2006

K ‘ Millions K ‘ Millions
Cash flows from operating Activities:

Net profit before tax 1,032

Adjustments for:
Depreciation 700
Loss on sale of tangible non-current assets 20
Interest 10
––––––
Operating profit before working
capital changes 1,762
Increase in inventory (80)
Increase in receivables (130)
Increase in payables 85
––––––
Cash generated from operations 1,637

55
Interest paid (10)
Tax paid (145)
Dividends paid (270)
––––––
Net cash from operating Activities 1,212

Cash flow from investing Activities:

Purchase of non-current assets (2,800)

Receipts from sales of tangible
non-current assets 180

Cash flows from financing Activities:

Proceeds from issue of share capital 1,280

Repayment of long-term borrowing (100)
––––––
1,180
––––––
Net increase/ (decrease) in cash and cash equivalents (228)
Cash and cash equivalents at the beginning of period 170
––––––
Cash and cash equivalents at end of period (58)
––––––

Note
Dividends paid and interest paid may be shown in either operating Activities or
financing Activities.
Students should be prepared to answer question on the cash flows that ask for
commenting, for example, see the comments in the solution to an illustration 1.

Workings:
Non-current assets
K ‘ Millions K ‘ Millions
Balance b/f 2,700 Depreciation 700
New non-current assets (bal) 2,800 Disposals 200
Balance C/F 4,600
–––––– –––––––
5,500 5,500
–––––– ––––––

Tax
K ‘ Millions K ‘ Millions
Tax paid (balancing figure) 145 Balance b/f 145
Balance C/F 180 Income
Statement 180
–––––– –––––––
325 325
–––––– –––––––

56
 (b) Comment on the financial position of ZamCop Ltd as shown by the cash flow
statement

There has been a net outflow of cash K228, 000,000 that has left the company with an
overdraft of K58, 000,000.
There was significant expenditure on non-current assets of K2, 800,000,000 during
the year. This should help improve operational efficiency and future profitability.
Additional ordinary shares were issued which resulted in a cash inflow of
K1, 280,000,000. This will result in future cash outflows in the form of dividends.
Long term loans of K100, 000,000 were repaid which will reduce interest payments
in future.
There has been an increase in receivables of K130, 000,000 which may mean
customers are taking longer to pay and consequently having an adverse impact on
cash flows.

(c) Briefly state some of the ways in which a company could manipulate the year-end
cash position.
(i) Offering short-term incentives to customers to increase sales.
(ii) Reducing the selling price to increase sales.
(iii) Cutting expenses.
(iv) Disposing of assets.
(v) Delaying payments to credit suppliers.
(vi) Encouraging customers to pay early by offering discounts.
(vii) Resourcing effective debt collection procedures.

The following question is on how to prepare cash flow statement using the indirect
method. You will notice that from practice, the common method is indirect method.
Students should also know how to prepare using the direct method.
An illustration 2

You have been given the following information relating to a limited liability company
called Noble.
This company is preparing its financial statements for the year ended 31 May 2006.

Noble Ltd
Income statement for the year ended 31 May 2006
K ‘ Millions
Revenue 66,600
Cost of sales (13,785)
–––––––
Gross profit 52,815
Distribution costs (7,530)
Administrative expenses (2,516)
–––––––
Profit from operations 42,769
Investment income 146
Finance cost (1,177)
–––––––

57
Profit before tax 41,738
Tax (9,857)
–––––––
Net profit for the period 31,881
Accumulated profits brought
Forward at 1 June 2005 28,063
–––––––
Accumulated profits carried
Forward at 31 May 2006 59,944
–––––––
Noble Ltd
Balance Sheets as at 31 May
2006 2005
K ‘ Millions K ‘ Millions K ‘ Millions K ‘ Millions
Non-current assets
Cost 144,844 114,785
Accumulated depreciation (27,433) (26,319)
–––––––– –––––––
117,411 88,466
Current Assets
Inventory 24,931 24,065
Trade receivables 18,922 13,238
Cash 3,689 47,542 2,224 39,527
––––––– –––––––– ––––––– –––––––
Total assets 164,953 127,993
–––––––– –––––––
Equity and liabilities
Capital and reserves
Ordinary share capital 27,000 23,331
Share premium 14,569 10,788
Revaluation reserve 15,395 7,123
Accumulated profits 59,944 116,908 28,063 69,305
––––––– –––––––
116,908 69,305
Non-current liabilities
6% loan note 17,824 24,068
Current Liabilities
Bank overdraft 5,533 6,973
Trade payables 16,699 20,324
Taxation 7,989 30,221 7,323 34,620
––––––– –––––––– ––––––– –––––––
Total equity and liabilities 164,953 127,993

–––––––– –––––––
Additional information
(i) During the year ended 31 May 2006, the company sold a piece of equipment for
K3, 053,000,000, realising a profit of K1, 540,000,000. There were no other
disposals of non-current assets during the year.
(ii) Profit from operations is stated after charging depreciation of K5, 862,000,000.

58
(iii) There were no amounts outstanding in respect of interest payable or receivable as
at 31 May 2006 or 2005.
(iv) There were no dividends paid or declared during the year.
Required:
Prepare a cash flow statement for Noble for the year ended 31 May 2006 in
accordance with IAS 7 Cash Flow Statements.
Solution to illustration 2
Noble Ltd
Cash flow statement for the year ended 31 May 2006
K ‘ Millions K ‘ Millions
Cash flows from operating Activities
Net profit before tax 41,738
Adjustments for:
Depreciation 5,862
Investment income (146)
Interest paid 1,177
Profit on equipment disposal (1,540)
–––––––
Operating profit before working capital changes 47,091
Increase in inventory (866)
Increase in receivables (5,684)
Decrease in payables (3,625)
–––––––
Cash generated from operations 36,916
Interest received 146
Interest paid (1,177)
Tax paid (9,191)
–––––––
Net cash from operating Activities 26,694
Cash flows from investing Activities
Purchase of property, plant and equipment (28,048)
Proceeds from sale of equipment 3,053
–––––––
Net cash used in investing Activities (24,995)
Cash flows from financing Activities
Proceeds from issue of share capital 7,450
Repayment of long-term borrowing (6,244)
–––––––
Net cash used in financing Activities 1,206
–––––––
Net increase in cash and cash equivalents 2,905
Cash and cash equivalents at the beginning of period (4,749)
–––––––
Cash and cash equivalents at end of period (1,844)
–––––––
Notes
IAS 7 allows interest paid to be an operating cash flow or a financing cash flow. Interest
received can be an operating cash flow or an investing cash flow.

59
Workings
1 Taxation
K ‘ Millions K ‘ Millions
Paid (Balancing figure) 9,191 Balance b/f 7,323
Balance C/F 7,989 Income
statement 9,857
––––––– –––––––
17,180 17,180
––––––– –––––––

K ‘ Millions
2 Disposal of assets
Proceeds 3,053
Less NBV (Balancing figure) (1,513)
––––––
Profit on sale 1,540
––––––

3 Non-current Asset NBV

K ‘ Millions K ‘ Millions
B/fwd 88,466 Depreciation 5,862
Revaluation 8,272 Disposal NBV (W2) 1,513
Additions (Balancing figure) 28,048 C/Fwd 117,411
–––––––– ––––––––
124,786 124,786

CHAPTER 4

IAS 14 - SEGMENT REPORTING.

Objective
The objective of this standard is to establish for reporting financial information by
segment information about the different types of products and services an enterprises
produces and the different geographical areas in which it operates to help users of
financial statements to:
 Have a better understanding of the enterprises past performance
 Have a better assessment of the enterprises risk and return
 Be able to make more informed judgment about the enterprise as a whole.

Who should apply the IAS 14?

Only enterprises whose equity or debt securities are publicly traded like on the Lusaka
stock exchange need to disclose segment information. Other enterprises that produce

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financial statement which comply with IAS’s are encouraged to disclose segment
information voluntarily, in such a case IAS 14 must be followed entirely not simply in
part.
In what form can a business be dividend?

There are two main ones:

 Business segment
 Geographical segment

A business segment: is a distinguishable component of an enterprise that is engaged in

providing an individual product or service or a group of related products or service and
that is subject to risk and return that are different from those of other business segments.
Factors that should be considered in determining whether products and services are
related include:
 The nature of the products or services,
 The nature of the production process,
 The type or class of customer for the products or services,
 The methods used to distribute the products or provide the service,
 If applicable the nature of the regulatory environment for example banking
insurance or public utilities.

A geographical segment: is a distinguishable component of an enterprise that is engaged

in providing products or services within a particular economic environment and that is
subject to risk and returns that are different from those of components operating in other
economic environment. Factors that should be considered in identifying geographical
segments include:
 Similarity of economic and political conditions,
 Relationships between operations in different geographical area,
 Proximity of operations,
 Special risk associated with operations in a particular area,
 Exchange control regulations,
 The underlying currency risks.

A reportable segment: is a business segment or a geographical segment identified based

on the foregoing definitions for which segment information is required to be disclosed by
this standard.

How you can be able to identify:

An enterprises organizational and internal reporting structure will normally provide

evidence of whether its dominant source of geographical risk results from location of its
assets or the location of its customers. Accordingly an enterprises looks to this structure
to determine whether its geographical segment should be based on the location of its
assets or on the location of its customers.
Determining the composition of a business or geographical segment involves a certain
amount of judgment.
In marking that judgment enterprises management takes into account the objective of
reporting financial information by segment as a forth in this standard and the qualitative

61
characteristics of financial statement as identified in the IASC frame, work for the
preparation and presentations of financial statement.

The following additional terms are used in this standard, with the meanings specified:
 Segment revenue. Is revenue reported in the enterprises income statement that is
directly attributable to a segment and the relevant portion of enterprises revenue
that can be allocated on a reasonable basis to a segment whether from sales to
external customers or from transactions with other segments of the same
enterprise. Segment revenue does not include:
o Extraordinary items
o Interest or dividend income including interest earned on advances, loans,
or other segments, unless the segment’s operations are primary of a
financial nature.
o Gains on sales of investments or gains on extinguishments of debt unless
the segment’ s operations are primarily of a financial nature.

 Segment expenses. Are expenses resulting from the operating activities of a

segment that is directly attributable to the segment and relevant portion of an
expense that can be allocated on a reasonable basis to the segment including
expenses relating to sales to external customers and expenses to transaction with
other segment of the same enterprises. Segment expense dose not include:
o Extraordinary items
o Interest, including interest incurred on advances or loans from other
segments unless the segment’s operations are primarily of a financial
nature.
o Losses on sales of investment or losses on extinguishments of debt unless
the segment’ s operation are primarily of a financial nature.
o Income tax expenses,
o General administrative expense, head office and other expenses that arise
at the enterprises level and relate to the enterprises as a whole. However,
costs are sometimes incurred at the enterprises level on behalf of a
segment. Such costs are segment expenses if they relate to the segment’s
operating activities and they can be directly attributed or allocated to the
segment on a reasonable basis.

 Segment assets. Are those operating assets that are employed by a segment in its
operating activities and they either, can be directly attributable to the segment or
can be allocated to the segment on a reasonable basis.

 Segments liabilities. Are those operating liabilities that result from the operating
activities of a segment and that either are directly attributable to the segment or
can be allocated to the segment on a reasonable basis.

 Segments accounting policies. Are the accounting policies adopted for

preparing and presenting the financial statement of the consolidated group or
enterprises as well as those accounting policies that relates specifically to segment
reporting.

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The definitions of segment revenue, segment expenses, segment assets, and liabilities
include amounts of such items, that are directly attributable to a segment and amounts
of such items that can be allocated to a segment on a reasonable basis. An enterprise
looks to its internal financial reporting system as the starting point for identifying those
items that can be directly attributed or reasonably allocated to segment. That is there is a
presumption that amounts that have been identified with segments for internal financial
reporting purposes are directly attributable or reasonably allocated to segments for the
purposes of measuring the segment revenue, segment expenses, segment asset and
segment liabilities of reportable segments.

Reportable segments.
Two or more internally reported business segments or geographical segments that are
substantially similar may be combined as a single business segment or geographical
segments. Two or more business or geographical segments are substantially similar only
if:
 They exhibit similar long term financial performance,
 They are similar in all of the factors in the appropriate definition.

Conditions for reporting:

A business segment or geographical segment should be identified as a reported segment

if a majority of its revenue is earned from sales to external customers and:
 Its revenue from sales to external customers and from transactions with other
segment is 10% or more of the total revenue, external and internal of all
segments or
 Its segment result, whether profit or loss is 10% or more of the combined result
of all segments in profit or the combined results of all segments in loss which ever
is greater in absolute amounts,
 Its assets are 10% or more of the total assets of all segments.

If an internally reported segment is below all of the threshold stated above then:
 That segment may be designated as reported segment despite its size,
 If not designated as a reportable segment despite its size that segment may be
combined into separately reportable segment with one or more other similar
internally reported segments that are also below all of the thresholds of
significance,
 If that segment is not separately reported or combined, it should be included as an
unallocated reconciling item.

If total external revenue attributable to reportable segment constitute less than 75% of the
total consolidated or enterprises revenue additional segment should be identified as
reported segment even if they do not meet the 10% threshold unit, at least 75% of total
consolidated or enterprises revenue is included in reported segment.

The 10% threshold in this standard are intended to be a guide for determining
materiality for any aspect of financial reporting other than identifying reported business
and geographical segments. By limiting reportable segments to those that earn a majority

63
of their revenue from sales to external customers, this standard does not require that the
difference stages of vertically integrated operations be identified as separate business
segments.

A segment identified as a reported segment in the immediately preceding periods because

it satisfied the relevant 10 % thresholds should continue to be a reportable segment for
the current period notwithstanding that its revenue results and assets all no longer exceed
the 10% threshold if the management of the enterprises judges the segment to be of
continuing significance.

If a segment is identified as a reportable segment in the current period, it satisfies the

relevant 10%, prior periods segment data that is presented for comparative purposes
should be restated to reflect the newly reported segment as a separate segment even if
that segment did not satisfy the 10% threshold in the prior periods unless it is
impracticable to do so.
IAS 14 requires management to assess the dominant source of an entity’s risk and return
in order to assess whether the primary segment-reporting format will be by business or
geographical.

Disclosure.

Primary reporting format.

An enterprise should disclose segment revenue for each reportable segment; revenue
from sales to external customers and segment revenue from transaction with other
segment should be separately reported.
An enterprise should disclose the total carrying amounts of segment assets for each
reportable segment.
An enterprise should disclose segment liabilities for each reportable segment.
An enterprise should disclose the total amount of expenses included in segment results
for depreciation and amortization of segment assets for the period for each reportable
segment.
An enterprise is encouraged but not required to disclose the nature and amounts of any
items of segments revenue and segment expenses that are of such size nature or incidence
that their disclosure is relevant to explain the performance of each reportable segment for
the period.
An enterprise should disclose for each reportable segment the total amount of significant
non-cash expenses other than deprecation and amortisation for which were included in
segment expenses and therefore deducted in measuring segment results.

An enterprise should present a reconciliation between the information disclosed for

reportable segment and the aggregated information in the consolidated or enterprises
financial statement. In presenting the reconciliation, segment revenue should be
reconciled to enterprise revenue from external customers, segment results should be
reconciled to a comparable measure of enterprise’s operating profits or loss as well as to
enterprise’s net profit or loss, segment asset should be reconciled to enterprises assets and
segment liabilities should be reconciled to enterprise’s liabilities.

Secondary segment information.

If an enterprise’s primary format for reporting segment information is business segment,
it

64
should also report the following information:

Segment revenue from external customers by geographical area based on the

geographical location of its customers for each geographical segment whose revenue
from sales to external customers is 10% or more of total enterprise revenue from sales to
all external customers.

Total carrying amount of segment assets by geographical location, of assets for each
geographical segment assets are 10% or more of the total assets of all geographical
segment.

The total cost incurred during the period to acquire segment assets that are expected to be
used during more than one period by geographical location of assets for each
geographical segment whose segment assets are 10% or more of the total assets of all
geographical segment.

If an enterprises primary format for reporting segment information is geographical

segment, it should also report the following segment information for each business
segment whose revenue from sales to external customers is 10% or more of total
enterprises revenue from sales to all external customers or whose segment assets are 10%
or more of the total assets of all business segment:
 Segment revenue from external customers,
 Total carrying amounts of segment assets,
 The total costs incurred during the period to acquire segment
assets that are expected to be used during more than one period.
Other disclosure includes change in accounting policies adopted for segment reporting.

Illustration 1
(i) Large companies often conduct their operations across many different industrial and
geographical areas. IAS 14 ‘Segment Reporting’ is based on the principle that, without
supplementary information, the ‘aggregated’ financial statements of such companies are
of little use to analysts and other users of financial statements.

Required:
Describe how the provision of segment information is intended to assist users of
financial statements, and identify the main problems of providing segment
information.

(ii) The Southern crossing group is a large public company that operates in a single
geographical market. Its directors have identified three distinguishable business
segments; food processing, paint manufacturing and retailing of
motor vehicles. The following information is available regarding its operations for the
year to 31 March 2006:

– Segment sales revenue of the group (including inter-segment sales of K250 million) is
K8, 250 million made up of K2, 700 million from food processing; K3, 150 million from
paint manufacturing and the remainder from motor vehicle retailing. The motor vehicle
division sold cars at a gross profit of 20% to the other two divisions.

65
– The segment operating profit (before interest, tax and associated company income) is
K1, 870 million (including the profit from inter-segment sales). Food processing made a
profit of K700 million and paint manufacturing made a profit of K650 million.
– The segment operating profit does not include K500 million of administration
overheads, which cannot be apportioned on a reasonable basis, nor K30 million interest
received and K120 million finance costs.
– The group’s share of the results of its equity accounted associated company (see below)
is K300 million.
– The group’s total assets are K8, 900 million. These are attributable to K2, 500 million
to food processing, K2, 700 million to paint manufacturing, K2, 000 million to motor
vehicle retailing and K1, 400 million carrying value of the associated company
investment. The associate operates entirely within the food-processing sector. The
remainders of the total assets are long-term investments in corporate bonds.

Note: you may assume that the assets and related depreciation charges have been adjusted
for the unrealised profits in the motor vehicles.

– The group’s total liabilities are K1, 200 million. These are attributable to K500 million
to food processing, K450 million to paint manufacturing, and K250 million to motor
vehicle retailing.

Required:
Prepare a segment report for Southern Crossing for the year ended 31 March 2006
incorporating the above information in accordance with IAS 14.

Solution to illustration 1
(i) The financial statements of large diversified companies are an aggregation of all their
separate Activities. Their results are a composite of their individual segments. Each of the
separate segments may have different results. The segments may have wide ranges of
profitability, cash flows, growth, future prospects and risks. Without information on these
separate segments, these differences would be concealed and it would be impossible for
users of financial statements to properly assess past performance and future prospects.
IAS 14 ‘Segment Reporting’ requires primary and secondary reporting formats, which
are based on business and geographical segments. Providing information on sales
revenues, results (profit) and net assets of each segment goes some way to resolving the
difficulties outlined above.

The main problems with the provision of segmental information are:

– Defining what is a reportable segment. Although accounting standards give guidance
on this, ultimately it is a matter for the directors to determine. This means that
comparability between different companies can be impaired as they
may be using different interpretations of what constitute reportable segments. IAS 14 has
both primary and secondary reporting formats (by product group and geographically or
vice versa). Similar companies may choose different primary
formats to each other.

66
– Apportionment between the segments of some costs on a reasonable basis can be
difficult. This could be true for many common costs such as central administration. The
Standard says where a reasonable basis of apportionment cannot be found they should be
shown as a deduction from the aggregated profit and not apportioned. However, it is
possible that companies will use the apportionment of such costs to manipulate the
relative profitabilities of their different segments.
– Similar to the above there are some assets and liabilities that cannot be attributed to
individual segments. Interest bearing assets are an example of this, as too are some forms
of borrowing. Again, the Standard says that such assets and liabilities should not be
allocated to segments. Related interest receivable and finance costs are also examples of
common items as referred to above.

(ii) Southern Crossing – Segment report Year to 31 March 2006

Food Paint Motors Total
K ‘ Millions K ‘ Millions K ‘ Millions K ‘ Millions
Revenue
External sales 2,700 3,150 2,150 8,000
Inter-segment sales nil nil 250 250
—— —— —— ——
Total revenue 2,700 3,150 2,400 8,250
—— —— —— ——
Results
Segment profit 700 650 470 (w (i)) 1,820
Unallocated corporate expenses (500)
——
Operating profit 1,320
Interest expense (120)
Interest income 30
Group share of associate 300 300
——
Group profit before tax 1,530
Other information
Segment assets 2,500 2,700 2,000 7,200
Investment in associate 1,400 1,400
Unallocated corporate assets 300
——
Consolidated total assets 8,900
Segment liabilities (500) (450) (250) (1,200)
——
Total net assets 7,700
——
Working
(i) The profit before tax of K1, 870 million given in the question needs to be adjusted
for K50 million profit (deducted) made on inter-segment sales (K250 million ×
20%).

67
68
CHAPTER 5

IAS 16: NON CURRENT ASSETS

Where assets held by an enterprise have a limited useful life to that enterprise, it is
necessary to apportion the value of an asset used in a period against the revenue it has
helped to create, If an asset’s life extends over more than one accounting period.

With the exception of land held on freehold or long leasehold every non-current asset
eventually wears out over time. When a business acquires a non-current asset it will have
some ideas about how long it’s useful life will be.

Definitions:

Depreciation is defined as the allocation of the depreciable amount of an asset over its
estimated useful life.

Depreciable asset are assets which:

 Are expected to be used during more than one accounting period,
 Have a limited useful life,
 Are held by an enterprise for use in the production or supply of goods and services
 for rental to others or for administrative purposes.

Useful life is ether

 The period over which a depreciable asset is expected to be used by the
enterprise,
 The number of production units or hours expected to be obtained from the use of
asset by the enterprise.
The following factors should be considered when estimating the useful life:
 Physical wear and tear,
 Obsolescence,
 Legal or other limits on the use of the assets.

The useful life should be reviewed periodically and depreciation rates adjusted for the
current and future periods if expectations vary significantly from the original estimates.

Depreciable amount of depreciable assets is the historical cost or other amount

substitute for historical cost in the financial statement less the estimated residual value.

Details:
An item of property, plant and equipment, which qualifies for recognition, as an asset
should initially be measured at it’s cost. The cost comprises:
It’s purchase price including, import duties and non-refundable purchase taxes, and
Any directly attributable costs of bring the asset to working condition for its intended
use,
Any trade discounts and rebates are deducted in arriving at the purchase price.

69
Activity 1

Kabwe, a food retailer, decided to start a home delivery service from 1 November 2005.
As Kabwe had no vehicles suitable for use by the new service, it purchased three small
delivery vehicles to enable him to provide the service.
The invoice for the vehicles included the following details:
K’000
Cost price – per vehicle 12,000
Less: Trade discount (2,400)
9,600
Delivery charge 250
Customs duty 4,500
VAT 2,670
One vehicle 17,020

Three vehicles 51,060

1 year’s insurance for the three vehicles 3,900
Total cost of three vehicles 54,960

What is the cost of the Delivery vans?

Remember the cost should include the following costs:

 Actual cost of the car,

 Import duties, and non refundable purchase taxes,
 Any directly attributable costs to bring the asset to working condition,
 Less any trade discounts and rebates,

Solution:
The cost is made up of the following items:
K’000
Actual price 12,000
Less
T Discount (2,400)
9,600
Delivery costs 250
Duty 4,500
Total per Van 14,350

Note that VAT cannot be included if the company is registered for VAT as the company
can claim the VAT as input VAT. If it is not registered then it would be included as part
of the cost.
The insurance cannot be included in the cost of the Van as they are costs not directly
attributable to bring the van in working condition.
So the total cost for 3 Vans is K14, 350,000 * 3 = K43, 050,000.00 If VAT was not
included as the company will claim it. If VAT were included it would be K51,060,000.00

When payment for an item of property plant and equipment is deferred beyond normal
credit terms, its cost is the cash price equivalent the difference between this amount and

70
the total payment is recognised as interest expenses over the period of credit (in the
income statement) unless it is capitalised.

Administration and other general overheads are not a component of the cost unless they
can be directly attributed to the acquisition of the asset or brining the asset to its working
condition.

The cost of a self-constructed asset (asset made by the company) is determined using
the same principles as for an acquired asset. If an enterprise makes similar asset’s for sale
in the normal course of business, the cost of the asset is usually the same as the cost of
producing the asset for sale. Abnormal amounts are not included in the cost of the asset.

An item of asset may be acquired in exchange or part exchange for a dissimilar item of
asset or other asset. The cost of such an item is measured at the fair value of the asset
received which is equivalent to the fair value of the asset given up, adjusted by the
amount of any cash or cash equivalent transferred. Under these circumstances, the asset
given up is written down and this written down value assigned to the new asset.

Subsequent expenditure relating to an item of property, plant and equipment that has
already been recognised should be added to the carrying amount, of the asset when it is
probable that future economic benefit in excess of the originally assessed standards of
performance, of the existing asset will flow to the enterprises. All other subsequent
expenditure should be recognised as an expense in the period in which it is incurred.

Subsequent expenditure on property, plant, and equipment is only recognized as an asset

when the expenditure improves the condition of the asset beyond its originally assessed
standard of performance.

Expenditure on repairs or maintenance on assets is made to restore or maintain the future

economic benefits that an enterprise can expect from the originally assessed standard of
performance of the asset, such should be recognized as an expense.

Major components of some items of assets may require replacement at given intervals.
The components are accounted for as separate asset’s because they have useful lives
different from those of the other item’s of the asset to which they relate. Therefore, the
component is accounted for as the acquisition of a separate asset and replaced asset is
written off.
Measurement subsequent to initial recognition:
Benchmark treatment:
Subsequent to initial recognition as an asset, an item of property, plant, and equipment
should be carried at its cost less any accumulated depreciation and any accumulated
impairment losses.

Allowed alternative treatment:

Subsequent to initial recognition as an asset, an item of property, plant, and equipment
should be carried at a revalued amount being its fair value at the date of revaluation less
any subsequent accumulated depreciation, and subsequent accumulated impairment loses.
Revaluation should be made with sufficient regularity, such that the carrying amount
does not differ materially from that which would be determined using fair value at
balance sheet date.

71
How revaluation should be done

When an asset is revalued, any accumulated deprecation at the date of the revaluation is
either:

Restated proportionately with the change in the gross carrying amount of the asset, so
that the carrying amount of the asset after revaluation equals its revalued amount. This
method is often used when an asset is revalued by mean of an index to its depreciated
replacement cost.

Eliminated against the gross carrying amount of the asset and the net amount restated to
the revalued amount of the asset.

When an item of property, plant, and equipment is revalued, the entire class of property,
plant, and equipment to which that asset belongs should be revalued.
When an asset-carrying amount is increased because of a revaluation the increase, should
be credited directly to equity under the heading of revaluation surplus. However, a
revaluation increase should be recognized as income to the extent that, it reverses a
revaluation decrease of the same asset previously recognized as an expense.

When an asset’s carrying amount is decreased because of a revaluation, the decrease

should be recognized as an expense. However, a revaluation decrease should be charged
directly against any related revaluation surplus to the extent that the decrease dose not
exceed the amount held in the revaluation surplus in respect of that same asset.

How depreciation charge should be done

The depreciable amount of an item of property, plant and equipment should be allocated
on a systematic basis over its useful life. The deprecation method used should reflect the
pattern in which the asset’s economic benefits are consumed by the enterprise. The
depreciation charge for each period is recognized as an expense, unless it is included in
the carrying amount of another asset.

However, when the allowed alternative treatment is adopted, a new estimate of

depreciation charge is made at the date of any subsequent revaluation of the asset. The
estimate is based on the residual value prevailing at the date of the estimate, for similar
asset’s which have reached the end of their useful lives and which have operated under
conditions similar to those in which the asset will be used.

Method’s of depreciation
A variety of depreciation method’s can be used, to allocate the depreciable amount of an
asset on a systematic basis over the useful life. These methods’s include:
 Straight line method,
 Diminishing balance method,
 Sum of the units method,
 Machine operating hours,
 Output method.

72
The method used for an asset is selected based on the expected pattern of economic
benefits and is consistently applied from period to period unless there is a change in the
expected pattern of the economic benefits from the asset.

The useful life of an item of asset should be reviewed periodically, and if expectation’s
are significantly different from previous estimate, the depreciation charge, for the current
and future periods should be adjusted.

The depreciation method applied to asset’s, should be reviewed periodically and if there
has been a significant change in the expected pattern of economic benefits from those
asset’s, then the method should be changed to reflect the changed pattern. When such a
change in depreciation method is necessary, the change should be accounted for as a
change in accounting estimates and the depreciation charge for the current and future
periods should be adjusted. We will look at the treatment later in IAS 8.

Disposals of assets
An asset should be removed from the balance sheet on disposal or when it is withdrawn
from use or when no future economic benefits are expected from its. The gains and loss
on disposal, is the difference between the proceeds and the carrying amount and should
be recognized in the income statement’s. That means that any surplus revaluation on the
asset should be transferred to the profit and loss retained account.

How non-current asset’s should be shown in the balance sheet and notes required.
For each class of property, plant and equipment disclose:
 Basis for measuring carrying amount
 Deprecation methods used
 Useful lives or depreciation rates
 Gross carrying amount and accumulated deprecation and impairment losses
 Reconciliation of the carrying amount at the beginning and the end of the period
showing:

- Additions
- Disposals
- Acquisitions through business combination
- Revaluation increases
- Impairment losses
- Reversals of impairments losses
- Depreciation
- Net foreign exchange difference on translation
- Other movements

Also disclose the following:

 Restrictions on title,
 Expenditures to construct property, plant and equipment during the period;
 Commitments to acquire property, plant and equipment;
 Compensation from third parties for items of property, plant and equipment
that were impaired, lost or given up, that is included in profit or loss.

73
If the property, plant and equipment is stated at revaluation amount’s certain additional
disclosure are required:

 The effective date of the revaluation,

 Whether an independent valued was involved,
 The method and significant assumptions used in estimating fair values,
 The extent to which fair value were determined, directly by reference to
observable prices in an active markets or recent markets transaction on arms
length terms or were estimated using other valuation techniques
 Carrying amount that would have been recognized had the assets been carried
under the cost model,
 The revaluation surplus, including changes during the period and distribution
restriction.

An example of the layout should be like:

Extract of the balance sheet.
31 December 2006 31 December 2005
K ‘ Millions K ‘ Millions
Non-current assets
Property, plant and equipment (note 1) X X
Note 1 Property, plant and equipment
Land and building Plant Total
K ‘ Millions K ‘ Millions K ‘ Millions
Cost or valuation:
At 1 January 2006 X X X
Additions:
Purchases X X X
Revaluation X - X
–––– –––– ––––
X X X
Less:
Disposal (X) (X) (X)
–––– –––– ––––
At 31 December 2006 X X X
–––– –––– ––––
Accumulated depreciation:
At 1 January 2006
Charge for year X X X
Revaluation (X) - (X)
Disposal (X) (X) (X)
–––– –––– ––––
At 31 December 2006 X X X
–––– –––– ––––
Carrying value on:
31 December 2006 X X X
31 December 2005 X1 X X

74
Example 1
Sable Land PLC is a publicly listed company.
Details of Sable Land PLC’s non-current assets at 1 October 2005 were:

Land and building Plant Total

K ‘ Millions K ‘ Millions K ‘ Millions
Cost/valuation 280 150 430
Accumulated
Depreciation/amortisation 1 (40) (105) 1 (145)
–––– –––– ––––
Net book value 240 45 285
–––– –––– ––––

The following information is relevant:

(i) The land and building were revalued on 1 October 2004 with K 80 million attributable
to the land and K 200 million to the building. At that date the estimated remaining life of
the building was 25 years. A further revaluation was not needed until 1 October 2005
when the land and building were valued at K 85 million and K 180 million respectively.
The remaining estimated life of the building at this date was 20 years.
(ii) Plant is depreciated at 20% per annum on cost with time apportionment where
appropriate. On 1 April 2005 new plant costing K 45 million was acquired. In addition,
this plant cost K 5 million to install and commission. No plant is more than four years
old.
There were no disposals of non-current assets during the year to 30 September 2006

Required:
(i) Prepare balance sheet extracts of sable land PLC’s non-current assets as at 30
September 2006 (including comparative figures), together with any disclosures
required (other than those of the accounting policies) under current International
Financial Reporting Standards.
(ii) Explain the usefulness of the above disclosures to the users of the financial
statements.

Solution to Example 1
30 September 2006 30 September 2005
Non-current assets
K’million K’million
Property,
plant and equipment (note 1) 316 285
Note 1 Property, plant and equipment
Land and building Plant Total
K’million K’million K’million
Cost or valuation:
At 1 October 2005 280 150 430
Additions --- 50 5 50
Revaluation (5 – 20) (15) 1 nil 1 (15)
–––– –––– ––––
At 30 September 2006 265 200 465
–––– –––– ––––

75
Accumulated depreciation:
At 1 October 2005 1 40 105 145
Charge for year 11 91 35 1 44
Revaluation 1 (40) 1 nil 1 (40)
–––– –––– ––––
At 30 September 2006 9 140 149
–––– –––– ––––
Carrying value:
30 September 2006 256 1 60 316
30 September 2005 240 45 284

Note:
(i) The land and buildings were revalued by an appropriately qualified value on an
existing use basis on 1 October 2005.
They are being depreciated on a straight-line basis over a 25-year life. Plant is
depreciated at 20% per annum on cost.

(ii) The usefulness of the above disclosures:

Users can determine which type of non-current assets a business owns. There is a
great deal of difference between owning say, land and buildings compared with plant.
The above figures give an illustration of this; the property has increased in value
whereas the plant has not. Another factor relevant to this distinction is that it is
usually easier to raise finance using property as security.

It is useful to know whether non-current assets are carried at historical cost or at

revalued amount. If a company is using historical cost, it may be that balance sheet
values are seriously understated with a consequential effect on depreciation charges.

Information on accumulated depreciation gives a broad indication of the age of the

relevant assets. In the case of Sable Land, other than the plant acquired during the
year, plant is almost fully depreciated. The implication of this, assuming the
depreciation policy is appropriate, is that further acquisitions will be required in the
near future.

This in turn has future cash flow implications.

It can also be noted that no disposals of plant have occurred, thus the acquisition of
plant represents an increase in capacity. This may be an indication of growth.

Example 2
The plant account of a company is shown below:
Plant – Cost
K’000 K’000
1 January 2005 Balance
B/d 380 1 October Transfer disposal
account – cost of plant sold 30
1 April Cash – Plant 51
31 Dec Bal C/D 401
431 431

76
The company’s policy is to charge depreciation on plant at 20% per year on the straight-
line basis, with proportionate depreciation in years of purchase and sale.
What should the company’s plant depreciation charge be for the year ended 31
December 2005?
A K 82,150
B K 79,150
C K 77,050
D K 74,050

Solution to Example 2

1 January 2005 to 31st September 2005

K
K380, 000 X 9/12 X 20% = 57, 000

1 April 2005 to 31 December 2005

K51, 000 X 9/12 X 20% = 7, 650

1 October to 31 December 2005

(K380, 000- K30, 000) X 3/12 X 20% = 17, 500
82, 150
The answer is A K82, 150

Example 3

The accounting records of P & W Logistics, a limited liability company included the
following balances at 30 June 2004:

K’million
Office buildings – cost 1,600
Office buildings – accumulated depreciation
Office buildings – (10 years at 2% per year) 1, 320

Plant and machinery – cost (all purchased in 2004 or later) 1, 840

Plant and machinery – accumulated depreciation
Plant and machinery – (straight line basis at 25% per year) 1, 306

During the year ended 30 June 2005 the following events occurred:

2004
1 July it was decided to revalue the office building to K2, 000,000,000 with no change to
the estimate of its remaining useful life.
1 October new plant costing K200, 000,000 was purchased.

2005
1 April Plant, which had cost K240, 000,000 and with accumulated depreciation at 30
June 2004 of K180, 000,000 was sold for K70, 000,000.

It is the company’s policy to charge a full year’s depreciation on plant in the year of
acquisition and none in the year of sale.

77
Required:
Prepare the following ledger accounts to record the above balances and events:
(a) Office building:
Cost/valuation,
Accumulated depreciation,
Revaluation reserve.

(b) Plant and machinery:

Cost,
Accumulated depreciation,
Disposal.

Solution to Example 3

(a) Office building – cost/valuation

K’million K’million
1 July 2004 Balance 1,600
1 July Revaluation 400 Balance 2,000
–––––––––– ––––––––––
2,000 2,000
–––––––––– ––––––––––
Office building – accumulated depreciation
K’million K’million
1 July 2004 1 July 2004 Balance b/d 320
Revaluation reserve 320

30 June 2005 Balance C/D 50 30 June 2005

Income statement
(W1) 50
––––––––– –––––––––
370 370
––––––––– –––––––––
Revaluation reserve
K’million

1 July 2004 Office building – cost 400

1 July 2004 Office building
– Depreciation 320
–––––––––
30 June 2005 b/d 720
–––––––––

78
(b) Plant and machinery – cost

K’million K’million
1 July 2004 Balance b/d 840 1 April 2005
Transfer disposal 240
1 Oct 2004 Cash 200 30 June 2005 Balance C/D 800
–––––––––– ––––––––––
1,040 1,040
–––––––––– ––––––––––

1 July 2005 Balance b/d 800

Plant and machinery – accumulated depreciation

K’million K’million
1 July 2004 Balance b/d 306
1 April 2005
Transfer – disposal 180
30 June 2005 Balance C/D 326 30 June
Income statement (W2) 200
–––––––––– ––––––––––
506 506
–––––––––– ––––––––––

Plant and machinery – disposal

K’million K’million
1 April 2005
Transfer – cost 240 1 April 2005
Transfer – depreciation 180
30 June 2005 Cash 70
Profit on disposal (P/L) 10
–––––––––– ––––––––––
250 250
–––––––––– ––––––––––
Workings:

1 Depreciation of office building

K2m/40 (remaining useful life) = K50, 000,000

2 Depreciation of plant and machinery

25% x (K840, 000,000 – K240, 000,000 + K200, 000,000) = K200, 000,000

79
CHAPTER 6

IAS 33: EARNINGS PER SHARE

The objective of IAS 33 is to improve the comparison of the performance of different
entities in the same period and of the same entity in different accounting periods, by
prescribing the method for determining the number of shares to be included in the
calculating of earnings per share and by specifying their presentation.

Scope
This standard should be applied by enterprises whose ordinary shares or potential
ordinary shares are publicly traded, and by enterprises that are in the process of issuing
ordinary shares or potential ordinary shares in public securities markets.

An enterprises which has neither ordinary shares nor potential ordinary shares which are
publicly traded but which discloses earnings per shares should calculate and disclose
earnings per share in accordance with this standard.

The following terms are used in this standard with the meaning specified:
An ordinary share is an equity instrument that is subordinate to all other classes of
equity instrument.

A potential ordinary share is a financial instrument or other contract that may

entitle its holders to ordinary shares.

Warrants and options are financial instruments that give the holder the right to
purchase ordinary share.

A financial instrument is any contract that gives to both a financial asset of one
enterprise and a financial liability or equity instrument of another enterprise.

An equity instrument is any contract that evidences a residual interest in the assets
of an enterprise after deducting all of its liabilities.
Fair value is the amount for which an asset could be exchanged or a liability settled
between knowledgeable, willing parties in an arms length transaction.

Basic earnings per share.

This is calculated by dividing the net profit or loss for the period attributable to ordinary
shareholders by the weighted average number of ordinary shares outstanding during the
period.

The net profit or loss for the period attributable to ordinary shares should be the net profit
or loss for the period after deducting preference dividends. All items of income and
expenses, which are recognized in a period including tax expenses, extraordinary items
and minority interest are included in the determination of the net profit or loss for the
period. The amount of net profit attributable to preference shareholders including
preference dividends for the period is deducted from the net profit for the period in order

80
to calculate the net profit or loss for the period. The amount of preference dividends that
is deducted from the net profit for the period is:
The amount of any preference dividends on non cumulative preference share declared in
respect of the period.
The full amount of the required preference dividends for cumulative preference shares for
the period whether or not the dividends have been declared. The amount of preference
dividends for the period does not included the amount of any preference dividends for
cumulative preference share paid or declared during the current period in respect of
previous periods.

For calculating basic earnings per share, the number of ordinary share should be the
weighted average number of ordinary share outstanding during the period. It is the
number of ordinary shares outstanding at the beginning of the period adjusted by the
number of ordinary share bought back or issued during the period multiplied by a time
weighting factor. The time weighting factor is the number of days that the specific shares
are outstanding as a proportion of the total number of days in the period.
In most cases, shares are included in the weighted average number of shares from the
date consideration is receivable for example:

Ordinary shares issued in exchange for cash are included when cash is receivable.
Ordinary shares issued on the voluntary reinvestment of dividends on ordinary or
preference shares are included at the dividend payment date.

Ordinary shares issued because of the conversion of a debt instrument to ordinary

shares are included as of the date interest ceases accruing.

Ordinary shares issued in place of interest or principal on other financial instrument

are included as of the date interest ceases accruing.

Ordinary shares in exchange for the settlement of a liability of the enterprises are
included as of the settlement date.

Ordinary shares issued as consideration for the acquisition of an asset other than cash
are included as of the date on which the acquisition is recognized.

Ordinary shares issued for the rendering of service to the enterprise is included as the
service are rendered.

In these and other cases, the timing of the inclusion of ordinary shares is determined by
specific terms and conditions attaching to their issue. Due consideration should be given
to the substance of any contract associated with the issue.

81
The formula for Basic EPS:

Profits available to equity shareholders

Number of equity shares

Activity 1
The summarized accounts of Lions PLC for the years ended 2004 and 2005 showed:

Profit and loss account extract:

2004 2005
K’million K’million

Revenue 980 1,170

Operating profit 35 43.2
Finance cost 3.96 3.96
Profit before tax 31.04 39.24
Tax expenses 9.31 11.77
Profit after tax 21.73 27.47
Dividends:
Preference .16 .16
Ordinary 4.6 5.83
Profit after tax & Dividend 16.97 21.48

Balance sheet extract:

K’million K’million
Share capital and reserves
Ordinary shares K0.25 each 19.8 19.8
8% preference shares K1 each 2 2
Profit and loss 62.78 84.26

Solution to activity 1
The formula for Basic EPS:

Profits available to equity shareholders

Number of equity shares

2005
Profits available
to equity shareholders K21.57 million K27.31 million

Number of equity shares 79.2million 79.2million

The basic EPS is: 27.23 ngwee 34.48 ngwee

82
There are other events however, which change the number of shares outstanding without
a corresponding change in resources. In theses circumstances it is necessary to make
adjustment so that the current and prior periods EPS figures are comparable.

Seven such events are:

 Capitalization or bonus issue,
 Rights issue,
 Convertible preferred shares,
 Share warrants and options,
 Contingently issuable shares,
 Employee stock purchase plans,
 Contractual rights to purchase shares.

Capitalization or bonus issue

In a capitalisation or bonus issue or a share split1 ordinary shares are issued to existing
shares for no additional consideration. Therefore, the number of ordinary shares
outstanding is increased without an increase in resources. The number of ordinary shares
outstanding before the event is adjusted for the proportionate change in the number of
ordinary shares outstanding as if the event had occurred at the beginning of the earliest
period reported. Rather than calculate a weighted average the standard requires that the
bonus shares be treated as if they had occurred at the beginning of the period. The EPS
from the previous year should also be recalculated using the new number of shares in
issue to allow comparison with the current years EPS.

Activity 2
Lions PLC have 10 million ordinary shares in issue on 1st January 2005. On 1st July 2005
the company made a bonus issue of 2 million fully paid bonus share on 30th June
2005.on that date every shareholder received one bonus share for every five held. The
profit for the year was K14.0 million. The basic EPS for the year ended 31st December
2004 was 114 ngwee.

Solution to activity 2
The total shares are now 12 million shares.
The Basic EPS for December 2005 is calculated on the 12 million shares.

K14, 000,000/12,000,000 = 116.67 ngwee

The above figure of 116.67 ngwee is not compatible with the figure for December 2004,
which is 114 ngwee. Because the number of shares are different. To make them the same
we must restate the previous ratio.

114*10m/12m = 95 ngwee
Rights issue
1
The dividing of a company exists stock into multiple shares. In a 2-for-1 split, each stockholder receives an additional share
for each share he or she holds.
Notes:
This is usually a good indicator that a company's share price is doing well. However, a stock split doesn't
give you any more value, just twice as many shares.
In the U.K., a stock split is referred to as a "scrip issue," "bonus issue," "capitalization issue," or "free
issue."

83
With regard to rights issue, the ordinary shares at the time of exercise or conversion of
potential ordinary shares will not usually give rise to a bonus element. Since the potential
ordinary shares will usually have been issued for full value. In a rights issue, the exercise
price is often less than the fair value of the share. Therefore, such a rights issue
includes a bonus element. The number of ordinary share to be used in calculating basic
earnings per shares for all periods prior to the rights issue is the number of ordinary
shares outstanding prior to the issue multiplied by the following factor:

Fair value per share immediately prior to the exercise of rights

Theoretical ex rights fair value per share

The theoretical ex rights fair value per share is calculated by adding the aggregated fair
value of the share immediately prior to the exercise of the rights to the proceeds from the
exercise of the rights and dividing by the number of the shares outstanding after the
exercise of the rights. The fair value for the purposes of this calculating is established at
the close of the last day on which the shares are traded together with the rights.

The formula for the theoretical ex – right price is:

Fair value of all outstanding shares + total amount received from exercise of rights
Number of shares outstanding prior to exercise + number of shares issued in the
exercise

To obtain the EPS for the current year you should:

 Multiply the number of share before the rights issue by the fraction of the year
before the date of issue and by the factor above.
 Multiply the total number of shares after the rights issue by the fraction of the
year after the date of issue and add to the figure arrived at in the above point.
 The number of shares so calculated should be dividend into the total earnings.
 For the previous years EPS, it has to be recalculated by using the following
formula:

TERP x Previous years EPS

Fair Value

This is necessary to make comparison meaning full between the years.

Activity 3
Lions PLC had 1,000,000 ordinary shares outstanding on 1st January 2005. On 1st
October 2005 when the fair value of a Lions PLC share was K8, 000 the company made a
rights issue of 1 ordinary share for every 2 previously held, at a price of K5, 000 per
share. The earnings of the company for the year ended 31st December 2005 were K450
million. The basic EPS that had been reported in the 2004 accounts was K500.

Required what is the basic EPS for years 2005 and 2004?

The steps to follow are:

84
 Determine the TERP,

Number Values of shares

K
Pre rights 2 16,000 (2 old shares*K8, 000)
Rights 1 5,000 (1 new share * K5, 000)
Post rights 3 21,000

TERP = K21, 000/3 = K7, 000 per share

 Multiply the number of share before the rights issue by the fraction of the year before
the date of issue and by the factor above.

Number of share before * # of months before the rights issue * factor (FV/TERP)

1,000,000 * 9/12 * K8, 000/K7, 000 = 857,142.85

Multiply the total number of shares after the rights issue by the fraction of the year
after the date of issue and add to the figure arrived at in the above point.

Total number of share (before the rights issue and the rights issue) * # of months after
the rights issue

The rights issue was 1 for 2 that means that for 1,000,000 old shares you get 500,000
shares for the rights issue. After the rights issue the total shares are 1,500,00.

1,500,000 * 3/12 = 375,000

Therefore, the total number of shares used is:

857,142.85 + 375,000 = 1,232,142.85

The number of shares so calculated should be dividend into the total earnings to get
the basic EPS.

The earning in 2005 is K450, 000,000

Weighted average shares are 1,232,142.85

Basic EPS is = 450,000,000/1,232,142.85 = K365.22 per share

For the previous year’s EPS, it has to be recalculated by using the following formula:

TERP x Previous years EPS

Fair Value

The previous year EPS was K500 per share.

K7, 000 / K8, 000* K500 = K437.50 per share

85
Diluted EPS.
Dilution2 is defined as a reduction in earnings per share or an increase in loss per share
resulting from the assumption that convertible instruments are converted, that options or
warrants are exercised, or that ordinary shares are issued upon the satisfaction of
specified conditions.
A company may have in issue same securities, which do not have any claim to a share of
equity earnings but may give, rise to such a claim in the future. These securities include:
A separate class of equity share, which at present is not entitled to, any dividend but will
be later;
Convertible loan stock or preference share;
Options and warrants;
Contingently issuable shares.

Convertible loan stocks or preference shares

Convertible loan stocks are defined as stock or bond (paying a fixed interest) that may
be converted into a stated number of shares at a specific date.

Convertible preference share are defined as that shares that can be converted into
common shares at a fixed conversion price.

In such circumstances, the future number of shares ranking for dividend might increase in
future after the convention of the convertible loan stocks or the preference shares, which
in turn results in a fall in the EPS.
Where potential ordinary shares are actually issued, the basic EPS will be affected due to
two factors:
The number of shares in issue will increase,
The profits available to the shareholders may increase, may be due to the savings of
interest on convertible loan stocks.

The standard IAS 33 requires that companies publish both the basic EPS, which is
essentially the actual, historical figure calculated using the above procedures and a
diluted EPS.
The diluted EPS is a hypothetical figure that tells the shareholders what would have
happened if the potential shares had actually been in issue throughout the period.
Disclosing this figure gives the shareholders an indication of the extent to which their
EPS could be affected by the exercise of any conversion or other rights.

The earnings calculated for basic EPS should be adjusted by the post tax effect of:
Any dividends on dilative potential ordinary shares that were deducted to arrive at
earnings for basic EPS
Interest recognized in the period for the dilative potential ordinary share. The numerator
should be adjusted for the after tax effects of interest charged in relation to dilative
potential ordinary shares.
Any other changes, in income or expense that would result from the convention of the
dilative potential ordinary shares.

2
The change in earnings per share or book value per share that would result if all warrants and stock options were exercised and all
convertible securities were converted.

86
How to calculate the diluted EPS

The number of ordinary shares is the weighted average number of ordinary shares
calculated for the basic EPS plus the weighted average number of ordinary shares that
would be issued on the conversion of the dilative potential ordinary shares in ordinary
shares.
It should be assumed that dilative ordinary shares were converted into ordinary shares at
the beginning of the period or later at the actual date of issue.

The pro forma:

The earnings
K’million
Profits for the period X
Add back loan stock interest net tax X
Profit to be used X
The number of shares:
Number of shares
Basic weighted average X
Add shares on conversion X
Number of shares to be used X
Activity 4

At 31st December 2004 and 2005, the issued share capital of a company consisted of
2,000,000 ordinary shares of K1 each. On 1st October 2000 the company issued K1.5
billion of 18% convertible loan stocks for cash at par. Each K15, 000 nominal of the
loan stock may be converted at any time during the four years ended 31st December 2007
into the number of ordinary shares set out below:

31st December 2004 140 ordinary shares

31st December 2005 130 ordinary shares
31st December 2006 120 ordinary shares
31st December 2007 110 ordinary shares

The profit before interest and taxation for the year ended 31st December 2004 and 2005
amounted to K9 billion and K9.8 billion respectively, all from continuing operation.
Company tax for both periods is 30% on the profit after interest.

Calculate the basic and diluted EPS for the year ended 31st December 2004 and
2005.
Solution to activity 4
Trading results summary
2004 2005
K’ million K’ million
Profit before interest
And taxation 9,000 9,800
Less:
Finance cost (K1.5billion @ 18%) (270) (270)
Profit after interest before
Taxation 8,730 9,530

87
Less:
Taxation expenses @ 30% (2,619) (2,859)
Profit after taxation 6,111 6,671
Basic EPS

Number of share existing now before the convention of the convertible loan stock is
2,000,000.
K6, 111,000,000 K6, 671,000,000
2,000,000 2,000,000

Basic EPS is K3, 055.50 K3, 335.50

Diluted EPS
You assume the convention has taken place and at the start of each the year

For 2004
We need to calculate the number of loan stock share available.
K1, 500,000,000/ K15, 000 = 100,000 convertible loan stock shares.
Each loan stock as at 31st December 2004 you get 140 ordinary shares. So for the 100,000
loan stock shares you will have 1,400,000 (100,000*140), The share on convention plus
the existing share of 2,000,000 the total shares would be 3,400,000.

For 2005
We need to calculate the number of loan stock share available.
K1, 500,000,000/ K15, 000 = 100,000 convertible loan stock shares.
Each loan stock as at 31st December 2005 you get 130 ordinary shares. So for the 100,000
loan stock shares you will have 1,300,000 (100,000*130), The share on convention plus
the existing share of 2,000,000 the total shares would be 3,300,000.

The profit should be adjusted because if the loan is converted it will mean that the
company will save the interest on the loan. So the profit should be higher.
2004 2005
K’ million K’ million
Profit before interest
And taxation 9,000 9,800
Less:
Finance cost - -
Profit after interest before
Taxation 9,000 9,800
Less:
Taxation expenses @ 30% (2,700) (2,940)
Profit after taxation 6,300 6,860

Diluted EPS for 2004 = K6, 300,000,000 / 3,400,000 = K1, 852.94

Diluted EPS for 2005 = K6, 860,000,000 / 3,300,000 = K2, 078.78

The diluted EPS is disclosed as a supplementary figure.

88
Share option and warrants3.
Where a company has potential ordinary shares in issue the dilutive EPS needs to
consider the effects on the earnings and on the number of shares issued if the potential
ordinary shares are converted into ordinary shares. In the case of options and warrants, it
is not immediately obvious what the effects on the future earnings are likely to be.
Therefore, the standard requires that the assumed proceeds from the issue of shares under
the options and warrants should be considered as comprising:

The issue of a number of ordinary shares at fair value having no dilative effects,
The issue of a number of ordinary shares for no consideration with a consequential
dilative impact on the number of shares in issue.

The following formula determines the number of shares, which have no effect so that
they can be removed to leave only share with effect.

The formula is:

Shares under option or warrants * exercise price / fair value of ordinary shares.
The pro forma:
The earnings:
K’ million
Profits for the periods X
Profit to be used X

The number of shares:

Number of shares
Basic weighted average X
Add shares issued at nil Consideration X
Number of shares to be used X

Activity 5

Lions PLC have 5 million ordinary shares in issue during its accounting year ended 31st
December 2005. The profit after tax for that period was K10.5 billion and the average
price of an ordinary share was K5, 000. Throughout the year the company has had 1
million share options outstanding to subscribe for 1 ordinary share at K4, 000.

Calculate the basic EPS and the diluted EPS.

Solution to activity 5

The basic EPS is calculated as:

The formula for Basic EPS:

3

Share option
A privilege sold by one party to another, that offers the buyer the right, but not the obligation, to buy or sell a security at an agreed-
upon price, during a certain period of time or on a specific date.
Warrant
A derivative security, that gives the holder the right to purchase securities (usually equity) from the issuer at a specific
price within a certain time frame

89
 Profits available to equity shareholders
Number of equity shares

K10, 500,000,000
5,000,000

K2,100 per share

Diluted EPS
Currently the company has actual share in issue of 5 million. Now the share options are
classed as potential share. Meaning that the holders of the options can exercise to buy the
ordinary shares in the company. Currently they have not done so. IAS 33 says even if,
now they have not changed, we assume that they have converted to ordinary shares from
the share option.

Currently we have 1,000,000 shares in options, if converted it would mean that the
company will receive K4, 000,000,000 (1,000,000* K4, 000).
The company will have to issue 1 ordinary share for every 1 option; in total 1000000
ordinary shares will be issued.

Now the company’s share is trading at a price of K5, 000 per share. We issue the new
shares at K 4,000 per share. The holders of the option will benefit. This is where you
consider the following point’s above that is:

“Therefore, the standard requires that the assumed proceeds from the issue of shares
under the options and warrants should be considered as comprising:
The issue of a number of ordinary shares at fair value having no dilative effects,
The issue of a number of ordinary shares for no consideration with a consequential
dilative impact on the number of shares in issue.

The following formula determines the number of shares, which have no effect so that
they can be removed from the total to leave only share with effect”.

The formula is:

Shares under option or warrants x exercise price / fair value of ordinary shares.

If we use the above formula it will give as the number of

1,000,000 x K4, 000 / K5, 000 = 800,000

The 800,000 shares are the ones without a dilutive effect. We need share that have a
dilative effect, 1,000,000 – 800,000 = 200,000. 200000 are the shares with a dilutive
effect.
The total shares then become 5,000,000 + 200,000 = 5,200,000.

The diluted EPS is

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K10, 500,000,000 / 5,200,000 = K 2,019.23 per share

Contingently issuable shares.

Ordinary shares that are issuable upon the satisfaction of certain conditions are called
contingently issuable shares. Where such shares are issued they are only included in the
calculation of the EPS when all the necessary conditions have been satisfied. Therefore
the dilative EPS is based on the assumption that the new shares are issued at the
beginning of the year when the conditions are meet in that year. Note that many
employee share option schemes operate in this manner.

Dilative potential ordinary shares.

Anti dilution4 is defined as an increase in earnings per share or a reduction in loss per
share resulting from the assumption that convertible instruments are converted, that
options, warrants are exercised, or that ordinary shares are issued upon the satisfaction of
specified condition.
Potential ordinary shares should, be treated as dilative when and only when their
conversion to ordinary shares would decrease net profit per share from continuing
ordinary operations.
An enterprise uses net profit from continuing ordinary activities as the control number,
that is used to establish whether potential ordinary shares are dilative or anti dilative. The
net profit from continuing ordinary activities is the net profit from ordinary activities
after deducting preference dividend and after excluding items relating to discontinued
operation therefore it excludes extraordinary item and the effects of changes in
accounting policies and correction of fundamental errors.
Potential ordinary shares are anti dilative when their conversion to ordinary shares
increases earnings per share from continuing ordinary operations or decrease loss per
share from continuing ordinary operations. The effects of anti dilative potential ordinary
shares are ignored in calculating dilative earnings per share.
In considering whether potential ordinary shares are dilative or anti dilative each issue or
series of potential ordinary shares is considered separately rather than in aggregate. The
sequence in which potential ordinary shares are considered may affect whether or not
they are dilative. Therefore, in order to maximise the dilative of basic earnings per share
each issue or series of potential shares is considered in sequence from the most dilative to
the least dilative.
Note the final dilative EPS will incorporate the potential effect of the conversions. That is
only the potential ordinary share’s that have an effect; those without an effect are
excluded.

The steps are:

Calculate the EPS for each item that is the income on each item dividend by the shares
for each item.

Identifying the dilative share to include in the diluted EPS that is working on the
continuing operations net profit.
4
Dilution: A reduction in earnings per share or an increase in loss per share resulting from the assumption that convertible instruments
are converted, that options or warrants are exercised, or that ordinary shares are issued upon the satisfaction of specified conditions.
Anti dilution: An increase in earnings per share or a reduction in loss per share resulting from the assumption that convertible
instruments are converted, that options or warrants are exercised, or that ordinary shares are issued upon the satisfaction of specified
conditions

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Finally, calculate the basic EPS and the diluted EPS including only those potential shares
that have a dilative effect.

An enterprise should present basic and diluted earnings per share on the face of the
income statement, for each class of ordinary shares that has a different right to share in
the net profit for the period. An enterprise should present basic and diluted earnings per
share with equal prominence for all periods presented. This standard requires an
enterprise to present basic and diluted earnings per shares even if the amount disclosed
are negative.

An enterprise should disclose the following:

The amount used as the numerators in calculating basic and diluted earnings per share
and a reconciliation of those amounts to the net profit or loss for the period.
The weighted average number of ordinary shares used as the denominator in
calculating basic and diluted earnings per share and the reconciliation of these
denominators to each other.

The basic and the diluted EPS need to be disclosed on the face of the income
statement with equal prominence being given to each.

Instruments (including contingently issuable shares) that could potentially dilute basic
earnings per share in the future, but were not included in the calculation of diluted
EPS because they are anti dilutive for the period(s) presented.

A description of those ordinary share transactions or potential ordinary share

transactions that occur after the balance sheet date and that would have changed
significantly the number of ordinary shares or potential ordinary shares outstanding at
the end of the period if those transactions had occurred before the end of the reporting
period. Examples include issues and redemptions of ordinary shares, warrants and
options, conversions, and exercises.

Illustration 1
CCJ PLC has in issue 1,200,000 Ordinary shares of K1 each and 100,000 18% Preference
shares of K300 each. Income statement for the year to 31 March 2005 is shown below:

K’ 000 K’ 000
Profit before interest and tax 528,934
Interest paid 6,578
Profit before tax 522,356
Taxation 125,860
Profit after tax 396,496
Dividends: Ordinary 10,800
Dividends: Preference 1,800 12,600
Retained profit for year 383,896

What figure should be reported as basic earnings per share as defined in IAS 33?
A 319·9 ngwee

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B 328·9 ngwee
C 330·4 ngwee
D 435·3 ngwee
The answer is B ((396,496,000 – 1,800,000) / 1,200,000)

Example 2
The financial statements of a company may include the following items:
(i) Profit from discontinued activities,
(ii) Exceptional items,
(iii) Preference dividends,
(iv) Ordinary dividends.

Which of the above items are included in the calculation of the earnings figure when
calculating basic earnings per share (as defined by IAS 33 – Earnings per share)?
A (i), (ii) and (iii)
B (i), (iii) and (iv)
C (ii), (iii) and (iv)
D (i), (ii) and (iv)

The answer is A

Example 3

Lions PLC are another company about which Mr. Cephas Mpeta has obtained the
following information from its published financial statements:

Earnings per share:

Year to 30 September 2005 2004
Basic earnings per share K25 K20

The earnings per share are based on attributable earnings of K5 billion (K3 billion in
2004) and 200 million ordinary shares in issue throughout the year (150 million weighted
average number of ordinary shares in 2004).

Balance sheet extracts: K’ million K’ million

18 % Convertible loan stock 200 200

The loan stock is convertible to ordinary shares in 2008 based on 70 new shares for each
K100 of loan stock.

Note to the financial statements:

There are directors’ share options (in issue since 2002) that allow Lions PLC directors to
subscribe for a total of 50 million new ordinary shares at a price of K1, 500 each.
(Assume the current rate of income tax for Lions PLC is 25% and the market price of its
ordinary shares throughout the year has been K2, 500)
Mr. Cephas Mpeta has read that the trend of the earnings per share is a reliable measure
of a company’s profit trend. He cannot understand why the increase in profits is 67%
(K3billion to K5 billion), but the increase in the earnings per share is only 25% (K20 to

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K25). He is also confused by the company also quoting diluted earnings per share figure,
which is lower than the basic earnings per share.

Required:
(i) Explain why the trend of earnings per share may be different from the trend of
the reported profit, and which is the more useful measure of performance;
(ii) Calculate the diluted earnings per share for Lions PLC based on the effect of the
convertible loan stock and the directors’ share options for the year to 30 September
2002 (ignore comparatives); and
(iii) Explain the relevance of the diluted earnings per share measure.

Solution to Example 3

(i) The trend shown by a comparison of a company’s profits over time is rather a ‘raw’
measure of performance and can be misleading without careful interpretation of all the
events that the company has experienced. In the year to 30 September 2005, Lions PLC’s
EPS has increased by 25% (from K20 to K25), whereas its profit has increased by a
massive 67% (from K3 billion to K5 billion). It is not possible to determine exactly what
has caused the difference between the percentage increase in the EPS and the percentage
increase in the reported profit of Lions PLC, but a simpler example may illustrate a
possible explanation. Assume company A acquired company B by way of a share
exchange. Both companies had the same market value and the same profits. A
comparison of A’s post combination profits with its pre-combination profits would be
very misleading. They would have appeared to double. This is because the post
combination figures incorporate both companies’ results, whereas the pre-combination
profits would be those of company A alone (assuming it is not accounted for as a uniting
of interest). The trend shown by the earnings per share goes some way to addressing such
distortion. In the above the increase in post combination profit would also be
accompanied by an increase in the issued share capital (due to the share exchange) thus
the reported EPS of company A would not be distorted by its acquisitive growth. It can
therefore be argued that the trend of a company’s EPS is a more reliable measure of its
earnings performance than the trend shown by its reported profits.

(ii) Now that in this question we have both the convertible loan stocks and share options,
we need to identify which of the two are dilutive and anti dilutive. We only take the share
of those that are dilutive and exclude the anti dilutive. Refer to the last sub heading of the
notes. We need to take the following steps.
Calculate the EPS for each item that is the income on each item dividend by the shares
for each item.
Identifying the dilative share to include in the diluted EPS that is working on the
continuing operations net profit.
Finally, calculate the basic EPS and the diluted EPS including only those potential shares
that have a dilative effect.

First lets determine the number of shares on each that is the loan and the option, and any
savings resulting from the conversion of each.

18% convertible loan stock.

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Currently the company is paying interest of 18% of the K200 million resulting in paying
interest of K36 million per year. If the holders of the loan stock changed to become
shareholders in the company, the company will not pay the K36 million interest. The K36
million will be a saving for the company. Remember that the profits above are after
interest and tax. It will mean that the company’s profit will increase by K36 million and
tax of K9 million (K36 million x 25%). We take the after tax savings which is K27
million (K36 million less K9 million).
When the loan stock is converted to shares this will increase the number of share.
The question say for every K100 loan stock the holders will get 70 new shares in the
company. It will mean that in total the K200 million loan stock when converted it will
give rise 140 million ordinary share.
Summary on the loan stock profit will increaser by K27 million and number of share by
140 million.

Share option

The directors will receive 50 million shares and pay the company for each share get K1,
500. Currently the market value of the share is trading for K2, 500. It means that the
directors are going to benefit. Therefore, the share option should be split into two. Those
share that are dilutive effect and non-dilutive effect.

The formula is:

Shares under option or warrants x exercise price / fair value of ordinary shares.

50,000,000 x K1, 500/ K2, 500 = 30 million have no effect hence should be excluded.
The only shares that have a dilutive effect are 20 million (50 million – 30 million)

Profit on New shares Effect per share Result

continuing issued K
operations
K
As reported 5,000,000,000 200,000,000 25
profit
18% 27,000,000 140,000,000
convertible loan
stock
5,027,000,000 340,000,000 14.79 Dilutive
Share options - 20,000,000
5,027,000,000 360,000,000 13.96 Dilutive

From the table above both the convertible loan stock and the directors’ share options will
give rise to dilution.
Diluted EPS year to 30 September 2005:
Earnings K5, 027 billion (basic K5, 000 million + K27 million loan stock)
Number of shares 360 million (basic 200 million + 140 million re loan stock + 20 million
options) Diluted EPS K 13·96 per share

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The basic EPS K25 per share (K5, 000,000,000/200,000,000)
(iii) The relevance of the diluted earnings per share measure is that it highlights the
problem of relying too heavily on a company’s basic EPS when trying to predict future
performance. There can exist certain circumstances which may cause future EPS to be
lower than current levels irrespective of future profit performance. These are said to
cause a dilution of the EPS. Common examples of diluting circumstances are the
existence of convertible loan stock or share options that may cause an increase in the
future number of shares without being accompanied by a proportionate increase in
earnings. It is important to realise that a diluted EPS figure is not a prediction of what the
future EPS will be, but it is a ‘warning’ to shareholders that, based on the current level of
earnings, the basic reported EPS would be lower if the diluting circumstances had
crystallised. Clearly future EPS will be based on future profits and the number of shares
in issue.

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97
CHAPTER 7

IAS 20 - GOVERNMENT GRANTS AND

ASSISTANCE
The following are same terms used in the standard:

Government: refers to government or its agencies and local or international

Government assistance: is action by government to provide an economic specific to an

enterprise qualifying under certain criteria. The standard does not cover for indirect
assistance.

Government grant: refers assistance by government in the form of transfer of resource

to an enterprise in return for past or future compliance with certain conditions relating to
the operating activities of the enterprise.

Grants related to assets: are government grants whose primary condition is that an
enterprise qualifying for them should purchase, construct or otherwise acquire.

Grants related to income: are government grants other than those relating to assets.

Forgivable loans: loans, which the lender undertakes to waive repayment of under
certain prescribed conditions.

Aims of governments

The purpose is to encourage an enterprise to embark on a course of action, which it

would not normally have taken if the assistance was not provided.

Why account for government grant

The objective of IAS 20 is to prescribe the accounting for, and disclosure of, government
grants and other forms of government assistance,

Comparison of financial statements with prior periods and with other enterprises.
Types of government grants
The following are the types of grants5:
 Subsidies
 Subventions
 Premiums
This standard IAS 20 should be applied in accounting for and in the disclosure of
government grants, and in the disclosure of other forms of government assistance.

The standard does not cover the following:

 Government grants covered under IAS 41 Agriculture,
5
Refer to the appendix on the list of grants at the end of this chapter

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  Government participation in the ownership of the enterprise,
 Government assistance that is provided for the enterprise in the form of
benefits such as;
a) Income tax holidays,
b) Investment tax credits, accelerated depreciation allowance,
c) Reduced income tax rates.

The government grant including non monetary grants at fair value should not be
recognized until there is reasonable assurance that:
 The enterprise will comply with the conditions attaching to them,
 The grant will be received.

Once a government grant is recognized, any related contingent liability or asset is treated
in accordance with IAS 37 provision, contingent liabilities and assets.
Government grants should be recognized as income over the period necessary to match
them with the related costs with which they are intended to compensate on a systematic
basis. They should not be credited directly to shareholders interest.

Two approaches may be used:

 Capital approach,
 Income approach.

Capital approach:
Grant is a financing device and should be dealt with as such in the balance sheet.
Since no repayment is expected, they should be credited directly to shareholders
interest.
It is inappropriate to recognize government grant in the income statement since they
are not earned but represent an incentive provided by government without related
costs.

Income approach:
Since grants are receipts from a source other than shareholders, they should not be
credited directly to shareholders interest but should be recognized as income in
appropriate period.

The enterprise earns them through compliance with their conditions and meeting the
envisaged obligations. They should be recognized as income and matched against the
costs.

A government grant that becomes receivable as compensation for expenses or losses

already incurred or for the purposes of giving immediate financial assistance to the
enterprise with no future related costs should be recognized as income of the period in
which it becomes receivable as an extraordinary item if appropriate.

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Two acceptable methods of presentation in financial statement of grants related to assets
are:
 Set up the grant as deferred income which is recognized as income on a
systematic and rational basis over useful life of the asset,
 Deduct the grant in arriving at the carrying amount of the asset. The
grant is recognized as income over the life of the depreciable asset by
way of a reduced
 depreciation charge.

A government grant that becomes repayable should be accounted for as a revision of an

accounting estimate (IAS 8). Repayment of a grant related to income should be applied
first against any unamortized deferred credit set up in respect of the grant. To the extent,
that the repayment exceeds any such deferred credit or where no deferred credits exist the
repayment should be recognized immediately as an expense. Repayment of a grant
related to an asset should be recorded by increasing the carrying amounts of the asset or
reducing the deferred income balance by the amount repayable. The cumulative
additional depreciation that would have been recognized to date as an expenses in the
absence of the grant should be recognized immediately as an expenses.

Summary of the treatments:

Purpose of the grant Recognised in the income statement.

To give immediate financial support When receivable
To reimburse previously incurred costs When receivable
To finance general activities over a period In the relevant period
To compensate for a loss of income In the relevant period

Illustration 1
A company opens a new factory in a development area and receivers a government grant
of K15 million in respect of capital equipment costing K100 million. It depreciates all
plant and machinery at 20% pa straight line.

Required:
Show the balance sheet extract to record the grant in the first year under the income
and capital approach.

Solution to illustration 1

Option 1: on the income approach:

If the income approach is used the whole amount of the grant of K15 million is deducted
from the assets cost of K100 million to give the cost of the assets as K85 million.
The depreciation will be calculated on the K85 million.

K85 million x 20% = K17 million

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Extract
In the income statement

Depreciation K17 million

In the balance sheet

Cost 85
Depreciation (17)
NBV 68

Option 2: on the capital approach

The grant will be deferred over the period of the assets, and an amount will have to be
taken to the income statement over the period of use of the asset. In the question, you can
use the same rate of depreciation to take the grant to the income statement.
No deduction is made on the cost of the asset.
The amount taken to the credit of the income statement is:
K15 million x 20% = K3 Million
From the K15 million, K3 million will be subtracted to give a balance of K12 million to
be shown under non-current liability in the balance.
K’000
Grant 15,000
Less
P/L 3,000
Balance 12,000

The depreciation is calculated as:

K100 million x 20% = K20 million

This amount will be in the expenses in the income statement.

The balance sheet will have:

K’ million
Cost 100
Less
Depreciation 20
NBV 80
Extract of the balance sheet:
K’ million
Non current assets
Plant 80

Non-current liability
Deferred grant 12

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The following should be disclosed:
The accounting policy adopted for grants including methods of presentation adopted in
the financial statement,
The nature and extent of government grant recognized in the financial statement and an
indication of other forms of government assistance from which the enterprise has directly
benefited,
Unfulfilled conditions and other contingencies attaching to government assistance that
has been recognized.

Appendix on the list of grants:

In economics, a subsidy is a kind of financial government assistance, such as a grant, tax

break, or trade barrier, in order to encourage the production or purchase of a good. The
term subsidy may also refer to assistance granted by others, such as individuals or non-
government institutions.

Examples are:
Direct subsidies,
Direct subsidies are the most simple and transparent, and arguably the least frequently
used. In theory, they would involve a direct cash transfer to the recipient. For obvious
reasons, this may be politically unacceptable or even illegal.

Indirect Subsidies
Indirect subsidy is a term sufficiently broad that it may cover most other forms of
subsidy. The term would cover any form of subsidy that does not involve a direct
transfer.

Tax Subsidy
A tax subsidy is any form of subsidy where the recipients receive the benefit through the
tax system, usually through the income tax, profit tax, or consumption tax systems.
Examples may include tax deductions for workers in certain industries, accelerated
depreciation for certain industries or types of equipment, or exemption from consumption
tax (sales tax or value added tax).

Production subsidies
In certain cases (to encourage the development of a particular industry, for example),
governments may provide direct production subsidies - cash payments for production of a
given good or service. Frequently, production subsidies are less easily identifiable, such
as minimum price policies. Indirect production subsidies may be less easy to identify,
such as infrastructure subsidies.

Regulatory advantages
Policy may directly or indirectly favor one industry, company, product, or class of
producer over another by means of regulations. For example, a requirement that full-time
government inspectors (at company expense) be present to inspect meat may favor large
producers; conversely, if small producers were not required to undergo meat inspections
at all, this may constitute a subsidy to that class of producer. It may not be evident or
clear that there is a subsidy in many cases.

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Infrastructure subsidies
Infrastructure subsidies may be used to refer to a form of indirect production subsidy,
whereby the provision of infrastructure (at public expense) may effectively be useful for
only a limited group of potential users, such as construction of roads at government
expense for a single logging company. The implication is that those users or industries
benefit disproportionately from the provision of that infrastructure, at the expense of
taxpayers.

In some cases, the "subsidy" may refer to favoring one type of production or
consumption over another, effectively reducing the competitiveness or retarding the
development of potential substitutes. For example, it has been argued that the use of
petroleum, and particularly gasoline, has been "subsidized" or favored by U.S. defense
policy, reducing the use of alternative energy sources and delaying their commercial
development.

Trade protection (Import)

Measures used to limit imports from other countries may constitute another form of
hidden subsidy. The economic argument is that consumers of a given product are forced
to pay higher prices for a given good than they would pay without the trade barrier; the
protected industry has effectively received a subsidy. Such measures include import
quotas, import tariffs, import bans, and others.

Export subsidies (trade promotion)

Various tax or other measures may be used to promote exports that constitute subsidies to
the industries favored. In other cases, tax measures may be used to ensure that exports are
treated "fairly" under the tax system. The determination of what constitutes a subsidy (or
the size of that subsidy) may be complex. In many cases, export subsidies are justified as
a means of compensating for the subsidies or protections provided by a foreign state to its
own producers.

Procurement subsidies
Governments everywhere are relatively large consumers of various goods and services.
Subsidies may occur in this process by choice of the products consumed, the producer,
the nature of the product itself, and by other means, including payment of higher-than-
market prices for goods purchased.

Consumption subsidies
Governments everywhere provide consumption subsidies in a number of ways: by
actually giving away a good or service, providing use of government assets, property, or
services at lower than the cost of provision, or by providing economic incentives (cash
subsidies) to purchase or use such goods. In most countries, consumption of education,
health care, and infrastructure (such as roads) are heavily subsidized, and in many cases
provided free of charge. In other cases, governments literally purchase or produce a good
(such as bread, wheat, gasoline, or electricity) at higher prices than the cost of sale to the
public (which may require rationing to control the cost).
The provision of true public goods through consumption subsidies is an example of a
type of subsidy that economics may recognize as efficient. In other cases, such subsidies
may be reasonable second-best solutions; for example, while it may be theoretically
efficient to charge for all use of public roads, in practice, the cost of implementing a
system to charge for such use may be unworkable or unjustified.

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In other cases, consumption subsidies may be targeted at a specific group of users, such
as large utilities, residential home-owners, and others.

Tax breaks and corporate welfare

This is a reduction in the normal rate of a particular class of taxes targeted towards an
individual or group of companies. Often this is described as "corporate welfare", although
that term is also used as a blanket term for all other forms of subsidies. Larger companies
who are planning to open a new factory, for example, shop around for a location which
will provide them with the biggest tax breaks in a process called a race to the bottom.
Locations provide these tax breaks because they often feel that the benefits of job
creation will more than offset the decline in tax revenues. Governments of all levels may
do this to encourage employment in under-developed areas. Subsidies are given as
protection to smaller producers to help them compete with larger companies, to help
correct international trade imbalances, to aid industry deemed critical to national security,
and to help industry compete with other countries - due to subsidies being common
practice throughout the world.

Subventions
Provision of help, aid, or support given by a government to an institution for research.

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CHAPTER 8

IAS 36: IMPAIRMENT LOSS

Objective
To ensure that assets are carried at no more than their recoverable amount, and to define
how recoverable amount is calculated.

Scope
IAS 36 applies to all assets except:
Inventories
Assets arising from construction contracts
Deferred tax assets
Assets arising from employee benefits
Financial assets
Investment property carried at fair value
Certain agricultural assets carried at fair value
Insurance contract assets
Assets held for sale

Therefore, IAS 36 applies to (among other assets):

 Land
 Buildings
 Machinery and equipment
 Investment property carried at cost
 Intangible assets
 Goodwill
 Investments in subsidiaries, associates, and joint ventures
 Assets carried at revalued amounts under IAS 16 and IAS 38

Key Definitions
Impairment: An asset is impaired when its carrying amount exceeds its recoverable
amount.

Carrying amount: the amount at which an asset is recognized in the balance sheet after
deducting accumulated depreciation and accumulated impairment losses.

Recoverable amount: The higher of an asset's fair value less costs to sell (sometimes
called net selling price) and its value in use.

Fair value: The amount obtainable from the sale of an asset in a bargained transaction
between knowledgeable, willing parties.

105
Value in use: The discounted present value of estimated future cash flows expected to
arise from:
The continuing use of an asset, and from
Its disposal at the end of its useful life.

Identifying an asset that may be impaired

At each balance sheet date, all assets must be reviewed to look for any indication that an
asset may be impaired (its carrying amount may be in excess of the greater of its net
selling price and its value in use). IAS 36 has a list of external and internal indicators of
impairment. If there is an indication that an asset may be impaired, then you must
calculate the asset’s recoverable amount.
The recoverable amounts of the following types of intangible assets should be measured
annually whether or not there is any indication that it may be impaired. In some cases, the
most recent detailed calculation of recoverable amount made in a preceding period may
be used in the impairment test for that asset in the current period:

 An intangible asset with an indefinite useful life.

 An intangible asset not yet available for use.
 Goodwill acquired in a business combination.

Indications of Impairment

External sources:
 Market value declines
 Negative changes in technology, markets, economy, or laws
 Increases in market interest rates
 Company stock price is below book value

Internal sources:
 Obsolescence or physical damage
 Asset is part of a restructuring or held for disposal
 Worse economic performance than expected

These lists are not intended to be exhaustive. Also, must consider materiality. Further, an
indication that an asset may be impaired may indicate that the asset's useful life,
depreciation method, or residual value may need to be reviewed and adjusted.

Determining Recoverable Amount

If fair value less costs to sell or value in use is more than carrying amount, it is not
necessary to calculate the other amount. The asset is not impaired if fair value less costs
to sell cannot be determined, then recoverable amount, is value in use for assets to be
disposed of, recoverable amount is fair value less costs to sell.

Fair Value Less Costs to Sell is

If there is a binding sale agreement, use the price under that agreement less costs of
disposal.
If there is an active market for that type of asset, use market price less costs of
disposal. Market price means current bid price if available, otherwise the price in the

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most recent transaction.
If there is no active market, use the best estimate of the asset's selling price less costs
of disposal.

Costs of disposal are the direct added costs only (not existing costs or overhead).

Value in Use

The calculation of value in use should reflect the following elements:

An estimate of the future cash flows the entity expects to derive from the asset in an arm's
length transaction;
Expectations about possible variations in the amount or timing of those future cash flows;
The time value of money, represented by the current market risk-free rate of interest;
The price for bearing the uncertainty inherent in the asset; and
Other factors, such as liquidity, that market participants would reflect in pricing the
future cash flows the entity expects to derive from the asset.

Cash flow projections should be based on reasonable and supportable assumptions, the
most recent budgets and forecasts, and extrapolation for periods beyond budgeted
projections. IAS 36 presumes that budgets and forecasts should not go beyond five years;
for periods after five years, extrapolate from the earlier budgets. Management should
assess the reasonableness of its assumptions by examining the causes of differences
between past cash flow projections and actual cash flows. Cash flow projections should
relate to the asset in its current condition – future restructurings to which the entity is not
committed and expenditures to improve or enhance the asset's performance should not be
anticipated.
Estimates of future cash flows should not include cash inflows or outflows from
financing activities, or income tax receipts or payments.

Discount Rate
In measuring value in use, the discount rate used should be the pre-tax rate that reflects
current market assessments of the time value of money and the risks specific to the asset.
The discount rate should not reflect risks for which future cash flows have been adjusted
and should equal the rate of return that investors would require if they were to choose an
investment that would generate cash flows equivalent to those expected from the asset.
For impairment of an individual asset or portfolio of assets, the discount rate is the rate
the company would pay in a current market transaction to borrow money to buy that
specific asset or portfolio.
If a market-determined asset-specific rate is not available, a surrogate must be used that
reflects the time value of money over the asset's life as well as country risk, currency risk,
price risk, and cash flow risk. The following would normally be considered:

 The enterprise's own weighted average cost of capital;

 The enterprise's incremental borrowing rate; and
 Other market borrowing rates.

Recognition of an Impairment Loss

An impairment loss should be recognized whenever recoverable amount is below
carrying amount.
The impairment loss is an expense in the income statement (unless it relates to a

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 revalued asset where the value changes are recognized directly in equity).
Adjust depreciation for future periods.

Cash-Generating Units
Recoverable amount should be determined for the individual asset, if possible.
If it is not possible to determine the recoverable amount (fair value less cost to sell and
value in use) for the individual asset, then determine recoverable amount for the asset's
cash-generating unit (CRU). The CRU is the smallest identifiable group of assets:
That generates cash inflows from continuing use, and
That is largely independent of the cash inflows from other assets or groups of assets.

Impairment of Goodwill

Goodwill should be tested for impairment annually.

To test for impairment, goodwill must be allocated to each of the acquirer's cash-
generating units, or groups of cash-generating units, that are expected to benefit from the
synergies of the combination, irrespective of whether other assets or liabilities of the
acquire are assigned to those units or groups of units. Each unit or group of units to which
the goodwill is so allocated shall:
Represent the lowest level within the entity at which the goodwill is monitored for
internal management purposes; and
Not be larger than a segment based on either the entity's primary or the entity’s secondary
reporting format determined in accordance with IAS 14 Segment Reporting.

A cash-generating unit to which goodwill has been allocated shall be tested for
impairment at least annually by comparing the carrying amount of the unit, including the
goodwill, with the recoverable amount of the unit:

If the recoverable amount of the unit exceeds the carrying amount of the unit, the unit and
the goodwill allocated to that unit is not impaired.
If the carrying amount of the unit exceeds the recoverable amount of the unit, the entity
must recognize an impairment loss.

The impairment loss is allocated to reduce the carrying amount of the assets of the unit
(group of units) in the following order, because these assets values are judged to be
subjective:
First, reduce the carrying amount of any goodwill allocated to the cash-generating unit
(group of units);
Other intangible assets and reduce the carrying amounts of the other assets of the unit
(group of units) on a pro rata basis.

The carrying amount of an asset should not be reduced below the highest of:
 Its fair value less costs to sell (if determinable);
 Its value in use (if determinable); and
 Zero.

If the preceding rule is applied, further allocation of the impairment loss is made pro rata
to the other assets of the unit (group of units).

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Reversal of an Impairment Loss

The same approach as for the identification of impaired assets, assess at each balance
sheet date whether there is an indication that an impairment loss may have decreased. If
so, calculate recoverable amount. You should note the following points when reversing
for impairment.
No reversal for unwinding of discount.
The increased carrying amount due to reversal should not be more than what the
depreciated historical cost would have been if the impairment had not been recognized.
Reversal of an impairment loss is recognized as income in the income statement.
Adjust depreciation for future periods.
Reversal of an impairment loss for goodwill is prohibited.

Disclosure
Disclosure by class of assets:
 Impairment losses recognized in the income statement,
 Impairment losses reversed in the income statement,
 Which line item(s) of the income statement,

Disclosure by segment:
 Primary segments only (usually product line or industry),
 Impairment losses recognized,
 Impairment losses reversed,
Other disclosures:
If an individual impairment loss (reversal) is material, disclose:
 Events and circumstances resulting in the impairment loss.
amount of the loss.
 Individual asset: nature and segment to which it relates.
 Cash generating unit: description, amount of impairment loss (reversal) by class of
assets and segment.
If recoverable amount is fair value less costs to sell, disclose the basis for determining
fair value.
If recoverable amount is value in use, disclose the discount rate.

If impairment losses recognized (reversed) are material in aggregate to the financial

statements as a whole, disclose:
 Main classes of assets affected,
 Main events and circumstances,

Detailed Disclosure of information about the estimates used to measure recoverable

amounts of cash generating units containing goodwill or intangible assets with indefinite
useful lives is required.

Illustration 1

(a) IAS 36 Impairment of assets, its main objective is to prescribe the procedures that
should ensure that an entity’s assets are included in its balance sheet at no more than their
recoverable amounts. Where an asset is carried at an amount in excess of its recoverable

109
amount, it is said to be impaired and IAS 36 requires an impairment loss to be
recognised.

Required:
(i) Define an impairment loss explaining the relevance of fair value less costs to sell
and value in use; and state how frequently assets should be tested for impairment;

(ii) Explain how an impairment loss is accounted for after it has been calculated.

(b) The financial controller of the Minno Group of Companies, a public listed company,
has identified the matters below which she believes may indicate impairment to one or
more assets:
(i) Minno Group of Companies owns and operates an item of plant that cost K640,
000 and had accumulated depreciation of K400, 000 at 1 October 2004. It is being
depreciated at 12.5% on cost. On 1 April 2005 (exactly half way through the year) the
plant was damaged when a factory vehicle collided into it. Due to the unavailability of
replacement parts, it is not possible to repair the plant, but it still operates, albeit at a
reduced capacity. Also, it is expected that as a result of the damage the remaining life of
the plant from the date of the damage will be only two years. Based on its reduced
capacity, the estimated present value of the plant in use is K150, 000. The plant has a
current disposal value of K20, 000 (which will be nil in two years’ time), but Minno
Group of Companies has been offered a trade-in value of K180, 000 against a
replacement machine which has a cost of K1 million (there would be no disposal costs
for the replaced plant). Minno Group of Companies is reluctant to replace the plant as it
is worried about the long-term demand for the product produced by the plant. The trade-
in value is only available if the plant is replaced.

Required:
Prepare extracts from the balance sheet and income statement of Minno Group of
Companies in respect of the plant for the year ended 30 September 2005. Your
answer should explain how you arrived at your figures.

(ii) On 1 April 2004 Minno Group of Companies acquired 100% of the share capital
of Mukande Mineral Water Ltd, whose only Activity is the extraction and sale of pure
mineral water. Mukande Mineral Water Ltd had been profitable since its acquisition, but
bad publicity resulting from several consumers becoming ill due to a contamination of
the water supply in April 2005 has led to unexpected losses in the last six months. The
carrying amounts of Mukande Mineral Water Ltd’s assets at 30 September 2005 are:

K’000
Brand (Quencher – see below) 7,000
Land containing spa 12,000
Purifying and bottling plant 8,000
Inventories 5,000
–––––––
32,000
–––––––
The source of the contamination was found and it has now ceased.
The company originally sold the bottled water under the brand name of ‘Quencher’, but
because of the contamination it has rebranded its bottled water as ‘Mwanzi Pure water’.

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After a large advertising campaign, sales are now starting to recover and are approaching
previous levels. The value of the brand in the balance sheet is the depreciated amount of
the original brand name of ‘Quencher’.
The directors have acknowledged that K1·5 million will have to be spent in the first three
months of the next accounting period to upgrade the purifying and bottling plant.
Inventories contain some old ‘Quencher’ bottled water at a cost of K2 million; the
remaining inventories are labelled with the new brand ‘Mwanzi Pure water’. Samples of
all the bottled water have been tested by the health authority and have been passed as fit
to sell. The old bottled water will have to be relabelled at a cost of K250, 000, but is then
expected to be sold at the normal selling price of (normal) cost plus 50%.

Based on the estimated future cash flows, the directors have estimated that the value in
use of Mukande Mineral Water Ltd at 30 September 2005, calculated according to the
guidance in IAS 36, is K20 million. There is no reliable estimate of the fair value less
cost to sell of Mukande Mineral Water Ltd.

Required:
Calculate the amounts at which the assets of Mukande Mineral Water Ltd should
appear in the consolidated balance sheet of Minno Group of Companies at 30
September 2005. Your answer should explain how you arrived at your figures.

Solution to Illustration 1

(a) (i) An impairment loss arises where the carrying amount of an asset is higher than its
recoverable amount. The recoverable amount of an asset is defined in IAS 36 Impairment
of assets as the higher of its fair value less costs to sell and its value in use (fair value less
cost to sell was previously referred to as net selling price). Thus an impairment loss is
simply the difference between the carrying amount of an asset and the higher of its fair
value less costs to sell and its value in use.

Fair value:

The fair value could be based on the amount of a binding sale agreement or the market
price where there is an Active market. However many (used) assets do not have Active
markets and in these circumstances the fair value is based on a ‘best estimate’ approach
to an arm’s length transaction. It would not normally be based on the value of a forced
sale.
In each case the costs to sell would be the incremental costs directly attributable to the
disposal of the asset.

Value in use:

The value in use of an asset is the estimated future net cash flows expected to be derived
from the asset discounted to a present value. The estimates should allow for variations in
the amount, timing and inherent risk of the cash flows. A major problem with this
approach in practice is that most assets do not produce independent cash flows i.e. cash
flows are usually produced in conjunction with other assets. For this reason, IAS 36
introduces the concept of a cash-generating unit (CGU), which is the smallest identifiable
group of assets, which may include goodwill, that generates (largely) independent cash
flows.

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Frequency of testing for impairment:
Goodwill and any intangible asset that is deemed to have an indefinite useful life should
be tested for impairment at least annually, as too should any intangible asset that has not
yet been brought into use. In addition, at each balance sheet date an entity must consider
if there has been any indication that other assets may have become impaired and, if so, an
impairment test should be done. If there are no indications of impairment, testing is not
required.

(ii) Once an impairment loss for an individual asset has been identified and calculated it
is applied to reduce the carrying amount of the asset, which will then be the base for
future depreciation charges. The impairment loss should be charged to income
immediately. However, if the asset has previously been revalued upwards, the
impairment loss should first be charged to the revaluation surplus. The application of
impairment losses to a CGU is more complex. They should first be applied to eliminate
any goodwill and then to the other assets on a pro rata basis to their carrying amounts.
However, an entity should not reduce the carrying amount of an asset (other than
goodwill) to below the higher of its fair value less cost to sell and its value in use if these
are determinable.

(b) (i) The plant had a carrying amount of K240, 000 on 1 October 2004. The accident
that may have caused impairment occurred 1 April 2005 and an impairment test would be
done at this date. The depreciation on the plant from 1 October 2004 to 1 April 2005
would be K40, 000 (640,000 x 12.5% x 6/12) giving a carrying amount of K200, 000 at
the date of impairment. An impairment test requires the plant’s carrying amount to be
compared with its recoverable amount. The recoverable amount of the plant is the higher
of its value in use of K150, 000 or its fair value less costs to sell. If Minno Group of
Companies trades in the plant it would receive K180, 000 by way of a part exchange, but
this is conditional on buying new plant which Minno Group of Companies is reluctant to
do. A more realistic amount of the fair value of the plant is its current disposal value of
only K20, 000. Thus the recoverable amount would be its value in use of K150, 000
giving an impairment loss of K50, 000 (K200, 000 – K150, 000). The remaining effect on
income would be that a depreciation charge for the last six months of the year would be
required. As the damage has reduced the remaining life to only two Years (from the date
of the impairment) the remaining depreciation would be K37, 500 (K150, 000/ 2 years x
6/12). Thus extracts from the financial statements for the year ended 30 September 2005
would be:

Balance sheet extract

Non-current assets K
Plant (150,000 – 37,500) 112,500

Income statement extract

Plant depreciation (40,000 + 37,500) 77,500

Plant impairment loss 50,000

(ii) There are a number of issues relating to the carrying amount of the assets of Mukande
Mineral Water Ltd that have to be considered. It appears the value of the brand is based
on the original purchase of the ‘Quencher’ brand. The company no longer uses this brand

112
name; it has been renamed ‘Mwanzi Pure water’. Thus it would appear the purchased
brand of ‘Quencher’ is now worthless. Mukande Mineral Water Ltd cannot transfer the
value of the old brand to the new brand, because this would be the recognition of an
internally developed intangible asset and the brand of ‘Mwanzi Pure water’ does not
appear to meet the recognition criteria in IAS 38. Thus prior to the allocation of the
impairment loss, the value of the brand should be written off, as it no longer exists. The
inventories are valued at cost and contain K2 million worth of old bottled water
(Quencher) that can be sold, but will have to be relabelled at a cost of K250, 000.
However, as the expected selling price of these bottles will be K3 million (K2 million x
150%), their net realisable value is K2, 750,000. Thus it is correct to carry them at cost
i.e. they are not impaired. The future expenditure on the plant is a matter for the
following year’s financial statements.

Applying this, the revised carrying amount of the net assets of Mukande Mineral Water
Ltd’s cash-generating unit (CGU) would be K25 million (K32 million – K7 million re the
brand). The CGU has a recoverable amount of K20 million, thus there is an impairment
loss of K5 million. This would be applied first to goodwill (of which there is none) then
to the remaining assets pro rata. However under IAS2, the inventories should not be
reduced as their net realisable value is in excess of their cost. This would give revised
carrying amounts at 30 September 2005 of:
K’000
Brand nil
Land containing spa (12,000 – (12,000/20,000 x 5,000)) 9,000
Purifying and bottling plant (8,000 – (8,000/20,000 x 5,000)) 6,000
Inventories 5,000
20,000

CHAPTER 9

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IAS 38: INTANGIBLES AND IFRS 3: FAIR VALUES IN
ACQUISITION ACCOUNTING
Objective

The objective of IAS 38 is to prescribe the accounting treatment for intangible assets that
are not dealt with specifically in another IAS. The Standard requires an enterprise to
recognise an intangible asset if, and only if, certain criteria are met. The Standard also
specifies how to measure the carrying amount of intangible assets and requires certain
disclosures regarding intangible assets.

Scope

IAS 38 applies to all intangible assets other than:

 Financial assets
 Mineral rights and exploration and development costs incurred by mining and oil
and
 gas companies
 Intangible assets arising from insurance contracts issued by insurance companies
 Intangible assets covered by another IAS, such as intangibles held for sale,
deferred
 Tax assets, lease assets, assets arising from employee benefits, and goodwill.
Goodwill
 Is covered by IFRS 3
 IFRS 3 – also has been covered in this chapter

Key Definitions
Intangible asset: An identifiable non-monetary asset without physical substance. An
asset is a resource that is controlled by the enterprise as a result of past events (for
example, purchase or self-creation) and from which future economic benefits (inflows of
cash or other assets) are expected. Thus, the three critical attributes of an intangible asset
are:
 Identifiability
 Control (power to obtain benefits from the asset)
 Future economic benefits (such as revenues or reduced future costs)

Identifiability: An intangible asset is identifiable when it:

Is separable (capable of being separated and sold, transferred, licensed, rented, or
exchanged, either individually or as part of a package) or
Arises from contractual or other legal rights, regardless of whether those rights are
transferable or separable from the entity or from other rights and obligations.

Examples of possible intangible assets include:

 Computer software
 Patents
 Copyrights
 Motion picture films
 Customer lists

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  Mortgage servicing rights
 Licenses
 Import quotas
 Franchises
 Customer and supplier relationships
 Marketing rights

Intangibles can be acquired:

 By separate purchase
 As part of a business combination
 By a government grant
 By exchange of assets
 By self-creation (internal generation)

Recognition

IAS 38 requires an enterprise to recognise an intangible asset, whether purchased or self-

created (at cost) if, and only if:
 It is probable that the future economic benefits that are attributable to the asset
will flow to the enterprise; and
 The cost of the asset can be measured reliably.

This requirement applies whether an intangible asset is acquired externally or generated

internally. IAS 38 includes additional recognition criteria for internally generated
intangible assets (see below).
The probability of future economic benefits must be based on reasonable and supportable
assumptions about conditions that will exist over the life of the asset. The probability
recognition criterion is always considered to be satisfied for intangible assets that are
acquired separately or in a business combination.

If recognition criteria not met.

If an intangible item does not meet both the definition of and the criteria for recognition
as an intangible asset, IAS 38 requires the expenditure on this item to be recognised as an
expense when it is incurred.

Business combinations.
There is a rebuttable presumption that the fair value (and therefore the cost) of an
intangible asset acquired in a business combination can be measured reliably. An
expenditure (included in the cost of acquisition) on an intangible item that does not meet
both the definition of and recognition criteria for an intangible asset should form part of
the amount attributed to the goodwill recognised at the acquisition date. IAS 38 notes,
however, that non-recognition due to measurement reliability should be rare.
The only circumstances in which it might not be possible to measure reliably the fair
value of an intangible asset acquired in a business combination are when the intangible
asset arises from legal or other contractual rights and either:

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  Is not separable; or
 Is separable, but there is no history or evidence of exchange transactions for the
same or similar assets, and otherwise estimating fair value would be dependent on
immeasurable variables.

Reinstatement.
The Standard also prohibits an enterprise from subsequently reinstating as an intangible
asset, at a later date, an expenditure that was originally charged to expense.

Initial Recognition:

 Research and Development Costs

o Charge all research cost to expense.
o Development costs are capitalised only after technical and commercial
feasibility of the asset for sale or use have been established. This means
that, the enterprise must intend and be able to complete the intangible
asset and either uses it or sells it and be able to demonstrate how the asset
will generate future economic benefits.

If an enterprise cannot distinguish the research phase of an internal project to create an

intangible asset from the development phase, the enterprise treats the expenditure for that
project as if it were incurred in the research phase only.

 In-process Research and Development Acquired in a Business Combination

A research and development project acquired in a business combination is recognised as
an asset at cost, even if a component is research. Subsequent expenditure on that project
is accounted for as any other research and development cost (expensed except to the
extent that the expenditure satisfies the criteria in IAS 38 for recognising such
expenditure as an intangible asset).

 Internally Generated Brands, Mastheads, Titles, Lists

Brands, mastheads, publishing titles, customer lists and items similar in substance that are
internally generated should not be recognised as assets.

 Computer Software
o Purchased should be capitalised.
o Operating system for hardware include in hardware cost
o Internally developed (whether for use or sale) charge to expense until
technological feasibility, probable future benefits, intent and ability to use
or sell the software, resources to complete the software, and ability to
measure cost.
o Amortisation over useful life, based on pattern of benefits (straight-line is
the default).

 Certain Other Defined Types of Costs

The following items must be charged to expense when incurred:
 Internally generated goodwill
 Start-up, pre-opening, and pre-operating costs
 Training cost

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  Advertising cost
 Relocation costs

Initial Measurement
Intangible assets are initially measured at cost.

Measurement Subsequent to Acquisition: Cost Model and Revaluation Models

Allowed
An entity must choose either the cost model or the revaluation model for each class of
intangible asset.

Cost model. After initial recognition the benchmark treatment is that intangible assets
should be carried at, cost less any amortisation and impairment losses.

Revaluation model. Intangible assets may be carried at a revalued amount (based on fair
value) less any subsequent amortisation and impairment losses only if fair value can be
determined by reference to an Active market. Such Active markets are expected to be
uncommon for intangible assets. Examples where they might exist:

 Milk quotas.
 Stock exchange seats.
 Taxi medallions.

Under the revaluation model, revaluation increases are credited directly to "revaluation
surplus" within equity except to the extent that it reverses a revaluation decrease
previously recognised in profit and loss. If the revalued intangible has a finite life and is,
therefore, being amortised (see below) the revalued amount is amortised.

Classification of Intangible Assets Based on Useful Life

Intangible assets are classified as:
 Indefinite life: No foreseeable limit to the period over which the asset is
expected to generate net cash inflows for the entity.
 Finite life: A limited period of benefit to the entity.

Measurement Subsequent to Acquisition: Intangible Assets with Finite Lives

The cost less residual value of an intangible asset with a finite useful life should be
amortised over that life.
 The amortisation method should reflect the pattern of benefits.
 If the pattern cannot be determined reliably, amortise by the straight-line
method.
 The amortisation charge is recognised in profit or loss unless another IFRS
requires that it be included in the cost of another asset.
 The amortisation period should be reviewed at least annually.

The asset should also be assessed for impairment in accordance with IAS 36.

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Measurement Subsequent to Acquisition: Intangible Assets with Indefinite Lives

An intangible asset with an indefinite useful life should not be amortised.

Its useful life should be reviewed each reporting period to determine whether events and
circumstances continue to support an indefinite useful life assessment for that asset. If
they do not, the change in the useful life assessment from indefinite to finite should be
accounted for as a change in an accounting estimate.
The asset should also be assessed for impairment in accordance with IAS 36.

Subsequent Expenditure
Subsequent expenditure on an intangible asset after its purchase or completion should be
recognised as an expense when it is incurred, unless it is probable that this expenditure
will enable the asset to generate future economic benefits in excess of its originally
assessed standard of performance and the expenditure can be measured and attributed to
the asset reliably.

Disclosure
For each class of intangible asset, disclose:
 Useful life or amortisation rate
 Amortisation method
 Gross carrying amount
 Accumulated amortisation and impairment losses
 Line items in the income statement in which amortisation is included
 Reconciliation of the carrying amount at the beginning and the end of the period
showing:
o Additions (business combinations separately)
o Assets held for sale
o Retirements and other disposals
o Revaluations
o Impairments
o Reversals of impairments
o Amortisation
o Foreign exchange differences
 Basis for determining that an intangible has an indefinite life
 Description and carrying amount of individually material intangible assets
 Certain special disclosures about intangible assets acquired by way of government
grants
 Information about intangible assets whose title is restricted
 Commitments to acquire intangible assets

Additional disclosures are required about:

 Intangible assets carried at revalued amounts
 The amount of research and development expenditure recognised as an expense in
the current period

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Illustration 1
(a) During the last decade it has not been unusual for the premium paid to acquire control
of a business to be greater than the fair value of its tangible net assets. This increase in
the relative balance sheet proportions of intangible assets has made the accounting
practices for them all the more important. During the same period, many companies have
spent a great deal of money internally developing new intangible assets such as software
and brands. IAS 38 ‘Intangible Assets’ was revised in March 2005 and prescribes the
accounting treatment for intangible assets.

Required:
In accordance with IAS 38, discuss whether intangible assets should be recognised,
and if so, how they should be initially recorded and subsequently amortised in the
following circumstances:
 When they are purchased separately from other assets;
 When they are obtained as part of acquiring the whole of a business; and
 When they are developed internally.

Note: your answer should consider goodwill separately from other intangibles.

(b) Twikatane Holdings PLC is a public listed company. It has been considering the
accounting treatment of its intangible assets and has asked for your opinion on how the
matters below should be treated in its financial statements for the year to 31 March 2005.

(i) On 1 October 2004 Twikatane Holdings PLC acquired National Drug Company Ltd, a
small company that specialises in pharmaceutical drug research and development. The
purchase consideration was by way of a share exchange and valued at K35 Billion. The
fair value of National Drug Company Ltd’s net assets was K15 Billion (excluding any
items referred to below). National Drug Company Ltd owns a patent for an established
successful drug that has a remaining life of 8 years. A firm of specialist advisors, M & L
Brand, has estimated the current value of this patent to be K10 Billion, however the
company is awaiting the outcome of clinical trials where the drug has been tested to treat
a different illness. If the trials are successful, the value of the drug is then estimated to be
K15 Billion. Also included in the company’s balance sheet is K2 Billion for medical
research that has been conducted on behalf of a client.

(ii) Twikatane Holdings PLC has developed and patented a new drug, which has been
approved for clinical use. The costs of developing the drug were K12 Billion. Based on
early assessments of its sales success, M & L Brand has estimated its market value at
K20 Billion.

(iii) Twikatane Holdings PLC’s manufacturing facilities have recently received a

favourable inspection by government medical scientists. As a result, of this the company
has been granted an exclusive five-year licence to manufacture and distribute a new
vaccine. Although the licence had no direct cost to Twikatane Holdings PLC, its directors
feel it’s granting is a reflection of the company’s standing and have asked M & L Brand
to value the licence. Accordingly, they have placed a value of K10 Billion on it.

(iv) In the current accounting period, Twikatane Holdings PLC has spent K3 Billion
sending its staff on specialist training courses. Whilst these courses have been expensive,

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they have led to a marked improvement in production quality and staffs now need less
supervision. This in turn has led to an increase in revenue and cost reductions. The
directors of Twikatane Holdings PLC believe these benefits will continue for at least
three years and wish to treat the training costs as an asset.

(v) In December 2004, Twikatane Holdings PLC paid K5 Billion for a television
advertising campaign for its products that will run for 6 months from 1 January 2005 to
30 June 2005. The directors believe that increased sales as a result, of the publicity will
continue for two years from the start of the advertisements.

Required:
Explain how the directors of Twikatane Holdings PLC should treat the above items
in the financial statements for the year to 31 March 2005.

Note: The values given by M & L Brand can be taken as being reliable
measurements. You are not required to consider depreciation aspects.

Solution to illustration 1

Goodwill:
International Accounting Standards state that goodwill is the difference between the
purchase consideration and the fair value of the acquired business’s identifiable
(separable) net assets. Identifiable assets and liabilities are those that are capable of being
sold or settled separately, i.e. without selling the business as a whole. Purchased goodwill
should be recognised on the balance sheet at this value and subject it to impairment over
its estimated useful economic life, the standard does not allow the writing off of the
purchased goodwill over its life. IAS 38 specifically states that internally generated
goodwill (but not necessarily other intangibles) cannot be capitalised.

Other intangibles:
Where an intangible asset other than goodwill is acquired as a separate transaction, the
treatment is relatively straightforward. It should be capitalised at cost and amortised over
its estimated useful economic life (similar rules apply to the lives of other intangible
assets as apply to goodwill as referred to above). The fair value of the purchase
consideration paid to acquire an intangible is deemed to be it’s cost.
Intangibles purchased as part of the acquisition of a business should be recognised
separately to goodwill, if they can be measured reliably. Reliable measurement does not
have to be at market value, techniques such as valuations based on multiples of turnover
or notional royalties are acceptable. This test is not meant to be overly restrictive and is
likely to be met in valuing intangibles such as brands, publishing titles, patents etc. The
amount of intangibles that may be recognised is restricted, such that their recognition
cannot create negative goodwill (as a balancing figure). Any intangible not capable of
reliable measurement will be subsumed within goodwill.
Recognition of internally developed intangibles is much more restrictive. IAS 38 states
that internally generated brands, mastheads, publishing titles, customer lists and similar
other items should not be recognised as intangible assets as these items cannot be
distinguished from the cost of developing the business as a whole. The Standard does
require development costs to be capitalised if they meet detailed recognition criteria.

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(b) (i) The purchase consideration of K35 million should be allocated as:
K Billion
Net tangible assets 15
Work in progress 2
Patent 10
Goodwill 8
—–
35
—–
The difficulty here is the potential value of the patent if the trials are successful. In effect,
this is a contingent asset and on an acquisition, contingencies have to be valued at their
fair value. There is insufficient information to make a judgment of the fair value of the
contingent asset and in these circumstances; it would be prudent to value the patent at
K10 Billion. The additional K5 Billion is an example of where an intangible cannot be
measured reliably and thus it should be subsumed within goodwill. The other issue is that
although research cannot normally be treated as an asset, in this case the research is being
done for another company and is in fact work in progress and should be recognised as
such.
(ii) This is an example of an internally developed intangible asset and although the
circumstances of its valuation are similar to the patent acquired above it cannot be
recognised at M & L Brand’s valuation. Internally generated intangibles can only be
recognised if they meet the definition of development costs in IAS 38. Internally
generated intangibles are permitted to be carried at a revalued amount (under the allowed
alternative treatment) but only where there is an active market of homogeneous assets
with prices that are available to the public. By their very nature drug, patents are unique
(even for similar types of drugs) therefore; they cannot be part of a homogeneous
population. Therefore, the drug would be recorded at its development cost of K12 Billion.

(iii) This is an example of a ‘granted’ asset. It is neither an internally developed asset

nor a purchased asset. In one sense, it is recognition of the standing of the company that
is part of the company’s goodwill. IAS 38’s general requirement requires intangible
assets to be initially recorded at cost and specifically mentions granted assets. IAS 38
also refers to IAS 20 ‘Accounting for Government Grants and Disclosure of Government
Assistance’ in this situation. This standard says that both the asset and the grant can be
recognised at fair value initially (in this case they would be at the same amount). If fair
values are not used for the asset, it should be valued at the amount of any directly
attributable expenditure (in this case this is zero). It is unclear whether IAS 38’s general
restrictive requirements on the revaluation of intangibles as referred to in (a) above (i.e.
the allowed alternative treatment) are intended to cover granted assets under IAS 20.

(iv) There is no doubt that a skilled workforce is of great benefit to a company. In this
case, there is an enhancement of revenues and a reduction in costs and if resources had
been spent on a tangible non-current asset that resulted in similar benefits they would be
eligible for capitalisation. However, the Standard specifically excludes this type of
expenditure from being recognised as an intangible asset and it describes highly trained
staff as ‘pseudo-assets’. The main reason is the issue of control (through custody or legal
rights). Part of the definition of any asset is the ability to control it. In the case of
employees (or, as in this case, training costs of employees) the company cannot claim to

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control them, as it is quite possible that employees may leave the company and work
elsewhere.

(v) The benefits of effective advertising are often given as an example of goodwill (or
an enhancement of it). If this view is accepted, then such expenditures are really
internally generated goodwill, which cannot be recognised. In this particular case, it
would be reasonable to treat the unexpired element of the expenditure as a prepayment
(in current assets) this would amount to 3/6 of K5 Billion i.e. K2.5 Billion. This
represents the cost of the advertising that has been paid for, but not yet taken place. In the
past, some companies have treated anticipated continued benefits as deferred revenue
expenditure, but this is no longer permitted, as it does not meet the Standard’s recognition
criteria for an asset.

IFRS 3 - FAIR VALUES IN ACQUISITION ACCOUNTING

Goodwill

Recognition and measurement of goodwill. Goodwill is recognized by the acquirer as

an asset from the acquisition date and is initially measured as the excess of the cost of the
business combination over the acquirer's share of the net fair values of the acquiree's
identifiable assets, liabilities and contingent liabilities.

No amortisation of goodwill. The new IFRS 3 prohibits the amortisation of goodwill.

Instead, goodwill must be tested for impairment at least annually in accordance with IAS
36 Impairment of Assets.

Negative goodwill. If the acquirer's interest in the net fair value of the acquired
identifiable net assets exceeds the cost of the business combination, that excess
(sometimes referred to as negative goodwill) must be recognised immediately in the
income statement as a gain. Before concluding that "negative goodwill" has arisen,
however, the standard requires that the acquirer reassess the identification and
measurement of the acquiree's identifiable assets, liabilities, and contingent liabilities and
the measurement of the cost of the combination.

Disclosure

 Amount of any negative goodwill recognised in profit or loss

 Details about the factors that contributed to recognition of goodwill

Brands and other intangible assets that are allegedly very similar in nature to goodwill
should therefore be subsumed under the heading of goodwill. It is therefore necessary to
consider whether or not the practice of separate recognition of brands is in keeping with
the principle. However the one feature, which distinguishes brands names from goodwill,
is that brands names are often capable of being separately realised. The IAS 38 allows for
the possibility that the useful economic life could be infinite and also revaluation of
brands.

The standard states that:

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 Intangible fixed assets that are purchased separately should be capitalised at costs,
 Intangible assets that are acquired as part of the acquisition of a business should
be recognised separately from goodwill only if their value can be measured
reliably on initial recognition,
 Internally developed intangible assets should only be recognised if they have a
readily ascertainable market value.

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CHAPTER 10

ACCOUNTING FOR LEASES – IAS 17

What is a lease?
A lease is simply an agreement between two parties for the hire of an asset. The lessor is
the legal owner of the asset who rents out the asset to the lessee. At the end of the lease,
the asset is returned to the lessor. The lessee will pay a lease rental to the lessor in return
for the use of the asset. The accounting treatment for the lease entirely depends on the
nature of the lease. For accounting purposes all leases are classified into one of two
categories, they are either deemed to be ‘finance leases’ or ‘operating leases’.

What are operating leases?

The accounting standard takes a similar approach as an operating lease is defined as a
lease, which is not a finance lease.

An operating lease is defined as a lease other than a finance lease.

At it is most clear cut an operating lease is a very short-term agreement for the
Temporary hire of an asset, e.g., hiring a car for two weeks to take on holiday.

Accounting treatment for operating leases

The accounting treatment for an operating lease is straightforward for both the lessor and
the lessee. The lessee has incurred an operating expense, so the lease rental payable is
written off in the income statement. The lessee has to disclose in the notes to the accounts
the amount charged in the year and the amount of the payments to which the entity is
committed at the year-end.
The lessor has earned revenue from renting out the asset and accordingly recognises the
lease rental receivable as income in the income statement.
The lessor should also show the asset in the balance sheet, and provide for deprecation.
Any amounts not received by the end of the year should be shown as receivables in the
balance sheet.

What’s a finance lease?

A finance lease is one where the risks and rewards of the ownership pass to the lessee.
How it is determined that risks and rewards have passed is a subjective issue and one on
which accounting standards give guidance. At its most clear cut, however, a finance lease
is a long-term agreement representing a loan made by the lessor to the lessee to buy the
asset.

A finance lease is a lease that transfers substantially all the risks and rewards
of the ownership of an asset to the lessee.

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Legally, of course, a finance lease is a rental agreement, and legally the lessee has not
bought the asset as title remains with the lessor. However, to account for the finance lease
in accordance with its legal form would be a betrayal of the concept of ‘substance over
form’. This important concept requires that the commercial reality of events and
transactions be reported in the financial statement if they are to be relevant to the users of
the financial statements and if the financial statements are to be true and fair.

Accounting treatment of finance leases - by the lessee

When a lessee enters into a finance lease it is getting access to the risks and rewards of
the asset and accordingly the lessee reflects substance by recognising the asset in its own
accounts. This is consistent with definition of and recognition criteria of an asset.

An asset is defined as the rights or other access to the future economic benefits
controlled by an entity as a result of past transaction or events

When a lessee enters into a finance lease it is obliged to make the lease rental payments
for the duration of the lease, and accordingly the lessee reflects the substance by
recognising a liability. This is consistent with the definition of and recognition criteria of
a liability.

A liability is defined as an obligation to transfer economic benefits as a result

of past transaction or events.

The lessee strictly capitalises the present value of the minimum lease payments as the
fixed asset and this is the amount also recorded as the liability. The present value of the
minimum lease payments normally equates to the cash price. The asset has to be
depreciated over the shorter of the period of the lease and the useful life of the asset. The
loan accrues interest, which should be recognised to give a constant periodic return on the
balance of the outstanding loan. The rental payment is not therefore simply a revenue
expense but represents partly the repayment of the capital element of the loan and partly
the finance charge on the loan (i.e., interest). The total finance charge is the difference
between the minimum lease payments and the present value of the minimum lease
payments.
This can also be explained in double entry terms
When a finance lease is entered into, the lessee has to record an asset and a liability:

DR Fixed Assets X  

CR Creditors - Obligations under finance leases   X

When a lease rental is paid this is recorded as:    

DR Creditors - Obligations under finance leases X  

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CR Cash   X

At the end of the financial period depreciation will have to be

   
provided on the asset

DR Income statement a/c depreciation expense X  

CR Provision for Depreciation   X

At the end of the financial period a finance charge (interest) has to

   
be recorded on the creditor:

DR Income statement a/c interest payable and similar charges X  

CR Creditors - Obligations under finance leases   X

On the balance sheet the finance lease, creditor obligation under finance leases will have
to be split between current and non-current liability. In the notes to the balance sheet a
separate listing in the fixed asset schedule is required to distinguish assets legally owned
and those held subject to finance leases. In the notes to the income statement, the amount
of the interest charged that was in respect of finance leases must be disclosed.

Accounting treatment of finance leases - by the lessor

Such lessor’s are normally banks or similar lending institutions. When entering into a
finance lease the lessor is in substance getting a loan, which will be repaid with interest.
Despite having legal title to the asset subject to the lease, the lessor does not recognise
this as an asset on its balance sheet, as it does not control the asset and does not have
access to the future economic benefits. The lessor does however have the asset of a future
income stream and accordingly recognises a debtor ‘net investment in finance leases’.

Why is the classification of leases important?

To recap, if a lease is classified and correctly accounted for as a finance lease, the lessee
will recognise an asset, but more significantly a liability as well; but if the lease is treated
as an operating lease then no liability is recognised in the lessee’s financial statements.
Some companies may be concerned about the level of debt included on the balance sheet,
as this will increase the reported gearing ratio. A high gearing ratio might be perceived as
undesirable if, for example, the company was looking to borrow more funds. It might
prove more difficult or expensive to do so as the company’s accounts would already
include high liabilities. Accordingly, lessees may well have a preference to account for a
lease as an operating lease rather than a finance lease to take the liability off the balance
sheet. Prior to the introduction of IAS 17, Accounting for Leases many lessees did not
distinguish between the two types of leases and accounted for all leases in accordance
with their legal form. It is argued that this amounted to creative accounting as it took
liabilities off the balance sheet.

How are leases classified?

The classification of a lease as either a finance lease or an operating lease hinges on
whether the risks and rewards of ownership pass to the lessee. This is subjective and it is
important that all the terms of the lease are reviewed so that the substance of the lease
agreement can be identified. For example:

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  Repairs, maintenance, insurance
If the lessee is responsible for repairing, maintaining and insuring the asset, then this is
consistent with the behavior of the owner of the asset, and would support the contention
that the lease is a finance lease. In these, circumstance the lessee has the risk of the cost
of repairs and of idle time but has the reward if the asset never breaks down!
 Length of the lease
If the lease period is for substantially all of the assets estimated useful economic life, then
this would support the argument that the lease was a finance lease. The lessee would be
the beneficiary of the economic value of the asset, as only an immaterial residue value
would be returned to the lessor.
 Bargain options
If the lease contains a clause to the effect that the lessee can either renew the lease or buy
the asset at the end of the lease term for a peppercorn (notional) amount, then this would
support the contention that the lease is a finance lease. The lessee will enjoy the reward if
the asset turns out to have a longer than expected life. It suggests that the lessee will have
exclusive access to the future economic benefits of the asset, which is consistent with the
concept that the asset ‘belongs’ to the lessee even though the lessee does not have legal
title.
 The 90% test
If at the inception of the lease the present value of the minimum lease payments amounts
to substantially all (90% or more) of the fair value of the leased asset (this normally
equates to the cash price), it is presumed to be a finance lease. It is often commented that
this test is over relied on in practice. It should be noted that the 90% test is a guide not a
rule.

Apportionment of rental payments.

When the lessee makes a rental payment, it will comprise two elements,
 Interest charge
 Capital cost

There are three methods of allocating the finance charge:

 Straight line method

This method is the easiest to calculate but does not provide us with a constant rate of
interest. It simply allocates the same amount of interest to each finance period.

 Sum of digits method (rule of 78)

The method approximates to the actuarial method; splitting the total interest (with out
reference to a rate of interest) in such a way that the greater proportion of the interest falls
in the earlier years.
The sum of digits can be calculated using a simple formula:

N (N+1)/2
Where N is the number of finance periods

 Actuarial method

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The actuarial method is the best and most scientific method. It derives from the comm.
Sense assumption that the interest charged by Lessor Company will equal the rate of
return desired by the company, multiplied by the amount of capital it has invested.
The interest rate will be provided.

Repossessions
Subject to various legal requirements, the seller may repossess goods sold on hire
purchase if the hirer fails to maintain his payments. The ledger accounts should be closed
to a repossession account, which is credited with, the value at which the items is brought
back into inventory and any penalty sums receivable. Any balance will be the profit or
loss on the repossession account.

Disclosure: lessees – finance lease.

 Carrying amounts of the assets
 Reconciliation between total minimum lease payments and their present value.
 Amounts of minimum lease payments at balance sheet date and the present value
there of for
o The next year
o Years 2 to 5 years
o Beyond 5 years
 Contingent rent recognized as expense
 Total future minimum sublease income under non cancelable sublease
 General description of significant leasing arrangement including contingent rent
provision, renewal or purchase options, and restrictions imposed on dividends,
borrowing or further leasing

Disclosure: lessees – operating lease
 Amounts of minimum lease payments at balance sheet date under noncancellable
operating leases for:
o The next year;
o Years 2 through 5 combined;
o Beyond five years;
 Total future minimum sublease income under noncancellable subleases;
 Lease and sublease payments recognised as income for the period;
 Contingent rent recognised as an expense; and
 General description of significant leasing arrangements, including contingent rent
provisions, renewal or purchase options, and restrictions imposed on dividends,
borrowings, or further leasing.

Disclosure: Lessor’s - Finance Lease

 Reconciliation between gross investment in the lease and the present value of
minimum lease payments;
 Gross investment and present value of minimum lease payments receivable for:
o The next year;
o Years 2 through 5 combined;
o Beyond five years;

 Unearned finance income;

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  Unguaranteed residual values;
 Accumulated allowance for uncollectible lease payments receivable;
 Contingent rent recognised in income; and
 General description of significant leasing arrangements.

Disclosure: Lessor’s - Operating Lease

 Amounts of minimum lease payments at balance sheet date under noncancellable
operating leases in the aggregate and for:
o The next year;
o Years 2 through 5 combined;
o Beyond five years;
 Contingent rent recognised as income; and
 General description of significant leasing arrangements

Sale and Leaseback Transactions

For a sale and leaseback transaction that results in a finance lease, any excess of proceeds
over the carrying amount is deferred and amortised over the lease term.
For a transaction that results in an operating lease:
 If the transaction is clearly carried out at fair value - the profit or loss should be
recognised immediately;
 If the sale price is below fair value - profit or loss should be recognised
immediately, except if a loss is compensated for by future rentals at below market
price, the loss it should be amortised over the period of use;
 If the sale price is above fair value - the excess over fair value should be deferred
and amortised over the period of use; and
 If the fair value at the time of the transaction is less than the carrying amount - a
loss equal to the difference should be recognised immediately.

Illustration 1

(a) Recording the substance of transactions, rather than their legal form, is an important
principle in financial accounting. Abuse of this principle can lead to profit manipulation,
non-recognition of assets and substantial debt not being recorded on the balance sheet.

Required:
Describe how the use of off balance sheet financing can mislead users of financial
statements.

Note: your answer should refer to specific user groups and include examples where
recording the legal form of transactions may mislead them.

(b) Angela has entered into the following transactions during the year ended 30
September 2005:

(i) In September 2005 Angela sold (factored) some of its trade receivables to Omar, a
finance house. On selected account, balances Omar Leasing paid Angela 80% of their
book value. The agreement was that Omar Leasing would administer the collection of the
receivables and remit a residual amount to Angela depending upon how quickly

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individual customers paid. Any balance uncollected by Omar Leasing after six months
will be refunded to Omar Leasing by Angela.

(ii) On 1 October 2005 Angela owned a freehold building that had a carrying amount
of K7·5 million and had an estimated remaining life of 20 years. On this date it sold the
building to Finance Leasing Company Ltd for a price of K12 million and entered into an
agreement with Finance Leasing Company Ltd to rent back the building for an annual
rental of K1·3 million for a period of five years. The auditors of Angela have commented
that in their opinion the building had a market value of only K10 million at the date of its
sale and to rent an equivalent building under similar terms to the agreement between
Angela and Finance Leasing Company Ltd would only cost K800, 000 per annum.
Assume any finance costs are 10% per annum.

(iii) Angela is a motorcar dealer selling vehicles to the public. Most of its new
vehicles are supplied on consignment by two manufacturers; Japan’s used cars and Toko
used cars, which trade on different terms.
Japan’s used cars supplies cars on terms that allow Angela to display the vehicles for a
period of three months from the date of delivery or when Angela sells the cars on to a
retail customer if this is less than three months. Within this period Angela can return the
cars to Japan’s used cars or can be asked by Japan’s used cars to transfer the cars to
another dealership (both at no cost to Angela). Angela pays the manufacturer’s list price
at the end of the three-month period (or at the date of sale if sooner). In recent years
Angela has returned several cars to Japan’s used cars that were not selling very well and
has also been required to transfer cars to other dealerships at Japan’s used car’s request.
Toko used car’s terms of supply are that Angela pays 10% of the manufacturer’s price at
the date of delivery and 1% of the outstanding balance per month as a display charge.
After six months (or sooner if Angela chooses), Angela must pay the balance of the
purchase price or return the cars to Toko used cars. If the cars are returned to the
manufacturer, Angela has to pay for the transportation costs and forfeits the 10% deposit.
Because of this, Angela has only returned vehicles to Toko used cars once in the last
three years.

Required:
Describe how the above transactions and events should be treated in the financial
statements of Angela for the year ended 30 September 2005. Your answer should
explain, where relevant, the difference between the legal form of the transactions
and their substance.

Solution to illustration 1

(a) Most forms of off balance sheet financing have the effect of what is, in substance,
debt finance either not appearing on the balance sheet at all or being netted off
against related assets such that it is not classified as debt. Common examples
would be structuring a lease such that it fell to be treated as an operating lease
when it has the characteristics of a finance lease, complex financial instruments
classified as equity when they may have, at least in part, the substance of debt and

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‘controlled’ entities having large borrowings (used to benefit the group as a
whole), that are not consolidated because the financial structure avoids the entities
meeting the definition of a subsidiary.

The main problem of off balance sheet finance is that it results in financial
statements that do not faithfully represent the transactions and events that have
taken place. Faithful representation is an important qualitative characteristic of
useful information (as described in the Framework for the preparation and
presentation of financial statements). Financial statements that do not faithfully
represent that which they purport to lack reliability. A lack of reliability may
mean that any decisions made on the basis of the information contained in
financial statements are likely to be incorrect or, at best, sub optimal.

The level of debt on a balance sheet is a direct contributor to the calculation of an

entity’s balance sheet gearing, which is considered as one of the most important
financial ratios. It should be understood that, to a point, the use of debt financing
is perfectly acceptable. Where balance sheet gearing is considered low, borrowing
is relatively inexpensive, often tax efficient and can lead to higher returns to
shareholders. However, when the level of borrowings becomes high, it increases
risk in many ways. Off balance sheet financing may lead to a breach of loan
covenants (a serious situation) if such debt were to be recognised on the balance
sheet in accordance with its substance.

High gearing is a particular issue to equity investors. Equity (ordinary shares) is

sometimes described as residual return capital. This description identifies the
dangers (to equity holders) when an entity has high gearing. The dividend that the
equity shareholders might expect is often based on the level of reported profits.
The finance cost of debt acts as a reduction of the profits available for dividends.
As the level of debt increases, higher interest rates are also usually payable to
reflect the additional risk borne by the lender, thus the higher the debt the greater
the finance charges and the lower the profit. Many off balance sheet finance
schemes also disguise or hide the true finance cost which makes it difficult for
equity investors to assess the amount of profits that will be needed to finance the
debt and consequently how much profit will be available to equity investors.
Furthermore, if the market believes or suspects an entity is involved in ‘creative
accounting’ (and off balance sheet finance is a common example of this) it may
adversely affect the entity’s share price.

An entity’s level of gearing will also influence any decision to provide further
debt finance (loans) to the entity. Lenders will consider the nature and value of
the assets that an entity owns which may be provided as security for the
borrowings. The presence of existing debt will generally increase the risk of
default of interest and capital repayments (on further borrowings) and existing
lenders may have a prior charge on assets available as security. In simple terms if
an entity has high borrowings, additional borrowing is more risky and
consequently more expensive. A prospective lender to an entity that already has
high borrowings, but which do not appear on the balance sheet is likely to make
the wrong decision. If the correct level of borrowings were apparent, either the
lender would not make the loan at all (too high a lending risk) or, if it did make

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 the loan, it would be on substantially different terms (e.g. charge a higher interest
rate) so as to reflect the real risk of the loan.

Some forms of off balance sheet financing may specifically mislead suppliers that
offer credit. It is a natural precaution that a prospective supplier will consider the
balance sheet strength and liquidity ratios of the prospective customer. The
existence of consignment inventories may be particularly relevant to trade
suppliers. Sometimes consignment inventories and their related current liabilities
are not recorded on the balance sheet as the wording of the purchase agreement
may be such that the legal ownership of the goods remains with the supplier until
specified events occur (often the onward sale of the goods).

This means that other suppliers cannot accurately assess an entity’s true level of
trade payables and consequently the average payment period to suppliers, both of
which are important determinants in deciding whether to grant credit.

(b) (i) Debt factoring is a common method of entities releasing the liquidity of
their trade receivables. The accounting issue that needs to be decided is whether
the trade receivables have been sold, or whether the income from the finance
house for their ‘sale’ should be treated as a short term loan. The main substance
issue with this type of transaction is to identify which party bears the risks (i.e. of
slow and non-payment by the customer) relating to the asset. If the risk lies with
the finance house (Omar), the trade receivables should be removed from the
balance sheet (derecognised in accordance with IAS 39). In this case, it is clear
that Angela still bears the risk relating to slow and non-payment. The residual
payment by Omar Leasing depends on how quickly the receivables are collected;
the longer it takes, the less the residual payment (this imputes a finance cost). Any
balance uncollected by Omar Leasing after six months will be refunded by
Angela, which reflects the non-payment risk.

Thus the correct accounting treatment for this transaction is that the cash received
from Omar Leasing (80% of the selected receivables) should be treated as a
current liability (a short term loan) and the difference between the gross trade
receivables and the amount ultimately received from Omar Leasing (plus any
amounts directly from the credit customers themselves) should be charged to the
income statement. The classification of the charge is likely to be a mixture of
administrative expenses (for Omar Leasing collecting receivables), finance
expenses (reflecting the time taken to collect the receivables) and the impairment
of trade receivables (bad debts).

(ii) This is an example of a sale and leaseback of a property. Such

transactions are part of normal commercial activity, often being used as a way to
improve cash flow and liquidity. However, if an asset is sold at an amount that is
different to its fair value there is likely to be an underlying reason for this. In this
case, it appears (based on the opinion of the auditor) that Finance Leasing
Company Ltd has paid Angela K2 million more than the building is worth. No
(unconnected) company would do this knowingly without there being some form
of ‘compensating’ transaction. This sale is ‘linked’ to the five-year rental
agreement. The question indicates the rent too is not at a fair value, being K500,

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 000 per annum (K1, 300,000 – K800, 000) above what a commercial rent for a
similar building would be.

It now becomes clear that the excess purchase consideration of K2 million is an

‘in substance’ loan (rather than sales proceeds – the legal form) which is being
repaid through the excess (K500, 000 per annum) of the rentals. Although this is a
sale and leaseback transaction, as the building is freehold and has an estimated
remaining life (20 years) that is much longer than the five year leaseback period,
the lease is not a finance lease and the building should be treated as sold and thus
derecognised.

The correct treatment for this item is that the sale of the building should be
recorded at its fair value of K10 million, thus the profit on disposal would be
K2·5 million (K10 million – K7·5 million). The ‘excess’ of K2 million (K12
million – K10 million) should be treated as a loan (non-current liability). The
rental payment of K1·3 million should be split into three elements; K800, 000
building rental cost, K200, 000 finance cost (10% of K2 million) and the
remaining K300, 000 is a capital repayment of the loan.

(iii) The treatment of consignment inventory depends on the substance of the

arrangements between the manufacturer and the dealer (Angela). The main issue
is to determine if and at what point in time the cars are ’sold’. The substance is
determined by analysing which parties bear the risks (e.g. slow moving/obsolete
inventories, finance costs) and receive the benefits (e.g. use of inventories,
potential for higher sales, protection from price increases) associated with the
transaction.

Supplies from Japan’s used cars

Angela has, and has actually exercised, the right to return the cars without penalty (or
been required by Japan’s used cars to transfer them to another dealer), which would
indicate that it has not ‘bought’ the cars. There are no finance costs incurred by Angela,
however Angela would suffer from any price increases that occurred during the three-
month holding/display period. These factors seem to indicate that the substance of this
arrangement is the same as its legal form i.e. Japan’s used cars should include the cars in
its balance sheet as inventory and therefore Angela will not record a purchase transaction
until it becomes obliged to pay for the cars (three months after delivery or until sold to
customers if sooner).

Supplies from Tokyo used cars

Although this arrangement seems similar to the above, there are several important
differences. Angela is bearing the finance costs of 1% per month (calling it a display
charge is a distraction). The option to return the cars should be ignored because it is not
likely to be exercised due to commercial penalties (payment of transport costs and loss of

133
deposit). Finally, the purchase price is fixed at the date of delivery rather than at the end
of six months. These factors strongly indicate that Angela bears the risks and rewards
associated with ownership and should recognise the inventory and the associated liability
in its financial statements at the date of delivery.

CHAPTER 11

IAS 2: INVENTORIES

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The objective of IAS 2 is to prescribe the accounting treatment for inventories. It
provides guidance for determining the cost of inventories and for subsequently
recognising an expense, including any write-down to net realisable value. It also provides
guidance on the cost formulas that are used to assign costs to inventories.

Scope
Inventories include assets held for sale in the ordinary course of business (finished
goods), assets in the production process for sale in the ordinary course of business (work
in process), and materials and supplies that are consumed in production (raw materials).
However, IAS 2 excludes certain inventories from its scope:

 Work in process arising under construction contracts

 Financial instruments
 Biological assets related to agricultural Activity and agricultural produce at the
point of harvest

Also, while the following are within the scope of the standard, IAS 2 does not apply to
the measurement of inventories held by:

Producers of agricultural and forest products, agricultural produce after harvest, and
minerals and mineral products, to the extent that they are measured at net realisable value
(above or below cost) in accordance with well-established practices in those industries.
When such inventories are measured at net realisable value, changes in that value are
recognised in profit or loss in the period of the change.

Commodity brokers and dealers who measure their inventories at fair value less costs to
sell. When such inventories are measured at fair value less costs to sell, changes in fair
value less costs to sell are recognised in profit or loss in the period of the change.

Fundamental Principle of IAS 2

Inventories are required to be stated at the lower of cost and net realisable value (NRV).

Measurement of Inventories
Cost should include all:
 Costs of purchase (including taxes, transport, and handling) net of trade discounts
received
 Costs of conversion (including fixed and variable manufacturing overheads) and
 Other costs incurred in bringing the inventories to their present location and
condition.

Inventory cost should not include:

 Abnormal waste
 Storage costs
 Administrative overheads unrelated to production
 Selling costs
 Foreign exchange differences arising directly on the recent acquisition of
inventories invoiced in a foreign currency
 Interest cost when inventories are purchased with deferred settlement terms.

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The standard cost and retail methods may be used for the measurement of cost, provided
that the results approximate Actual cost.

For inventory items that are not interchangeable, specific costs are attributed to the
specific individual items of inventory.

For items that are interchangeable, IAS 2 allows the FIFO or weighted average cost
formulas. The LIFO formula, which had been allowed prior to the 2003 revision of IAS
2, is no longer allowed.

The same cost formula should be used for all inventories with similar characteristics as to
their nature and use to the enterprise. For groups of inventories that have different
characteristics, different cost formulas may be justified.

Write-Down to Net Realisable Value (NRV)

NRV is the estimated selling price in the ordinary course of business, less the estimated
cost of completion and the estimated costs necessary to make the sale. Any write-down to
NRV should be recognised as an expense in the period in which the write-down occurs.
Any reversal should be recognised in the income statement in the period in which the
reversal occurs.

Benchmark treatment
The preferred cost formula is that the cost of inventories should be assigned by using the:
 FIFO method
 Weighted average method

Allowed alternative treatment

Allows the costs of inventories to be assigned by using
 LIFO method

Expense Recognition
IAS 18, Revenue, addresses revenue recognition for the sale of goods. When inventories
are sold and revenue is recognised, the carrying amount of those inventories is recognised
as an expense (often called cost-of-goods-sold). Any write-down to NRV and any
inventory losses are also recognised as an expense when they occur.

Disclosure
Required disclosures:
 Accounting policy for inventories.
 Carrying amount, generally classified as merchandise, supplies, materials, work in
progress, and finished goods. The classifications depend on what is appropriate
for the enterprise.
 Carrying amount of any inventories carried at fair value less costs to sell.
 Amount of any write-down of inventories recognised as an expense in the period.
 Amount of any reversal of a write down to NRV and the circumstances that led to
such reversal.
 Carrying amount of inventories pledged as security for liabilities.
 Cost of inventories recognised as expense (cost of goods sold). IAS 2
acknowledges that some enterprises classify income statement expenses by nature

136
 (materials, labour, and so on) rather than by function (cost of goods sold, selling
expense, and so on). Accordingly, as an alternative to disclosing cost of goods
sold expense, IAS 2 allows an enterprise to disclose operating costs recognised
during the period by nature of the cost (raw materials and consumables, labour
costs, other operating costs) and the amount of the net change in inventories for
the period). This is consistent with IAS 1, Presentation of Financial Statements,
which allows presentation of expenses by function or nature.

Illustration 1
(a) The following information relates to five dissimilar inventories items:

Cost (K) Net realizable value (K)

Item A 48,000,000.00 51,000,000.00
Item B 22,000,000.00 20,000,000.00
Item C 17,000,000.00 22,000,000.00
Item D 15,000,000.00 20,000,000.00
Item E 60,000,000.00 45,000,000.00
162,000,000.00 158,000,000.00

What is the value of the closing inventory to be included in the income and balance sheet
for the year ended 31st March 2006.

Solution to illustration 1

Cost (K) Net realizable Lower of cost and

value (K) net realisable value
(K)
Item A 48,000,000.00 51,000,000.00 48,000,000.00
Item B 22,000,000.00 20,000,000.00 20,000,000.00
Item C 17,000,000.00 22,000,000.00 17,000,000.00
Item D 15,000,000.00 20,000,000.00 15,000,000.00
Item E 60,000,000.00 45,000,000.00 45,000,000.00
162,000,000.00 158,000,000.00 145,000,000.00

The value is K145, 000,000.00

Illustration 2

(a) IAS 2 inventories requires inventories of raw materials and finished goods to valued
in financial statement at the lower of cost and net realizable value.

Requirements
(i) The standard states that in arriving at the cost of inventory methods such as
last in first out (LIFO) are not usually appropriate. Explain how LIFO is
applied.

137
 (ii) Describe two methods of arriving at the cost of inventory, which is
acceptable under IAS 2 and explain why they are regarded as acceptable, and
LIFO is not.
(iii) Explain how the cost of a inventory of finished goods held by the
manufacturer would normally be arrived at when obtaining the figures for the
financial statement.

(b) Mr next Mulenga is a manufacturer of garden furniture. The company has

consistently used FIFO (first in first out) in valuing inventory, but it is interested to
know the effect on its inventory valuation of using LIFO (last in first out) and
weighted average cost instead of FIFO. At 28th February 2006 the company had a
inventory of 4000 standard plastic tables, and has computed its value on each of the
three bases as:

Basis Unit cost (K) Total value (K)

FIFO 16,000.00 64,000,000.00
LIFO 12,000.00 48,000,000.00
Weighted average 13,000.00 52,000,000.00

During March 2006 the movement on the inventory of tables were as follows:

Received from factory

Date Number of units Production per unit
8th march 3,800 15,000.00
22nd march 6,000 18,000.00
Sales
Dates Number of units
12th march 5,000
18th march 2,000
24th march 3,000
28th march 2,000

On a FIFO basis the inventory at 31st march 2006 was K32, 400,000.00

Requirements
Compute what the value of the inventory at 31st march would be using
(i) LIFO method
(ii) Weighted average method

Solution to illustration 2
(a)
(i) Last in first out goods in inventory are valued at the price of the earliest
purchases, because goods sold are taken to be valued at the latest purchases price.
(ii) First in first out. Under the FIFO, inventory is valued at the price of the most
recent purchases, whether or not it is composed of these particular items.
Average cost. Inventory is priced at the weighted average price at each item has been
purchased during the year.
The two methods are acceptable because they represent actual cost or a reasonably close
approximation to actual; cost. LIFO is not approved for general use because it does not

138
normally give a sufficiently close approximation to actual price and the general dislike of
the method by the tax authorities.
(iii) The cost of in inventory of finished goods would be arrived at by taking the cost
of the labour and material used in their manufacture plus an allocation of overheads. In
allocating overheads, a normal level of production must be assumed and selling and
general administration overheads are excluded.

(b)
Using the LIFO method

Receipts Issue Balance

Date Details Quantity Value Quantity Value Quantity Value

K’000 K’000 K’000
1st Balance 4,000 48,000
march b/wd
8th Receipts 3,800 57,000 7,800 105,000
march from
production
12th Issued 5,000 71,400 2,800 33,600
march
18th Issued 2,000 24,000 800 9,600
march
22nd Receipts 6,000 108,000 6,800 117,600
march from
production
24th Issued 3,000 54,000 3,800 63,600
march
28th Issued 2,000 36,000 1,800 27,600
march

The closing inventory is 1,800 units valued at K27, 600,000

The cost of the issued units is K185, 400,000

Using the weighted average method

139
 Receipts Issue Balance

Date Details Quantity Value Quantity Value Quantity Value Average

K’000 K’000 K’000 price K
1st Balance 4,000 52,000 13,000
march b/wd
8th Receipts 3,800 57,000 7,800 109,000 13,974.35
march from
production
12th Issued 5,000 69,871.75 2,800 39,128.25
march
18th Issued 2,000 27,948.70 800 11,179.55
march
22nd Receipts 6,000 108,000 6,800 119,179.55 17,526.40
march from
production
th
24 Issued 3,000 52,579.2 3,800 66,600.35
march
28th Issued 2,000 35,052.8 1,800 31,547.55
march

The closing inventory is 1,800 units valued at K31, 547,550

The cost of the issued units is K 185,452,450

140
CHAPTER 12
IAS 11: CONSTRUCTION CONTRACTS
The objective of IAS 11 is to prescribe the accounting treatment of revenue and costs
associated with construction contracts.

What Is a Construction Contract?

A construction contract is a contract specifically negotiated for the construction of an
asset or a group of interrelated assets.

Under IAS 11, if a contract covers two or more assets, the construction of each asset
should be accounted for separately if (a) separate proposals were submitted for each
asset, (b) portions of the contract relating to each asset were negotiated separately, and (c)
costs and revenues of each asset can be measured. Otherwise, the contract should be
accounted for in its entirety.

Two or more contracts should be accounted for as a single contract if they were
negotiated together and the work is interrelated.

If a contract gives the customer an option to order one or more additional assets,
construction of each additional asset should be accounted for as a separate contract if
either (a) the additional asset differs significantly from the original asset(s) or (b) the
price of the additional asset is separately negotiated.

What Is Included in Contract Revenue and Costs?

Contract revenue should include the amount agreed in the initial contract, plus revenue
from alternations in the original contract work, plus claims and incentive payments that

(a) are expected to be collected and (b) that can be measured reliably.
The standard elaborates on the types of uncertainty, which depends on the outcome of
future events that affects the measurement of contract revenue,
 An agreed variation
 Cost escalation clauses
 Penalties
 Number of units varies in a contract

In the case of any variation claim or incentive payments two factors should be assessed to
determine whether contract revenue should be recognized:
 Whether it is probable that the customer will accept the variation
 Whether the amounts of the revenue can be measured reliably

Contract costs should include costs that relate directly to the specific contract, plus costs
that are attributable to the contractor’s general contracting Activity to the extent that they
can be reasonably allocated to the contract, plus such other costs that can be specifically
charged to the customer under the terms of the contract.

Costs that relate directly to a specific contract include the following:

141
  Site labour costs
 Costs of materials
 Deprecation of plant and equipment
 Costs of hiring plat and equipment
 Costs of design
 Costs of rectification and guarantee work
 Claims by third parties

Accounting

If the outcome of a construction contract can be estimated reliably, revenue and costs
should be recognised in proportion to the stage of completion of contract Activity. This is
known as the percentage of completion method of accounting. To be able to estimate the
outcome of a contract reliably, the enterprise must be able to make a reliable estimate of
total contract revenue, the stage of completion, and the costs to complete the contract.
If the outcome cannot be estimated reliably, no profit should be recognised. Instead,
contract revenue should be recognised only to the extent that contract costs incurred are
expected to be recoverable and contract costs should be expensed as incurred.

The stage of completion of a contract can be determined in a variety of ways:

 Including the proportion that contract costs incurred for work performed to date
bear to the estimated total contract costs,
 Surveys of work performed, or
 Completion of a physical proportion of the contract work

An expected loss on a construction contract should be recognised as an expense as soon

as such loss is probable.

The following suggested method breaks the process down into five logical steps:

 Compare the contract value and the total costs expected to be incurred on the
contract. If the loss is foreseen, then it must be charged against profits. If the loss
has already been charged in previous years then only the difference between the
losses as previously and currently estimated need to be charged.
 Using the percentage completed to date or other formula given calculate sales
revenue attributable to the contract for the period
 Calculate the cost of sales:

K’ Million
Total contract costs x percentages complete X
Less any costs charged in previous periods (X)
X
Add foreseeable losses X
Cost of sales X

 Deduct the cost of sales for the period as calculated above from the working in
progress at cost up to the total balance on the account. If the cost of sales transfer
exceeds this balance then show the excess as a provision for liabilities and
charges or as an accrual.

142
  Calculate sales revenue and compare this with the total progress payments to date:
o If the sales revenue exceeds advance from customer an amount
recoverable on the contract is established and separately disclosed within
receivable.
o If the advance from customers as assets exceeds sales then the excess is
disclosed within payables.

Disclosure
 Amount of contract revenue recognised;
 Method used to determine revenue;
 Method used to determine stage of completion; and
 For contracts in progress at balance sheet date;
o Aggregate costs incurred and recognised profit
o Amount of advances received
o Amount of retentions

Presentation
 The gross amount due from customers for contract work should be shown as an
asset.
 The gross amount due to customers for contract work should be shown as a
liability.

Illustration 1

(a) (i) Mine rocks Plc is a large public listed company involved in the construction
industry. Accounting standards normally require construction contracts to be accounted
for using the percentage (stage) of completion basis. However, under certain
circumstances they should be accounted for using the completed contracts basis.

Required:
Discuss the principles that underlie each of the two methods and describe the
circumstances in which their use is appropriate.

(ii) Mine rocks Plc is part way through a contract to build a new football stadium at a
contracted price of K300 million.

Details of the progress of this contract at 1 April 2005 are shown below:
K million
Cumulative sales revenue invoiced 150
Cumulative cost of sales to date 112
Profit to date 38

The following information has been extracted from the accounting records at 31 March
2005:

143
 K million
Total progress payment received for work certified at 29 February 2005 180
Total costs incurred to date (excluding rectification costs below) 195
Rectification costs 17

Mine rocks Plc has received progress payments of 90% of the work certified at 29
February 2005. Mine rocks PLC’s surveyor has estimated the sales value of the further
work completed during March 2005 was K20 million.

At 31 March 2005, the estimated remaining costs to complete the contract were K45
million.
The rectification costs are the costs incurred in widening access roads to the stadium.
This was the result of an error by Mine rocks PLC’s architect when he made his initial
drawings.
Mine rocks Plc calculates the percentage of completion of its contracts as the proportion
of sales value earned to date compared to the contract price.

All estimates can be taken as being reliable.

Required:
Prepare extracts of the financial statements for Mine rocks Plc for the above
contract for the year to 31 March 2005.

Solution to Illustration 1

(a) (i) Long-term construction contracts span more than one accounting year-end. This
leads to the problem of determining how the uncompleted transactions should be dealt
with over the life of the contract. Normal sales are not recognized until the production
and sales cycle is complete. Prudence is the most obvious concept that is being applied in
these circumstances, and this is the principle that underlies the completed contract basis.
Where the outcome of a long-term contract cannot be reasonably foreseen due to inherent
uncertainty, the completed contracts basis should be applied.
The effect of this is that sales revenue earned to date is matched to the cost of sales and
no profit is taken.
The problem with the above is that for say a three year contract it can lead to a situation
where no profits are recognised, possibly for two years, and in the year of completion the
whole of the profit is recognised (assuming the contract is profitable). This seems
consistent with the principle that only realised profits should be recognised in the income
statement. The problem is that the overriding requirement is for financial statements to
show a true and fair view which implies that financial statements should reflect economic
reality. In the above case, it can be argued that the company has been involved in a
profitable contract for a three-year period, but its financial statements over the three years
show a profit in only one period. This also leads to volatility of profits, which many
companies feel is undesirable and not favored by analysts. An alternative approach is to
apply the matching/accruals concept, which underlies the percentage of completion
method. This approach requires the percentage of completion of a contract to be assessed
(there are several methods of doing this) and then recognising in the income statement
that percentage of the total estimated profit on the contract. This method has the
advantage of more stable profit recognition and can be argued shows a more true

144
In addition, fair view than the completed contract method. A contrary view is that this
method can be criticised as being a form of profit smoothing which, in other
circumstances, is considered to be an (undesirable) example of creative accounting.
Accounting standards require the use of the percentage of completion method where the
outcome of the contract is reasonably foreseeable. It should also be noted that where a
contract is expected to produce a loss, the whole of the loss must be recognised as soon as
it is anticipated.

(ii) Mine rocks Plc – income statement extract – year to 31 March 2005 (see working
below):
K million
Sales revenue 70
Cost of sales (64 +17) (81)
——
Loss for period (11)
——

Mine rocks Plc – balance sheet extracts – as at 31 March 2005

Current assets
Gross amounts due from customers for contract work (w (iii)) 59

Workings:
Cumulative Cumulative Amounts for year
1 April 2005 31 March 2005
K million K million K million
Sales 150 (w (i)) 220 70
Cost of sales (112) (w (ii)) (176) (64)
Rectification costs nil (17) (17)
––– ––– –––
Profit (loss) 38 (w (ii)) 27 (11)
––– ––– –––

(i) Progress payments received are K180 million. This is 90% of the work certified
(at 29 February 2005), therefore the work certified at that date was K200 million. The
value of the further work completed in March 2005 is given as K20 million, giving a total
value of contract sales at 31 March 2005 of K220 million.
(ii) The total estimated profit (excluding rectification costs) is K60 million:
K million
Contract price 300
Cost to date (195)
Estimated cost to complete (45)
——
Estimated total profit 60
——

The degree of completion (by the method given in the question) is 220/300
Therefore, the profit to date (before rectification costs) is K44 million (K60 million ×
220/300). Rectification costs must be charged to the period they were incurred and not

145
spread over the remainder of the contract life. Therefore, after rectification costs of K17
million the total reported contract profit to 31 March 2005 would be K27 million.
With contract revenue of K220 million and profit to date of K44 million, this means
contract costs (excluding rectification costs) would be K176 million. The difference
between this figure and total cost incurred of K195 million is part of the K59 million of
the amount due from customers shown in the balance sheet.
(iii) The gross amounts due from customers is cost to date (K195 million + K17 million)
plus cumulative profit (K27 million) less progress billings (K180 million) = K59 million.
4J–INTBD
Illustration 2
Turn Construction specialises in construction contracts. One of its contracts, with Better
Homes, is to build a complex of luxury flats. The price agreed for the contract is K40
million and its scheduled date of completion is 31 December 2005. Details of the contract
to 31 March 2004 are:

Commencement date 1 July 2003

Contract costs: K000
Architects’ and surveyors’ fees 500
Materials delivered to site 3,100
Direct labour costs 3,500

Overheads are apportioned at 40% of direct labour costs

Estimated cost to complete (excluding depreciation – see below) 14,800
Plant and machinery used exclusively on the contract cost K3, 600,000 on 1 July 2003.
At the end of the contract, it is expected to be transferred to a different contract at a value
of K600, 000. Depreciation is to be based on a time apportioned basis.

Inventory of materials on site at 31 March 2004 is K300, 000.

Better Homes paid a progress payment of K12, 800,000 to Turn Construction on 31
March 2004.

At 31 March 2005 the details for the construction contract have been summarised as:
Contract costs to date (i.e. since the start of the contract) excluding all depreciation
20,400,000
Estimated cost to complete (excluding depreciation) 6,600,000
A further progress payment of K16, 200,000 was received on 31 March 2005.
Turn Construction accrues profit on its construction contracts using the percentage of
completion basis as measured by the percentage of the cost to date compared to the total
estimated contract cost.

Required:
(a) Prepare extracts of the financial statements of Turn Construction for the
construction contract with Better Homes for:
(i) The year to 31 March 2004;
(ii) The year to 31 March 2005.

Solution to Illustration 2

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(a) (i) Turn Construction – Income statement (extracts) – year to 31 March 2004
K000
Sales revenue (40,000 × 35% (w (i))) 14,000
Cost of sales (w (i)) (9,100)
______
Profit on contract 4,900
______

Balance sheet (extracts) as at 31 March 2004

Non-current assets
Plant and machinery (3,600 – 900 (w (ii))) 2,700

Current assets
Amount due from customer (w (iii)) 1,500

(ii) Turn Construction – Income statement (extracts) – year to 31 March 2005

K000
Sales revenue (40,000 × 75% – 14,000 (w (i))) 16,000
Cost of sales (22,500 – 9,100 (w (i))) (13,400)
_______
Profit on contract 2,600
_______
Balance sheet (extracts) as at 31 March 2005

Non-current assets
Plant and machinery (3,600 – 900 – 1,200 (w (ii))) 1,500

Current assets
Amount due from customer (w (iii)) 1,000

Workings (all figures K000):

(i) Contract costs as at 31 March 2004:
Architects’ and surveyors’ fees 500
Materials used (3,100 – 300 inventory) 2,800
Direct labour costs 3,500
Overheads (40% of 3,500) 1,400
Plant depreciation (9 months (w (ii))) 900
______
Cost at 31 March 2004 9,100
Estimated cost to complete:
Excluding depreciation 1 4,800
Plant depreciation (3,600 – 600 – 900) 2,100 16,900
______ _______
Estimated total costs on completion 26,000
_______

Percentage of completion at 31 March 2004 (9,100/26,000) = 35%

147
Contract costs as at 31 March 2005:
Summarised costs excluding depreciation 20,400
Plant depreciation (21 months at K100 per month) 2,100
_______
Cost to date 22,500
Estimated cost to complete:
Excluding depreciation 6,600
Plant depreciation (9 months) 900 7,500
______ _______
Estimated total costs on completion 30,000
_______

Percentage of completion at 31 March 2005 (22,500/30,000) = 75%

(ii) The plant has a depreciable amount of K3, 000 (3,600 – 600 residual value)
Its estimated life on this contract is 30 months (1 July 2003 to 31 December 2005)
Depreciation would be K100 per month i.e. K900 for the period to 31 March 2004;
K1, 200 for the period to 31 March 2006; and a further K900 to completion.
(iii) Amount due from customer at 31 March 2004:
Contract cost incurred (9,100 + 300 materials inventory) 9,400
Recognised profit 4,900
_______
14,300
Cash received at 31 March 2004 (12,800)
_______
Amount due at 31 March 2004 1,500
_______
Amount due from customer at 31 March 2005:
Contract costs incurred 22,500
Recognised profit (4,900 + 2,600) 7,500
_______
30,000
Cash received – 31 March 2004 (12,800)
– 31 March 2005 (16,200) (29,000)
_______ _______
Amount due at 31 March 2005 1,000
_______

Chapter 13

148
IAS 37 - PROVISIONS, CONTINGENT LIABILITIES AND ASSETS

The objective of IAS 37 is to ensure that appropriate recognition criteria and

measurement bases are applied to provisions, contingent liabilities and contingent assets
and that sufficient information is disclosed in the notes to the financial statements to
enable users to understand their nature, timing and amount. The key principle established
by the Standard is that a provision should be recognised only when there is a liability i.e.
a present obligation resulting from past events. The Standard thus aims to ensure that
only genuine obligations are dealt with in the financial statements. Planned future
expenditure, even where authorised by the Board of Directors or equivalent governing
body, is excluded from recognition.

Back ground.
The previous lack of an accounting standard on provisions had allowed entities to make
large one-off provisions in years where a high level of underlying profits were generated.
These provisions, often known as ‘big bath provisions’ were then available to shield
expenditure in future years, where perhaps the underlying profits were not expected to be
as good. There was concern that some entities were using the lack of regulation over
provisions as a means of profit smoothing.

This perception means that preparers are often inclined to reporting as smooth a trend of
profits as is possible. Clearly, financial statements should reflect economic reality and if
profits fluctuate then the equity investors should be informed through the annual report.
Profit smoothing can therefore be seen as an attempt to mislead the equity investors. The
key aim of IAS 37 is to ensure that provisions are made only where there are valid
grounds for them.

Scope
IAS 37 excludes obligations and contingencies arising from:
 Financial instruments carried at fair value (but IAS 37 does apply to financial
instruments carried at amortised cost)
 Non-onerous executory contracts
 Insurance company policy liabilities (but IAS 37 does apply to non-policy-related
liabilities of an insurance company)

 Items covered by another IAS, for example, IAS 11: Construction Contracts,
applies to obligations arising under such contracts; IAS 12: Income Taxes, applies
to obligations for current or deferred income taxes; IAS 17: Leases, applies to
lease obligations; and IAS 19: Employee Benefits, applies to pension and other
employee benefit obligations.

Apart from the specific exemptions mentioned in the standard, it is worth noting that the
IAS 37 views a provision as a liability. The word ‘provision’ is often used in a wider
sense to provide for the possible loss in carrying value of an asset. Two well-known
examples of this wider usage would be a ‘provision’ for doubtful debts and a ‘provision’
for depreciation. IAS 37 does not address accounting for ‘provisions’ of this nature.

Key Definitions
Provision:

149
A liability of uncertain timing or amount. The key aspect of this definition is that a
provision is a liability. IAS 37 defines a liability as an obligation of an entity to transfer
economic benefits as a result of past transactions or events. This second definition is
consistent with the proposed Statement of Principles and also with, Reporting the
Substance of Transactions. The standard distinguishes provisions from other liabilities
such as trade payables and accruals. This is on the basis of the fact that for a provision
there is uncertainty about the timing or amount of the future expenditure. Whilst
uncertainty is clearly present in the case of certain accruals, the uncertainty is generally
much less than for provisions.

Liability:
 Present obligation as a result of past events
 Settlement is expected to result in an outflow of resources (payment)

Contingent liability:
 A possible obligation depending on whether some uncertain future event occurs,
or
 A present obligation whose payment is not probable or the amount cannot be
measured reliably

Contingent asset:
 A possible asset 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
enterprise.

Recognition of a Provision
An enterprise must recognise a provision if and only if:
 A present obligation (legal or constructive) has arisen as a result of a past event
(the obligating event),
 Payment is probable (‘more likely than not’), and
 The amount can be estimated reliably.

Obligating Event
An obligating event is an event that creates a legal or constructive obligation and,
therefore, results in an enterprise having no realistic alternative but to settle the
obligation.

Constructive Obligation
A constructive obligation arises if past practice creates a valid expectation on the part of a
third party, for example, a retail store that has a long-standing policy of allowing
customers to return merchandise within, say, a 30-day period.
The existence or otherwise of a legal obligation is fairly easy to identify. Constructive
obligations are more problematic.

IAS 37 defines a constructive obligation as:

   

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 An obligation that derives from an entity’s Actions
where:
 By an established pattern of past practice,
published policies or a sufficiently specific
current statement, the entity has indicated
to other parties that it will accept certain
responsibilities; and
 As a result, the entity has created a valid
expectation on the part of those other
parties that it will discharge those
responsibilities.

This definition basically means that the mere intention to undertake a particular course of
action is not sufficient to warrant a provision under IAS 37. An obligation always
involves another party to whom the obligation is owed. It is not necessary, however, to
know the identity of the party to whom the obligation is owed — frequently the
obligation may be to the public at large.

Prior to IAS 37, many companies would have provided for the consequences of actions
approved by the directors at a board meeting. Under IAS 37, a management or board
decision does not give rise to a constructive obligation unless the decision has been
communicated to those affected by it in a way that raises a valid expectation in them that
the entity will discharge its responsibilities.

A possible obligation (a contingent liability) is disclosed but not accrued. However,

disclosure is not required if payment is remote.

In rare cases, for example in a lawsuit, it may not be clear whether an enterprise has a
present obligation. In those cases, a past event is deemed to give rise to a present
obligation if, taking account of all available evidence, it is more likely than not that a
present obligation exists at the balance sheet date. A provision should be recognised for
that present obligation if the other recognition criteria described above are met. If it is
more likely than not that, no present obligation exists; the enterprise should disclose a
contingent liability, unless the possibility of an outflow of resources is remote.

For the purpose of the IAS, a transfer of economic benefits is regarded as ‘probable’ if
the event is more likely than not to occur. This appears to indicate a probability of more
than 50%. However, the standard makes it clear that where there is a number of similar
obligations the probability should be based on considering the population as a whole,
rather than one single item. For example, if a company has entered into a warranty
obligation then the probability of transfer of economic benefits may well be extremely
small in respect of one specific item. However, when considering the population as a
whole the probability of some transfer of economic benefits is quite likely to be much
higher. If there is a greater than 50% probability of some transfer of economic benefits
then a provision should be made of the expected amount.

Where an obligation exists, but the probability of transfer of economic benefits is 50% or
less then, there is a contingent liability.

Meaning of ‘reasonable estimate’

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The IAS states that a Reasonable Estimate of a range of outcomes is almost always
possible. In the very rare cases where it is not, then no provision is recognised and the
liability is disclosed as a contingent liability.

Definition and treatment of contingencies

Definition of a contingent liability

IAS 37 defines a contingent liability as:
 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 entity’s control; or

 A present obligation that arises from past events but is not recognised because:
o It is not probable that a transfer of economic benefits will be required to
settle the obligation; or
o The amount of the obligation cannot be measured with sufficient
reliability.

The word ‘possible’ could conceivably be taken to mean any mathematical probability
from 0% to 100%. It seems consistent with what was described in the previous section
regarding the word ‘possible’ as referring to a situation where the probability of the
existence of a liability and/or the transfer of economic benefits is 50% or less. If the
probability is more than 50% then there is a provision and as such should recognise a
liability in the financial statements.

Treatment of a contingent liability

Contingent liabilities should not be recognised in financial statements but they should be
disclosed. The required disclosures are:
 A brief description of the nature of the contingent liability;
 An estimate of its financial effect;
 An indication of the uncertainties that exist;
 The possibility of any reimbursement.

Definition and treatment of contingent assets

A contingent asset is defined as:

A possible asset that arises from past events and

  whose existence will be confirmed by the  
occurrence of one or more uncertain future
events not wholly within the entity’s control.

The IAS states that a contingent asset should not be recognised. Only when the
realisation of the related economic benefits are virtually certain should recognition take
place. At that point, the asset is no longer a ‘contingent asset’.

Measurement of Provisions

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The amount recognised as a provision should be the best estimate of the expenditure
required to settle the present obligation at the balance sheet date, that is, the amount that
an enterprise would rationally pay to settle the obligation at the balance sheet date or to
transfer it to a third party.

This means:
 Provisions for one-off events (restructuring, environmental clean-up, settlement of
a lawsuit) are measured at the most likely amount.
 Provisions for large populations of events (warranties, customer refunds) are
measured at a probability-weighted expected value.
 Both measurements are at discounted present value using a pre-tax discount rate
that reflects the current market assessments of the time value of money and the
risks specific to the liability.

In reaching its best estimate, the enterprise should take into account the risks and
uncertainties that surround the underlying events. Expected cash outflows should be
discounted to their present values, where the effect of the time value of money is
material.

If some or all of the expenditure required to settle a provision is expected to be

reimbursed by another party, the reimbursement should be recognised as a reduction of
the required provision when, and only when, it is virtually certain that reimbursement
will be received if the enterprise settles the obligation. The amount recognised should not
exceed the amount of the provision.

In measuring a provision, consider future events as follows:

 Forecast reasonable changes in applying existing technology
 Ignore possible gains on sale of assets
 Consider changes in legislation only if virtually certain to be enacted

Remeasurement of Provisions
 Review and adjust provisions at each balance sheet date
 If outflow no longer probable, reverse the provision to income.

Examples of Provisions

Circumstance Accrues a Provision?

Restructuring by sale of an Accrue a provision only after a binding sale

operation agreement

Restructuring by closure or Accrue a provision only after a detailed formal

reorganisation plan is adopted and announced publicly. A
Board decision is not enough

Warranty Accrue a provision (past event was the sale of

defective goods)

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 Land contamination Accrue a provision if the company's policy is to
clean up even if there is no legal requirement to
do so (past event is the obligation and public
expectation created by the company's policy)

Customer refunds Accrue if the established policy is to give

refunds (past event is the customer's expectation,
at time of purchase, that a refund would be
available)

Offshore oil rig must be Accrue a provision when installed, and add to
removed and sea bed restored the cost of the asset

Abandoned leasehold, four Accrue a provision

years to run

CPA firm must have staff No provision (there is no obligation to provide

training for recent changes in the training)
tax law

A chain of retail stores is self- No provision until a an Actual fire (no past
insured for fire loss event)

Self-insured restaurant, people Accrue a provision (the past event is the injury
were poisoned, lawsuits are to customers)
expected but none have been
filed yet

Major overhaul or repairs No provision (no obligation)

Onerous (loss-making) contract Accrue a provision

Further notes:
The accounting treatment is shown in the following table:

Likelihood of occurrence Material contingent asset Material contingent

liability
Remote No disclosure allowed* No disclosure
Possible No disclosure allowed* Disclose by note
Probable Disclose by note Make a provision
Virtually certain Accruals Make a provision

* Note that disclosure is not allowed for remote or possible contingent gains. The
prudence concept dictates that contingent gains are treated with more caution than
contingent losses.

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Determining the level of probability:

Likelihood Level of probability

Remote 0-5%
Possible 5-50%
Probable 50-95%
Virtually certain 95-100%

Restructuring
A restructuring is:
 Sale or termination of a line of business
 Closure of business locations
 Changes in management structure
 Fundamental reorganisation of company

Restructuring provisions should be accrued as follows:

 Sale of operation: Accrue provision only after a binding sale agreement. If the
binding sale agreement is after balance sheet date, disclose but do not accrue
 Closure or reorganisation: Accrue only after a detailed formal plan is adopted and
announced publicly. A board decision is not enough.
 Future operating losses: Provisions should not be recognised for future operating
losses, even in a restructuring
 Restructuring provision on acquisition (merger): Accrue provision for terminating
employees, closing facilities, and eliminating product lines only if announced at
acquisition and, then only if a detailed formal plan is adopted 3 months after
acquisition.

Restructuring provisions should include only direct expenditures caused by the

restructuring, not costs that associated with the ongoing Activities of the enterprise.

The Nature of the Debit Entry?

When a provision (liability) is recognised, the debit entry for a provision is not always an
expense. Sometimes the provision may form part of the cost of the asset. Examples:
obligation for environmental clean up when a new mine is opened or an offshore oilrig is
installed.

Use of Provisions
Provisions should only be used for the purpose for which they were originally recognised.
They should be reviewed at each balance sheet date and adjusted to reflect the current
best estimate. If it is no longer probable that an outflow of resources will be required to
settle the obligation, the provision should be reversed.
Disclosures
Reconciliation for each class of provision:
 Opening balance
 Additions
 Used (amounts charged against the provision)
 Released (reversed)
 Unwinding of the discount

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  Closing balance

Prior year reconciliation is not required.

For each class of provision, a brief description of the following is required:
 Nature
 Timing
 Uncertainties
 Assumptions
 Reimbursement

Illustration 1
IAS 37: ‘Provisions, Contingent Liabilities and Contingent Assets’ was issued in 1998.
The Standard sets out the principles of accounting for these items and clarifies when
provisions should and should not be made. Prior to its issue, the inappropriate use of
provisions had been an area where companies had been accused of manipulating the
financial statements and of creative accounting.

Required:
(a) Describe the nature of provisions and the accounting requirements for them as
contained in IAS 37.
(b) Explain why there is a need for an accounting standard in this area. Illustrate
your answer with three practical examples of how the standard addresses
controversial issues.

(c) Mukape Sports sells sports goods and clothing through a chain of retail outlets. It
offers customers a full refund facility for any goods returned within 28 days of their
purchase provided they are unused and in their original packaging.
In addition, all goods carry a warranty against manufacturing defects for 12 months from
their date of purchase.

For most goods, the manufacturer underwrites this warranty such that Mukape Sports is
credited with the cost of the goods that are returned as faulty. Goods purchased from one
manufacturer, Z Clothing, are sold to Mukape Sports at a negotiated discount which is
designed to compensate Mukape Sports for manufacturing defects. No refunds are given
by Z Clothing, thus Mukape Sports has to bear the cost of any manufacturing faults of
these goods.

Mukape Sports makes a uniform mark up on cost of 25% on all goods it sells, except for
those supplied from Z Clothing on which it makes a mark up on cost of 40%. Sales of
goods manufactured by Z Clothing consistently account for 20% of all Mukape Sports ’s
sales.

Sales in the last 28 days of the trading year to 30 September 2005 were K1, 750,000. Past
trends reliably indicate that 10% of all goods are returned under the 28-day return
facility. These are not faulty goods. Of these 70% are later resold at the normal selling
price and the remaining 30% are sold as ‘sale’ items at half the normal
retail price.

156
In addition to the above-expected returns, an estimated K160, 000 (at selling price) of the
goods sold during the year will have manufacturing defects and have yet to be returned
by customers. Goods returned as faulty have no resale value.

Required:
Describe the nature of the above warranty/return facilities and calculate the
provision Mukape Sports is required to make at 30 September 2005:
(i) For goods subject to the 28 day returns policy; and
(ii) For goods that are likely to be faulty.
(c) Lusaka Rock buster has recently purchased an item of earth moving plant at a total
cost of K24 million. The plant has an estimated life of 10 years with no residual
value, however its engine will need replacing after every 5,000 hours of use at an
estimated cost of K7·5 million. The directors of Lusaka Rock buster intend to
depreciate the plant at K2·4 million (K24 million/10 years) per annum and make a
provision of K1, 500 (K7·5 million/5,000 hours) per hour of use for the replacement
of the engine.

(d) Required:
Explain how the plant should be treated in accordance with International
Accounting Standards and comment on the Directors’ proposed treatment.

Solution to illustration 1

(a) IAS 37: ‘Provisions, Contingent Liabilities and Contingent Assets’ only deals with
those provisions that are regarded as liabilities. The term ‘provision’ is also generally
used to describe those amounts set aside to write down the value of assets such as
depreciation charges and provisions for diminution in value (e.g. provision to write down
the value of damaged or slow moving inventory). The definition of a provision in the
Standard is quite simple; provisions are liabilities of uncertain timing or amount. If there
is reasonable certainty over these two aspects, the liability is a creditor. There is clearly
an overlap between provisions and contingencies. Because of the ‘uncertainty’ aspects of
the definition, it can be argued that to some extent all provisions have an element of
contingency. The IASB distinguishes between the two by stating that a contingency
is not recognised as a liability if it is either only possible and therefore yet to be
confirmed as a liability, or where there is a liability but it cannot be measured with
sufficient reliability. The IASB notes the latter should be rare.

The IASB intends that only those liabilities that meet the characteristics of a liability in
its framework for the preparation and presentation of Financial Statements should be
reported in the balance sheet. IAS 37 summarises the above by requiring provisions to
satisfy all of the following three recognition criteria:
– There is a present obligation (legal or constructive) as a result of a past event;
– It is probable that a transfer of economic benefits will be required to settle the
obligation;
– The obligation can be estimated reliably.

A provision is triggered by an obligating event. This must have already occurred; future
events cannot create current liabilities.

157
The first of the criteria refers to legal or constructive obligations. A legal obligation is
straightforward and uncontroversial, but constructive obligations are a relatively new
concept. These arise where a company creates an expectation that it will meet
certain obligations that it is not legally bound to meet. These may arise due to a published
statement or even by a pattern of past practice. In reality, constructive obligations are
usually accepted because the alternative action is unattractive or may damage the
reputation of the company. The most commonly quoted example of such is a commitment
to pay for environmental damage caused by the company, even where there is no legal
obligation to do so.

To summarise: a company must provide for a liability where the three defining criteria of
a provision are met, but conversely a company cannot provide for a liability where they
are not met. The latter part of the above may seem obvious, but it is an area where there
has been some past abuse of provisioning as is referred to in (b).

(b) The main need for an accounting standard in this area is to clarify and regulate when
provisions should and should not be made. Many controversial areas including the
possible abuse of provisioning are based on contravening aspects of the above
definitions. One of the most controversial examples of provisioning is in relation to future
restructuring or reorganisation costs (often as part of an acquisition). This is sometimes
extended to providing for future operating losses. The attraction of providing for this type
of expense/loss is that once the provision has been made, the future costs are then
charged to the provision such that they bypass the income statement (of the period when
they occur). Such provisions can be glossed over by management as ‘exceptional items’,
which analysts are expected to disregard when assessing the company’s future
prospects. If this type of provision were to be incorporated as a liability as part of a
subsidiary’s net assets at the date of acquisition, the provision itself would not be charged
to the income statement. IAS 37 now prevents this practice as future costs and operating
losses (unless they are for an onerous contract) do not constitute past events.

Another important change initiated by IAS 37 is the way in which environmental

provisions must be treated. Practice in this area has differed considerably. Some
companies did not provide for such costs and those that did often accrued for them on
an annual basis. If say a company expected environmental site restoration cost of K10
million in 10 years time, it might argue that this is not a liability until the restoration is
needed or it may accrue K1 million per annum for 10 years (ignoring discounting).
Somewhat controversially this practice is no longer possible. IAS 37 requires that if the
environmental costs are a liability (legal or constructive), then the whole of the costs
must be provided for immediately. That has led to large liabilities appearing in some
companies’ balance sheets.

A third example of bad practice is the use of ‘big bath’ provisions and over provisioning.
In its simplest form this occurs where a company makes a large provision, often for non-
specific future expenses, or as part of an overall restructuring package. If the provision is
deliberately overprovided, then its later release will improve future profits. Alternatively,
the company could charge to the provision a different cost than the one it was originally
created for. IAS 37 addresses this practice in two ways:

By not allowing provisions to be created if they do not meet the definition of an

obligation; and specifically preventing, a provision made for one expense to be used for a

158
different expense. Under IAS 37, the original provision would have to be reversed and a
new one would be created with appropriate disclosures. Whilst this treatment does not
affect overall profits, it does enhance transparency.

(c) Guarantees or warranties appear to have the attributes of contingent liabilities. If the
goods are sold faulty or develop a fault within the guarantee period there will be a
liability, if not there will be no liability. The IASB view this problem as two separate
situations. Where there is a single item warranty, it is considered in isolation and often
leads to a discloseable contingent liability unless the chances of a claim are thought to be
negligible. Where there are a number of similar items, they should be considered as a
whole. This may mean that whilst the chances of a claim arising on an individual item
may be small, when taken as a whole, it should be possible to estimate the number of
claims from past experience. Where this is the case, the estimated liability is not
considered contingent and it must be provided for.

(i) Mukape Sports’ 28-day refund policy is a constructive obligation. The company
probably has notices in its shops informing customers of this policy. This would create an
expectation that the company will honour its policy. The liability that this
creates is rather tricky. The company will expect to give customers refunds of K175, 000
(K1, 750,000 x 10%). This is not the liability because 70% of these will be resold at the
normal selling price, so the effect of the refund policy for these goods is that the profit on
their sale must be deferred. The easiest way to account for this is to make a provision for
the unrealised profit. This has to be calculated for two different profit margins:

Goods manufactured by Z Clothing (at a mark up of 40% on cost):

K24, 500 (K175, 000 x 70% x 20%) x 40/140 = K7, 000
Goods from other manufacturers (at a mark up of 25% on cost)
K98, 000 (K175, 000 x 70% x 80%) x 25/125 = K19, 600
The sale of the remaining 30% at half the normal selling price will create a loss. Again,
this must be calculated for both groups of sales:
Goods manufactured by Z Clothing were originally sold for K10, 500 (175,000 x 30% x
20%). These will be resold (at a loss) for half this amount i.e. K5, 250. Thus a provision
of K5, 250 is required.
Goods manufactured by other manufacturers were originally sold for K42, 000 (175,000
x 30% x 80%). These will be resold (at a loss) for half this amount i.e. K21, 000. Thus a
provision of K21, 000 is required.
The total provision in respect of the 28-day return facility will be K52, 850 (7,000 +
19,600 + 5,250 + 21,000).

(ii) Goods likely to be returned because they are faulty require a different treatment.
These are effectively sales returns.
Normally the manufacturer will reimburse the cost of the faulty goods. The effect of this
is that Mukape Sports will not have made the profit originally recorded on their sale. This
applies to all goods other than those supplied by Z Clothing. Thus, these sales returns
would be K128, 000 (160,000 x 80%) and the credit due from the manufacturer would be
K102, 400 (128,000 x 100/125 removal of profit margin). The overall effect is that
Mukape Sports would have to remove profits of K25, 600 from its financial statements.
For those goods supplied by Z Clothing, Mukape Sports must suffer the whole loss as this
is reflected in the negotiated discount.

159
Thus, the provision required for these goods is K32, 000 (160,000 x 20%), giving a total
provision of K57, 600 (25,600 + 32,000).

(d) The Directors’ proposed treatment is therefore incorrect because the replacement of
the engine is an example of what has been described as cyclic repairs or replacement.
Whilst it may seem logical and prudent to accrue for the cost of a replacement engine as
the old one is being worn out, such practice leads to double counting. Under the
Directors’ proposals, the cost of the engine is being depreciated as part of the cost of the
asset, albeit over an incorrect time period. The solution to this problem lies in IAS 16:
‘Property, Plant and Equipment’. The plant constitutes a ‘complex’ asset i.e. one that may
be thought of as having
separate components within a single asset. Thus part of the plant K16·5 million (total cost
of K24 million less K7·5 assumed cost of the engine) should be depreciated at K1·65
million per annum over a 10-year life and the engine should be depreciated at K1, 500
per hour of use (assuming machine hour depreciation is the most appropriate method). If
a further provision of K1, 500 per machine hour is made, there would be a double charge
against profit for the cost of the engine.

IAS 37 also refers to this type of provision and says that the future replacement of the
engine is not a liability. The reasoning is that the replacement could be avoided if, for
example, the company chose to sell the asset before replacement was due. If an item does
not meet the definition of a liability, it cannot be provided for.

Illustration 2

IAS 37: ‘Provisions, Contingent Liabilities and Contingent Assets’ was issued in
September 1998 and became effective for accounting periods beginning on or after 1 July
2000. It supersedes certain part’s of IAS 10 in respect of contingencies.

Required:

(a) (i) Explain the need for an accounting standard in respect of provisions.
(ii) Describe the principles in IAS 37 of accounting for provisions. Your answer
should refer to definitions and recognition and measurement criteria.

(b) Desco is a company involved in the electricity generating industry. It operates some
nuclear power stations for which environmental clean-up costs can be a large item of
expenditure. The company operates in some countries where environmental costs have to
be incurred as they are written into the licensing agreement, and in other countries where
they are not a legal requirement. The details of a recent contract Desco entered into are as
follows:

A new nuclear power station has been built at a cost of K200 million and was brought
into commission on 1 October 2000. The licence to produce electricity at this station is
for 10 years. This is also the estimated economic life of the power station. The terms of
the licence require the power station to be demolished at the end of the licence. It also
requires that the spent nuclear fuel rods (a waste product) have to be buried deep in the
ground and the area ‘sealed’such that no contamination can be detected. Desco will also

160
have to pay for the cost of cleaning up any contamination leaks that may occur from the
water-cooling system that surrounds the fuel rods when they are in use.

Desco estimates that the cost of the demolition of the power station and the fuel rod
‘sealing’ operation will be K180 million in ten years time. The present value of these
costs at an appropriate discount rate is K120 million. From past experience, there is a
30% chance of a contaminating water leak occurring in any 12 month period. The cost of
cleaning up a leak varies between K20 million and K40 million depending on the severity
of the contamination.
Extracts from the company’s draft financial statements to 30 September 2005 relating to
the contract after applying the company’s normal accounting policy for this type of
power station are:

Income Statement charges: K million

Non-current asset depreciation (power station) 10% x K200 million 20
Provision for demolition and ‘sealing’ costs 10% x K180 million 18
Provision for cleaning up contamination due to water leak
(30% x an average of K30 million) 9
47

Balance sheet:
Tangible Non-current assets:
Power station at cost 200
Depreciation (20)
180
Non-current liabilities:
Provision for environmental costs (K18 + K9 million) 27

Note: no contamination from water leakage occurred in the year to 30 September 2005.
Desco is concerned that its current policy does not comply with IAS 37 ‘Provisions,
Contingent Liabilities and Contingent Assets’ and has asked for your advice.

Required:
(i) Comment on the acceptability of Desco’s current accounting policy, and redraft
the extracts of the financial statements in line with the regulations of IAS 37.
Note: your answer should ignore the ‘unwinding’ of the discount to present value.
(ii) Assuming Desco was operating the nuclear power station in a country that does
not legislate in respect of the above types of environmental costs. Explain the effect
this would have on your answer to (i) above.
Note: your answer should include a consideration of what Desco’s environmental
policy might be.

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Solution to illustration 2

(a) (i) The use of provisions can have a significant effect on a company’s financial
statements. They arise in many areas of business and often relate to controversial
areas such as restructuring costs, environmental and decommissioning liabilities,
and guarantees and warranties. Provisions have often been based on
management’s intentions rather than on the existence of a relevant liability.

(b) In the recent past, there has been much criticism of the use and abuse of
provisions. The main area of abuse has been that of ‘profit smoothing’ or creating
artificial growth. In essence, this amounts to creating a provision, usually for
some future intended expenditure, when a company’s profits are healthy, and
subsequently releasing the provision through the income statement to offset the
expenditure when it occurs. This has the effect of reducing the profit in the years
in which provisions are made and increasing profits in the years in which they are
released. A common complaint is that provisions created for a specific purpose
(or type of expenditure) are aggregated with other provisions and subsequently
used to offset expenditures of future years that were not (and should not have
been) provided for. Such provisions were often very large and treated as
extraordinary or exceptional items. This treatment may have caused some users to
disregard the expense in the belief that it was a non-recurring item thus
minimizing the adverse impact of the provision. Extreme cases occurred where
provisions were deliberately over provided with the intention that their release in
future years would boost profits.

© In some cases provisioning was used to ‘create’ profits rather than just smooth them.
This occurs if a provision is created without it being charged to the income statement
before its subsequent release. The most common examples of this were provisions for
restructuring costs as a consequence of an acquisition. The effect of such provisions
was that they added to the goodwill rather than being debited to the income statement.
This practice created the ironic situation that (given an agreed purchase price) the
more restructuring a company needed and the larger its anticipated losses were, the
greater was the reported value of the acquired company’s goodwill. Many
commentators, including the IASC, thought this perverse and IAS 22: ‘Business
Combinations’ has gone a great way to prevent this practice, although it has not been
eliminated completely.

Some of the above practices are often referred to as ‘big bath’ provisioning.

(ii) IAS 37: is intended to establish appropriate recognition and measurement

criteria for provisions and contingent assets and liabilities.

It also requires much more detailed disclosure of provisions. Although not

specifically referred to in the IAS, it does not apply to the ‘traditional’ type of
provision that is used to write down the value of an asset e.g. bad debts provisions or
provisions for depreciation of non-current assets, nor does it apply to executory
contracts or provisions required by other accounting standards such as a deferred tax

162
 provision. The main thrust of IAS 37’s definition of a provision is that it represents a
liability of uncertain timing or amount. This is further expanded upon in that a
liability is an obligation (which may be legal or constructive) which will probably
require an entity to transfer economic benefits that result from a past transaction or
event.

This definition relies heavily on the IASC’s ‘Framework’. The distinction between a
provision and a creditor (or accrual) is the degree of uncertainty in the timing or
amount of the liability. A contingent liability is (i) a possible obligation which will be
confirmed only by the occurrence of uncertain future events that are not wholly
within the entity’s control, or (ii) where there is an obligation but it is not possible to
measure it with sufficient reliability. In essence, if an obligation is probable it is a
liability, if it is only possible (presumably less than a 50% chance) then it is a
contingent liability. The definition of a contingent asset is a ‘mirror’ of that of a
liability.
0DYAC Paper 10(Y)
An event is an obligating one if there is no realistic possibility of it being avoided.
This is obviously the case if it is enforceable by law, but IAS 37 adds to this the
concept of a constructive obligation. A constructive obligation derives from an
established pattern of past practice or some form of public commitment to accept
certain responsibilities that create a valid expectation on the part of other parties that
the entity will discharge them. Although the concept of a constructive obligation does
introduce an element of subjectivity, the new definition is intended to prevent
provisions being made as a result of future intentions by management.

The last element of the definition is that of “reliable measurement”. This is taken to
be the best estimate of the expenditure required to settle the obligation at the balance
sheet date. The estimate may be based on a range of possible outcomes and it should
take into account any surrounding risk and uncertainty and the time value of money if
it is material (i.e. settlement may be some years ahead). Also where there are a
number of similar obligations (e.g. product warranties) the estimate should be based
(often statistically) on the class as a whole. The IAS considers that the circumstances
in which a reliable estimate cannot be made will be extremely rare, but if they do
exist the liability should be treated as a contingent liability and given appropriate
disclosures in the notes to the financial statements.

(c) (i) Desco’s current policy of providing for environmental costs relating to the
demolition of the power station and ‘sealing’ the fuel rods on an annual basis is
no longer acceptable under the requirements of IAS 37: ‘Provisions, Contingent
Liabilities and Contingent Assets’. The Statement requires that where an entity
has a present obligation that will (probably) require the transfer of economic
benefits as a result of a past event, then a provision is required for the best
estimate of the full amount of the liability. If the liability is measured in expected
future prices this should be discounted at a nominal rate. Applying these
principles means the company would provide for K120 million (not K180
million) for environmental costs on 1 October 2000 as this is the date the
obligation arose. An interesting aspect of the provision is the accounting entries to
record it. The credit entry is shown in the balance sheet under ‘non-current
liabilities’ as would be expected, but the debit is included as part of the cost of the
asset i.e. the power station.

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 This is a relatively controversial treatment because in effect it is ‘grossing up’ the
balance sheet (initially) by the amount of the liability and creating an asset of
equivalent value. Understandably, some commentators believe that non-current assets
that have been increased by the cost of a future liability will confuse many users of
accounts and calls into question the nature of an asset. The effect on the income
statement of IAS 37’s requirements are not too different from the company’s current
treatment (ignoring the error of using K180 million). As the carrying value of the
power station (which now includes the amount of the provision as well as the cost of
the asset) is depreciated over its 10 year life, the provision is effectively charged to
income over the life of the asset. This has the same effect on profit as the previous
policy.

The treatment of the provision for contamination leaks needs careful consideration
because it could be argued that the obligating event relating to such a cost is the
occurrence of a leak. As this has not happened there is no liability and therefore a
provision should not be made.
An alternative view is that it is the generation of electricity that creates the possibility
of a leakage and, as this has occurred, a liability should be recognised.

The difference between a liability and a contingent liability is one of probability. If it

is probable (presumably more than a 50% chance) then it is a liability that should be
provided for, conversely if it is not probable, it is a contingent liability which should
be disclosed by way of a note to the financial statements. In any 12 month period
there is only a 30% chance of a contamination occurring. It could be argued that the
liability is therefore not probable, as turned out to be the case in the current year.
There is an alternative view that over the expected period of electricity generation (of
10 years), statistically there will be three leakages causing contamination that will
cost a total of K90 million. As the company has produced a tenth of the electricity, it
should provide for a tenth of the expected contamination costs. On balance and
applying prudence, it would be acceptable to provide K9 million for contamination
costs each year.

Applying the above would give the following revised extracts:

Income Statement charge: K million

Non-current asset depreciation 10% x (K200 million + K120 million) 32
Provision for clean up of contamination leaks 10% x K90 million
(or 30% x K30 million) 9
41
Balance sheet:
Tangible Fixed assets:
Power station at ‘cost’ (K200 million + K120 million) 320
Depreciation (32 )
288
Non-current liabilities:
Provision for environmental costs (K120 million + K9million) 129

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 (iii) In part (i) the environmental legislation in relation to this industry created an
obligation which led to a provision for the consequent liability. In the absence
of environmental legislation there would be no legal or enforceable obligation.
However, IAS 37 refers to a ‘constructive’ obligation. This occurs where there
is a valid expectation by other parties that an entity will discharge its
responsibilities. A constructive obligation usually derives from a company’s
actions. These may be in the form of an established pattern of past practice, a
published policy statement or by indications to other parties that it will accept
certain responsibilities.

Thus if it can be established that Desco has a publicly known policy of environmental
cleaning up, or has a past record of doing so when it is not legally required to, then this
could be taken as giving rise to a constructive obligation and the treatment of the
environmental costs would be the same as in part (i). If there is no legal requirement to
incur the various environmental costs, and Desco has not created an expectation that it
will be responsible for such costs, then there is no obligation and no provision
should be made. The power station would be recorded at a cost of K200 million and
depreciated at K20 million per annum.

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Chapter 14

IAS 10: EVENTS AFTER THE BALANCE SHEET DATE

Events after Balance Sheet Date explained

Events after the balance sheet date and before financial statements are issued can have
important effects on the financial statements. For example, the bankruptcy of a major
customer would normally be evidence that the trade receivable should be written off or an
allowance made as at the balance sheet date.
There is another type of event after the balance sheet date — one that does not affect the
position at the balance sheet date, but which still needs disclosure in some way to prevent
users being misled. An example of such an event might be a material fall in the market
value of investments.

Key definitions:

Event after the balance sheet date: An event, which could be favourable or
unfavourable, that occurs between the balance sheet date and the date that the financial
statements are authorised for issue6.

Adjusting event: An event after the balance sheet date that provides further evidence of
conditions that existed at the balance sheet, including an event that indicates that the
going concern assumption in relation to the whole or part of the enterprise is not
appropriate.

Non-adjusting event: An event after the balance sheet date that is indicative of a
condition that arose after the balance sheet date.

Details
Events after the balance sheet date are dividend into two types, corresponding to the two
examples just given. The definition in IAS 10 is:

Events after the balance sheet date are those events, both favourable and unfavourable,
that occur between the balance sheet date and the date when the financial statements are
authorised for issue.

Two types of events can be identified:

(a) Those that provide evidence of conditions that existed at the balance sheet date
(adjusting events after the balance sheet date); and
(b) Those that are indicative of conditions that arose after the balance sheet date (non-
adjusting events after the balance sheet date).

Material adjusting events require changes to the financial statements.

Examples of such events given in IAS 10 are:
6
The date on which the financial statements are approved by the board of directors is the date
the board of directors formally approves a set of documents as the financial statements.

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(a) The resolution of a court case, as the result of which a provision has to be recognised
instead of the disclosure by note of a contingent liability;
(b) Evidence of impairment of assets:
(i) Bankruptcy of a major customer;
(ii) Sale of inventories at prices.

Suggesting the need to reduce the balance sheet figure to the net value actually realised.

Non-adjusting events do not, by definition, require an adjustment to the financial

statements, but if they are of such importance that non-disclosure would affect the ability
of users of the financial statements to make proper evaluations and decisions, the
enterprise should disclose by note:
 The nature of the event;
 An estimate of its financial effect, or a statement that such an estimate cannot be
made.

Examples of such events given in IAS 10 are:

(a) Decline in market value of investments;
(b) Announcement of a plan to discontinue part of the enterprise;
(c) Major purchases and sales of assets;
(d) Expropriation of assets by government;
(e) Destruction of a major asset by fire etc;
(f) A major business combination after the balance sheet date;
(g) Sale of a major subsidiary;
(h) Major dealings in the company's ordinary shares;
(i) Abnormally large changes in asset prices or foreign exchange rates;
(j) Changes in tax rates with a significant effect on current and deferred tax assets;
(k) Entering into significant commitments or contingent liabilities;
(l) Commencing major litigation arising solely out of events after the balance sheet date.

Further provisions of IAS 10

(a) Authorization for issue of financial statements

An enterprise should disclose the date when the financial statements were authorised for
issue and who gave that authorisation. If the owners or others have the power to amend
the financial statements after issue, that fact should be disclosed.

(b) Going concern

If the management decides after the balance sheet date that it is necessary to liquidate the
enterprise, the financial statements should not be prepared on a going concern basis.
(There was a provision in `old' IAS 10 that the financial statements should be adjusted if
events after the balance sheet date showed that a part of the enterprise was no longer a
going concern. This requirement is withdrawn in `new' IAS 10 on the grounds that under
IAS 1: Presentation of Financial Statements, the going concern assumption applies to an
enterprise as a whole.)

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(c) Dividends
The big change in the current IAS 10 is that proposed dividends may no longer be
recognised as liabilities if, as will normally be the case, they are proposed or declared
after the balance sheet date.
IAS 1: Presentation of Financial Statements, requires the disclosure of proposed
dividends and IAS 10 states that this disclosure may be given in one of two ways:
 By note;
 On the face of the balance sheet as a separate component of equity.

For examination purposes, the disclosure by note will be simpler, unless the question
specifies the use of the other method.

Conclusion
The requirements of IAS 10 are broadly the same as the previous version with the
important exception of those for proposed dividends, which are now to be treated as they
are treated in the USA.

Disclosure
Non-adjusting events should be disclosed if they are of such importance that non-
disclosure would affect the ability of users to make proper evaluations and decisions. The
required disclosure is:
 The nature of the event and
 An estimate of its financial effect or a statement that a reasonable estimate of the
effect cannot be made.

A company should update disclosures that relate to conditions that existed at the balance
sheet date to reflect any new information that it receives after the balance sheet date
about those conditions.

Companies must disclose the date when the financial statements were authorised for issue
and who gave that authorisation. If the enterprise's owners or others have the power to
amend the financial statements after issuance, the enterprise must disclose that fact.

ILLUSTRATIONS

Illustration 1
(a) Published financial statements include all transactions that took place during the
Accounting period. Sometimes transactions or events that take place outside of the
Accounting period are included in the financial statements as well.

Required:
Explain how IAS 10:– Events after the balance sheet date defines such events and
what adjustments (if any) need to be made to the financial statements as a result of
such events.

(b) During April 2006, excessive rain fell in the Northwestern province where MetFab's
Ltd main factory and warehouse facilities are situated. At the end of April 2006, the
rainfall caused heavy flooding and MetFab's factory and warehouse was standing in three

168
meters of water. The factory plant and equipment were damaged but can be fully
repaired. However, all of MetFab's inventory was badly damaged and was written off.
MetFab's equipment repairs and inventory write-offs were insured and the insurance
company has agreed to pay for the repairs and the replacement of the inventory. As it will
be some time before the factory is able to operate normally again, MetFab Ltd has
decided to purchase finished goods inventory from outside suppliers during the period
that the factory will be closed for repairs. During the period when MetFab Ltd is buying
in inventory instead of manufacturing its own products, its profits will be reduced by a
material amount.

Required:
Explain how MetFab Ltd should treat this situation in its financial statements for
the year to 31 March 2006.

Illustration 2

IAS 10: Events after the Balance Sheet date was published in January 2000.

(a) What is an event after the balance sheet date in the context of this statement?
(b) What is the difference between an adjusting event and non-adjusting event?
(c) State with reasons whether the following are adjusting or non adjusting events”
(i) The professional valuation of a property one month after the balance sheet date
at a figure of K 300,000,000. below the current book value.
(ii) The declaration of a dividend of K6 billion one month after the balance sheet
date relating to the year ended on the balance sheet date.
(iii) The destruction of a company’s warehouse by fire, two weeks after the
balance sheet date. The loss on the building and inventory amounted to K10
billion. Due to an administrative problem neither was insured.

Solution to illustration 1

(a) The standard starts first to define what is an event after the balance sheet date, as
an event, which could be favourable or unfavourable, that occurs between the
balance sheet date and the date that the financial statements are authorised for
issue. What this means is that, let say the year-end is 31st December 2006, the
board approves the accounts on the 15th April 2007. The 31st December 2006 is
the balance sheet date. The 15th April 2007 is the date the accounts are approved.
The period between 31st December and 15th April is the period we are looking at
of the event occurring or not occurring which is favorable or not favorable.

Events after the balance sheet date are dividend into two types:

Those that provide evidence of conditions that existed at the balance sheet date and
occur before the accounts are approved (adjusting events after the balance sheet
date); and
(b) Those that are indicative of conditions that did not exist at the balance sheet date
but arose before the accounts are approved (non-adjusting events after the balance
sheet date).
Material adjusting events require changes to the financial statements that is in the
income statement and balance sheet.

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 Non-adjusting events do not, by definition, require an adjustment to the financial
statements7, but if they are of such importance that non-disclosure would affect the
ability of users of the financial statements to make proper evaluations and decisions,
the enterprise should disclose by way of a note to the balance sheet.

(b) From the situation you will notice that at the balance sheet date, which is 31 st
march 2006 the factory and warehouse where fine no floods. It was during the month
of April 2006 that the flooding occurred. The situation would be treated as non-
adjusting event. Because the condition did not exist at the balance sheet date it
occurred after the 31st march 2006 but before the accounts are approved.

The company will be required to disclosure by way of a note in the balance sheet to
warn the readers of the accounts. The disclosures would include a description of the
flooding, what was damaged. A statement should be made to the effect that though
the flooding affected the machinery and inventory, these items were insured and the
insurance company has agreed to replace the whole damaged inventory and repair the
damaged machinery as it is in a repairable state. The company should disclose the
fact that during the period the factory machinery will be under going repairs the
company will have to buy the inventory ready made from other supplies and this will
increase the cost of the inventory and reduce the profit’s for the company.

Solution to illustration 2

(a) An event after the balance sheet date is an event favourable and unfavorable,
which occurs between the balance sheet date and the date on which the financial
statements are approved by the board of directors.

(b) An adjusting event is an event which occurs after the balance sheet date which
provides evidence of a condition existing at the balance sheet and should be reflected
in the financial statements.

(c) A non-adjusting event is an event, which concerns a condition, which did not exist
at the balance sheet date. It does not result in change to the figures in the financial
statement, but should be disclosed in the notes to the financial statements if it is so
material that its non-disclosure would affect the ability of users of the statement to
assess the financial position properly.

(i) This is an adjusting event; sine the valuation provides information about a
condition existing at the balance sheet date. It would be a non-adjusting event if it
could be demonstrated that the decline in value occurred after the year-end.
(ii) This is a non-adjusting event as the standard says any dividend declared after
the balance sheet date cannot be a liability.
(iii) This is a non-adjusting event, as the fire did not exist at the balance sheet date
as a condition. The amount may be material to require disclosure by way of a note.

7
Financial statement mean the income statement and balance sheet

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Chapter 15

INTERPRETATION OF ACCOUNTS
Financial statements are made up of the Profit and Loss Account or Income Statement,
the Balance Sheet and Cash Flow statement. The profit and loss account, the balance
sheet and the cash flow statement show the activity of an entity and are prepared to help
interested persons decide on questions such as how efficient the resources been used.

The analysis and interpretation of these statements can be done by calculating certain
ratios between one item and another and the using the ratios for comparison in terms of
profitability, liquidity and efficiency, either between one year and the next for a particular
business, in order to identify any trend (better or worse) results than before or between
one organisation and another to establish which organisation has performed better and in
what ways.

The users of accounting information include the following:-

 Investors
 Employees
 Lenders and banks
 Suppliers and creditors
 Customers
 Governments
 Public
 Management
 Analysts

In this particular case, there is need to consider an organisation, which is a profit-making

organisation. Some of the performance measures that can be considered include the
following:

 Financial performance measure

In the financial statement we will be looking at the past trends of the same
business, Actual results compared to budget and comparative information for
similar business or even different businesses.

 Non-financial performance measure

Are measures of performance based on non-financial information, which may
originate in and be used by operating departments to monitor and control their
activities without any accounting input.

Financial performance measures

Ratios can be grouped into five categories:
 Profitability and return ratios
 Long term solvency and stability ratios
 Short term solvency and liquidity ratios

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  Efficiency ratios
 Shareholder investment ratios

Ratio analysis
Ratios on their own are not sufficient for interpreting company’s performance and that
there are other items of information, which should be looked at for example:
 Comments in the chairman’s report and directors report;
 The age and nature of the company’s assets;
 Current and future developments in the company markets at home and overseas
recent acquisition or disposals of a subsidiary by the company;
 Exceptional items in the profits and loss account.
 Any other noticeable feature of the reports and accounts, such as post balance
sheet, qualified auditors report, the company taxation position etc.
 Access to detailed research libraries which would contain;
o Company press releases;
o Press comments;
o Results of other similar companies;
o Relevant trade press;
o Personal interview with senior executives of the corporation;

1. Profitability and return ratios

The profitability ratios are used to check whether the company is generating an
acceptable return for its shareholders. The profitability ratios are in two types that is:
 Primary ratios
 Secondary ratios.

The following are the primary ratios:

(a) Return on capital employed (ROCE)

The return on capital employed is the most important profitability ratio. It measures the
relationship between the amount invested in the business and the return generated for
those investors.

ROCE = Profits on ordinary activities before interest and taxation x 100%

Capital employed*

*Capital employed = total assets less current liabilities (share capital + reserves + long
term debt)

(b) Return on equity (ROE)

It takes a rather narrow view of capital employed restricting the definition of the
investment made by the shareholders only.

ROE = Profit after tax and preference dividend x 100%

Ordinary shares and reserves

The choice of formula depends on the reason for calculating return on capital employed.
The first formula is most useful for measuring the overall effectiveness of the company’s
management. It can be used to compare the profitability of companies, which use debt

172
and equity in different proportions. The second formula is more useful when measuring
profitability from the point of view of individual shareholders.
Return on capital employed differs from the other ratios in that it is always desirable for
this percentage to be as high as possible. The level of return must be compared with the
return available from alternative investments, other similar companies in the industries,
and also with the level of risk undertaken.

The following are the secondary ratios:

(c) Net Profit margin:

This ratio indicates whether an enterprise is marking enough profits from its operations
after taking into account, selling and administrative expenses.
This ratio simply compares profit with turnover.

Net Profit margin = Profit before Interest and Tax x 100%

Turnover

(d) Gross Profit:

This ratio measures the gross profit as a percentage of sales and gives an indication of the
pricing policy of enterprises.

Gross Profit = Gross profit x 100%

Turnover

(e) Expenses Ratio:

This ratio measures the expenses as a percentage of sales. It can either be done on the
total expenses or individual expenses in relation to the sales. The major reason for
calculating this ratio is to check the expenses whether they are increasing or decreasing.
In the final analysis, profit is after expenses, hence for a company to make more profit it
should try to control expenses.

Expenses Ratio = Expenses x 100 %

Turnover

2. Efficiency ratios
The asset utilization ratios show how efficiently the assets are used to generate sales. The
following are the types of ratios:

(a) Asset turnover:

This ratio shows how effective the capital employed is used in generating sales.

Asset turnover = Turnover

Total assets less current liabilities

(b) Debtor’s turnover:

This represents an average length of time that an enterprise must wait after making a
credit sale before receiving the cash. It is advisable to compare this with the credit period
allowed by other competitors. A long period may reveal that the company is experiencing
difficulties in collecting debts from customers. Again, it is desirable for this ratio to be as
short as possible.

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Debtor’s turnover = Trade receivables x 365days
Turnover (Credit)

(c) Inventory turnover:

This ratio shows how effectively inventories are managed. A long period may suggest
that the enterprise is keeping excessive inventories levels and thus incurring significant
holding costs, storage, obsolescence, cost of funds tied up. A short period may indicate
the possibility of an inventory out situation.

Inventory turnover = Average inventory x 365 days

Cost of sales

(d) Creditors turnover:

This indicates the number of days an enterprise is taking in paying off its suppliers of
goods and services. Creditors are normally a cost free source of finance and enterprises
are encouraged to negotiate for long periods of payment.

Creditors turnover = Trade accounts payables x 365 days

Credit Purchase

The combination of asset turnover and profit margin will explain the ROCE.

Profit margin x asset turnover = ROCE

Profit margin = PBIT

Sales

Asset turnover = Sales

Capital employed

Other items to be looked at include:

(e) Operating cycle.
(f) Working capital management.
(g) Cash cycle.

3. Short-term solvency and liquidity ratios

While it is important for a business to be profitable, profit is not sufficient on its own to
guarantee survival. There must be sufficient liquid assets available to ensure that short-
term commitments can be met.

(a) Current ratio

This ratio is the measure of the company’s ability to meet its short-term debts. The higher
the ratio the greater the liquidity. A ratio of 2 to 1 is considered satisfactory. Too high a
ratio may indicate that the profitability may suffer, as idle current assets do not earn any
return. Before interpreting this ratio, care must be taken to consider the composition of
the current assets. An excessively large ratio may indicate an enterprise that is over
investing in working capital.

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 Current ratio = Current Asset
Current Liabilities

(b) Quick Ratio/Acid test

This ratio measures the ability of the enterprise to pay off maturing financial obligation
without relying on the sale of inventories, as conversion of inventory into cash may take
longer. A ratio of 1 to 1 is considered satisfactory.

Quick Ratio/Acid test = Current asset less inventory

Current Liabilities

Over trading occurs when a company expands without securing increased capital to fund
the expansion and the rise in working capital. The danger signs are:
 Inventory, debtors, creditors increasing.
 Cash/liquid investment decreasing.

(c) Cash flow ratio

The cash flow ratio is the ratio of a company’s net cash inflow to its total debts (current
liabilities and long term liabilities).

Cash flow ratio = Net cash inflow

Total debts

4. Long-term solvency and stability ratios

These ratios examine the long-term solvency of an enterprise by focusing on the
proportion of funds provided by owners and creditors. The acceptable level of gearing
varies according to the company’s ability to provide security and stability of its earnings
and according to the attitudes of lenders.

There are two alternatives:

(a) Debt ratio

A ratio that indicates what proportion of debt a company has relative to its assets. The
measure gives an idea to the leverage of the company along with the potential risks the
company faces in terms of its debt-load.

Debt ratio = Total Debt x 100%

Total Asset – Current Liabilities

General guide of 50% is safe.

(b) Capital Gearing Ratio

A general term describing a financial ratio that compares some form of owner's equity (or
capital) to borrowed funds. Gearing is a measure of financial leverage, demonstrating the
degree to which a firm's activities are funded by owner's funds versus creditor's funds

175
Capital Gearing Ratio = Prior charge capital x 100%
Total capital employed

Alternatively leverage = Shareholders equity

Total capital employed

The amount of debt used to finance a firm's assets. A firm with significantly more debt
than equity is considered to be highly leveraged.

Total capital employed is ordinary shares capital and reserves plus prior charge capital
plus long-term liabilities or provisions. Prior charge capital is preference shares and
debentures. A general guide of 50% is safe.

(c) Debt/Equity ratio

A measure of a company's financial leverage calculated by dividing long-term debt

by inventory holder equity. It indicates what proportion of equity and debt the company
is using to finance its assets.

Debt/Equity ratio = Total liability

Shareholders equity

Note: Sometimes only interest-bearing long-term debt is used instead of total liabilities in

the calculation. 

A high debt/equity ratio generally means a company has been aggressive in financing its
growth with debt. This can result in volatile earnings as a result of the additional interest
expense.

If a lot of debt is used to finance increased operations (high debt to equity), the company
could potentially generate more earnings than it would have without this outside
financing. If this were to increase earnings by a greater amount than the debt cost
(interest), then the shareholders benefit as more earnings are being spread around to the
same amount of shareholders. However, the cost of this debt financing may outweigh the
return that the company generates on the debt through investment and business activities
and become too much for the company to handle. This might lead to bankruptcy, which
would leave shareholders with nothing, so it is a delicate balance. This is what the
leverage effect is about and what the debt/equity ratio measures.

The debt/equity ratio will also be dependent on the industry in which the company
operates. For example, capital-intensive industries such as auto manufacturing tend to
have a debt/equity ratio above 2, while personal computer companies have a debt/equity
of under 0.5.

General guide of 100% is safe

(d) Interest cover

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This shows the debt servicing ability of the enterprises. The higher the ratio, the higher
the debt servicing ability. It measures the extent to which profits can decline without
causing financial loss to the enterprises and creating an inability to meet the interest cost.

Interest cover = PBIT (include interest receivable)

Interest payable

General guide of 3 or more is safe

5. Shareholder investment ratios

These ratios are very important to the investors in the context of making decisions about
whether to buy or sell shares. They are strong indicators of what investors think of the
firm’s past performance and future prospects.

(a) Earning per share (EPS)

It shows the amount of profit after corporation tax attributable to each ordinary share.
Normally a higher EPS indicates success.

Earning per share = PATPD

Number of Ordinary Shares

Where: PATPD is profit after tax and preference divided paid

(b) Dividend per share:

It shows the profit paid as dividend to each ordinary share. Normally a higher dividend
per share indicates success.

Dividend per share = Dividends

Number of ordinary Shares

(c) Dividend Cover:

This is the number of times the current years dividends could have been paid out of the
current years profit available to ordinary shares. It is a measure of security. A higher
figure indicates high levels of security. In other words, profits in the future years could
fall substantially and the company would still be able to pay the current level of
dividends. An alternative view of a high dividends cover is that it indicates that the
company operates a low dividend distribution policy.

Dividend Cover = Earnings per share

Net dividend per ordinary share

(d) Dividend yield

It is a partial measure of the investors return on ordinary shares. Shareholders may also
receive gains in the capital value of the shares whenever the share prices increase. This
ratio is normally lower for enterprises which retain a large proportion of their profits for
reinvestment purposes.

177
Dividend yield = Dividend on the shares for the year x 100%
Current market value of the shares (EX div)

(e) Price earning ratio (P/E)

This ratio is the inverse of the earnings yield and indicates the market expectation about
an enterprises future prospects.

Price earning ratio = Market price

EPS

(f) Earnings yield

This shows the rate of return earned by ordinary shareholders.

Earnings yield = EPS

Market price

Limitations of ratio analysis.

 Non availability of comparable information,

 Use of Historical or out of date information
 Use of historical or out of date information,
 Ratios are not definitive they are only a guide,
 Interpretation of ratios need careful analysis and should not be considered in
isolation,
 It is a subjective exercise,
 It can be subject to manipulation,
 Ratios are not defined in standard form.

Non-financial performance measures.

 Value for money: this means providing a service in a way, which is economical,
efficient, and effective. These are the 3E’s of VFM.
o Economy. Attaining the appropriate quantity and quality of physical
human and financial resources, which are the inputs at lowest cost.
o Efficiency. This is the relationship between goods or services produced
(outputs) and the resources used to produce them (inputs).
o Effectiveness. Is concerned with how well an entity is achieving its
objectives.

 The balanced scorecard8: This emphasizes on providing management with a set

of information, which covers all relevant areas of performance in an objective and
unbiased manner. The information may be both financial and non financial and
covers areas such as:
o Customers
o Internal
o Innovation and learning

8
See diagram 1

178
 o Financial

Financial Perspective - measures reflecting financial performance, for example debtor

management, cash flow, or return on investment. The financial performance of an
organization is fundamental to its success. Even non-profit organizations must make the
books balance. Financial figures suffer from two major drawbacks:
 They are historical. Whilst they tell us what has happened to the organization they
may not tell us what is currently happening, or be a good indicator of future
performance.
 It is common for the current market value of an organization to exceed the market
value of its assets. Tobin's-q measures the ratio of the value of a company's assets
to its market value. The excess value can be thought of as intangible assets. These
figures are not measured by normal financial reporting.

Customer Perspective - measures having a direct impact on customers and their

satisfaction, for example time taken to process a phone call, time to deliver the products,
results of customer surveys, number of complaints or competitive rankings.

Business Process Perspective - measures reflecting the performance of key business

processes, for example the time spent prospecting, number of units that required rework
or process cost.

Learning and Growth Perspective - measures describing the company's learning curve
for example, number of employee suggestions or total hours spent on staff training.

Useful information is obtained from ratio analysis and non-financial measurers. This
information can be used to compare the entity over a period. The comparison should give
some insight of whether the company ‘s situation has improved, worsened, or stayed
much the same between one year and the next.

The principal advantage of making comparison over time is that they give some
indications of progress and patterns. However, there are some weaknesses in such
comparisons, such as:

 Effects of inflation.
 The progress a company has made needs to be set in the context of:

179
 o What other companies have done.
o Whether there have been any special environmental influences on the
performance of the entity.
o Interest rates
o Exchange rates
o Government fiscal policy
o Government spending
o International factors
o Business cycles
o Legal factors
o Political factors

 Factors that contribute to corporate failure.

o Autocratic chief executive.
o Passive board.
o Lack of budgetary control
o Mistakes.

 Symptoms.
o Deteriorating ratios
o Creative accounting
o Declining morale and quality.

Illustration 1

You are presented with the following summarised accounts for M. Bwalya, a limited
liability company.
M. Bwalya Ltd
Income statement for the year ended 31 May 2006
K ‘ Millions
Revenue 160
Cost of sales (100)
–––––
Gross profit 60
Distribution & administrative expenses (35)
–––––
Profit from operations 25
Finance cost (5)
–––––
Profit before tax 20
Tax expense (10)
–––––
Net profit for the period 10
–––––

180
M. Bwalya Ltd
Balance sheet as at 31 May 2006
K ‘ Millions K ‘ Millions
Assets
Non-current assets 150

Current assets
Inventory 45
Trade receivables 25
Cash and bank 5 75
––– ––––
Total Assets 225
––––
Equity and liabilities:
Capital and reserves
K1 Ordinary shares 100
Reserves 30
––––
130
Non-current liabilities
10% loan notes 50

Current liabilities
Trade payables 30
Taxation 10
Dividends (for the year) 5 45
––– ––––
Total equity and liabilities 225
––––
The ratio values for M. Bwalya Ltd for 2005 and 2004 as well as the current average ratio
values for the industry sector in which M. Bwalya Ltd operates are as follows:

Ratio Historical Data Industry Average

2005 2004 2006
Return on capital employed (%) 16·2 14·7 16·2
Gross profit percentage (%) 30·4 34·7 32·3
Net profit percentage (%) 19·3 17·7 17·3
Quick/Acid test ratio 1·5 1·1 1·5
Receivables collection period (days) 32·0 44·0 35·0
Earnings per share (ngwee) 18·0 13·0 15·0

Required:
(a) Calculate the following ratios for M. Bwalya Ltd for the year ended 31 May 2006
and state clearly the formulae used for each ratio:
(i) Return on capital employed
(ii) Gross profit percentage
(iii) Net profit percentage

181
 (iv) Quick/Acid test ratio
(v) Receivables collection period
(vi) Earnings per share

(b) Using the additional information given and the ratios you calculated in part (a), write
a brief report on the financial performance of M. Bwalya Ltd, Indicate in your report
what additional information might be useful to help interpret the ratios.

Solution to illustration 1
Notes:
Students should be prepared to answer questions which will involve not only calculating
but also should be able to comment, and to make recommendations relating to what are
the problems the company is facing etc. The layout of the report should be taken into
account and do not forget your skills in communication. When you are analyzing it is
useful to be open minded and look for other factors that may have affected the
performance of the company, check with other companies in the industry, look for
economic factors, both local and international, political etc.
(a)
(i) Return on capital employed

= Net Profit before Interest & tax x 100%

Capital employed

25 x 100% = 13·9%
180

(ii) Gross profit percentage

= Gross Profit x 100%

–––––––––––
Revenue
60 x 100% = 37.5%
160

(iii) Net profit percentage

= Net Profit before interest and tax x 100%

Revenue
25 x 100% = 15.6%
160
(iv) Quick/Acid test ratio

= Current Assets – Inventory

–––––––––––––––––
Current Liabilities
75 - 45 = 0.67:1
45
(v) Receivables collection period
= Receivables x 365 days
–––––––––––

182
 Revenue
25 x 365 = 57 days
160

(vi) Earnings per share

= Profits on ordinary Activities after tax

–––––––––––––––––––––––––––––––
No. of ordinary shares in issue
10 = 10 ngwee per share
100
* Alternative definitions are also acceptable

(b)
Brief Report

To: MD
From: ZICA Student
Date June 2006
Subject: Financial Appraisal of M. Bwalya Ltd Using Accounting Ratios

Introduction
The purpose of this report is to analyse the financial performance M. Bwalya Ltd over the
last three years using accounting ratios.
The report specifically comments on the following ratios:
– Return on capital employed;
– Gross profit percentage;
– Net profit percentage;
– Quick/acid test ratio;
– Receivables collection period; and
– Earnings per share

The report also highlights what other information would be useful to help interpret the
performance of the organization.

Return on capital employed (ROCE)

The return on capital employed has declined over the last three years from 16·2% to
13·9% and is now well below the Industry average of 16·2%. This should be a cause for
concern to the board of directors because if investors can obtain a higher return elsewhere
then they may withdraw their investment. Alternatively, they may seek to change the
management Board. It would be helpful to have more information on the market in which
M. Bwalya Ltd operates e.g. is the market growing or declining, are there many buyers
and sellers or just a few.

Gross profit percentage

The gross profit percentage has risen over the period from 30·4% to 37·5%. Clearly, the
company has either:
(i) Increased the selling price of its goods, e.g. perhaps it is able to sell at a premium
because of perceptions regarding the quality of the goods sold.

183
(ii) Reduced the cost of its supplies. Possibly changing suppliers or obtaining greater
discounts as sales, volume has increased.

It would be useful to know what the company is selling and the volume of sales analysed
by product and year.

Net profit percentage

The net profit percentage has declined over the period from 19·3% to 15·6% and is
significantly below the industry average of 17·3%. This is worrying considering the
increase in the gross profit percentage over the same period. The decline in the net profit
percentage suggests that the costs may not be tightly controlled within the company.
More detailed information on expenditure during the period would be helpful in
identifying the reasons for the decline in profitability.

Quick (or acid test) ratio

The quick ratio has also declined significantly during the period from 1·5 to 0·67
suggesting the company may be experiencing liquidity problems. This view is also
supported when the ratio is compared to the industry average, which is over double that
of M. Bwalya Ltd. The level of inventory may be a concern as it is tying up cash. More
information on the type of inventory and the level of inventory turnover would be useful.

Receivables collection period

The time taken to collect debts has increased over the period from 32 days to 57 days.
This seems very high when compared to the industry average debt collection period of
just 35 days. The ratio suggests that there is little control over debt collection.

In addition, the lengthening of the collection period means it is more likely that some
debts will not be paid by customers.
The poor control over debt collection is a factor contributing to the adverse liquidity
situation of the company.

Earnings per share (EPS)

The earnings per share deteriorated over the period from 18 ngwee per share to 10 ngwee
per share. This level of EPS is also significantly below the industry average and it is
likely to discourage potential investors from investing in the company and may not be
sufficient to keep existing shareholders.

Conclusion
Although the company has managed to increase its gross profit over the period, this has
not resulted in a similar increase in net profit. In summary, the ratios indicate poor
internal control of costs and poor management of working capital. The return on capital
employed and the EPS ratios are unlikely to be sufficiently attractive to potential
investors or to existing shareholders.

Singed:……………………………

184
Illustration 2
The financial statements of Ethan & Suw, a company limited by liability, for the years
ended 31 May 2005 and 31 May 2006 are summarised below.

Income statements for the years ended:

31 May 2005 31 May 2006

K ‘ Millions K ‘ Millions K ‘ Millions K ‘ Millions

Revenue 20,000 26,000

Cost of sales (15,400) (21,050)
––––––– –––––––
Gross profit 4,600 4,950
Expenses:
Administrative (800) (900)
Selling and distribution (1,550) (1,565)
Depreciation (110) (200)
Loan note interest – (105)
––––––– –––––––
(2,460) (2,770)
––––––– –––––––
Net profit 2,140 2,180
––––––– –––––––

Balance sheets as at:

31 May 2005 31 May 2006
K Millions K Millions K Millions K Millions
Non current assets
At cost 4,600 5,600
Accumulated depreciation (800) (1,000)
––––––– –––––––
3,800 4,600

Current assets
Inventory 6,000 6,700
Receivables 4,400 6,740
Bank 120 960
––––––– 10,520 ––––––– 14,400
––––––– –––––––
14,320 19,000
––––––– –––––––
Capital and reserves
Issued share capital 8,000 8,000
Accumulated profit 3,120 5,300
––––––– –––––––
11,120 13,300
Non-current liabilities
7% Loan notes – 1,500
Current liabilities 3,200 4,200
––––––– –––––––

185
 14,320 19,000
––––––– –––––––

Additional Information
During 2006, Ethan & Suw issued loan notes of K1, 500,000 at 7% per annum to fund the
expansion of the business. The additional cash was received on 1 June 2005.

Required:
(a) Calculate the following ratios for Ethan & Suw for both years.
 Gross profit percentage
 Net profit percentage
 Return on equity
 Inventory turnover
 Quick ratio
 Receivables collection period
State the formulas used for calculating the ratios.
(b) Comment on the success of the business expansion as indicated by the ratios you
have calculated in part (a).
(c) Briefly explain the factors Ethan & Suw should consider in deciding whether to
raise finance by issuing loan notes rather than issuing more shares.

Solution to illustration 2
2005 2006
K ‘ Millions K ‘ Millions

Gross profit percentage

= Gross profit x 100% 4,600 x 100 = 23·00% 4,950 x 100 = 19·04%

––––––––– ––––––– –––––––
Sales 20,000 26,000

Net profit percentage

= Net profit x 100 2,140 x 100 = 10·70% 2,180 x 100 = 8·38%

––––––––––– ––––––– –––––––
Sales revenue 20,000 26,000

Return on equity

= Net Profit x 100 2,140 x 100 = 19·24% 2,180 x 100 = 16·39%

–––––––––– ––––––– –––––––
Equity 11,120 13,300

Inventory turnover
= Cost of goods sold 15,400 = 2·57 times 21,050 = 3·14 times
–––––––––––––––– –––––––– –––––––
Inventory 6,000 6,700
Quick ratio

186
 = Current assets – inventory 4,520 = 1·41: 1 7,700 = 1·83: 1
––––––––––––––––––––– ––––––– –––––––
Current liabilities 3,200 4,200

Receivables collection
Period
= Receivables x 365 4,400 x 365 = 80·30 days 6,740 x 365 = 94·62 days
––––––––– ––––––– –––––––
Sales 20,000 26,000

(b) Relevant comments could include the following:-

 It is difficult to judge the success of the expansion over such a short period of
time.
 The profitability ratios have deteriorated.
 The reduction in the gross profit percentage could be due to difficult trading
conditions or that the selling prices have been lowered to generate sales.
 The deterioration in the net profit percentage is partly due to the reduced gross
profits.
 The rate of inventory turnover has improved which might suggest that
profitability in the future will improve.
 The quick ratio has improved; this is partly due to the increase in cash, which may
indicate that not all the cash raised from issuing the debentures has been invested.
 The receivables collection period has increased which may indicate poor credit
control, or longer credit terms being offered to customers, or increased sales due
to the success of the expansion.

(c) Some of the factors Ethan & Suw should consider when deciding whether to raise
finance by loan notes rather than issuing more shares include the following:-
 Loan notes pay a fixed level of interest. Therefore, the company will find
budgeting for the cash flows straightforward.
 Loan note holders are non-current creditors of the company and therefore do not
control the company, unlike shareholders who own the company and will be able
to vote on issues affecting the company.
 If company profits fall, then share dividends do not have to be paid. However, the
interest on loan notes will still have to be paid regardless of the level of profit.
 Shareholders will often expect dividend payments to grow over time, therefore
increasing the cost to the company.
 If the company were to be wound up, then loan note holders would rank higher
than ordinary shareholders.

187
Chapter 16

SHARE CAPITAL TRANSACTION

Historical cost accounting (HCA): this is the term used to denote the range of accounting
practice and techniques currently operating which have been built up over the years as
company law has developed and accounting practices codified. The main items in the
definition is that:
 All transaction is recorded at the historical cost (which is reality and not
speculative).
 The transaction are thus recorded and matched with the income.

Capital maintenance: profit can be measured as the difference between how wealthy a
company is at the beginning and at the end of an accounting period. This wealth can be
expressed in terms of the capital of a company as shown in its opening and closing
balance sheet. A business, which maintains its capital unchanged during an accounting
period can be, said to have broken even. Once capital has been maintained any excess is
the profits.

In conventional, historical cost accounts assets are stated in the balance sheet at the
amount it cost to acquire them. Capital is simply the difference between asset and
liabilities. If prices are rising it is possible for a company to show a profit in its historical
cost account despite having identical physical asset and owing identical liabilities at the
beginning and end of its accounting period.

Criticism of historical cost accounting.

 Fixed asset values are unrealistic.
 Deprecation is inadequate to finance the replacement of fixed asset.
 Holding gains on inventory are included in profits.
 Profits and losses on holding of net monetary items are not shown
 The true effects of inflation on the capital maintenance is not shown
 Comparison over time is unrealistic.

Advantages of historical cost accounting:

 They are easy to prepare, easy to read, and understand.
 In periods of low inflation, HCA, are seen as a reasonable reflection on the reality
of the given situation.

The Issue and Forfeiture of Shares.

The Articles of Association usually delegate the power to allot and issue shares to the
directors. The formal procedure is that the subscriber applies for shares and the directors
accept his offer by resolving at a board meeting to allot shares to him. His/her name is

188
entered in the register of members, a share certificate is issued and within one month of
allotment, a return is submitted to the registrar.

As a general rule if, a company issues ordinary shares for cash, it must first offer them to
its existing ordinary shareholders in proportion to their shareholding. This is called a
Rights Issue. If they do not accept the shares within a given period 9 the company may
then offer the shares to non-members. A private company may by terms of its
Memorandum or Article permanently exclude the members right of pre-emption. A
public company may authorise its directors to allot ordinary shares for cash without first
offering the shares to members.

When a company issues shares it must obtain consideration at least equal in value to the
nominal value10 of the shares. Shares cannot be issued at a discount. The entire
consideration does not have to be received at the time of allotment and the holders of
such partly paid shares are liable to pay the balance. Usually the company may make a
call for the balance or any part of it under a procedure laid down in the Articles. When a
call has been made, the capital is Called Up to that extent and when the shareholders pay
for the call it is paid normally up to that extent.

The share premium11 account may be repaid to members under a reduction of share
capital authorised by the court but may not be distributed as a dividend. It may be used in
the following ways:
 Issuing full paid bonus to members.
 Writing off:
o Preliminary expenses of company formation.
o Share or debenture issue expenses like commission and discounts.
 In certain circumstances paying any premium payable when the company redeems
redeemable shares or debenture.

Accounting for an issue of share for cash.

If subscription monies are payable in instalments, entries are made initially to

Application and Allotment Accounts and Call Account. Balance on these accounts is
eventually transferred to Share Capital and Share Premium accounts. Occasionally, a
shareholder may fail to pay amounts due on allotment or on a call. If the Articles of
Association so allows the company may confiscate the shares without refund of any
amounts paid to date. The shares are not cancelled but their called up value is transferred
from share capital account to a forfeited share account (the share premium account if any
is not affected) until they are reissued. Forfeited shares may be reissued at any price
provided that the total amount received is not less then the par value of the shares.

The following procedure and accounting entries are followed:

Application: Where potential shareholders apply for shares in the company and send
cash to cover the amount applied for.

9
Check with the Zambian companies Act 1994
10
Nominal value of K1
11
When shareholders pay the price of a share above the nominal value. The nominal value is K1
per share. Price paid is K2.5 per share. The K1.5 per share is the share premium.

189
 Allotment: The company allocates shares to the successful applicant and return cash
to unsuccessful applicant.
Call: Where the purchase price is payable in instalment the company will call for
instalment on their due dates of payment.
Forfeiture: If a shareholder fails to pay a call, his shares may be forfeited without the
need to return the money he paid. These are then reissued to other shareholders.

The accounting entries are:

Debit Bank
Credit Application and allotment a/c

Being Application Proceeds.

Debit Application and allotment a/c
Credit Bank

Being Money returned to over subscribers

Debit Bank
Credit Application and allotment a/c

Being Cash on allotment

Debit Application and allotment a/c
Credit Share capital a/c
Credit Share premium a/c

Being Allotment of shares

Debit Call a/c
Credit Share capital a/c

Being call of final instalment owed.

Debit Bank
Credit Call a/c

Being cash receipts banked

Debit Investment: own shares (forfeit a/c)
Credit Call a/c

Being forfeited shares

Debit Bank a/c
Credit Investment: own shares (forfeit a/c)

Being Reissue of forfeited shares

Debit Investment: own shares (forfeit a/c)
Credit Share premium a/c

Being Additional premium on reissue

Distributable Profits.

190
Distribution is defined as every description of distribution of a company’s asset to
members of the company whether in cash or otherwise with the exception of:
 Bonus shares
 Redemption or purchase of the company own shares
 A distribution of assets to shareholders in a winding up
 Paying off paid up shares capital
 Shares not fully paid up.

Companies must not make a distribution except out of profits available for the purpose.
These are accumulated realized profits less its accumulated realized losses. Unrealised
profits cannot be distributed nor must a company apply unrealised profits to pay up
debentures or any unpaid amounts on issued shares. Capitalisation of realised profits is
the use of profits to issue bonus shares and to transfer to the Capital Redemption Reserve.
As a point of exceptions IAS 1 allows that any excess depreciation on revalued fixed
assets above the amount of deprecation that would have been charged on its historical
cost can be treated as a realised profit for the purpose of distribution. It may nevertheless
to be regarded as distribution unless local legislation states otherwise.

The profits available for the purpose are: K

Accumulated realised profits: capital and revenue (unless used
for earlier distribution or capitalisation of reserves) x
Less: accumulated realised losses: capital and revenue (x)
Distributable profits x

This is the maximum payment for limited companies

Some countries may impose restriction on the distribution of public companies and listed
companies. A public company cannot make a distribution if at the time:
The amount of its net asset is less than the combined total of its called up share capital
plus its undistributable reserves.
The distribution will reduce the amount of its net assets to below the combined total of its
Called Up Share Capital plus its undistributable reserve.

The undistributable reserves are Share Premium, Capital Redemption Reserve, any
surplus of unrealised profits over unrealised losses, any other reserve which cannot be
distributed whether by statute or the company’s Memorandum or Article of Association.
Where such restriction applies all accumulated distributable profits both realised and
unrealised must exceed the accumulated realised and unrealised losses of the company
before any distribution can be made.
K
Distributable profits as above X
Less net unrealised losses: capital and revenue (X)
Distributable profits for public companies X

Or
Net assets X
Less share capital (X)
Less undistributable reserves:
Share premium X
Capital Redemption Reserve X

191
Accumulated surplus of unrealised profits
Over unrealised losses X
Other forbidden reserve (by statue or company’s
Memo/ Articles) X
(X)
Distributable profits X

The difference between the realised profits and realised losses is the maximum possible
distribution. Includes consideration of unrealised profits and unrealised losses so that if
unrealised losses exceeds, unrealised profits the amount of distribution that can be made
will be reduced by the amounts of the deficit.

The relevant accounts, which should be used to determine the distributable profits, are the
recent audited annual accounts. If the auditors qualify the accounts, they must state in
their reports whether they consider that the proposed distribution would contravene the
Act. The directors of a company must have regard to the interest of the company’s
employee’s in general as well as the shareholders.

Redemption of Shares.
Any limited company is permitted without restriction to cancel unissued shares and in
that way to reduce its Authorized Share Capital. If a limited company with a share capital
wishes to reduce its issued share capital it may do so provided that:
 It has power to do in its articles of association,
 It passes a special resolution,
 It obtains confirmation of the reduction from the court.

There are three basic methods of reducing share capital and these are:-
 Extinguish or reduce liability on partly paid shares.
 Cancel Paid Up Share capital, which has been lost, or which is no longer
represented by available assets.
 Pay off part of the paid up shares capital out of surplus assets.

When an application is made to the court, its concern is the effect of the reduction on the
company’s ability to pay its debts. If the court is satisfied that the reduction does not
prejudice creditors and is fair in its effect on shareholders, it approves the reduction by
marking an order to that effect. The court has powers to require the company to add the
word “and reduced” to its name at the end or to publish the reason for or information
about the reduction.

There is a general prohibition against any voluntary acquisition by a company of its own
shares. Exceptions are:
 Purchase its own shares in compliance with an order of the court,
 Issue redeemable shares and then redeem them,
 Purchase its own shares under certain specified procedures,
 Forfeit or accept the surrender of its shares,
 Accept shares as a gift.

The conditions for the issue and redemption of redeemable shares are:

192
  The Articles must give authority for the issue of redeemable shares.
 Redeemable shares may only be issued if at the time of issue the
company also has issued shares, which are not redeemable.
 Redeemable shares may only be redeemed if they are fully paid.
 The terms of redemption must provide for payment on redemption.
 The shares may be redeemed out of distributable profits. Or the proceeds
of a new issue of shares or capital in accordance with the relevant rule.
 Any premium payable on redemption must be provided out of
distributable profits subject to an exception that provided regulation,
which prevented companies from redeeming shares except by
transferring a sum equal to the nominal value of shares redeemed from
distributable profits reserves to a non-distributable capital redemption
reserve. This reduction in distributable reserve is an example of the
capitalization of profits where previously distributable profits become
undistributable. The purpose of this is to prevent companies from
reducing their shares capital investment so as to put creditors of the
company at risk.

When a company redeems some shares or purchases some of its own shares they should
be redeemed out of distributable profits or out of the proceeds of a new issue of shares. If
there is any premium on redemption, the premium must be paid out of distributable
profits. however if the shares were issued at a premium then any premium payable on
their redemption may be paid out of the proceeds of a new share issue made for the
purpose up to an amount equal to lesser of the aggregate premium received on issue of
the redeemable share or the balance on the share premium account.

A private company may redeem or purchase its own shares out of capital but only on
condition that the nominal value of shares redeemed or purchased both exceeds the
proceeds of any new shares issued to finance the redemption or purchase or first exhausts
the distributable profits of the company entirely. In such a situation a transfer must be
made to the Capital Redemption Reserve of the amount by which distributable profits
exceed the premium on redemption or purchase. If the premium on redemption or
purchase exceeds the total of the distributable profits the difference must be deducted
from non-redeemable shares capital and there will be no Capital Redemption Reserve.
K
Calculation of the PCP (permissible capital payment)
Purchase price of shares redeemed / purchased X
Less: available distributable profits (X)
Less: Proceeds of fresh issue (X)
PCP X

Nominal value of shares purchased / redeemed less proceeds of new issue + PCP.
If positive transfer to CRR
If negative, debit amount to share premium, share capital or any non-distributable
reserves.

The advantages of share redemption or purchase are as follows:

All companies:
 Use of surplus funds

193
  Flexibility to alter capital structure

Unquoted companies:
 Increase marketability of shares
 Aids employee share schemes
 Attracts new capital
 Retention of family control on death / retirement

Illustration 1
Chisenga PLC had a balance on its share capital account of K2 billion and a balance on
share premium of K600 million. The directors decided to issue a further 50,000,000 K1
shares for a K1, 400 each.
The issue was announced and all applicants were asked to send a cheque for K100 for
every share applied for. A total of 110,000,000 shares were applied for on the due date.
The directors decided to reject the smaller application and returned application moneys
for a total of 10,000,000 shares. The remaining applicants were allotted one share for
every two applied for, deemed K200 per share paid.

Applicants were asked to pay a further K900 per share, this being deemed to include the
share premium associated with the issue. All allotment moneys were received by the due
date.
A final call of K300 per share was made. Payments were received in respect of
49,500,000 shares. The holder of 500,000 shares defaulted on this call and his shares
were forfeited. The forfeited shares were reissued for K500 each.

Required

Prepare the following accounts:

(a) Share capital Account
(b) Share premium Account
(c) Application and allotment Account
(d) Call Account
(e) Investment in own shares

Solution to illustration 1

We begin by using the journal

Details Debit K Credit K

Bank 11,000,000,000
Application a/c 11,000,000,000

Being Application Proceeds

on 110,000,000 shares @ K100
per share.
Application a/c 1,000,000,000 1,000,000,00
Bank a/c 0

Being Money returned to

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 over subscribers shares
Application a/c 10,000,000,000
Share capital a/c 10,000,000,000

Being the transfer to the

capital a/c
Bank 45,000,000,000
Allotment a/c 45,000,000,000

Being Cash on allotment

Allotment a/c 45,000,000,000
Share capital a/c 25,000,000,000
Share premium a/c 20,000,000,000

Being transfer to capital a/c

and share premium a/c
Bank a/c 14,850,000,000
Call a/c 14,850,000,000

Being cash receipts on final

call.
Investment: own shares 150,000,000
(forfeit a/c)
Call a/c 150,000,000

Being forfeited shares

Call a/c 15,000,000,000
Share capital a/c 15,000,000,000

Being transfer to capital a/c

Bank a/c 250,000,000
Investment: own shares 250,000,000
(forfeit a/c)

Being Reissue of forfeited

shares
Investment: own shares (forfeit 100,000,000
a/c)
Share premium a/c 100,000,000

Being transfer to Share

premium a/c

Ledger Accounts

Share capital a/c

K’000 K’000
Balance C/D 2,000,000
Application a/c 10,000,000

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 Allotment a/c 25,000,000
Final call a/c 15,000,000

Share premium a/c

K’000 K’000
Balance C/D 600,000
Allotment a/c 20,000,000
Investment in own 100,000

Application a/c
K’000 K’000
Bank 11,000,00
Bank 1,000,000
Capital 10,000,000

Allotment a/c
K’000 K’000

Bank 45,000,000
Capital a/c 25,000,000
Share premium a/c 20,000,000

Final call a/c

K’000 K’000
Bank 14,850,000
Investment in own 150,000
Capital a/c 15,000,000

Investment in own shares a/c

K’000 K’000
Final call a/c 150,000
Bank 250,000
Share premium a/c 100,000

Illustration 2
The directors of AMS PLC have decided to make a bonus issue of one share for every
three previously held. The company’s Balance Sheet just before the issue was as follows:

AMS PLC: Balance Sheet as at 31st December 2006

K billion
Non current assets 14
Current assets 4
Total assets 18

Share capital 9

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Profit 4
Non current liabilities 5
Equity and liabilities 18

Required
Redraft AMS PLC Balance Sheet to take the bonus issue into account. Show also the
journal entry to bring about your change.

Solution to illustration 2

Details Debit K Credit K

Profit and loss a/c 3,000,000,000
Share capital a/c 3,000,000,000

Being the capitalisation of

bonus shares

AMS PLC: Balance Sheet as at 31st December 2006

K billion
Non current assets 14
Current assets 4
Total assets 18

Share capital 12
Profit 1
Non current liabilities 5
Equity and liabilities 18

Illustration 3
The company is owned by Lungu’s family, one of whose members wants to sell her
shares and retire. The other shareholders are keen to keep all of the company’s shares in
the family but none can afford to buy the retiring shareholders equity. It has therefore,
been decided that the company will purchase 100,000,000 shares for K 180,000,000

Lungu Ltd: Balance Sheet as at 30th September 2006

K’000
Non current assets 4,000,000

Share capital – K1 shares fully paid 2,000,000

Share premium 500,000
Profit and loss 1,500,000
4,000,000
Required
(a) Show how the above adjustment will be effected.
(b) How has the transfer to the Capital Redemption Reserve protected creditors?

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(a)
Details Debit K’000 Credit K’000
Share capital a/c 100,000,000
Profit and loss a/c 80,000,000
Bank 180,000,000

Being the purchase of share

Profit and loss a/c 100,000,000
Capital redemption reserve
a/c 100,000,000

Being the creation of a CRR

Lungu Ltd: Balance Sheet as at 30th September 2006

Non current assets 3,8200,000

Share capital – K1 shares fully paid 1,900,000

Share premium 500,000
Capital redemption reserve 100,000
Profit and loss 1,320,000
3,820,000

(b)Clearly both the company’s capital and net assets have been reduced by
K180, 000,000. The transfer to Capital Redemption Reserve has however used part of the
company’s distributable profits to replace the permanent capital which was used to make
the repurchase. There is however some protection from the fact that distributable profits
place an upper limit on such payments.

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Chapter 17

JOINT VENTURES

Objective
When you have studied this chapter you should be able to:
 Interpret Joint Venture transactions
 Account for Joint Ventures
 Analyse results of Joint Venture transactions

Introduction
Definition:
A joint venture is a partnership confined to a particular commercial undertaking,
which is usually of limited duration. It can be entered into by individuals,
partnerships or companies. The accounting treatment depends on whether or not
separate books are opened for the joint venture transactions

Separate books

Where the venture has a full set of books, the transactions are recorded in exactly the
same way as for an ordinary partnership. A separate Profit and Loss account can be
extracted from which each venture will be credited or debited with the agreed share
of the profit or loss.

No separate books

Often (and certainly in examination questions), due to the short life time or size of
the joint venture, it is not considered worthwhile opening a new set of books to
record what may only be a few transactions. In this case, each venturer will record
transactions on behalf of the venture in his/her own books, alongside his other
business dealings. There are two alternative methods of achieving this:

Each venturer records only those transactions which affect him/her. The profit and
loss account must then be prepared in Memorundum fashion.

Or

One (or each) venturer can record all the transactions in his own books, in which case
the Profit and Loss can be prepared in Double Entry fashion.

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Method (a) – Using a memorandum profit and loss account

Each venturer will keep a joint venture account in which to record the transactions
into which he/she enters. This represents a personal account with the joint venture,
and is therefore debited and credited with amounts due to and from the venture in the
form of purchases, sales, expenses, stock taken over, profit shares, etc.

At the end of the venture each party will render a statement of his transactions to the
other, so that they can be combined into a Memorandum Profit and Loss Account,
outside the books.

Each party will then take up his profit share into his own books, and the balances
remaining on the joint accounts settled by cash transfers.

Example

A and B undertake a joint venture sharing profits in the ratio 2 :1. A makes a
purchase of K4.7m and cash sales of K5m. B makes purchases of K5.3m and cash
sales of K5.8m. At the end of the venturer the unsold stock is taken over by A at an
agreed valuation of K400,000.
Required:
Prepare the memorandum joint venture profit and loss account

Solution

A’s books

Note: this is a personal account with the joint venturer itself, NOT a personal account
with B.
Joint venture with B account
K’000 K’000
Amounts due from venture Amounts due to venture
Purchases 4,700 Cash sales 5,000
Profit share 800 Stock 400
-- Cash received from B (balance) 100
5,500 5,500

B’S books

Note: this is a personal account with the joint venturer itself, NOT a personal account
with A.
Joint venture with A account

K,000 K,000
Amounts due from venture Amounts due to venture
Purchases 5,300 Cash Sales 5,800
Profit share 400
Cash paid to A (balance) 100 - --

200
 5,800 5,800

Nobody’s books
Memorandum joint venture profit and loss account
K’000 K’000

Sales (5,000 + 5,800) 10,800

Purchase (4,700 + 5,300) 10,000
Less: Closing stock 400
Cost of sales 9,600
Gross profit
1,200

A – two-thirds 800
B – one third 400

Notes:
(i) The profit is computed outside the books – it represents the extra
wealth generated by the venture which is due to the venturers.
Each will take his share up into his own books by:
Dr Joint venture
Cr Profit and loss account (i.e., his own profit and loss
account)

(ii) Where a venturer takes over a venture (e.g., socks) he is effectively buying
it from the venture and must therefore credit his joint venture
account:
Dr Purchases/fixed asset account
Cr Joint venture account

(iii) The physical movement of joint venture stock between ventures never
gives rise to any accounting entries. Stock only appears in the
books if it is taken over by a venturer.

(iv) The balance remaining on the joint venture accounts represents the cash
due respectively to and from the joint venture

(v) If a separate bank account is opened for the joint venture, transactions
with third parties will be recorded in the double entry books since
each venturer will only enter the receipts and payments which affect
him/her personally. Instead, a Memorandum Joint Venture cash
book must be opened.
1.7 Method (b) – all transaction recorded in double entry form

With the first method, the two sets of books needed to be looked at together to
obtain a complete picture of the joint venture. The main feature of the second
method is that each venturer incorporates all the transactions into his/her own
books by means of two double entry accounts:

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 (a) joint venture account – this acts as a profit and loss account;
(b) personal account with the other venturer

Example
Using the same facts as in the previous example.
A’s books
Joint venture profit and loss account
K’000 K.000
Purchases 4,700 Sales 5,000
B’s purchases 5,300 B’s sales 5,800
Profit c/d 1,200 Stock taken over 400
11,200
11,200
General profit and loss a/c: Profit b/d 1,200
Two-thirds 800
B’s account one third 400 _____
1,200 1,200

B’s personal account

K’000 K’000
Joint venture profit and Joint venture profit and loss
Account: sales 5,800 account: Purchases
5,300
Profit share 400
Cash to A (balance) 100
5,800 5,800
In B’s books a similar joint venture profit and loss account would appear,
and a personal account with A.

Notes on accounting treatment in A’s books

(i) The venture profit is appropriated by:
Dr Joint venture profit and loss account
Cr Profit and loss account – A’s share
Cr B’s account – his share
(ii) Any stock or fixed asset taken over would be treated in the books
of A as follows:
(a) By A:
Dr Purchases/fixed assets
Cr Joint venture profit and loss account
(b) By B:
Dr B’s account
Cr Joint venture profit and loss account
In both cases with agreed take – over value.
(iii) As before, NO entries are made where stock merely changes its
location.
(iv) B’s personal account is cleared by a cash payment
(v) If a separate bank account is opened for the joint venture, each
venturer would keep a join venture cash book within his
double entry books of account.

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Chapter 19

BUSINESS COMBINATIONS AND

CONSOLIDATED FINANCIAL STATEMENTS

Objective
When you have studied this chapter you should be able to identify the general
characteristic of parent company, investment, subsidiary and associated undertakings

Group structure and control relations

Introduction
A group of companies consist of a holding or parent company and one or more
subsidiary companies which are controlled by the holding company. Legally the
results of a group must be presented as a whole or consolidated or presented as if
the companies were a single company. IAS 27 Consolidated financial
statements and accounting for investments in subsidiaries defines some key
terms as follows:

a) Control

‘the power to govern the financial and operating policies of an entity so

as to obtain benefits from its activities.’

b) Subsidiary

‘is an entity, including an unincorporated entity such as a partnership,

that is controlled by another entity (known as the parent.)’

c) Parent

An enterprise that has one or more subsidiaries under its control.

d) Group

‘is a parent company and all its subsidiaries.’

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 e) Consolidated financial statements
‘are the financial statements of a group presented
as those of a single economic entity.’

1.2 Group structure

There are different types of structures such as:

Direct interest, where the holding company has only direct interest in the shares of
its subsidiaries.

Indirect holdings, where the holding company owns shares or has interest in the
sub subsidiaries. (Note: for examination purposes Indirect Holdings of sub
subsidiaries are excluded )

In a group structure one of the most important points is that of control. Mostly,
this will involve the holding company or parent company owning a majority of
the ordinary shares in the subsidiary and therefore carry the normal voting rights.
This control is assumed to exist according to IAS 27 when the parent owns more
than half (over 50%) of the voting power of an enterprise. There are however
circumstances where the parent company may own only minority (50% or less) of
the voting power in the subsidiary and yet still has control and these are listed
below:
(a) The parent has power over more than half of the voting rights by virtue of
an agreement with other investors;

(b) The parent has power to govern the financial and operating policies of the
entity under a statute or an agreement;

(c) The parent has power to appoint or remove the majority of the members of
the board of directors or equivalent governing body, and control of the
entity is by that board or body; or

(d) The parent has power to cast the majority of votes at meetings of the board
of directors or equivalent governing body, and control of the entity is by
that board or body.

1.3 Accounting treatment

IAS 27 states that in preparing consolidated financial statements, an entity

combines the financial statements of the parent and its subsidiaries line by line by
adding together like items of assets, liabilities, equity, income and expenses. In
order that the consolidated financial statements present financial information
about the group as that of a single economic entity, the following steps are then
taken:
(a) the carrying amount of the parent’s investment in each subsidiary and the
parent’s portion of equity of each subsidiary are eliminated (see IFRS 3,
which describes the treatment of any resultant goodwill);

(b) minority interests in the profit or loss of consolidated subsidiaries for the
reporting period are identified; and

204
 (c) minority interests in the net assets of consolidated subsidiaries are
identified separately from the parent shareholders’ equity in them.

Minority interests in the net assets consist of:

(i) the amount of those minority interests at the date of the original
combination calculated in accordance with IFRS 3; and

(ii) the minority’s share of changes in equity since the date of the
combination.

1.4 Exclusion and exemption from requirement to prepare group

accounts

There are circumstances when a parent need not prepare consolidated

financial statements. This can take place when the parent is itself a
wholly owned (usually 90% or more of the voting rights is held)
subsidiary. The permission of the minority shareholders must be
obtained for not presenting consolidated financial statements.

If a parent company takes advantage of this exemption it must disclose the

following:

a) Reasons why consolidated financial statements have not been

presented

b) Bases on which subsidiaries are accounted for in the parent’s

separate financial statements

c) Name and registered office of its parent that publishes consolidated

financial statements.
A parent that elects in accordance with IAS 27 not to present
consolidated financial statements, and presents only separate financial
statements, must comply to strict rules because this is a common
method used by enterprises to manipulate their results.

IAS 27 identifies two circumstances where a subsidiary should be excluded

from consolidation:

Control is meant to be temporally – the subsidiary was acquired and is held

exclusively with a view to its subsequent disposal in the near future.

The subsidiary operates under severe long term restrictions. These significantly
impair its ability to transfer funds to the parent.

1.5 Disclosure requirements

Disclosures must be made in accordance with the accounting standards and
some of these are:

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  Listing of the significant subsidiaries including the name, country of
incorporation or residence, proportion of ownership interest and, if different,
proportion of voting power held.

 Where applicable, the reasons for not consolidating a subsidiary and nature
of the relationship between the parent and a subsidiary of which the
subsidiary does not own more than 50% of the voting power.

 Name of an enterprise in which more than 50% of voting power is owned

but which because of the absence of control, is not a subsidiary.

 Effect of the acquisition and disposal of subsidiaries on the financial position

at the reporting date, the results for the reporting period and on the
corresponding amounts for the preceding period

Chapter 19

THE CONSOLIDATED BALANCE SHEET

General procedure

Each company in a group prepares its accounting records and annual financial
statements in the usual way. From the individual companies’ Balance Sheets, the
holding company prepares a Consolidated Balance Sheet for the group.

In preparing consolidated financial statements, an entity combines the financial

statements of the parent and its subsidiaries line by line by adding together like
items of assets, liabilities, equity, income and expenses. In order that the
consolidated financial statements present financial information about the group
as that of a single economic entity, the following steps are then taken:

(a) The carrying amount of the parent’s investment in each subsidiary and the
Parent’s portion of equity of each subsidiary are eliminated or cancelled.

206
 (b) Minority interests in the profit or loss of consolidated subsidiaries for the
reporting period are identified; and

(c) Minority interests in the net assets of consolidated subsidiaries are

identified separately from the parent shareholders’ equity in them.

Other matters to be dealt with include Goodwill on consolidation and dividends.

Cancellation
The preparation of a Consolidated Balance Sheet, in a very simple form consists of two
stages.
From the individual accounts of the parent company and each subsidiary, cancel out
items which appear as an asset in one company and a liability in another.
Add together all the uncancelled assets and liabilities throughout the group.

Example

The Parent (Holding) company has just bought 100% of the shares of subsidiary
company. Below are the balance sheets of both companies just before consolidation.

Balance sheets at 31 December 2005

P ltd S ltd
Km Km Km Km
Assets
Non-current assets 60 40
Investment in S ltd at cost* 50 -
Current asset 40 40
Total Assets 150 80
Equity and liabilities
Ordinary share capital (K1 shares) 100 50*
Reserves (P & l a/c) 30 -
Current liabilities 20 30
Total equity and liabilities 150 80

* Cancellation items
This leaves a Balance Sheet showing:
the net assets of the whole group (P+S);
the share capital of the group which is always solely the share capital of
the parent company (P only); and profits and losses made by the group.

So, by cross casting the net assets of each company, and taking care of the
investment in S ltd and the share capital of S ltd we arrive at the
Consolidated Balance Sheet given below:

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 Parent and Subsidiary Consolidated Balance Sheet as at 31 Dec 2005
Km Km
Assets
Non-current assets (60+40) 100
Current Assets (40+40) 80
Total assets 180
Equity and liabilities
Ordinary Share Capital 100
Reserves (P & L a/c) 30
Current liabilities (20+30) 50
Total equity and liabilities 180

Note: under no circumstances will any share of any subsidiary

company ever be included in the figure of share capital on the
Consolidated Balance Sheet.

Part cancellation
An item may appear in the Balance Sheet of a Parent company and its Subsidiary,
but not at the same amounts due to the fact that:
Parent company may have acquired shares in the subsidiary at a price greater or
less than their par value.

Parent company may not have acquired all the shares in the subsidiary, partly
owned thereby giving rise to the issue of minority interest.

The inter-company trading balances may not be the same because of goods in
transit

One company may have issued loan notes of which a proportion only is taken up
by the other company.

The procedure is to cancel out as far as possible similar items from both balance
sheets and remaining uncancelled amounts will appear in the consolidated balance
sheet.

Example

The Balance sheets of P Ltd and of its subsidiary S Ltd have been prepared up to
31March 2006 and has owned all the ordinary shares and 40% of the loan notes of
S Ltd since its incorporation.

P Ltd Balance sheet as 31 March 2006

K’000 K’000
Assets
Non-current assets:
Tangible assets 120,000
Investments in S Ltd ,at cost
80,000 ordinary shares of K1,000 each 80,000
K20m of 12% loan notes in S Ltd 20,000
220,000

208
 Current assets
Inventories 50,000
Receivables 40,000
Current account with S Ltd 18,000
Cash 4,000
112,000
Total assets 332,000

Equity and liabilities

Capital and reserves
100,000 ordinary shares @K1,000 100,000
Reseves 95,000
Current liabilities
Payables 47,000
Taxation 15,000
10% Loan stock 75,000
332,000

S Ltd Balance sheet as at 31 March 2006

K000 K’000
Assets
Non-current assets:
Tangible assets 100,000
Current assets
Inventories 60,000
Receivables 30,000
Cash 6,000
96,000
Total assets 196,000

Equity and liabilities

Capital and reserves
80,000Ordinary shares
of K1, 000 each fully paid 80,000
Reserves 28,000
108,000
Current liabilities
Payables 16,000
Current account with P Ltd 12,000
Taxation 10,000
38,000
12% loan stock. 50,000
Total equity and liabilities 196,000

The difference on current account arises because of goods in transit.

Required

209
 Prepare the consolidated balance sheet of P Group.

Solution

P group consolidated balance sheet as at 31 March 2006

K’000 K’000
Assets
Non-current assets:
Tangible assets (120,000 + 100,000) 220,000
Current assets
Inventories (50,000 + 60,000) 110,000
Receivables (40,000 + 30,000) 70,000
Goods in transit (18,000 – 12,000) 6,000
Cash (4,000 + 6,000) 10,000
196,000
Total assets 416,000

Equity and liabilities

Capital and reserves
100,000,000 Ordinary shares
of K1 each fully paid 100,000
Reserves (95,000 + 28,000) 123,000
223,000
Current liabilities
Payables (47,000 + 16,000) 63,000

Taxation (15,000 + 10,000) 25,000

88,000
12% loan notes (50,000 – 20,000) x 40% 30,000
10% loan notes 75,000
Total equity and liabilities 416,000

Minority Interest

Shares held by or on behalf of persons other than the parent undertaking and its
subsidiary. A proportion of the net assets of such subsidiaries in fact belongs to
investors from outside the group (minority interest).

The main decision to make on accounting principles is whether to consolidate all

the net assets of S Ltd (subsidiary), or merely to consolidate the proportion of the
net assets represented by the shares held and the proportion of the reserves which
apply to those shares.

The dominant principle is that the directors are preparing accounts of their
custody of all the assets under their control, even though there are owners other
than the holding company.

210
 The generally accepted procedure is to calculate the proportion of Ordinary
Shares, Preferred Shares and Reserves attributable to minority interests and show
this figure as a liability in the consolidated balance.
K’000
Called up share capital X
Reserves X
Minority interest X
X

Example

P Ltd has owned 75% of the share capital of S Ltd since the date of S Ltd’s
incorporation. Their latest balance sheets are given below:

Balance sheet P Ltd S Ltd

Assets K’000 K’000
Non – current assets
Tangible assets 50,000 35,000
30,000,000 K1 ordinary shares in S Ltd at cost 30,000 -
Net current assets 25,000 15,000
Total assets 105,000 50,000
Equity and liabilities
80,000 K1,000 ordinary shares 80,000 40,000
Reserves 25,000 10,000
Total equity and liabilities 105,000 50,000

Required.
Prepare the consolidated balance sheet.
Solution

The amount of net assets attributable to minority interests is calculated as follows:

K’000
Minority share of share capital (25% x 40,000,000) 10,000
Minority share of reserves (25% x 10,000,000) 2,500
12,500

S Ltd net assets are consolidated despite the fact that the company is only 75% owned
as follows:

P Ltd Group – Balance sheet

Assets K’000
Non – current assets
Tangible assets (50,000 + 35,000) 85,000
Net current assets (25,000 + 15,000) 40,000

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 Total assets 125,000
Equity and liabilities
80,000 K1 ordinary shares 80,000
Reserves (25,000 + 75% x 10,000) 32,500
Minority interest 12,500
Total equity and liabilities 125,000

1.5 Goodwill arising on consolidation

When the investment in the subsidiary costs more or less than the net assets
acquired in the subsidiary, there will be a difference between the cost of the
investment in the subsidiary and the share capital of the subsidiary.
The difference is Goodwill which can be calculated as follows:

Goodwill consolidation schedule

Goodwill
K’000 K’000
Cost of investment X
Share of net assets acquired as represented by:
Ordinary share capital X
Share premium X
Reserves on acquisition X
Group share % % (X)
Goodwill X
Example

Balance sheets at 31 December 2004

P Ltd S Ltd
Km Km Km Km
Assets
Non-current assets
Tangible assets 60 40
Investment in S Ltd (at cost) 60
Current assets 30 40
Total assets 150 80

Capital and reserves

Ordinary share capital(K1 Shares 100 50
Profit and loss account 30 -
Current liabilities 20 30
150 80

P Ltd acquired all the shares in S Ltd on 31 December 2004 for a cost of
K60m
Required:
Prepare consolidated balance sheet

Solution
In this case the cost of the shares in S Ltd exceeds S Ltd’s share capital by
K10m. This is the goodwill on consolidation or premium on acquisition. It
represents the excess of the purchase consideration over the fair value of

212
 the net assets acquired. The calculations may be set out as a consolidation
schedule as follows:
Km Km Notes
Cost of investment 60 1
Less: Share of net assets acquired (at fair value):
Ordinary share capital 50 2
Profit and loss account -- 3
50
Group share x 100% (50) 4
10 5

Notes to the calculations

1 The cost of investment will appear in the balance sheet of P Ltd. If
there more than one investment, details will be given of the cost of
individual investment in the question.

2 We are actually comparing the cost of investment with the net assets of the
subsidiary acquired, as represented by the Share Capital and Reserves of
the subsidiary at the date of acquisition. Remember Net assets = Capital
+ Reserves.

3 In this case there are no reserves of the subsidiary to consider. However, it

is important to note here that the reserves which are taken into
consideration in the calculation of goodwill are those at the date of
acquisition of the subsidiary. Whilst the share capital of the subsidiary is
unlikely to have altered since that date, the profit and loss account will
have changed.

4 As 100% of the shares in S Ltd were acquired, we compare the cost of the
shares with 100% of the net assets of S Ltd. If only a proportion of the
shares are acquired, say 90%, we compare the cost of those shares with the
appropriate share (90%) of the net assets acquired.

5 The resulting purchased goodwill can be written off using one of two
methods:
(a) Immediate elimination against reserves on acquisition of
the subsidiary (the preferred treatment); or
(b) Amortisation (depreciation) through the profit and loss
account over its estimated useful life.
Having first calculated goodwill, the net assets of the holding company
and the subsidiary can be cross cast and the company and the Consolidated
Balance Sheet completed as follows:
P Ltd
Consolidated balance sheet as at 31 December 2004
Km Km
Fixed assets K(60 + 40) 100
Current assets K(30 + 40) 70
170
Ordinary share capital 100
Profit and loss account K(30 – 10) 20

213
 Payables K(20 + 30) 50
170
Conclusion:
Goodwill represents the difference between the amount paid to acquire the
net assets of a subsidiary and the fair value of those net assets.

1.6 Inter-company items

The individual Balance Sheets of the holding company and subsidiary companies
are likely to include inter-company items i.e., amount owing between the group
companies. These inter-company items must be eliminated when the Consolidated
Balance Sheet is prepared, in order to show the proper position of the economic
unit, the group.

Current accounts

At the year end, the current accounts may not agree, due to the existence of in-
transit items such as goods in transit or cash. The usual rules are:

a) If the goods or cash are in transit between the parent company and the
subsidiary, make the adjusting entry to the balance sheet of the
parent company, irrespective of the direction of transfer i.e.,
Dr Cash in transit
Cr Current account with subsidiary
Note that this is for the purpose of consolidation only.

b) If the goods or cash are in transit between subsidiaries, then adjust in the
books of the ultimate recipient.

Once in agreement, the current accounts may be contrad and cancelled as part of
the process of cross casting the upper half of the balance sheet. This can
be achieved, along with any other adjustments, as a working paper which
would show:

The upper half of the balance sheet of each company;

All adjustments of these figures along with cancelled inter-company
items; and
The final figures which will appear in the upper half of the Consolidated
Balance Sheet, resulting from the cross casting of items in (i) and
(ii) above.

However, as this working paper would take time to generate in an exam, it

is useful to use the Balance Sheets given in the examination paper itself to
form this working paper.

Example
Balance sheets as at 31 December 2004
P Ltd S Ltd
K’000 K’000

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 Investment in S Ltd at cost 19,000
S Ltd current account 10,000
P Ltd current account (9,000)
Cash at bank 10,000 23,000
Sundry net assets 41,000 16,000
80,000 30,000
Share capital 50,000 10,000
Profit and loss account 30,000 20,000
80,000 30,000

P Ltd bought 7,500 shares in S Ltd on 1 January 2004 when the balance
on the profit and loss account reserve of S Ltd was K12m. The
current account difference has arisen as a cheque sent by S Ltd to P
Ltd on 30 December 2004 was not received by P Ltd until 3 January
2005.

Required:
Prepare Consolidated Balance Sheet as at 31 Dec 2004.

Solution

An adjustment for cash in transit has to be made before the consolidation can be
completed. An extra step is therefore required in the consolidation procedure; it is
a good idea to make this sort of adjustment early on so that it is not forgotten.

Step 1 Shareholdings in S Ltd

%
Group 75
Minority 25
100

Step 2 Adjustments
K’000 K’000
Cash in transit
Dr Cash in transit 1,000
Cr S Ltd current account
(P Ltd’s balance sheet) 1,000

Cancel the current accounts which are now in agreement. (Note

that at this stage the top half of the consolidated balance
sheet can be prepared – a useful tip for the exam room when
time is of the essence)
H Ltd S Ltd Group
K’000 K’000 K’000
Investment in S Ltd (at cost) 19,000
S Ltd current account (1,000)10,000
H Ltd current account (9,000)
Cash at Bank 10,000 23,000 33,000
Cash in transit (1,000) - 1,000

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 Sundry net assets 41,000 16,000 57,000
80,000 30,000 91,000
Step 3 Goodwill
K’000 K’000
Cost of investment 19,000
Less: Share of net assets of S Ltd at the
Acquisition date
Share capital 10,000
Profit and loss account 12,000
22,000
Group share x 75%
(16,500)
Goodwill – write off to reserves 2,500
Step 4 Reserves
Consolidated income statement
K’000
P Ltd: 30,000
S Ltd: 75% (20,000 – 12,000) 6,000
Less: Goodwill written off (2,500)
33,500
Step 5 Minority interest
Net assets of S Ltd at balance sheet date
K’000
Share capital 10,000
Profit and loss account 20,000
30,000
x 25%
7,500
Step 6 P Ltd
Consolidated balance sheet at 31 December 2004
K’000
Cash at Bank (10,000 + 23,000) 33,000
Cash in transit 1,000
Sundry net assets 57,000
91,000
Share capital 50,000
Profit and loss account 33,500
Minority interest 7,500
91,000
Note that when accounts between members of a group disagree as a result of cash
in transit, the balance sheets show the correct position from each individual
company’s point of view, but adjustment is required before the consolidation can
be performed. The two current accounts will then cancel as the balance sheets are
cross-cast.

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Chapter 20

THE CONSOLIDATED INCOME STATEMENT

1.1 General procedure

Just as the income statement of a single company shows the results of the year’s
trading of that company, so does the consolidated income statement show the
results of trading in the year by the parent company together with its
subsidiaries.

Consolidated Income Statements are prepared by combining the information

given in the income statements of the individual companies, after making
adjustments that may be necessary to eliminate inter-company items, unrealized
profits and so on.
Example

P Ltd acquired, several years ago, the entire (100%) ordinary share capital of S
Ltd. Their results for the year ended 30 November 2004 were as follows:
P ltd S ltd
K’000 K’000
Turnover 8,500,000 2,200,000
Total costs (7,650,000) (1,980,000)
Trading profit before taxation 850,000 220,000
Taxation 400,000 100,000
Profit for the year retained 450,000 120,000

The consolidated income statement is arrived at by a simple combining exercise.

P Ltd
Consolidated Income Statement for the year ended 30 November 2004
K’000
Turnover (8,500,000+2,200,000) 10,700,000
Total costs (7,650,000+1,980,000) (9,630,000)
Group profit on ordinary activities before taxation 1,070,000
Tax on profit on ordinary activities 500,000
Profit for the year retained 570,000

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1.2 Minority interest

What would happen if in the previous example P Ltd acquired only 75% of the
share capital of S ltd? This does not affect turnover and cost of sales. They
remain the same as we wish to show total income under the control of the Parent
company directors. The minority shareholders’ interest in the income statement is
shown after the group tax charge.

A 25% minority interest would appear as follows in the consolidated income

statement.

Consolidated income statement for year to 30 November 2004

K’000
Turnover 10,700,000
Total costs 9,630,000
Group profit on ordinary activities before tax 1,070,000
Tax on profit on ordinary activities 500,000
Group profit on ordinary activities after taxation 570,000
Minority interest (25% x K120m) (30,000)
Profit for the year retained(K450m+75% x K120m) 540,000

Revenue reserves brought forward

So far we have avoided the problem of revenue brought forward from the
previous year. As far as the consolidated profit and loss account is concerned, the
balance brought forward consists of:

a) P Ltd’s own profit and loss account balance brought forward; and

b) P Ltd’s share of the post – acquisition retained profits of S ltd.

Example

Facts as in the previous example, but you are provided with additional
information:
a) Profit and Loss account balances brought forward at the beginning of the
year amounted to K2, 300m for P Ltd and K400m for S Ltd.

b) P Ltd acquired the shares in S Ltd when the revenue reserves of S Ltd
amounted to K100m.

You are required to calculate the brought forward and carried forward figure for
the consolidated profit and loss account.
Solution
K’000
Brought forward
P ltd 2,300,000
S ltd 75% x (K400m- pre acquisition K100m) 225,000
2,525,000
Retained for the year 540,000

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 Carried forward 3,065,000

1.3 Inter-company trading

When one company in a group sells goods to another, the same amount is added
to the sales revenue of the first company and to the cost of sales of the second
company. The consolidation figures for turnover and cost of sales should
represent sales to, and purchases from, outsiders. An adjustment is therefore
necessary to reduce the turnover and cost of sales figures by the value of inter-
company sales during the year. The best way to deal with this is to calculate the
unrealized profit on unsold inventories at the year end and reduce consolidated
gross profit by this amount. Cost of sales will be the balancing figure.

Example

Suppose in our earlier example S Ltd had recorded sales to P Ltd of K500, 000
during 2004. S Ltd had purchased these goods from outside suppliers at a
cost of K300, 000. One half of the goods remained in P ltd’s stock at 30 November 2004.
Prepare the revised consolidated income statement.

The consolidated income statement for the year ended 30 November 2004
would now be as follows:
P Ltd
Consolidated income statement for year to 30 November 2004
K’000
Turnover (8,500,000+2,200,000-500,000) 10,200,000
Total costs (Balancing figure) 9,230,000
Group profit (7,650,000+1,980,000-100,000 *) 970,000
Tax on profit on ordinary activities (500,000)
Group profit on ordinary activities after taxation 470,000
Minority interest (25% x K120m -K100,000*) (29,975)
Profit for the year retained 440,025

* Provision for unrealized profit: ½ x (K500,000 – K300,000)

Inter-company dividends – ordinary shares

Most complications in preparing consolidated profit and loss accounts arise

because of dividends paid from one company to another.
Investment income of the parent company may, for example, include:

 ordinary dividends received (or receivable) from subsidiaries;

 income from trade investments

Only (b) is shown separately as income in the consolidated profit and loss
account, inter-company dividends being eliminated on consolidation.

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Example

The income statements for P Ltd and S Ltd for the year ended 31 August 2004 are
shown below. P Ltd acquired 75% of the ordinary share capital of S Ltd several
years ago

P Ltd S Ltd
K’000 K’000 K’000 K,000
Turnover 2,400,000 800,000
Total costs 2,160,000 720,000
Trading profit 240,000 80,000
Investment income:
Dividend received
From S Ltd 1,500
Dividend receivable
From S Ltd 6,000
7,500

247,500 80,000
Taxation 115,000 38,000
132,500 42,000
Dividends:
Paid - 2,000
Proposed 60,000 8,000
60,000 10,000
Retained profit for the year 72,500 32,000

Required

Prepare the consolidated income statement

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 Solution

The main point to remember is that inter-company dividends must be eliminated.

Furthermore, as far as the minority’s share of the subsidiary’s current year profits
is concerned, the object of the consolidated income statement is to show the
minority’s share of the profit after taxation, and note how this figure is split
between dividends and the retained profits.

Minority interest in profit of subsidiary are 25% x K42m = K10.5m

Consolidated income statement for the year ended 31 August 2004

K’000
Turnover (2,400 + 800) 3,200,000
Total costs(2,160 + 720) 2,880,000
Group profit 320,000
Taxation (115 + 38) 153,000
Profit after tax 167,000
Minority interests 10,500
Profit after tax attributable to P Ltd 156,500
Dividends proposed by P Ltd 60,000
Profit for the year retained 96,500

1.5 Inter –company dividends – preference shares

The main complication here is the calculation of the minority interests in the
profits of the subsidiary. It is essential to be clear about:

(a) the minority interests in the ordinary shares; and

(b) the minority interests in the preference shares.

Example

P Ltd acquired 80% of the ordinary share capital and 40% of the preference share
capital of S Ltd many years ago. The income statement of S Ltd for the current
year is:

K’000 K’000
Sales 2,700,000
Total costs 2,300,000
400,000
Taxation 140,000
260,000
Dividends:
Preference 10,000
Ordinary 80,000
90,000

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 Retained profits 170,000

Required
Compute the minority interests

Solution

Procedure
Minority
Total interests
K’000 K’000
Profit after taxation (S Ltd) 260,000
Less: Preference dividend 10,000 (60%) 6,000
Available for ordinary shareholders 250,000 (20%) 50,000
Total 56,000

The minority interest’ share of the profits of S Ltd amounts to K56m

The preference dividend normally represents the full entitlement to profits of the
shareholders. The ordinary dividend, however, represents how much of the
remaining profits will be paid to the ordinary shareholders or retained (for their
ultimate benefit) within the company. Therefore, the deduction of the preference
dividend from the total profits available to shareholders in S Ltd merely
represents the total profits accruing to one class of shareholder. The ordinary
dividend does not represent this and, therefore, is not relevant to the calculation.

1.6 Pre-acquisition profits

The main problem here is how to deal with the pre-acquisition profits of the new
subsidiary. The approach is to exclude the pre-acquisition items of the subsidiary
from the relevant group figures.

Example

The trading results of P Ltd and S Ltd for the year ended 31 July 2005 were as
follows:

P Ltd S Ltd
K’000 K’000
Turnover 1,430,000 600,000
Total costs 1,160,000 504,000
Trading profit 270,000 96,000
Less: Taxation 135,000 48,000

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 Retained profit 135,000 48,000
Reserves brought forward 900,000 200,000
1,035,000 248,000

P Ltd acquired 75% of the ordinary share capital of S Ltd on 28 February 2005.
Assume that profits are earned evenly over the year.

Required:
Prepare the consolidated income statement.

Solution

Consolidated income statement for the year ended 31 July 2005

K’000
Turnover (1,430,000 + 5/12 x 600,000) 1,680,000
Total costs (1,160,000 + 5/12 x 504,000) 1,370,000
Profit before taxation (270,000 + 5/12 x 96,000) 310,000
Taxation (135,000 + 5/12 x 48,000) 155,000
Profit after taxation 155,000
Minority interests (25% x 5/12 x (96,000 – 48,000)) 5,000
Profit for the financial year 150,000
Reserves brought forward 900,000
Reserves carried forward 1,050,000

NOTE: that the reserves brought forward can only consist of P Ltd’s reserves, as
S Ltd was not a subsidiary at that date

Chapter 21

AGRICULTURE

OBJECTIVE

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The objective is to describe the accounting treatment and disclosures related to
agricultural activity.

Definitions

IAS 41 identifies and defines the following terms:

Agricultural activity
“The management by an entity of the biological transformation of biological assets for
sale, into agricultural produce, or into additional biological assets” Agricultural
produce. “The Harvested product of the entity’s biological assets”Biological asset“ A
living animal or plant”. It is important to note that biological assets are often physically
attached to land such trees in a forest. Biological transformation “The process of
growth, degeneration, production, and procreation that cause qualitative or quantitative
changes in biological asset”.

Example

The table below provides various examples of biological assets,

agricultural produce and products that arise out of processing after harvest.

Biological assets Agricultural produce Products that are

the result of
processing
after harvest.
i) Vines Grapes Wine
ii) Pigs Carcass Sausages, cured ham
iii) Sheep Wool Yarn, carpet
iv) Dairy cattle Milk Cheese
v) Plants Harvested cane Sugar
Cotton Clothing

Recognition and Measurement

An entity shall recognize a biological asset or agricultural produce when

and only when:

The entity controls the assets as a result of past events it is probable that
future economic benefits associated with the asset will flow to the entity;
and the fair value or cost of the asset can be measured reliably.

Control in agricultural activity may be evidenced by; i.e. legal ownership

of cattle while future benefits may be assessed by measuring the
significant physical benefits.

How can we measure biological assets and agricultural produce?

Biological asset are measured on initial recognition and at each
balance date at its fair value less estimated point-of-sale costs, except
where fair value cannot be measured reliably. Point of sale costs include
commissions to brokers and dealers, levies by regulatory agencies and

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 commodity exchanges, but exclude transport and other costs to get assets
to market.

Agricultural produce harvested from an entity’s biological assets will be

measured at its fair value less estimated point-of-sale costs at the point of
harvest.

The determination of fair value for biological asset or agricultural produce

may be facilitated by grouping biological asset or agricultural produce
according to significant attributes such as age or quality, and these are
used in the market as a basis for pricing.

Gains or Losses

A gain or loss may arise on initial recognition of agricultural produce as a

result of harvesting.

A loss may arise on initial recognition of a biological asset, because

estimated point-of-sale costs are deducted in determining fair value less
estimated point-of-sale costs of a biological asset. A gain may arise on
initial recognition of a biological asset, such as when a calf is born.

1.5 Government grants

An unconditional government grant related to a biological asset

measured at its fair value less estimated point-of-sale costs shall
be recognised as income when, and only when, the government grant
becomes receivable.

If a government grant related to a biological asset measured at its

fair value less estimated point-of sale costs is conditional, including
where a government grant requires an entity not to engage in
specified agricultural activity, an entity shall recognise the
government grant as income when, and only when, the conditions
attaching to the government grant are met.

Terms and conditions of government grants vary. For example, a

government grant may require an entity to farm in a particular
location for five years and require the entity to return all of the
government grant if it farms for less than five years. In this case,
the government grant is not recognised as income until the five years
have passed. However, if the government grant allows part of the
government grant to be retained based on the passage of time, the entity
recognises the government grant as income on a time proportion basis.

Disclosure

An entity is required to disclose as far as possible in the form of a

narrative or quantified description.

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 The disclosure requirement is shown in the example of a dairy farming
entity below:

Example
XYZ Dairy Ltd
Balance sheet
31 December20X1 31 December 20X0

ASSETS

Non-current assets K K
Dairy livestock – immature (a) 52,060 47,730
Dairy livestock – mature (a) 372,990 411,840
Subtotal – biological assets 3 425,050 459,570
Property, plant and equipment 1,462,650 1,409,800
Total non-current assets 1,887,700 1,869,370

Current assets

Inventories 82,950 70,650

Trade and other receivables 88,000 65,000
Cash 10,000 10,000
Total current assets 180,950 145,650
Total assets 2,068,650 2,015,020

EQUITY AND LIABILITIES K K

Equity
Issued capital 1,000,000 1,000,000
Accumulated profits 902,828 865,000
Total equity 1,902,828 1,865,000

Current liabilities
Trade and other payables 165,822 150,020
Total current liabilities 165,822 150,020
Total equity and liabilities 2,068,650 2,015,020

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 (a) An entity is encouraged, but not required, to provide a quantified
description of each group of biological assets, distinguishing between
consumable and bearer biological assets or between mature and
biological assets, as appropriate. An entity discloses the basis
for making any such distinctions.

Income statement*
XYZ Dairy Ltd
Income statement Notes Year ended
31
December
20X1
K
Fair value of milk produced 518,240
Gains arising from changes in fair value
less estimated Point-of-sale costs of dairy livestock (3)
39,930
558,170
Inventories used (137,523)
Staff costs (127,283)
Depreciation expense (15,250)
Other operating expenses (197,092)
(477,148)
Profit from operations 81,022
Income tax expense (43,194)
Profit for the period 37,828

Statement of changes in equity*

XYZ Dairy Ltd Year ended 31 December 20X1

Statement of changes in equity
Accumulated
Share capital profits
Total
K K K

Balance at 1 January 20X1 1,000,000 865,000 1,865,000

Profit for the period 37,828 37,828
Balance
at 31 December 20X1 1,000,000 902,828 1,902,828

Cash flow statement

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 XYZ Dairy Ltd
Cash flow statement Notes Year
ended
31 December 20X1
K
Cash flows from operating activities
Cash receipts from sales of milk 498,027
Cash receipts from sales of livestock 97,913
Cash paid for supplies and to employees (460,831)
Cash paid for purchases of livestock (23,815)
111,294
Income taxes paid (43,194)
Net cash from operating activities 68,100
Cash flows from investing activities
Purchase of property, plant and equipment (68,100)
Net cash used in investing activities (68,100)
Net increase in cash 0
Cash at beginning of period 10,000
Cash at end of period 10,000

Notes

1 Operations and principal activities

XYZ Dairy Ltd (‘the Company’) is engaged in milk production for

supply to various customers. At 31 December 20X1, the Company
held 419 cows able to produce milk (mature assets) and
137 heifers being raised to produce milk in the future (immature
assets). The Company produced 157,584kg of milk with a
fair value less estimated point-of-sale costs of 518,240 (that is
20X1.

2 Accounting policies
Livestock and milk
Livestock are measured at their fair value less estimated point-of-
sale costs. The fair value of livestock is determined based
on market prices of livestock of similar age, breed, and genetic
merit. Milk is initially measured at its fair value less estimated
point-of- sale costs at the time of milking. The fair value of
milk is determined based on market prices in the
local area.
3 Biological assets

Reconciliation of carrying amounts of dairy livestock

20X1
Carrying amount at 1 January 20X1 459,570
Increases due to purchases 26,250
Gain arising from changes in fair value less estimated point-of-sale
costs attributable to physical changes* 15,350

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 Gain arising from changes in fair value less estimated point-of-sale
costs attributable to price changes* 24,580
Decreases due to sale (100,700)
Carrying amount at 31 December 20X1 425,050

* 4 Financial risk management strategies

The Company is exposed to financial risks arising from changes in

milk prices. The Company does not anticipate that milk
prices will decline significantly in the foreseeable future and,
therefore, has not entered into derivative or other contracts to
manage the risk of a decline in milk prices.

The Company reviews its outlook for milk prices regularly in

considering the need for active financial risk management.

CHAPTER 22

PUBLIC SECTOR ACCOUNTING AND REPORTING

1.1 Funds Accounting
One important objective of external financial reporting is to help users assess
accountability by “assisting in determining compliance with finance- related laws,
rules, and regulations.” To achieve this goal, state and local governments organize
and operate their accounting systems on a fund basis. State and local
governments frequently establish a large number of “funds” for internal
accounting purposes. Having internal “funds” often are useful or necessary to
provide the level of detail needed to ensure and demonstrate legal compliance. In
this regard, however, the goals of accounting differ somewhat from the objectives
of financial reporting. Whereas an accounting system must collect all of the data
needed to ensure and demonstrate legal compliance, financial reporting should be
concerned only with those aspects of compliance that are of importance to users
of general purpose external financial reports. Consequently, not every internal
“fund” should automatically be classified as a fund for purposes of external
financial reporting. As specifically noted in the authoritative accounting and
financial reporting standards, the use of unnecessary funds for financial reporting
purposes can “result in inflexibility, undue complexity, and inefficient financial
administration.” Accordingly, those same authoritative standards state that “only
the minimum number of funds consistent with legal and operating requirements
should be established.” Unfortunately, many state and local governments
continue to report more funds in their comprehensive annual financial reports than
are truly necessary to achieve the goals of general purpose external financial
reporting, thereby needlessly adding to the length and complexity of that report
and potentially increasing audit fees.

229
 It is generally recommended that every state or local government that uses fund
accounting establish clear criteria for determining whether a given internal “fund”
should be classified and reported as an individual fund in the government’s
comprehensive annual financial report The application of these criteria to
individual internal “funds” of the government should be documented. Whenever it
is possible to do so without sacrificing the goals of fund accounting, similar
internal “funds” should be combined into a single fund for external
financial reporting purposes.

For example:

• When a government has numerous debt issues outstanding, a single debt

service fund could be used in many instances for all of the
smaller debt issues

• Governments with numerous capital projects may wish to consider

combining their less significant projects into a single capital
projects fund.

• Grants for similar purposes (e.g., special education) could be combined

into a single special revenue fund.

• Governments could limit their use of internal service fund accounting to

situations where the difference on charges to other funds between
accrual and modified accrual accounting is expected to be
significant. Every state or local government that uses fund accounting
should periodically undertake a comprehensive
evaluation of its fund structure to ensure that individual funds that have
become
superfluous are eliminated as such from the fund. Elected officials
should be educated to the fact that accountability may be
achieved effectively and efficiently in many instances solely by the
use of internal
“funds.”

1.2 Cash Vs Accrual basis of accounting

The basis of accounting that may be adopted by any government and their
units will depend on pure cash basis at one extreme to the full accrual
basis at the other extreme. The financial statements prepared should
therefore be consistent with these bases.

The Cash basis of accounting

The cash basis of accounting recognises transactions and events only when
cash has been received or paid. Consistent with cash basis, a statement of
receipts and payments (or expenditure) is usually prepared to disclose
information about cash flow during a period and cash balances at the end
of that period.

230
 The elements of the financial statements will be cash receipts, cash

disbursements and cash balances. Receipts and disbursements will include

cash inflows and outflows from taxation, the provision of goods and
services, the purchase and sale of plant, equipment and investments, and
borrowing and other financing transactions.

The full Accrual Basis of accounting

Accrual basis means a basis of accounting under which
transactions and other events are recognized when they occur (and
not only when cash or its equivalent is received or paid).

Therefore, the transactions and events are recorded in the

accounting records and recognized in the financial statements of
the periods to which they relate. The elements recognized
under accrual accounting are assets, liabilities, net assets/equity,
revenue and expenses.

1.3.0 Commitment ledger

Commitment and control systems

The commitment and control systems aims at controlling expenditure
within the quarterly expenditure ceilings and cash releases made
by the Ministry of Finance and National Planning and avoiding
accumulation of arrears. Outstanding commitments and unpaid bills
are monitored on a monthly basis in order to ensure that line ministries
do not exceed the quarterly expenditure ceilings and bills or claims
are paid within 30 days.
This control system ensures that no commitments are entered when there
are no funds. The commitment and control systems forms part of
the Financial Management Systems operated at the Ministry of
Finance and National Planning. The Financial Management System
(FMS) is a system used by the Ministry of Finance to capture the
accounting data and information in each of the Ministry,
Department or Province controlled by a Controlling Officer. It
captures details such head number, budget type, year, quarter and sub
head.

The commitment ledger sits alongside the Nominal Ledger and shows for
each Nominal Account the commitment to expenditure.
Commitments may be raised via the Commitment module itself, the
Purchase Ledger and / or Purchasing. Posting the actual invoice causes the
transaction to be reversed out of the Commitment Ledger into the
Nominal Ledger. Commitment Accounting allows the
financial manager to produce reports showing actual and commitment

231
against budget, and provides the basis for the accurate forecasting and tight
cost control vital to preserve today's pressurised margins.

In order to ensure that all expenditure incurred by the Ministry or

department is captured, it must be committed in a ledger under
which that particular expenditure has been incurred. This assists to
know how much for instance has been spent on a particular head or
sub head and how much is remaining to be spent.

Information arising from the commitment ledgers has to be captured and

reported as returns and submitted to Budget Office for
consolidation with other returns. A commitment and expenditure
return, including cash releases is produced and contains the following
details:

 Expenditure type, e.g. personal emoluments including sub-heads

 Budget provision including supplementary
 Total commitment up to last month
 New commitment this month
 Total commitment to date
 Total expenditure to last month
 Expenditure this month
 Total expenditure to date
 Budget provision balance
 Outstanding commitment
 Cash actual release to date

1.4.0 Debt Sustainability Analysis

1.4.1 Public Debt Management

The specific macroeconomic objectives that are directed at public debt

management include the following:

Restoring a sustainable debt position both domestically and externally;

Strengthening public expenditure management and reducing domestic

borrowing

Improving the efficiency of government operations; and

Developing well functioning financial systems

1.4.2 It is necessary for countries to conduct a Debt Sustainability

Analysis (DSA), which may be for HIPC eligibility testing or for
determining whether a country is facing an unsustainable
debt situation. There are three key determinants of
sustainability: a) the existing stock of debt,
b) the development of fiscal and

232
external repayment capacity which is linked closely to
economic growth, and c) the availability and
concessionality of new external financing.

Conducting a Debt Sustainability Analysis provides important data

not only for improving specific debt management operations but
also in formulating accurate and prudent macroeconomic
policies (focusing on fiscal policies, economic growth and
assuring access to adequate concessional flows from the
international community). A Debt Sustainability Analysis serves to
highlight linkages between a country's fluctuating debt
service obligations and its revenue streams.
The conventional
measurement of whether a country is eligible for debt relief
under Highly Indebted Poor Countries (HIPC) terms = Net
Present Value (NPV) of debt to exports ratio of 150%

1.5 Performance measurement, analysis and reporting

The measurement and evaluation of performance are central to control and

mean posing four basic questions: -

What has happened?

Why has it happened?

Is it going to continue?

What are we going to do about it?

The first question can be answered by performance measurement.

Management will then have to hand far more useful information
than it would otherwise have in order to answer the other three questions.
By finding out what has actually been happening, senior management
can determine with considerable certainty which direction the company
is going in and, if all is going well, continue with the good work. Or,
if the performance measurements indicate that there are difficulties on
the horizon, management can then lightly effect a touch on the tiller or
even alter course altogether with plenty of time to spare.

As to the selection of a range of performance measures which are

appropriate to a particular company, this selection ought to be
made in the light of the company's strategic intentions which will have
been formed to suit the competitive environment in which it
operates and the kind of business that it is.

For example, if technical leadership and product innovation are to be the

key source of a manufacturing company's competitive advantage,
then it should be measuring its performance in this area relative to its
competitors. But if a service company decides to

233
differentiate itself in the marketplace on the basis of quality of
service, then, amongst other things, it should be monitoring and
controlling the desired level of quality.

Whether the company is in the manufacturing or the service sector, in

choosing an appropriate range of performance measures it will be
necessary however to balance them, to make sure that one
dimension or set of dimensions of performance is not stressed to the
detriment of others. The mix chosen will in almost every instance be different.
While most companies will tend to organise their accounting systems
using common accounting principles, they will differ widely in the
choice, or potential choice, of performance indicators.

Authors from differing management disciplines tend to categorise the

various performance indicators that are available as follows :-

competitive advantage   flexibility

financial performance   resource utilisation
quality of service   innovation

These Six generic performance dimensions fall into two conceptually

different categories. Measures of the first two reflect the success of
the chosen strategy, i.e. ends or results. The other four are factors that
determine competitive success, i.e. means or determinants.

Another way of categorising these sets of indicators is to refer to them

either as upstream or as downstream indicators, where, for
example, improved quality of service upstream leads to better
financial performance downstream.

Table 1. Upstream Determinants and Downstream Results

Performance Dimensions Types of Measures

Relative market share and position
Competitiveness
Sales growth, Measures re customer base
Profitability, Liquidity, Capital Structure,
Financial Performance
Market Rations, etc.
Reliability, Responsiveness, Appearance,
Cleanliness, Comfort, Friendliness,
Quality of Service
Communication, Courtesy, Competence, Access,
Availability, Security etc.
Volume Flexibility, Specification and Speed of
Flexibility
Delivery Flexibility

234
 Resource Utilisation Productivity, Efficiency, etc.
Performance of the innovation process,
Innovation
Performance of individual innovations, etc.

Source: "Performance Measurement in Service Businesses"

by Lin Fitzgerald, Robert Johnston, Stan Brignall, Rhian Silvestro
and Christopher Voss, page 8.

Who Does the Analysis?

Whether the indicators are of the financial variety or of the non-financial

sort, usually it is the functional managers themselves who prepare
their own indicators from data generated from within their own
departments.

Financial vs. Non-Financial

In many companies the familiar cry "everything here is viewed in terms

of the bottom line!" can be heard. In this sort of corporate environment,
financial indicators remain the fundamental management tool and could be
said to reflect the capital market's obsession with profitability as almost
the sole indicator of corporate performance. Opponents of this approach
suggest that it encourages management to take a number of actions, which
focus on the short term at the expense of investing for the long term. It
results in such action as cutting back on R & D revenue expenditure in an
effort to minimise the impact on the costs side of the current year's P & L,
or calling for information on profits at too frequent intervals so as to be
sure that targets are being met, both of which actions might actually
jeopardise the company's overall performance rather than improve it.

In general terms, the opponents of "the bottom line school" state that
because of the pre-eminence of money measurement in the
commercial world, the information derived from the many stages
preceding the preparation of the annual accounts, such as budgets,
standard costs, actual costs and variances, are actually just a one
dimensional view of corporate activity. Increasingly, over the past
decade, they have been emphasising that executives should come to
realise the importance of the non-financial type of performance
measurement.

Research in support of this approach has come up with new dictums for
the workplace : "the less you understand the business, the more
you rely on accounting numbers" and "the nearer you get to
operations, the more non-financial performance indicators you realise
could be valuable aids to better management"; or "graphs and bars
carry much more punch than numbers for the non-financial manager".

235
 But there is still a lot of resistance. Executives tend to avoid using multiple
indicators because they are difficult to design and sometimes difficult to
relate, one to another. They have a strong preference for single
indicators of performance which are well tried and which produce
ostensibly unambiguous signals. But the new school lays great
emphasis on the fact that multiple indicators are made necessary by the
sheer complexity of corporate activity.

  The Case for Non-Financial Performance Indicators

Professor R.S. Kaplan of Harvard Business School in The Evolution of

Management Accounting states: "..... if senior managers place too much
emphasis on managing by the financial numbers, the organisation's long
term viability becomes threatened." That is, to provide corporate decision
makers with solely financial indicators is to give them an incomplete set of
management tools.

The essential case is twofold; that firstly not every aspect of corporate
activity can be expressed in terms of money and secondly that if managers
aim for excellence in their own aspects of the business, then the company's
bottom line will take care of itself.

So what do non-financial indicators relate to? They relate to the following

functions: -

 manufacturing and production

 sales and marketing
 people
 research and development
 the environment

Whether the company is a manufacturer or a service provider, to be successful its

management should be concerned to ensure that:-

- products move smoothly and swiftly through the production cycle

- warranty repairs are kept to a minimum and turned round quickly

- suppliers' delivery performance is constantly monitored

- quality standards are continually raised

- sales orders, shipments and backlog are kept to a minimum

- there is overall customer satisfaction

- labour turnover statistics are produced in such a way as to identify

- managerial weaknesses

236
- R &D costs do not escalate

- the accounting and finance departments really understand the business

Looking at each of these areas in turn, the following non-exhaustive list of performance
measures is relevant. No one indicator should be over emphasised and no one indicator
should reign supreme for long in the corporate consciousness of executives or
management gurus

1. Manufacturing and Production Indicators

The sheer volume, variety and complexity of managerial issues surrounding the
production process makes this area of corporate activity a particularly rich one for non-
financial indicators. Performance indicators can be devised for all operational areas.

Non-financial indicators, depending on the exact nature of the production process,

might include the following:-

 indicators deriving from time and motion studies

 production line efficiency
 ability to change the manufacturing schedule when marketing
 plan changes
 reliability of component parts of the production line
 production line repair record
 keeping failures of finished goods to a minimum
 ability to produce against the marketing plan
 product life cycle

Indicators concerned with controlling production quality - right first time

 measurement of scrap
 tests for components, sub-assemblies and finished products
 fault analysis
 "most likely reasons" for product failures
 actual failure rates against target failure rates
 complaints received against the quality assurance testing programme
 annualised failures as a % of sales value
 failures as a % of units shipped
 various indicators of product / service quality
 various indicators of product / service reliability

Indicators concerned with the purchasing department's external relationships with

its suppliers

 inventory levels and timing of deliveries

 "just in time" inventory control measurements
 stock turnover ratio
 weeks stocks held

237
  suppliers delivery performance
 analysis of stock-outs
 parts delivery service record
 % of total requests supplied in time
 % supplied with faults

Indicators of sales delivery and service

 shipments vs. first request date

 average no. of days shipments late
 response time between enquiry and first visit

2. Sales and Marketing

 measurements based on "staying close to the customer"
 complaints re manuals
 complaints re packaging / ease of opening
 quality of packaging materials
 customer satisfaction analysis
 price of products comparisons
 check on unsuccessful visit reports
 monitoring repeated lost sales by individual salesmen
 sales commission analysis
 monitoring of enquiries and orders
 sales per 100 customers
 "strike rate" - turning enquiries into orders
 analysis of sales by product line
 by geographical area
 by individual customer
 by salesmen
 matching sales orders against sales shipments - the trend from the
mismatch
 backlog of orders analysis
 flash reports on sales
 publication of sales teams performance internally
 analysis of basic salaries and sales commissions
 share of the market against competitors
 share of new projects in the industry
 new product / service launch analysis
 time to turn round repairs
 delays in delivering to customers (customer goodwill)
 value of warranty repairs to sales over the period

3. People
 head count control
 head count by responsibility
 mix of staff analysis
 mix of business analysis vs. staff personnel needs
 skilled vs. non skilled
 management numbers vs. operations staff
 own labour / outside contractor analysis

238
  workload activity analysis
 vacancies existing and expected
 labour turnover
 labour turnover vs. local economy
 % of overtime worked to total hours worked
 absence from work
 staff morale
 cost of recruitment
 number of applicants per advert
 number of employees per advertising campaign
 staff evaluation techniques
 evaluation of staff development plans
 monitoring of specific departments, e.g. accounting
 speed of reporting to internal managers vs. HQ
 accuracy of reporting as measured by misallocations and
mispostings
 queries what reports mean
 monitoring of departments performance long term
 pay and conditions vs. competition

4. Research and Development

 evaluation vs. basic R&D objectives, strategic objectives and
project objectives
 product improvement against potential market acceptance
 R&D against technical achievement criteria, against cost and
markets
 R&D priority vs. other projects
 R&D vs. competition
 R&D technical milestones
 analysis of market needs over the proposed product / service life of
R&D outcome
 top management audit of R&D projects
 major programme milestones
 failure rates of prototypes
 control by visibility - releases, e.g. definition release, design
release, trial release, manufacturing release, first shipment release,
R&D release

5. Environment
 work place environment yardsticks
 cleanliness
 tidiness
 catering facilities vs. competition
 other facilities vs. competition ,etc.

6. Final Note

Many executives will talk freely in terms of quality and standards, of "just
in time" inventory control, and of other performance measurement
yardsticks and may be quite knowledgeable about them, but when

239
 questioned as to the exact nature of the non-financial measurements that
they actually have in place in the company will be hard-pressed to tell the
researcher what the company is in fact measuring on an on-going basis.
There is a lot of lip service paid to these measures, as opposed to those of
a purely financial nature, which are of course to a great extent the product
of regulation and company law. So, much remains to be done to broadcast
the merits of non-financial performance measurement indicators.

Chapter 23

BRANCH ACCOUNTS

Objective

When you have studied this chapter you should be able to do the following:
- Account for the activities of branches recorded in a single set of accounting
records.
- Account for the activities of branches where each branch maintains its own
distinct accounting records

1 Branch Accounting

1.1 Introduction

240
 One of the functions of accountancy is to assist in controlling by means of
recording the movement of men and materials. This control becomes more
complicated where the men and materials are located in more than one place
e.g. where there is head office in one location and branches in others. If the
central management at head office is to supervise branch activities properly, it
must be supplied with regular returns on a daily or weekly basis from the outlying
branches. Such branch accounting is normally considered under two heads:

(a) Where all the bookkeeping is done at the Head office on the basis of daily
returns of banking and sales from each branch;
(b) Where each branch keeps books of account and thus controls its own
activities.

2 One set of books

2.1 Introduction

Where a company owns a chain of off-licence or shoe shops it is very unlikely

that it will be considered worthwhile to employ a bookkeeper at each shop in
order to record the activities of that shop. More sensibly, the shop manager will be
required to bank his takings daily, forwarding the bank paying-in slip to his head
office together with a return showing stocks, sales, payments out of sales for local
purchases, etc. From these daily returns the head office accountant must keep
records which will:
(a) ensure that branch staff do not steal or lose cash or stocks;
(b) show the profitability of each branch.

There are a number of ways of doing this, none of which is entirely satisfactory.
The most popular is to put each branch onto a sort of ‘imprest system’. Stocks are
purchased at Head office and\invoiced to the branch at selling price. Then at any
moment of time the invoice price of the stocks in the branch shop plus the
bankings since the imprest was ‘topped up’ should equal the amount of the
‘imprest’ i.e. K10m. Where stock is particularly attractive to staff e.g., in the
liquor trade, it is customary to have a team of traveling stock takers who arrive
unannounced at branches and check the stocks plus bankings against the imprest
total.

The problem with invoicing branches at selling price is that when the annual
accounts are prepared the stock at branches must be included at cost price and not
selling price, and the ‘profit’ to the head office of invoicing stock not yet sold by
the branch must be eliminated. This is a rather ‘untidy’ accounting adjustment.

2.2 Stock invoiced at selling price with a ‘mark-up’ account

In this method three special accounts are opened at the head office for each
branch or shop. They are prepared with the aid of the daily or weekly returns from
each branch.

Branch X stock control account

241
 This account is charged by the head office with all the goods sent to
branch at selling price. The proceeds of sale by Branch X are credited to
the account so that at any moment of time the balance on this account is
the sales value of stocks at branch X. This gives good stock control.

Branch X mark –up account

This account shows the mark up or gross profit on all the stocks sent by
the head office to the Branch X. At the end of the period, if the ‘profit’ in
the closing stock at branch is carried down to the new period, the balance
on the account is the gross profit of Branch X which may be taken to the
general profit and loss account. The profit in the closing branch stock may
be deducted from the branch stock at selling price on the Branch X stock
control account to give the closing stock at Branch X at cost. This figure
will then be included on the company’s balance sheet. Thus the gross
profit of each branch is recorded.

Goods sent to Branch X account

This account is a ‘pending tray’. When the head office sends goods to
Branch X it will debit the Branch X stock control account with the selling
price of the goods and credit:

The ‘profit’ to the Branch X mark-up account; and

The ‘cost price’ to the Goods sent to Branch X account

At the end of the period the total of the Goods sent to Branch X account is
credited to (i.e. reduces) Purchases account. This means that the balance
on the Purchases account consists only of those purchases not sent to the
branches and is therefore part of the cost of sales of the head office.

Example

C ltd opened a new branch shop on 1 January. All the goods for sale at the shop
are purchased by the head office and charged to the branch at retail selling price
which is cost plus one-third. The branch banks its takings, without deduction, for
the credit of the head office. Although it is a cash business, the branch manager is
allowed to give credit in a few special cases.
The following information is relevant for the three months to 31 March:
K’000
Purchases 10,550
Sales at head office 1,600
Goods sent by head office to branch at selling price 12,000
Cash sales at branch 8,000
Credit sales by branch 2,000
Goods returned to head office at selling price 600
Cash collected from cash debtors 1,800
Branch expenses 1,000
Head office expenses 200

242
 Required:
Show by means of ledger accounts, the above transactions in the head office
books where all the records are kept. Prepare C Ltd’s trading and profit and loss
account and balance sheet extract.

Closing stock at branch was K1, 380,000 at invoice price. Closing stock at head
office was K800, 000 at cost.

Solution
Books of C Ltd

(Numbers in brackets refer to sequence of entries in key accounts).

SC = Stock control account; MU = Mark-up account; GS = Goods sent account.

New branch stock control account (SC)

K’000 K,000 K’000 K’000
(1) 1 Jan New branch (3) 1 Jan Cash (sales) 8,000
To MU – Profit 3,000 to
(2) 31 Mar Goods (4) 31 Mar Debtors 2,000
Sent to new (6) New branch
Branch cost 9,000 MU 150
12,000 (7) Goods sent to
New branch 450
600
31 Mar Balance c/d
Being
(8A) Closing stock
At selling price 1,380
(9) New branch MU
- normal loss
(bal fig after (8A)
Is inserted) 20
12,000 12,000
(8A) 1 Apr Balance c/d 1,380

New branch mark-up account (MU)

K’000 K’000

(6) 1 Jan New branch (3) 1 Jan New branch

to SC – Returns 150 to SC – Profit 3,000
31 Mar 31 Mar
(9) 31 Mar. New branch SC
- stock
difference 20
31 Mar. Balance c/d:
(8B) Profit in stock
of K1,380 345
Profit and loss
account (bal

243
 fig) 2,485
3,000 3,000
(8B) 1 Apr. Balance b/d 345

Goods sent to New branch account (GS)

K’000 K’000

(1) 1 Jan New branch (2) 1 Jan New branch SC

to SC – Returns 450 to cost 9,000
31 Mar 31 Mar
(11) 31 Mar. Purchases 8,550
9,000 9,000

Purchases

K’000 K’000
1 Jan. Sundries 10,550 (11) 31 Mar. Goods sent to
new branch 8,550
31 Mar. Trading
account 2,000

10,550 10,550

Head office sales

K’000 K’000
31 Mar. 1 Jan.
Trading to
account 1,600 31 Mar. Sundries 1,600

New branch debtors

K’000 K’000
(4) 1 Jan New branch SC (5) 1 Jan Cash 1,800
to – sales 2,000 to
31 Mar 31 Mar. Balance c/d 200
2,000 2,000
1 Apr. Balance b/d 200

Head office stocks

244
 K’000 K’000
31 Mar. Trading
account 800

New branch expenses

K’000 K’000
1 Jan.
to 31 Mar. Profit and
31 Mar. Sundries 200 loss account 200

Head office trading account for three months ended 31 March

K’000 K’000
Head office sales 1,600
Opening stock -
Purchases of head office 2,000
Less: Closing stock ( 800)

Cost of head office sales (1,200)

Gross profit 400

New branch gross profit 2,485
New branch expenses 1,000
Head office expenses 200

(1,200)

Net Profit 1,685

Balance sheet 31 March (extract)

K’000 K’000 K’000

Current assets:
Stock at cost:
Stock at head office 800
Stock at new branch 1,380
Less: Profit therein 345
1,035
1,835
Debtors:
Head office X
New Branch 200
200
Reserves:
Profit and loss account 1,685

245
Note: the treatment of the stock difference. When the closing stock at selling price of
K1,380,000 is inserted in New branch control account, there is found to be a loss of
stock of K20,000 at selling price. This is considered to be a ‘normal’ difference and has
therefore been written off against the New branch gross profit by charging the Mark-up
account with the full K20, 000. A ‘normal’ loss is an expected loss and this is charged
fully in arriving at branch gross profit. An ‘abnormal’ loss is an unexpected loss. The
cost of this appears separately in the profit and loss account.

For example, if stock were stolen:

Cr Branch stock control account SP of stock lost

Dr Pilferage account Cost of stock lost, to profit and loss
account
Dr Branch mark-up account Profit margin on stock lost

The main difficulty with this method of accounting for branches is the ‘split posting’
which is necessary when sending goods to the branch and in the treatment of
differences.

2.5 Activity

Chiza Ltd, with its head office at Ndola, operates a branch at Kitwe. All goods are
produced by head office and invoiced to and sold by the branch at cost plus one-third.

Other than the sales ledger kept at Kitwe, all transactions are recorded in the books at
Ndola
The following particulars are given of all the transactions at the branch during the year
ended 28 February 19X7:
K’000
Stock on hand, 1 March 19X6, at invoice price 4,400
Debtors on 1 March 19X6 3,946
Stock on hand, 28 February 19X7, at invoice price 3,948
Goods sent from Ndola during the year at invoice price 24,800
Credit sales 21,000
Cash sales 2,400
Returns to head office at invoice price 1,000
Invoice value of goods stolen 600
Bad debts written off 148
Cash from debtors 22,400
Normal loss at invoice price due to wastage 100
Cash discount allowed to debtors 428

You are required to write up the Branch stock account, Branch total debtors account
and Branch adjustment account (otherwise known as the mark-up account) for the year
ended 28 February 19X7, as they would appear in the office books.

2.6 Activity Solution

246
 Ndola books relating to Kitwe branch – year ended 28 February 19X7
Branch stock account (at selling price)

K’000 K’000
Opening stock 3,946 Sales:
Goods sent to branch 24,800 Credit 21,000
Cash 2,400
Returns to Ndola 1,000
Stock stolen 600
Normal loss 100
Apparent loss(bal fig) 152
Closing stock 3,948

29,200 29,200

Branch total debtors account

K’000 K’000
Opening debtors 4,400 Cash received 22,400
Credit sales 21,000 Cash discount 428
Bad debts written off 148
Closing debtors 1,970

24,946 29,946

Branch stock adjustment account

K’000 K’000
Mark up on: Opening provisions for unrealised
Returns to Ndola 250 profit (¼ x K4, 000) 1,100
Stock stolen 150 Mark up on goods sent 6,200
Normal and apparent losses 252
Gross profit (bal fig) 5,661
Closing provision
(¼ x K3,948) 987

7,300 7,300

* The gross profit figure is obtained as a balancing figure, but can be calculated as follows :

K’000 K’000
Gross profit
On sales (¼ x K23,400) 5,850
Less: Cost of losses:

247
Normal 100
Apparent 152
252 x ¾ = (189)
5,661

Note: since no indication is given as to the difference in the Branch stock account
(it could represent reductions in selling prices, loss of stock or loss of cash), the
whole amount has been written off against the branch gross profit i.e. treated as a
normal loss.

Stock invoiced at cost price with a ‘memo’ selling price column

The rather artificial selling price method is complicated when compared with a
cost price method. The advantage of the above method is that it immediately
reveals stock differences on the Branch stock control account.

One way of obtaining the best of both worlds is to use a cost price method but
keep a ‘memo’ column in the Branch stock account (no longer a stock ‘control’
account) of the selling price. Differences will then be revealed in the ‘memo’
column which can be acted upon by management.

Example

(Same as facts as Example 1 – note, however, the easier bookkeeping.)

C Ltd opened a new branch shop on 1 January. All goods for sale by the shop are
purchased by the head office and invoiced to the branch at cost price. Selling
price is cost plus one-third.
The branch banks its takings daily for the credit of the head office. The branch
manager is allowed to take a limited number of credit customers. The following is
for the first three months to 31 March:

K’000
Purchases 10,550
Sales at head office 1,600
Goods invoiced to branch at cost 9,000
Cash sales at branch 8,000
Credit sales by branch 2,000
Goods returned to head office at cost 600
Cash collected from branch debtors 1,800
Branch expenses 1,000
Head office expenses 200

Show by means of ledger accounts, the above transactions in the head

office books where all the records are kept. Prepare C Ltd’s trading and
profit and loss account.
Closing stock at head office K800, 000, at branch K1,035,000.

Solution

248
 Books of C Ltd

New branch stock account

Memo SP Memo SP
only only
K’000 K,000 K’000 K’000
1 Jan Goods sent 1 Jan Cash – Sales 8,000 8,000
to new branch 12,000 9,000 to Debtors – Sales 2,000 2,000
31 Mar 31 Mar Goods sent to new
31 Mar. Gross profit to branch 600
450
profit and loss 31 Mar. Balance c/d
account 2,485 - stock 1,380 1,035
Difference – Memo
only 20 -

12,000 11,485 12,000 11,485

1 Apr Balance c/d 1,380 1,035

Goods sent to New branch account

K’000 K’000

1 Jan New branch stock 1 Jan New branch stock

to – Returns 450 to 9,000
31 Mar 31 Mar
(11) 31 Mar. Purchases 8,550
9,000 9,000

Purchases account

K’000 K’000
1 Jan. Sundries 10,550 31 Mar. Goods sent to
new branch 8,550
31 Mar. Trading
account 2,000

10,550 10,550

Head office sales

K’000 K’000
31 Mar. 1 Jan.
Trading to
account 1,600 31 Mar. Sundries 1,600

249
 New branch debtors

K’000 K’000
1 Jan New branch stock 1 Jan Cash 1,800
to 2,000 to
31 Mar 31 Mar. Balance c/d 200
2,000 2,000
1 Apr. Balance b/d 200

Stocks

K’000 K’000
31 Mar. New branch stock 1,035
Trading account 800 31 Mar. Balance c/d 1,835
1,835 1,835

New branch expenses

K’000 K’000
1 Jan.
to 31 Mar. Profit and
31 Mar. Sundries 1,000 loss 1,000

New branch expenses

K’000 K’000
1 Jan.
to 31 Mar. Profit and
31 Mar. Sundries 200 loss 200

Head office trading account for three months ended 31 March

K’000 K’000
Head office sales 1,600
Opening stock -
Purchases of head office 2,000
Less: Closing stock 800

Cost of head office sales 1,200

Gross profit 400

Branch 2,485
2,885

New branch expenses 1,000

Head office expenses 200

250
 1,200

1,685

Note: the treatment of stock differences. A normal difference is already taken into
account in the Branch stock account. It is thrown up in the ‘memo column’. It is for that
reason that the ‘memo column’ is kept. For abnormal losses:

(a) Loss of cash i.e., gross profit has been earned:

Cr Branch stock account amount lost
Dr Pilferage account amount lost

(b) Loss of stock i.e., gross profit has not been earned.

The entry is as in (a) above but it is the cost of stock which is written off.

Example

Facts as in Example 2 (Chiza Ltd) but no mark-up account is used. The

apparent loss is, however, treated as abnormal for illustrative purpose.

Solution

Branch total debtors account appears the same as in the solution to

Example 2. The difference:
Branch stock account
Memo SP Memo SP
K’000 K,000 K’000 K’000
Opening Stock 4,400 3,300 Sales:
Goods sent to Branch 24,800 18,600 Credit 21,000 21,000
Gross profit to profit and Cash 2,400 2,400
Loss account - 5,775 Goods returned to
head office 1,000 750
Stock stolen 600 450
Normal loss (memo only) 100 Nil
Apparent loss to profit and
Loss account 152 114
Closing stock 3,948 2,961
29,200 27,675 29,200 27,675

The profit and loss account now shows:

K’000
Gross profit of branch 5,775
Less: Cost of abnormal loss 114
5,661

Treating the loss as a normal loss (Example2) the reported profit is:

Gross profit of branch 5,661

251
 Activity
If stock is invoiced to branch at branch selling price, which is cost
plus 25%, what is the selling price of goods costing:
K12m?
K36m?
What is the profit element in goods whose selling price is:
K55m?
K45, 385, 000?
In Example 2 what would be the branch gross profit if goods were
invoiced to and sold by the branch at cost plus 25%,closing stock at
28 February 19X7 was K3, 950, 000 and all other information
remained the same?

Activity solution
(a) (i) K15m
(ii) K45m
(iii) K11m
(iv) K9, 077, 000

(b) K 4, 480, 000

3. TWO SETS OF BOOKS

Introduction

Where proper books of accounts are kept at each branch e.g., in branches of
banks or insurance companies, each branch will control its own assets and
compute its own profit.

It is not then necessary for the head office to keep branch stock control
accounts or compute branch gross profit. However, new accounting problems
do arise at the end of the accounting period.

The preparation of final accounts on working papers.

The accounts which could be prepared from the set of books kept at head
office would only show details of head office income and expenditure and
head office assets (including advances to each branch). This would not be

252
 very meaningful. The accounts of the organization as a whole should show the
total assets and liabilities and the income and expenditure of the head office
and all the branches. These items must be gathered from two or more sets of
books. This is done by the accountant on working papers prepared, normally
at head office, from total balances sent in by the branch accountants. A
number of balances in the different sets of books are equal and opposite and
must be contra out in the working papers.

In this text we look at the position of understandings with one branch but in
practice there may be a hundred or so. The following accounts must be made
in relation to contra enties:

In head office books In branch books

Branch current account Head office current account (credit –this

(debit – an investment) is the branch’s ‘capital’ account)

Goods sent to branch accounts (credit) Goods from head office account (debit)

When the trial balances arrive at head office these four accounts may not be
equal and opposite. The head office accountant must examine the make-up of
the balances concerned and where necessary amend his books so that the
contra can be made. The normal reason for differences is that goods or cash
are, at the accounting date, in transit between head office and branch. They
will then have been entered in the books of the dispatching party at the
balance sheet date but will not be recorded by the receiving party until the
early days of the new accounting period. The head office accountant must
adjust for this by opening ‘in transit’ accounts in his books.

Another complication arises where the head office invoices stock to its
branches at a profit to itself. Where the stock is unsold at the balance sheet
date, the head office must make proper provision for this unrealised profit.
This provision will be created in the head office books as it is in those books
that the ‘paper’ profit has been taken. When the accounts of the head office
and branch are prepared, this provision in the head office books can be
conveniently deducted from the closing stock at branch to reduce it to ‘cost’
price.

Alternatively, the provision for unrealised profit could be maintained

permanently in each branch’s books, with the year end provision being offset
against the branch’s closing stock valued at cost to the branch. Such a
treatment is seen in some examination questions but is less common than
seeing the provision in the head office books. It is usually agreed that the
provision should be in the head office books since it is the head office which
has booked profits in its profit and loss account which are unrealised from a
combined viewpoint.

The preparation of the accountant’s working papers is something with which

you must be familiar. The method is indicated in the following sections.

253
The balance sheet

The balance sheet of a head office and its branch as at the same date look as follows :

Head office books.

Head office – Balance sheet.

K’000 K’000

Fixed assets 80
Branch account 40

Current assets 30
Current liabilities 10

20
140
Capital 100
Profit and loss account 40

140

Branch books
Branch – Balance sheet
K’000 K’000

Fixed assets 30

Current assets 20
Current liabilities 10

10
40

Head office account 40

Combined balance sheet

Head office and branch – Balance sheet

K’000 K’000

Fixed assets 110

Current assets 50
Current liabilities (20)

30

140

254
 Capital 100
Profit and loss account 40

140
Notes:

The branch account (in head office books) and the head office account (in branch
books) represent the two records of the one current account. The balances on the
two accounts should be equal and opposite. Provided that they are so, preparation
of the combined balance sheet is simple:

contra branch and head office accounts;

Combine all other items.

The branch account (in the head office books) should always show a debit balance.
It represents the investment by the head office in the branch.
It records all transactions between branch and head office.

The head office account (in the branch books) should always show a credit balance.
It represents the capital of the branch.
It records all transactions between branch and head office.

The office may be a sole trader, partnership or limited company. Knowledge of the
correct accounting treatment of each type of business unit will therefore be
required in this sort of problem.

To save time an alternative presentation of the three balance sheets would be in

columnar form.

Any provision for unrealized profit on branch stock that will be raised in head office
books if goods are invoiced to branch at more than cost price (see below) will
appear in the head office balance sheet under current liabilities, but will be
deducted from stock in the combined balance sheet. This will reduce branch stock
to cost for the purpose of the combined balance sheet.

The balances on the branch and head office accounts may not agree if there are, at
that date, items in transit between head office and branch. The accounts must be
brought into agreement before combined final accounts can be produced:

Cash in transit:

Dr Cash in transit
Cr Branch account
Goods in transit:

Dr Goods sent to branch

Cr Branch account - at invoice price

Also add these goods to head office closing stock at cost.

255
 It should be noted that the treatment of items in transit is always in the head office
books. Treatment of cash in transit introducing a new asset for balance sheet
purposes. The treatment of goods in transit reverses the original entry when the
goods were invoiced to the branch. Thus the assumption is made that goods in
transit at the year end have never left head office. To complete this reversal the
goods concerned must be added to head office closing stock, valued at cost.

Trading and profit and loss accounts

Head office trading and profit and loss account will show, in addition to sales,
goods sent to branch at invoice prices. These goods may be invoiced at cost which
raises no problems, or at cost plus some profit (usually equivalent to wholesale
price). To the extent that goods invoiced to branch at wholesale price remain
unsold at the year end, the head office will have taken credit for unrealised profit.
This amounts to the mark-up on the goods sent from head office that form part of
branch closing stock. Therefore:

Dr Head office profit and loss account

Cr Provision for unrealised profit on branch stock account.

With the amount needed to adjust the opening provision to the ‘profit mark up’ in
branch closing stock.

Branch trading and profit and loss account will add to outside purchases the goods
received from head office at invoice price to the branch.

Combined trading and profit and loss account must relate to the business as a
whole, ignoring goods transferred between branch and head office, and removing
profits earned by such transfers. Therefore:

(i) Goods sent to branch and goods received from head office contra out.
(ii) Opening stock figures for branch and head office; and
Closing stock figures for branch and head office; and
gross profit figures for branch and head office
will not cross-cast to the combined figures if goods are invoiced at cost
plus some profit.
(iii) Net profits must cross-cast.

Example

Head office Branch Adj Combined

K’000 K,000 K’000 K’000 K’000 K’000 K’000

Sales 45,000 14,000 59,000

Goods sent to branch 9,000 contra

Opening stock 10,000 3,000 (1,000) 12,000

Purchases 50,000 - 50,000

256
Goods from
Head office 9,000 contra
Closing stock (12,000) (4,500) 1,500 (15,000)

48,000 7,500 47,000

Gross profit 6,000 6,500 (500) 12,000

Office expenses 1,000 500 1,500
Provision for
unrealised profit 500** - (500) - .

1,500 500 1,500

Net profit 4,500 6,000 10,500

Goods have been consistently invoiced to the branch at wholesale price, cost plus 50%
i.e., extra provision is 1/3 x (4,500 – 3,000) = 500**. The unrealised profit in opening
stock is 1/3 x 3000 and closing stock is 1/3 x 4,500.

Example of final accounts

The trial balances at 31 December 19X9 of the head office of Besa Ltd and of
its branch in Ndola are as follows:

Dr Cr
Head office Branch Head office
Branch
K’000 K,000 K’000 K’000
Share capital 10,000
Profit and loss account 9,100
Stock 15,000 7,000
Creditors 6,300 1,500
Debtors 11,000 5,000
Sales 90,000 40,000
Purchases 60,000 20,000
Office expenses 19,000 4,400
Fixtures and Fittings:

257
 Cost 10,000 6,000
Depreciation 4,000 1,200
Goods sent to branch 12,200
Goods from head office 10,000
Cash and bank 4,000 1,000
Branch account 12,900
Head office account 10,700
Provision for unrealised profit 300

131,900 53,400 131,900 53,400

The following information is given:
Goods are invoiced by head office to the branch at cost plus 10%.
Stocks at 31 December 19X9 are head office K12m; branch K8m ( including
goods from head office at invoice price K5.5m).
Branch opening stock includes goods from head office at invoice price
K3.3m.
Goods at invoice price K2.2m are in transit from head office to branch at the
year end.
Fixtures and fittings are depreciated at 10% pa on cost.

You are required:

to prepare the trading and profit and loss account, in columnar form, for head
office, branch and Besa Ltd for the year ended 31 December 19X9; and
to prepare the balance sheet at 31 December 19X9.

Solution

(a) Head office Branch Adj Combined

K’000 K,000 K’000 K’000 K’000 K’000 K’000

Sales 90,000 40,000 130,000

Goods sent
to branch (W1) 10,000

Opening stock (W3) 15,000 7,000 (300) 21,700

Purchases 60,000 20,000 80,000
Goods from
Head office 10,000
Closing stock (W3) (14,000) (8,000) 500 (21,500)

61,000 29,000 80,200

Gross profit 39,000 11,000 (200) 49,800

258
Office expenses 19,000 4,400 23,400
Depreciation 1,000 600 1,600
Provision for
unrealised
profit (W2) . 200 - (200) - .

20,200 5,000 25,000

Net profit 18,800 6,000 24,800

(b) Balance sheet as at 31 December 19X9

K’000 K’000
Fixed assets:
Fixtures and fittings at cost 16,000
Less: Accumulated depression 6,800
9,200
Current assets:
Stock 21,500
Debtors 16,000
Cash and bank 5,000
42,500
Current liabilities: Creditors 7,800
34,700
43,900

Share capital 10,000

Profit and loss account (9,100 + 24,800) 33,900
43,900
WORKINGS
(W1) Ensure agreement of:
(i) branch and head office accounts;
(ii) goods sent to branch account and goods from head office account.
Make any adjusting entries required in the head office books.
Branch account
K’000 K’000
Balance b/d 12,900 Goods sent to branch accounts 2,200
Balance c/d 10,700
12,900 12,900
Goods sent to branch account
K’000 K’000
Branch account 2,200 Balance b/d 12,200
Balance c/d 10,000

12,200 12,200

The stock is treated as if it had not left head office and therefore included in head
office closing stock at cost:

100/110 x 2,200 = K2m

259
 (W2) Increase in provision for unrealised profit in stock held at branch:

K’000
Closing 10/100 x 5,000 500

Opening 10/110 x 3,300 300 (as shown in trial balance)

Profit and loss for year 200

(W3) Stock:
Opening Closing
K’000 K’000
Per head office 15,000 12,000
Stock in transit at cost - 2,000

Total for head office 15,000 14,000

Total for branch 7,000 8,000

22,000 22,000
Less: Unrealised profit per (2) above 300 500

Combined total at cost 21,700 21,500

Introduction of branch profit into head office books

Although the accounts of the undertaking would be prepared on working papers as shown
in the previous sub-section, the closing entries must be made in head office and branch
books as follows:

Branch books

The branch profit and loss account is prepared in the branch ledgers and the profit
thereon transferred to the branch’s capital account i.e., Head office account in the
branch books. The branch books are now ruled off but the Head office account
will exceed the branch account in head office books by the branch profit.

Head office books

The branch profit is introduced into the head office books:

Dr Branch account (say) K6,000

Cr Profit and loss account (say) K6,000

260
 being branch profit for the year.

Profit and loss account

K’000 K’000
Head office profit b/d 18,800
Branch profit 6,000

Combined profit per working

Papers 24,800

(See example of final accounts above)

The head office account now agrees with the branch account and the profit and
loss account in the head office books shows the combined profit of head office
and branch.

Summary of bookkeeping for branch transactions

Item Head office books Branch books

1 Goods from head Debit Branch account Debit Goods from HO

office to branch Credit Goods sent to branch account
account Credit Head office account

2 Cash from branch to Debit Cash book Debit Head office account
head office Credit Branch account Credit Cash book

3 Profit of branch for Debit Branch account Debit Profit & loss account
period Credit Profit & loss a/c of head of branch
office Credit Head office account

4 Items in transit at Debit Goods sent to branch a/c

end of period Debit Cash in transit account NO ENTRY
Credit Branch account

5 Expense paid by Debit Branch account Debit Expenses account

Head office on behalf Credit Cash book/creditor Credit Head office account
of branch

Activity

What accounting entry is required in head office books for goods sent to branch?
What increase in the provision for unrealised profit in head office books is required in
the following cases?
(i) (ii)

261
 K’000 K’000

Branch opening stock of goods from head office 12,000 99,000

Branch closing stock of goods from head office 15,000 112,000

assuming that stock is consistently invoiced at cost + 20%

What does the closing balance on the branch account in the head office books
represent?

3.11 Activity solution

(a) Dr Branch current account

Cr Goods sent to branch

(b) (i) K400,000

(ii) K2, 250,000

(c) The net assets of the branch.

CHAPTER SUMMARY

In this chapter we have looked at the problems of preparing accounts for a business
which conducts its activities through one or more branches. You need to be familiar both
with the case where all accounting records are maintained by head office, and with the
case where individual branches maintain their own accounts.

SELF TEST QUESTIONS

What is the difference between the two alternative methods of branch accounting?(1.1)

Where all the accounting entries are made in the head office books, what three ledger
account must the head office open for each branch? (2.2)

What is represented by the closing balance on the branch mark-up account?(2.2)

Where each branch keeps its own books of account, what is represented by the balance on
the ‘current account with branch’ in the head office books? (3.3)

Why might a provision for unrealised profit be necessary when combining the head office
and branch accounts? (3.3)

262
 Name two items that might explain the balances on the head office and branch accounts
not being equal and opposite. (3.3)

What is the double entry in the head office books at the year end for expenses paid by the
head office on behalf of the branch? (3.9)

What is the double entry in the branch books at the year end for cash still in transit to the
head office? (3.9)

EXAMINATION TYPE QUESTIONS

Kwabilo

Kwabilo is the proprietor of a driving business in Lusaka. He owns a shop which sells
handbags, cases and various leather goods. The business is organized from offices above
the shop, with ample storage space in the warehouse at the rear of the premises. Kwabilo
seeks to expand his business and has opened a branch shop in Ndola.

Sales are on cash or credit terms. Credit customers settle their accounts through the office
in Lusaka. This office maintains all the accounting records for the business. Kwabilo
undertakes the buying of goods, which are then charged out from the stores to the branch
at selling price i.e., cost plus 25% mark up.

The Branch Manager is responsible for banking cash takings on a daily basis, and is
permitted to use cash received from sales to meet local expenses and pay the shop wages
each week.

The Branch account is balanced monthly.

The following figures relate to the Ndola Branch for November 19X4, and are shown at
selling prices.
K’000
Balances at 1 November:
Branch Stock 21,620
Branch Debtors 14,270
Transactions during November:
Goods transferred to branch from store 119,330
Goods returned to store from branch 1,245
Cash banked in Ndola 54,837
Credit sales in Ndola 65,241
Damaged stock written off at Ndola 315
Credits sales returned by customer to Ndola 916
Receipts from Ndola credit customers banked in Lusaka 58,793
Branch expenses paid in Ndola 3,432
Branch wages paid in Ndola 1,920
Stock taken on 30 November at Ndola (at selling price) 13,500
Branch expenses paid by Lusaka office 14,861

263
 Bad debts written off Ndola branch debtors 1,815

Provision is to be made for a commission of 1% of branch gross profit to the Branch

Manager.

You are required:

(a) to write up the appropriate ledger accounts for the above transactions of the Ndola
Branch in the Head Office ledger. (17 marks)
(b) to advise Kwabilo of four possible reasons for any stock loss that has been shown up
by the accounts. (6 marks)
(Total: 23 marks)

Nyeleti Ltd
Nyeleti Ltd has a head office in Aytown and operates a branch in Beetown. The trial
balance at 30 April 19X8 showed the following:

Head office Branch

K’000 K,000 K’000 K’000
Share capital 60,000
Creditors 8,600 320
Debtors 11,400 1,920
Bank balance 10,800 3,400
Fixed assets 18,000 10,800
Stock at 30 April 19X7 at cost 14,000 9,780
Sale 100,000 50,000
Purchases 118,000
Retained profits 1,800
Expenses 11,800 9,620
Current account
Head office 24,000
Branch 22,000
Goods sent to branch 37,600 36,800
208,000 208,000 72,320 72,320
Further information obtained is:
Provision for depreciation of 10% per annum is charged on fixed assets.
Stock at 30 April 19X8, valued at cost, was at head office K14.4m and at the branch
K8.08m.
Cash in transit to head office was K1.2m.
Directors proposed a dividend of 10% of share capital.
You are required to:
Produce the following financial statements:
(a) trading and profit and loss account for the year ended 30 April 19X8 in columnar
form for the head office, the branch and the combined business; (8 marks)
(b) balance sheet at 30 April 19X8 for the company. (7 marks)
(Total: 15marks)

ANSWERS TO EXAMINATION TYPE QUESTIONS

Kwabilo
(a) Branch stock account
K’000 K’000

264
Opening stock b/d 21,620 Goods sent to
Goods sent to Branch – Returns 1,245
Branch 119,330 Branch Debtors
Branch Debtors Credit sales 65,241
Returns 916 Cash
Banked 54,837
Wages 1,920
Expenses 3,432
Branch Mark up –
Damaged stock 315
Stock Loss (bal fig) 1,376
Closing Stock c/d 13,500
141,866 141,866

Goods sent to branch

K’000 K’000
Branch Stock – Returns 996 Branch Stock 95,464

100/125 x 1,245 100/125 x 119,330

Trading account 94,468

95,464 95,464

Branch debtors
K’000 K’000
Balance b/d 14,270 Branch Stock – Returns 916
Branch Stock 65,241 Cash – Lusaka 58,793
Profit and loss – Bad debts 1,815
Balance c/d 17,987
79,511 79,511

Branch mark up account

K’000 K’000
Bal b/d
Branch Stock – returns Unrealised profit on stock
25/125 x 1,245 249 21,620 x 25/125 4,324
Branch Stock – Branch Stock
Damaged stock 315 25/125 x 119,330 23,866
Gross profit to Profit and loss 24,926
(Bal fig)
Bal c/d Unrealised Profit
25/125 x 13,500 2,700
28,190 28,190

265
 Extracts from head office profit and loss account
for the month to 30 November 19X4

K’000 K’000
Gross profit for Branch 24,926
Stock loss 1,376
Expenses – cash 3,432
Wages 1,920
Expenses – Lusaka payments 14,861
Bad debts 1,815
Commission 1% x 24,926 249
23,653
Net profit of Branch 1,273

(i) Goods stolen by staff or customers

(ii) Cash stolen by staff.
(iii) Errors in counting stock
(iv) Some stock not sold at 25% mark-up.
Stock payments made out of cash prior to banking not properly recorded.
Stock count did not tie in with deliveries to the branch.
(Tutorial notes:
Alternative answers for this question are:
Damaged stock
The cost of the damaged stock could have been charged to Head office profits and loss
account by:
K’000 K’000
Cr Branch Stock acc 315
Dr Mark-up a/c
25/125 x 315 63 (Lost profit)
Dr HO profit and loss a/c 252
100/125 x 315
315

The eventual net profit will be the same.

Commission is dependent on the definition of gross profit.
Extracts from Head Office profit and loss account.

This has been included as it is a ledger account which has relevant entries relating to the
branch. Alternatively a branch profit and loss account could have been prepared, with the
net profit being transferred to the Head Office profit and loss account.

Nyeleti Ltd.

Trading and profit and loss account for the year ended 30 April 19X8

Aytown Beetown
head office branch Total
K’000 K,000 K’000 K’000 K’000 K’000
Sales 100,000 50,000 150,000

266
Goods sent to branch 37,600

137,600
Cost of sales
Opening stock 14,000 9,780 23,780
Purchases/goods
From HO 118,000 36,800 118,000

132,000 46,580 141,780

Closing stock (W) 14,000 8,080 23,280
117,600 38,500 118,500
Gross profit 20,000 11,500 31,500
Less: Expenses
Depression 1,800 1,080 2,880
Other expenses 11,800 9,620 21,420
13,600 10,700 24,300

Net profit 6,400 800 7,200

Retained profit brought forward 1,800
9,000
Proposed dividend 6,000
Retained profit carried forward 3,000

CHAPTER 25

CONSIGNMENT ACCOUNTS

Objective
When you have completed this section you should be able to understand and perform
basic consignment calculations between consignor and consignee

1 Introduction
A business may not always find it possible to sell goods directly to its customers,
especially exports, unless the volume of sales justifies such a course of action.
This can be overcome by having to appoint a selling agent in that country or place
concerned. The agent is then responsible for organizing all aspects of marketing
the goods and collection of cash from customers and is remunerated on a
commission basis.
2.1 General principles

267
 Goods sent to an agent are usually dispatched in bulk and are termed as a
consignment. The party sending the goods is the consignor and the agent is the
consignee.
Both parties incur expenses in connection with the consignment. Periodically, the
consignee sends an Account Sales to the consignor. This is a document which
shows the sales made by the consignee, along with his expenses and commission.
A banker’s draft for the net balance may accompany the Account Sales.
The act of consigning goods to an agent does not constitute a sale by the
consignor but merely a transfer of location of the goods concerned. Ownership of
such goods remains vested in the consignor although they are in the possession of
the consignee.
The sale arise when the goods are sold by the consignee to the third parties.

2.2 Accounting entries – The consignor’s books

Transfers of goods are recorded by debiting a Consignment to (name of agent)
account and by crediting a good on consignment account. This procedure is
similar to that of certain branch accounting transactions whereby the movement of
goods from head office to branch is recorded as transfer, not as a sale.

The closing balance of Goods on Consignment is debited at the end of the period
and is credited to Trading Account to prevent distortion of the gross profit figure
on non-consigned goods which appears in that account.

The consignor debits the expenses which he incurs in connection with the
consignment to the Agent account, the opposite entries appearing in Bank, Cash,
Payables etc, as appropriate.

On receipt of the Account Sales the consignee’s expenses and commission are
debited to the Consignment to Agent account and sales are credited. The opposite
entries are posted to a personal account opened in the name of the agent.

At the end of the accounting period unsold stock in the agents possession is
valued and credited in the Consignment to Agent account to be carried down as a
debit at the start of the next accounting period.

Valuation of stock:
In arriving at the closing valuation, only amounts relating to unsold stock are
included; therefore the agent’s expenses incurred on the incoming consignment
are included but certain items of a marketing nature are excluded from the
calculation on the grounds that they relate to the goods which have been sold and
to those remaining unsold.

Closing stock value therefore comprises the aggregate of the initial cost of the
goods plus the attributable costs of both the consignor and consignee.

2.3 Example
Chembo consigned 4 crates, each containing 30 identical cycles, valued at
K3,000,000 to his agent Kanga on 1 April 2001.
Insurance and transport costs paid by Chembo amounted to K300,000 and
K500,000 respectively.

268
 Kanga paid insurance of K400,000, storage charges of K600,000 and
delivery charges of K100,000.
By the end of that quarter, Kanga had sold 90 of the cycles for
K14,400,000. He sent a cheque for the amount due after deducting
his agreed sales commission of 10%.

Required:
Prepare the appropriate accounts for the June 2002 quarter in Chembo’s ledger.

Solution

Chembo’s books
Goods on Consignment
K’000 K’000
Trading 12,000 Consignment to Kanga 12,000

Consignment to Kanga (part)

K’000 K’000
Goods on consignment 12,000 Balance c/d 12,800
Bank – Insurance 300
- transport 500
12,800 12,800

At this stage these are the only entries which Chembo is able to post.
Subsequently to receiving details from Kanga on the Account Sales he is able to
proceed as follows:

Consignment to Kanga (continuation)

K’000 K’000
Balance b/d 12,800 Kanga – sales 14,400
Kanga – Insurance 400 Stock c/d (W1) 3,450
- delivery 100
- storage 600
- commission 1,440
Profit and loss 2,510
17,850
17,850
Sock b/d 1,725

Workings (W1):
Goods 12,000
Insurance 300
Transport 500
Insurance 400
Storage 600

269
 13,800 x 30 = 1,725
120

Kanga
K’000 K’000
Consignment to Kanga 14,400 Consignment to Kanga
- insurance 400
- Storage 600
- delivery 100
- commission 1,440
Bank – settlement 11,860
14,400 14,400

2.5 Consignees books

On receipt of the consignment, the consignee makes a memorandum
record of quantities etc, but does not record their value in his
ledger.
However he opens an account in the name of consignor to which he debits
all the expenses which he incurs in connection with the
consignment, together with his commission on sales. Sales are credited to
this account.
2.6 Example
Facts as in the previous exercise you are required to prepare appropriate
account in Kanga’s ledger:

Chembo
K’000 K’000
Bank – insurance 400 Receivables – sales 14,400
- delivery 100
- storage 600
Commission received 1,440
Bank – settlement 11,860
14,400
14,400

Index

A Allowed alternative treatment 71

Amalgamation 12
A statement of recognised gains and
Amortisation 118, 122
losses 38
Anti dilution 91
Accounting policies 62
Application 189
Accrual 31
Appropriation account 1
Accrual Basis of accounting 230
Actuarial method 128
B
Adjusting event 166
Admission of a partner 7 Balanced scorecard 178
Allotment 189 Basic earnings per share 80

270
Benchmark treatment 71 Dividends yield 177
Biological asset 223
Bonus issue 83 E
Branch Accounting 240 Earnings per share 80
Business segment 60 Equity instrument 80
By Function 36 Event after the balance sheet date 166
By nature 37 External sources 106
C F
Call 189 FIFO method 136
Capital approach 99 Finance lease 124
Capital maintenance 188 Financial 234
Capital redemption reserve 198 Financial instrument 80
Carrying amount 105 Financing activities 49
Cash basis of accounting 230 Forfeiture of Shares 188
Cash equivalents 49 Forgivable loans 98
Cash flow statement 48 Funds Accounting 229
Cash-Generating Units 108
Commitment ledger 231 G
Comparative 31
Consignee 267 Geographical segment 60
Consignor 267 Going Concern 31
Consistency 31 Goodwill 10
Consolidated balance sheet 207 Government grants 98
Consolidated financial statements 203 Grants related to assets 98
Construction contracts 141 Grants related to income 98
Constructive obligation 151 Group 203
Contingent asset 150
H
Contingent liability 150
Contingently issuable shares 91 head office 254
Conversion of partnership 20 Highly Indebted Poor Countries 232
Convertible loan stocks 86 Historical cost accounting 188
Convertible preference share 86
Current accounts 214 I
IAS 1 37
D IAS 10 166
Death 9 IAS 11 141
Depreciable amount 69 IAS 14 60
Depreciable asset 69 IAS 16. 69
Dilative potential ordinary shares 91 IAS 17 124
Diluted EPS 86 IAS 2 135
Direct method 49 IAS 20 98
Discount Rate 107 IAS 27 203
Disposals of assets 73 IAS 33 80
Dissolution of partnership 17 IAS 36 105
Distributable Profits 190 IAS 37 149
Dividend Cover 177 IAS 38 114
Dividend per share 177 IAS 41 223
Dividends 168 IAS 7 48

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IFRS 3 122 Pre-acquisition profits 222
Impairment 105 Premiums 98
Impairment loss 105 Probable 155
Income approach 99 Provision 150
Income Statement 35 Public Debt Management 232
Indirect method 49
Intangibles 114 R
Inter-company items 213 Ratio analysis 172
Interest on drawings 2 Recoverable amount 105
Internal sources 106 Redemption of Shares 192
Interpretation of accounts 171 Remote 155
Inventories 135 Reportable segment 61
Investing activities 49 Reporting Period 32
Repossessions 128
J Retirement 9
Joint venture 199 Revaluation 72
Rights issue 84
L
Lessee 125 S
Lessor 126 Sale and Leaseback 129
LIFO method 136 Segment assets 62
Segment expenses 61
M Segment reporting 60
Materiality 31 Segment revenue 61
Merger 12 Segments accounting policies 62
Method’s of depreciation 72 Segments liabilities 62
Minority Interest 210 Share split 83
Statement of Changes in Equity 37
N Subsequent expenditure 71
Subsidiary 203
Negative goodwill 122 Subsidies 98
Non current assets 69 Subventions 98
Non-adjusting event 166
Non-Financial 234 T
Notes 39
Theoretical ex – right price 84
O Timeliness 32
Offsetting 31 U
Operating activities 49
Operating leases 124 Useful life 69
Options 80
Ordinary share 80 V
Value in use 106
P Virtually certain 155
Parent 203
Part cancellation 208 W
Partnership accounts 1 Warrants 80
Partnership Act 1890 3 Weighted average method 136
Permissible capital payment 193

272
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