Business Management Sciences and Economics

Faculty

Finance and Accounting Department

ACCN 101: Business Accounting

Study Notes

Finance and Accounting Department, UZ.

Lecturer: MR. [Link]
Contact Details:
E-mail: ssabawu@[Link]
Cellphone: +263 776 028 823

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 UNIT ONE

ACCOUNTING AS AN INFORMATION SYSTEM

1.1 Accounting

Of the several available definitions of ‘accounting’, the one developed by the American
Accounting Association is perhaps the most comprehensive (Anthony et al, 2007):

Accounting is the process of identifying, measuring and communicating economic

information about an entity to permit informed judgments and decisions by users of the
information.

An analysis of the definition leads to the following questions:

What is the process?

How is economic information identified?
How is economic information measured?
How is economic information communicated?
What is an entity?
Who are the users of economic information about an entity?
What types of judgments and decisions do these users make?

Accounting is a financial information system and can be viewed as a link between an

entity’s economic activities and the decision makers. As such, the answers to the above
questions constitute the content of this course.

The users of economic information about an entity can be classified into two major
categories, that is, internal users and external users. These two user groups have different
information needs because of their different relationships to the entity providing the
information. Accordingly, two major branches of accounting have evolved to meet the
different information needs of the internal users and external users, that is, management
accounting and financial accounting, respectively. The two branches of accounting have
different objectives, as they provide information with which to make different decisions.
All the information, however, comes from the same data base. The differences lie in the
selection and presentation of the communicated information.

Financial accounting is concerned with providing economic information about an entity

to external users. It makes available economic information about an entity by means of
‘general purpose’ financial statements, that is, the statement of financial position (balance
sheet), statement of profit or loss and other comprehensive income (income statement),
statement of changes in equity, statement of cash flows (cash flow statement) and notes
to the financial statements. Such general purpose financial statements provide a report on

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management’s handling of the activities of the entity for a limited, already expired
period. Accordingly, the information provided is a review of past financial performance
and current financial position. The report is prepared in accordance with certain external
standards which are widely known as generally accepted accounting principles (GAAP).

Management accounting is concerned with providing economic information about an

entity to internal users. The information is used by management in the planning and
control of the activities of the entity. The information is in the form of ‘specific purpose’
reports which are future oriented. Historical information is used only in so far as it is
necessary and useful in planning and decision-making. Planning and decision-making are
future oriented activities, not historical.

The major differences between financial accounting and management accounting are
summarized in the table below:

Financial accounting Management accounting

1. Provides economic information to 1. Provides economic information to
external users internal users
[Link] general purpose financial 2. Generates specific purpose statements
statements and reports
3. Reports on financial effects of past 3. Set up for future oriented reports
events
4. Must conform to external standards 4. Not subject to external standards
5. Uses objective data 5. Uses subjective data.

1.2 Forms of business entities

Business entities can be classified in terms of their form of ownership. The form of
ownership has legal implications which affect economic decisions by stakeholders. The
common forms of ownership encountered are sole proprietorships, partnerships,
companies and non-profit organizations.

Sole proprietorship
A sole proprietorship is a business owned by one person who operates it for his own
profit. At law, the business is not regarded as a separate legal entity, that is, there is no
separation between the business and the owner. As a result, the business will cease to
exist on the retirement or death of the owner. In addition, the sole proprietor has
unlimited liability, which means that his total wealth, not merely the amount originally
invested, can be taken to settle business debts. However, for accounting purposes, the
business is regarded as a distinct entity separate from the owner.

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Partnership
A partnership is a business owned by two or more people who operate it for profit. The
law does not recognize a partnership as a separate legal entity. Accordingly, a partnership
cannot enter into contracts in its own name, but must do so through the individuals who
make up the partnership, and the partnership ceases to exist on the death, retirement, or
admission of a partner. However, for accounting purposes, the partnership is regarded as
a distinct entity separate from the owners.

Most partnerships are established by a written contract known as a partnership

agreement/deed, although this is not obligatory. In a general partnership, all partners have
unlimited liability. In a limited partnership, one or more partners can be designated as
having limited liability, as long as at least one partner has unlimited liability. A limited
partner is usually prohibited from being active in the management of the entity.

Company
A company, or a corporation, is a form of business entity that is created by law as a
distinct legal person separate from the owners. Accordingly, it has the powers of an
individual in that it can sue and be sued, make and be party to contracts and acquire
property in its own name. It has a perpetual existence which is unaffected by changes in
the membership of the company. It has limited liability, which means that the owners are
only liable for the debts of the company up to the amount which they have agreed to
contribute.

There are two types of companies, that is, a private limited company and a public limited
company. A public limited company can offer its shares to members of the public, where
as a private limited company cannot.

Other forms of entities

Other forms of entities are co-operatives and non-profit organizations, such as charitable
organizations and clubs.

1.3 Separate entity concept

In accounting, a business is treated as a distinct entity separate from its owners. This is
known as the separate entity concept. Accordingly, every business for which separate
financial records are kept is an accounting entity. It is important to see the business as a
separate entity because transactions entered into by the business have to be dealt with
from the point of view of the entity whose books are being done, not from the point of
view of the owners.

A company, by law, is a legal person separate from its owners, the ordinary shareholders.
The separation in the financial statements of a company, as a business entity, from its
shareholders is, therefore, supported in concept by legal reality. Although the partnership
and sole proprietorship businesses are not legal persons, the separate entity concept is
applied in accounting.

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1.4 Importance of accounting information
Accounting information connects organizational structures of an entity. It supports
decision-making by a wide range of users. It is used by managers to draw up plans and
monitor implementation of those plans. Performance analysis of an entity is important in
SWOT analysis

Accounting information can provide management with answers to questions, such as:

• What are the future prospects of the entity?

• What can be done to improve the future prospects of the entity?
• Does/will the entity have adequate cash resources?
• What are the costs of producing a specific asset?
• Which one of the alternatives available is the most effective?

1.5 Ethics in accounting

Several definitions related to ethics can be considered:

• Ethics refers to a system or code of conduct based on moral duties, values and
obligations that indicates how we should behave within a constituted body or
society.
• Ethical behavior refers to conducts in organizations considered to be fair, just,
above and beyond constitutional law and relevant regulations.
• Professional ethics can be defined as a set of principles or rules which stipulates
in broad terms the responsibilities of a profession to clients, colleagues and the
society in general.

Importance of professional ethics in accounting:

• Protection of clients and the professionals alike

• Clarifies the ideals and responsibilities of the profession
• Enhancement of the profile of the profession
• Motivates and inspires practitioners
• Provides guidelines on acceptable conduct
• Raises the level of awareness and consciousness on issues
• Improves quality and consistency

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1.6 Questions

Question 1

The definition of ‘accounting’ makes reference to users of economic information about

an entity. Identify any four primary users of such economic information. What are the
information needs of these users?

Question 2

Compare and contrast the two major branches of accounting. Which one provides more
relevant economic information about an entity to users?

Question 3

Identify the three common forms of business ownership which have the objective of
making a profit. Outline the legal relationships between the entities and their owners.
What effect do these relationships have on the recording of financial effects of
transactions, events or conditions?

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 UNIT TWO

FINANCIAL REPORTING

2.1 Conceptual Framework for Financial Reporting

The Conceptual Framework for Financial Reporting is an IFRS Framework that can be
regarded as a constitution for financial accounting and reporting. The Conceptual
Framework sets out the objectives and concepts which underlie the preparation and
presentation of financial statements. To ensure the provision of information that is useful
in making economic decisions, it establishes the basis for determining which events
should be reported, how they should be measured and the format in which they should be
communicated to users. The specific objectives of the Conceptual Framework can be
summarized as follows:

• To assist the IASB in the development of IFRSs.

• To provide the basis for reducing the number of alternative accounting treatments.
• To assist national accounting standard setting bodies in the development of
national accounting standards.
• To assist the preparers of annual financial statements in applying IFRSs and in
dealing with topics that have yet to form the subject of an IFRS.
• To assist auditors in forming an opinion as to whether the financial statements
comply with IFRSs.
• To assist users of annual financial statements to interpret the information
contained therein.
• To provide interested parties with information on how the IASB approaches the
formulation of IFRSs.

A summary of the IASB Framework is given below.

2.1.1 History of the Framework

Framework for the Preparation and Presentation of Financial
April 1989
Statements (the Framework) was approved by the IASC Board
July 1989 Framework was published
April 2001 Framework adopted by the IASB.
Conceptual Framework for Financial Reporting 2010 (the IFRS
September 2010
Framework) approved by the IASB

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 2.1.2 Purpose and status of the Framework

The IFRS Framework describes the basic concepts that underlie the preparation and
presentation of financial statements for external users. The IFRS Framework serves as a
guide to the Board in developing future IFRSs and as a guide to resolving accounting
issues that are not addressed directly in an International Accounting Standard or
International Financial Reporting Standard or Interpretation.

In the absence of a Standard or an Interpretation that specifically applies to a transaction,

management must use its judgement in developing and applying an accounting policy
that results in information that is relevant and reliable. In making that judgement, IAS
8.11 requires management to consider the definitions, recognition criteria, and
measurement concepts for assets, liabilities, income, and expenses in the IFRS
Framework. This elevation of the importance of the [IFRS] Framework was added in the
2003 revisions to IAS 8.

2.1.3 The IFRS Framework

[Link] Scope

The IFRS Framework addresses:

• the objective of financial reporting

• the qualitative characteristics of useful financial information
• the reporting entity
• the definition, recognition and measurement of the elements from which financial
statements are constructed
• concepts of capital and capital maintenance

Chapter 1: The Objective of general purpose financial reporting

The primary users of general purpose financial reporting are present and potential
investors, lenders and other creditors, who use that information to make decisions about
buying, selling or holding equity or debt instruments and providing or settling loans or
other forms of credit. [F OB2]

The primary users need information about the resources of the entity not only to assess an
entity's prospects for future net cash inflows but also how effectively and efficiently
management has discharged their responsibilities to use the entity's existing resources
(i.e., stewardship). [F OB4]

The IFRS Framework notes that general purpose financial reports cannot provide all the
information that users may need to make economic decisions. They will need to consider
pertinent information from other sources as well. [F OB6]

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The IFRS Framework notes that other parties, including prudential and market regulators,
may find general purpose financial reports useful. However, the Board considered that
the objectives of general purpose financial reporting and the objectives of financial
regulation may not be consistent. Hence, regulators are not considered a primary user and
general purpose financial reports are not primarily directed to regulators or other parties.
[F OB10 and F BC1.20-BC 1.23]

Information about a reporting entity's economic resources, claims, and changes in

resources and claims

Economic resources and claims

Information about the nature and amounts of a reporting entity's economic resources and
claims assists users to assess that entity's financial strengths and weaknesses; to assess
liquidity and solvency, and its need and ability to obtain financing. Information about the
claims and payment requirements assists users to predict how future cash flows will be
distributed among those with a claim on the reporting entity. [F OB13]

A reporting entity's economic resources and claims are reported in the statement of
financial position. [See IAS 1.54-80A]

Changes in economic resources and claims

Changes in a reporting entity's economic resources and claims result from that entity's
performance and from other events or transactions such as issuing debt or equity
instruments. Users need to be able to distinguish between both of these changes. [F
OB15]

Financial performance reflected by accrual accounting

Information about a reporting entity's financial performance during a period, representing

changes in economic resources and claims other than those obtained directly from
investors and creditors, is useful in assessing the entity's past and future ability to
generate net cash inflows. Such information may also indicate the extent to which general
economic events have changed the entity's ability to generate future cash inflows. [F
OB18-OB19]

The changes in an entity's economic resources and claims are presented in the statement
of profit or loss and other comprehensive income. [See IAS 1.81-105]

Financial performance reflected by past cash flows

Information about a reporting entity's cash flows during the reporting period also assists
users to assess the entity's ability to generate future net cash inflows. This information
indicates how the entity obtains and spends cash, including information about its
borrowing and repayment of debt, cash dividends to shareholders, etc. [F OB20]

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The changes in the entity's cash flows are presented in the statement of cash flows. [See
IAS 7]

Changes in economic resources and claims not resulting from financial performance

Information about changes in an entity's economic resources and claims resulting from
events and transactions other than financial performance, such as the issue of equity
instruments or distributions of cash or other assets to shareholders is necessary to
complete the picture of the total change in the entity's economic resources and claims. [F
OB21]

The changes in an entity's economic resources and claims not resulting from financial
performance is presented in the statement of changes in equity. [See IAS 1.106-110]

Chapter 2: The Reporting entity

The chapter on the Reporting Entity will be inserted once the IASB has completed its re-
deliberations following the Exposure Draft ED/2010/2 issued in March 2010.

Chapter 3: Qualitative characteristics of useful financial information

The qualitative characteristics of useful financial information identify the types of

information which are likely to be most useful to users in making decisions about the
reporting entity on the basis of information in its financial report. The qualitative
characteristics apply equally to financial information in general purpose financial reports
as well as to financial information provided in other ways. [F QC1, QC3]

Financial information is useful when it is relevant and represents faithfully what it

purports to represent. The usefulness of financial information is enhanced if it is
comparable, verifiable, timely and understandable. [F QC4]

Fundamental qualitative characteristics

Relevance and faithful representation are the fundamental qualitative characteristics of

useful financial information. [F QC5]

Relevance

Relevant financial information is capable of making a difference in the decisions made by

users. Financial information is capable of making a difference in decisions if it has
predictive value, confirmatory value, or both. The predictive value and confirmatory
value of financial information are interrelated. [F QC6-QC10]

Materiality is an entity-specific aspect of relevance based on the nature or magnitude (or

both) of the items to which the information relates in the context of an individual entity's
financial report. [F QC11]

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Faithful representation

General purpose financial reports represent economic phenomena in words and numbers,
To be useful, financial information must not only be relevant, it must also represent
faithfully the phenomena it purports to represent. Implicit in faithful representation is
substance over form. This fundamental characteristic seeks to maximize the underlying
characteristics of completeness, neutrality and freedom from error. [F QC12] Information
must be both relevant and faithfully represented if it is to be useful. [F QC17]

Enhancing qualitative characteristics

Comparability, verifiability, timeliness and understandability are qualitative

characteristics that enhance the usefulness of information that is relevant and faithfully
represented. [F QC19]

Comparability

Information about a reporting entity is more useful if it can be compared with a similar
information about other entities and with similar information about the same entity for
another period or another date. Comparability enables users to identify and understand
similarities in, and differences among, items. [F QC20-QC21]

Verifiability

Verifiability helps to assure users that information represents faithfully the economic
phenomena it purports to represent. Verifiability means that different knowledgeable and
independent observers could reach consensus, although not necessarily complete
agreement, that a particular depiction is a faithful representation. [F QC26]

Timeliness

Timeliness means that information is available to decision-makers in time to be capable

of influencing their decisions. [F QC29]

Understandability

Classifying, characterizing and presenting information clearly and concisely makes it

understandable. While some phenomena are inherently complex and cannot be made easy
to understand, to exclude such information would make financial reports incomplete and
potentially misleading. Financial reports are prepared for users who have a reasonable
knowledge of business and economic activities and who review and analyze the
information with diligence. [F QC30-QC32]

Applying the enhancing qualitative characteristics

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Enhancing qualitative characteristics should be maximized to the extent necessary.
However, enhancing qualitative characteristics (either individually or collectively) cannot
render information useful if that information is irrelevant or not represented faithfully. [F
QC33]

The cost constraint on useful financial reporting

Cost is a pervasive constraint on the information that can be provided by general purpose
financial reporting. Reporting such information imposes costs and those costs should be
justified by the benefits of reporting that information. The IASB assesses costs and
benefits in relation to financial reporting generally, and not solely in relation to individual
reporting entities. The IASB will consider whether different sizes of entities and other
factors justify different reporting requirements in certain situations. [F QC35-QC39]

Chapter 4: The Framework: the remaining text

Chapter 4 contains the remaining text of the Framework approved in 1989. As the project
to revise the Framework progresses, relevant paragraphs in Chapter 4 will be deleted and
replaced by new Chapters in the IFRS Framework. Until it is replaced, a paragraph in
Chapter 4 has the same level of authority within IFRSs as those in Chapters 1-3.

Underlying assumption

The IFRS Framework states that the going concern assumption is an underlying
assumption. Thus, the financial statements presume that an entity will continue in
operation indefinitely or, if that presumption is not valid, disclosure and a different basis
of reporting are required. [F 4.1]

The elements of financial statements

Financial statements portray the financial effects of transactions and other events by
grouping them into broad classes according to their economic characteristics. These
broad classes are termed the elements of financial statements.

The elements directly related to financial position (statement of financial position) are: [F
4.4]

• Assets
• Liabilities
• Equity

The elements directly related to performance (statement of profit or loss and other
comprehensive income) are: [F 4.25]

• Income
• Expenses

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The statement of cash flows reflects both statement of profit or loss and other
comprehensive income elements and some changes in statement of financial position
elements.

Definitions of the elements relating to financial position

• Asset. An asset is a resource controlled by the entity as a result of past events and
from which future economic benefits are expected to flow to the entity. [F 4.4(a)]
• Liability. A liability is a present obligation of the entity arising from past events,
the settlement of which is expected to result in an outflow from the entity of
resources embodying economic benefits. [F 4.4(b)]
• Equity. Equity is the residual interest in the assets of the entity after deducting all
its liabilities. [F 4.4(c)]

Definitions of the elements relating to performance

• Income. Income is increases in economic benefits during the accounting period in

the form of inflows or enhancements of assets or decreases of liabilities that result
in increases in equity, other than those relating to contributions from equity
participants. [F 4.25(a)]
• Expense. Expenses are decreases in economic benefits during the accounting
period in the form of outflows or depletions of assets or incurrences of liabilities
that result in decreases in equity, other than those relating to distributions to
equity participants. [F 4.25(b)]

The definition of income encompasses both revenue and gains. Revenue arises in the
course of the ordinary activities of an entity and is referred to by a variety of different
names including sales, fees, interest, dividends, royalties and rent. Gains represent other
items that meet the definition of income and may, or may not, arise in the course of the
ordinary activities of an entity. Gains represent increases in economic benefits and as
such are no different in nature from revenue. Hence, they are not regarded as constituting
a separate element in the IFRS Framework. [F 4.29 and F 4.30]

The definition of expenses encompasses losses as well as those expenses that arise in the
course of the ordinary activities of the entity. Expenses that arise in the course of the
ordinary activities of the entity include, for example, cost of sales, wages and
depreciation. They usually take the form of an outflow or depletion of assets such as cash
and cash equivalents, inventory, property, plant and equipment. Losses represent other
items that meet the definition of expenses and may, or may not, arise in the course of the
ordinary activities of the entity. Losses represent decreases in economic benefits and as
such they are no different in nature from other expenses. Hence, they are not regarded as
a separate element in this Framework. [F 4.33 and F 4.34]

Recognition of the elements of financial statements

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Recognition is the process of incorporating in the statement of financial position or
statement of profit or loss and other comprehensive income an item that meets the
definition of an element and satisfies the following criteria for recognition: [F 4.37 and F
4.38]

• It is probable that any future economic benefit associated with the item will flow
to or from the entity; and
• The item's cost or value can be measured with reliability.

Based on these general criteria:

• An asset is recognized in the statement of financial position when it is probable

that the future economic benefits will flow to the entity and the asset has a cost or
value that can be measured reliably. [F 4.44]
• A liability is recognized in the statement of financial position when it is probable
that an outflow of resources embodying economic benefits will result from the
settlement of a present obligation and the amount at which the settlement will take
place can be measured reliably. [F 4.46]
• Income is recognized in the statement of profit or loss and other comprehensive
income when an increase in economic benefits related to an increase to an asset or
a decrease to a liability has arisen and that increase in economic benefits can be
measured reliably. This means, in effect, that recognition of income occurs
simultaneously with the recognition of increases in assets or decreases in
liabilities (for example, the net increase in assets arising on a sale of goods or
services or the decrease in liabilities arising from the waiver of a debt payable). [F
4.47]
• Expenses are recognized when a decrease in economic benefits related to a
decrease to an asset or an increase to a liability has arisen and that decrease in
economic benefits can be measured reliably and will not result in future economic
benefits flowing to the entity. This means, in effect, that recognition of expenses
occurs simultaneously with the recognition of an increase in liabilities or a
decrease in assets (for example, the accrual of employee entitlements or the
depreciation of equipment). [F 4.49]

Measurement of the elements of financial statements

Measurement involves assigning monetary amounts at which the elements of the

financial statements are to be recognized and reported. [F 4.54]

The IFRS Framework acknowledges that a variety of measurement bases are used today
to different degrees and in varying combinations in financial statements, including: [F
4.55]

• Historical cost
• Current cost
• Net realizable (settlement) value

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 • Present value (discounted)

Historical cost is the measurement basis most commonly used today, but it is usually
combined with other measurement bases. [F. 4.56] The IFRS Framework does not
include concepts or principles for selecting which measurement basis should be used for
particular elements of financial statements or in particular circumstances. Individual
standards and interpretations do provide this guidance, however.

Note:
In answering transaction specific questions based on the Conceptual Framework, only
refer to the criteria of the Conceptual Framework. Assume that the topic or
transaction/event does not form the subject of an accounting standard. Only the criteria of
the Conceptual Framework should provide the basis for the use of judgment in resolving
the accounting issue or problem. The approach to solving a transaction specific problem
is as follows:

1. Identify and define the element(s) e.g. an asset.

2. Apply the definition(s) to the transaction or event.
3. Apply the recognition criteria.
4. Discuss the qualitative characteristics.
5. Discuss the underlying assumption.
6. Conclusion.

Example 2.1

Mr Nharo, the managing director of Alpha Manufacturers Limited, questions the

recognition and disclosure of a finance lease entered into for machinery to the value of
$50 000, which is used in the company’s manufacturing process. He is of the opinion that
it is unnecessary to capitalize the machinery and the corresponding loan. Mr Nharo is
also of the opinion that too much information will be disclosed.
Required:

Explain to Mr Nharo, by only referring to the requirements of the Conceptual Framework

for Financial Reporting, why the finance lease should be capitalized and disclosed as
such.

Suggested answer

Alpha Manufacturers Limited

Capitalization of a finance lease

1. Asset

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(a) Definition of an asset
A resource controlled by an entity as a result of a past event and from which
future economic benefits are expected to flow to the entity.
(b) Applying the definition to the finance lease
• The machinery is under the control of Alpha Manufacturers Limited, as
the finance lease transferred substantially all the risks and rewards
associated with the ownership of the machinery from the lessor to the
lessee.
• The past event is the conclusion of the finance lease contract or
agreement.
• When the goods are manufactured and sold, future economic benefits
will flow to Alpha manufacturers Limited.
• Therefore, the finance lease meets the definition of an asset.

(c) Recognition
• It is probable that future economic benefits will flow to the entity, given
that the machinery is already being used in the manufacturing process
and it can be assumed that the company already has a market for the
goods being manufactured.
• The cost of the asset can be measured reliably i.e. the cash cost of the
machinery can be determined accurately as $50 000.
• Therefore, the machinery should be recognized as an asset in the
statement of financial position of Alpha Manufacturers Limited.

2. Liability
(a) Definition of a liability
A present obligation of the entity arising from a past event, the settlement of
which is expected to result in an outflow from the entity of resources
embodying economic benefits.
(b) Applying the definition to the finance lease
• A present obligation exists in the form of the contract balance, which
is equal to cash cost of asset + interest, i.e. obligation to pay lease
rentals.
• The past event is the conclusion of the finance lease contract or
agreement.
• The settlement of periodic lease installments will result in outflows
from Alpha Manufacturers Limited of resources embodying economic
benefits.

16
 • Therefore, the finance lease meets the definition of a liability, i.e. a
loan arises from the transaction.
(c) Recognition
• It is probable that outflows of resources embodying economic
benefits will result from the settlement of periodic lease installments.
• The amount at which the settlement will take place can be measured
reliably i.e. the contract balance and the periodic lease installments
can be determined with accuracy.
• Therefore, the loan (i.e. liability) arising from the finance lease should
be recognized in the statement of financial position.

3. Qualitative characteristics

(a) Fundamental qualitative characteristics

(i) Relevance
Information must be useful for the formulation of predictions and evaluation
of past predictions by users, i.e. for the assessment of future cash flows, their
timing and their certainty. The relevance of information about the finance
lease is affected by its nature and materiality.

(1) Nature
The nature of the information is defined by the type of lease contract, i.e. a
finance lease which transfers substantially all the risks and rewards
associated with the ownership of the machinery from the lessor to the
lessee.

(2) Materiality
Information is material if its omission or misstatement could influence the
economic decisions of users taken on the basis of the information in the
financial statements. The cash cost of the machinery of $50 000 is material
and so is the amount of the contract balance that will be settled.

As measured by the attributes of nature and materiality, the omission or

misstatement of the substance and economic reality of the finance lease
would influence the economic decisions of users.

17
(ii) Faithful representation
Information about the finance lease must represent faithful that which it either
purports to represent or could reasonably be expected to represent.

Transactions must be accounted for and presented in accordance with their

substance and economic reality, and not merely their legal form. The substance
and economic reality of the finance lease is that Alpha Manufacturers Limited
(i.e. the lessee) exercises control over the risks and rewards associated with the
leased machinery.

Information about the finance lease must be complete, neutral and free from
error.

(1) Completeness
Information about the finance lease must include all aspects necessary for the
user to understand the nature of transaction.

(2) Neutrality
Information about the finance lease must be free from bias.

(3) Free from error

Information about the finance lease must be free from error.

As measured by the attributes of substance over form, completeness, neutrality

and free from error, failure to capitalize the finance lease would violate the
requirements of faithful representation of information.

(b) Enhancing qualitative characteristics

(1) Comparability
Information about the finance lease is useful if it can be compared with similar
information from past periods for the same entity or with similar information
from other entities. The recognition, measurement and disclosure of finance
leases should be consistent, both within a single entity over time and between
different entities. Therefore, failure to capitalize the finance lease would result
in inconsistent treatment between entities, and thereby compromise
comparability. Comparability with previous periods within the same entity

18
 would also be compromised if the managing director’s proposal is a departure
from previous practice.
(2) Verifiability
That the finance lease transferred substantially all the risks and rewards
incidental to the ownership of the machinery from the lessor to the lessee can
be verified.

4. Underlying assumption

Going concern
The financial statements presume that an entity will continue in operation
indefinitely. Therefore, the leased machinery will be used as planned and the
lease obligations will also be settled as planned.

5. Conclusion
• The finance lease satisfies the definitions and recognition criteria of both an
asset and a liability.
• The substance and economic reality of the finance lease is that Alpha
Manufacturers Limited exercises control over the risks and rewards associated
with the leased machinery.
• Therefore, the machinery and corresponding loan should be capitalized at the
cash cost of $50 000.
• The machinery should be depreciated in accordance with the company’s
depreciation policy.
• The lease finance charges should be expensed as they are incurred.
• The loan should be amortized over the lease period.

2.2 IAS 1: Presentation of Financial Statements

IAS 1 Presentation of Financial Statements sets out the overall requirements for financial
statements, including how they should be structured, the minimum requirements for their
content and overriding concepts such as going concern, the accrual basis of accounting
and the current/non-current distinction. The standard requires a complete set of financial
statements to comprise a statement of financial position, a statement of profit or loss and
other comprehensive income, a statement of changes in equity and a statement of cash
flows.

19
IAS 1 was reissued in September 2007 and applies to annual periods beginning on or
after 1 January 2009.

2.2.1 Objective of IAS 1

The objective of IAS 1 (2007) is to prescribe the basis for presentation of general purpose
financial statements, to ensure comparability both with the entity's financial statements of
previous periods and with the financial statements of other entities. IAS 1 sets out the
overall requirements for the presentation of financial statements, guidelines for their
structure and minimum requirements for their content. [IAS 1.1] Standards for
recognizing, measuring, and disclosing specific transactions are addressed in other
Standards and Interpretations. [IAS 1.3]

2.2.2 Scope

Applies to all general purpose financial statements based on International Financial

Reporting Standards. [IAS 1.2]

General purpose financial statements are those intended to serve users who are not in a
position to require financial reports tailored to their particular information needs. [IAS
1.7]

2.2.3 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: [IAS 1.9]

• assets
• liabilities
• equity
• income and expenses, including gains and losses
• contributions by and distributions to owners
• 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.

2.2.4 Components of financial statements

A complete set of financial statements should include: [IAS 1.10]

• a statement of financial position at the end of the period

• a statement of profit or loss and other comprehensive income for the period

20
 • a statement of changes in equity for the period
• a statement of cash flows for the period
• notes, comprising a summary of accounting policies and other explanatory notes

When an entity applies an accounting policy retrospectively or makes a retrospective

restatement of items in its financial statements, or when it reclassifies items in its
financial statements, it must also present a statement of financial position as at the
beginning of the earliest comparative period.

An entity may use titles for the statements other than those stated above.

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 IFRSs. [IAS 1.14]

2.2.5 Fair presentation and compliance with IFRSs

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 IFRSs, with additional disclosure when
necessary, is presumed to result in financial statements that achieve a fair presentation.
[IAS 1.15]

IAS 1 requires that an entity whose financial statements comply with IFRSs make an
explicit and unreserved statement of such compliance in the notes. Financial statements
shall not be described as complying with IFRSs unless they comply with all the
requirements of IFRSs (including Interpretations). [IAS 1.16]

Inappropriate accounting policies are not rectified either by disclosure of the accounting
policies used or by notes or explanatory material. [IAS 1.16]

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. [IAS 1.19-20]

2.2.6 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. [IAS 1.25]

21
2.2.7 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. [IAS 1.27]

2.2.8 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. [IAS 1.45]

2.2.9 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.
[IAS 1.29]

2.2.10 Offsetting

Assets and liabilities, and income and expenses, may not be offset unless required or
permitted by an IFRS. [IAS 1.32]

2.2.11 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 face of financial
statements and notes, unless another Standard requires otherwise. [IAS 1.38]

If comparative amounts are changed or reclassified, various disclosures are required.

[IAS 1.41]

2.2.12 Structure and content of financial statements in general

Clearly identify: [IAS 1.50]

• the financial statements

• the reporting enterprise
• whether the statements are for the enterprise or for a group
• the date or period covered
• the presentation currency
• the level of precision (thousands, millions, etc.)

2.2.13 Reporting period

There is a presumption that financial statements will be prepared at least annually. If the
annual reporting period changes and financial statements are prepared for a different

22
period, the entity must disclose the reason for the change and a warning about problems
of comparability. [IAS 1.36]

2.2.14 Statement of financial position

An entity must normally present a classified statement of financial position, separating

current and non-current 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. [IAS 1.60] In either case, if an asset (liability) category combines amounts
that will be received (settled) after 12 months with assets (liabilities) that will be received
(settled) within 12 months, a note disclosure is required that separates the longer-term
amounts from the 12-month amounts. [IAS 1.61]

Current assets are cash; cash equivalents; assets held for collection, sale, or consumption
within the entity's normal operating cycle; or assets held for trading within the next 12
months. All other assets are non-current. [IAS 1.66]

Current liabilities are those expected to be settled within the entity'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. [IAS 1.69]

When a long-term debt is expected to be refinanced under an existing loan facility and
the entity has the discretion, the debt is classified as non-current, even if due within 12
months. [IAS 1.73]

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 reporting date, the
liability is current, even if the lender has agreed, after the reporting date and before the
authorization of the financial statements for issue, not to demand payment as a
consequence of the breach. [IAS 1.74] However, the liability is classified as non-current
if the lender agreed by the reporting date to provide a period of grace ending at least 12
months after the end of the reporting period, within which the entity can rectify the
breach and during which the lender cannot demand immediate repayment. [IAS 1.75]

Minimum items on the face of the statement of financial position [IAS 1.54]

(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

23
(h) trade and other receivables
(i) cash and cash equivalents
(j) assets held for sale
(k) trade and other payables
(l) Provisions
(m) financial liabilities (excluding amounts shown under (k) and (l))
(n) liabilities and assets for current tax, as defined in IAS 12
(o) deferred tax liabilities and deferred tax assets, as defined in IAS 12
(p) liabilities included in disposal groups
(q) non-controlling interests, presented within equity and
(r) issued capital and reserves attributable to owners of the parent

Additional line items may be needed to fairly present the entity's financial position. [IAS
1.54]

IAS 1 does not prescribe the format of the statement of financial position. 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 – non-current 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: [IAS
1.79]

• numbers of shares authorized, 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 equity

2.2.15 Statement of profit or loss and other comprehensive income

Comprehensive income for a period includes profit or loss for that period plus other
comprehensive income recognized in that period. As a result of the 2003 revision to IAS
1, the Standard is now using 'profit or loss' rather than 'net profit or loss' as the descriptive
term for the bottom line of the profit or loss section.

All items of income and expense recognized in a period must be included in profit or loss
unless a Standard or an Interpretation requires otherwise. [IAS 1.88] Some IFRSs require
or permit some components to be excluded from profit or loss and instead to be included
in other comprehensive income. [IAS 1.89]

24
The components of other comprehensive income include:

• changes in revaluation surplus (IAS 16 and IAS 38)

• actuarial gains and losses on defined benefit plans recognized in accordance with
IAS 19
• gains and losses arising from translating the financial statements of a foreign
operation (IAS 21)
• gains and losses on remeasuring financial assets at fair value through other
comprehensive income (IAS 39 and IFRS 9)
• the effective portion of gains and losses on hedging instruments in a cash flow
hedge (IAS 39).

An entity has a choice of presenting:

• a single statement of profit or loss and other comprehensive income or

• two statements:
o an statement displaying components of profit or loss (separate statement of
profit or loss) and
o a statement that begins with profit or loss and displays components of
other comprehensive income (statement of profit or loss and other
comprehensive income)

Minimum items on the face of the statement of profit or loss and other comprehensive
income should include: [IAS 1.82]

• revenue
• finance costs
• share of the profit or loss of associates and joint ventures accounted for using the
equity method
• tax expense
• 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 recognized on the
disposal of the assets or disposal group(s) constituting the discontinued operation
• profit or loss
• each component of other comprehensive income classified by nature
• share of the other comprehensive income of associates and joint ventures
accounted for using the equity method
• total comprehensive income

The following items must also be disclosed in the statement of profit or loss and other
comprehensive income as allocations for the period: [IAS 1.83]

• profit or loss for the period attributable to non-controlling interests and owners of
the parent
• total comprehensive income attributable to non-controlling interests and owners
of the parent

25
Additional line items may be needed to fairly present the entity's results of operations.
[IAS 1.85]

No items may be presented in the statement of profit or loss and other comprehensive
income (or in the statement of profit or loss, if separately presented) or in the notes as
'extraordinary items'. [IAS 1.87]

Certain items must be disclosed separately either in the statement of profit or loss and
other comprehensive income or in the notes, if material, including: [IAS 1.98]

• write-downs of inventories to net realizable value or of property, plant and

equipment to recoverable amount, as well as reversals of such write-downs
• restructurings of the activities of an entity and reversals of any provisions for the
costs of restructuring
• disposals of items of property, plant and equipment
• disposals of investments
• discontinued operations
• litigation settlements
• other reversals of provisions

Expenses recognized in profit or loss should be analyzed either by nature (raw materials,
staffing costs, depreciation, etc.) or by function (cost of sales, distribution, administrative,
other and finance). [IAS 1.99] If an entity categorizes by function, then additional
information on the nature of expenses – at a minimum depreciation, amortization and
employee benefits expense – must be disclosed. [IAS 1.104]

2.2.16 Statement of Cash Flows

Rather than setting out separate standards for presenting the statement of cash flows, IAS
1.111 refers to IAS 7 Statement of Cash Flows

2.2.17 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: [IAS 1.106]

• total comprehensive income for the period, showing separately amounts

attributable to owners of the parent and to non-controlling interests
• the effects of retrospective application, when applicable, for each component
• reconciliations between the carrying amounts at the beginning and the end of the
period for each component of equity, separately disclosing:
o profit or loss
o each item of other comprehensive income
o transactions with owners, showing separately contributions by and
distributions to owners and changes in ownership interests in subsidiaries
that do not result in a loss of control

26
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: [IAS 1.107]

• amount of dividends recognized as distributions, and

• the related amount per share

2.2.18 Notes to the Financial Statements

The notes must: [IAS 1.112]

• present information about the basis of preparation of the financial statements and
the specific accounting policies used
• disclose any information required by IFRSs that is not presented elsewhere in the
financial statements and
• provide additional information that is not presented elsewhere in the financial
statements but is 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 1.113]

IAS 1.114 suggests that the notes should normally be presented in the following order:

• a statement of compliance with IFRSs

• a summary of significant accounting policies applied, including: [IAS 1.117]
o the measurement basis (or bases) used in preparing the financial
statements
o 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 statement of
financial position, statement of profit or loss and other comprehensive income
(and statement of profit or loss , if presented), statement of changes in equity and
statement of cash flows, in the order in which each statement and each line item is
presented
• other disclosures, including:
o contingent liabilities (see IAS 37) and unrecognized contractual
commitments
o non-financial disclosures, such as the entity's financial risk management
objectives and policies (see IFRS 7)

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
recognized in the financial statements. [IAS 1.122]

Examples cited in IAS 1.123 include management's judgments in determining:

27
 • whether financial assets are held-to-maturity investments
• when substantially all the significant risks and rewards of ownership of financial
assets and lease 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 control

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 end of the
reporting period, that have a significant risk of causing a material adjustment to the
carrying amounts of assets and liabilities within the next financial year. [IAS 1.125]
These disclosures do not involve disclosing budgets or forecasts. [IAS 1.130]

The following other note disclosures are required by IAS 1.126 if not disclosed elsewhere
in information published with the financial statements:

• domicile and legal form of the entity

• country of incorporation
• address of registered office or principal place of business
• description of the entity's operations and principal activities
• if it is part of a group, the name of its parent and the ultimate parent of the group
• if it is a limited life entity, information regarding the length of the life

Disclosures about dividends

In addition to the distributions information in the statement of changes in equity (see

above), the following must be disclosed in the notes: [IAS 1.137] " the amount of
dividends proposed or declared before the financial statements were authorized for issue
but not recognized as a distribution to owners during the period, and the related amount
per share and " the amount of any cumulative preference dividends not recognized.

Capital disclosures

An entity should disclose information about its objectives, policies and processes for
managing capital. [IAS 1.134] To comply with this, the disclosures include: [IAS 1.135]

• qualitative information about the entity's objectives, policies and processes for
managing capital, including:
o description of capital it manages
o nature of external capital requirements, if any
o how it is meeting its objectives
• quantitative data about what the entity regards as capital
• changes from one period to another
• whether the entity has complied with any external capital requirements and

28
 • if it has not complied, the consequences of such non-compliance.

2.2.19 June 2011: IASB issued amendments to IAS 1

On 16 June 2011, the IASB published amendments to IAS 1 Presentation of Financial

Statements. The amendments to IAS 1 retain the 'one or two statement' approach at the
option of the entity and only revise the way other comprehensive income is presented:
requiring separate subtotals for those elements which may be 'recycled' (e.g. cash-flow
hedging, foreign currency translation), and those elements that will not (e.g. fair value
through OCI items under IFRS 9).

Amendments to IAS 1 Presentation of Financial Statements

• Preserve the amendments made to IAS 1 in 2007 to require profit or loss and OCI
to be presented together, i.e. either as a single statement of profit or loss and other
comprehensive income, or separate statement of profit or loss and a statement of
profit or loss and other comprehensive income — rather than requiring a single
continuous statement as was proposed in the exposure draft
• Require entities to group items presented in OCI based on whether they are
potentially reclassifiable to profit or loss subsequently. i.e. those that might be
reclassified and those that will not be reclassified
• Require tax associated with items presented before tax to be shown separately for
each of the two groups of OCI items (without changing the option to present items
of OCI either before tax or net of tax)
• Applicable to annual periods beginning on or after 1 July 2012, with early
adoption permitted.

2.3 Income taxes (IAS 12)

Entities are subject to income taxes. IAS 12, Income Taxes, prescribes the accounting for
both current tax and deferred tax. IAS 12 is summarized below.

2.3.1 Conceptual issues

The principal issue in accounting for income taxes is how to account for the current and
future tax effects related to:

• The future recovery/settlement of the carrying amount of assets and liabilities

recognized in the statement of financial position:
➢ A deferred tax liability should be recognized whenever recovery of the
carrying amount of the asset or settlement of the liability would result in
larger future tax payments;

29
 ➢ A deferred tax asset should be recognized whenever settlement of the
carrying amount of the liability or recovery of the carrying amount of the
asset would result in smaller future tax payments.

• Transactions and other events of the current period recognized in financial

statements:
➢ For transactions and other events recognized in the statement of profit or
loss and other comprehensive income, any related tax effects are also
recognized in the statement of profit or loss and other comprehensive
income;
➢ For transactions and other events recognized directly in equity, any related
tax effects are also recognized directly in equity.

2.3.2 Definitions

The following definitions are included in IAS 12:

Taxable profit
The profit for the period, determined in accordance with the rules established by the
taxation authorities, upon which incomes taxes are payable.

Tax expense/ tax income

The aggregate amount included in the determination of accounting profit or loss for the
period in respect of current tax and deferred tax.

Deferred tax
The tax attributable to temporary differences, i.e. taxes payable or recoverable in future
periods.

Deferred tax liabilities (DTL)

The amount of income taxes payable in future periods in respect of taxable temporary
differences.

Deferred tax assets (DTA)

The amount of income taxes recoverable in future periods in respect of:
• Deductible temporary differences;
• The carry forward of unused tax loses;
• The carry forward of unused tax credits.

Temporary differences (TD)

The differences between the carrying amount of an asset or liability in the statement of
financial position (balance sheet) and its tax base.

Taxable temporary differences (TTD)

30
The temporary differences that will result in taxable amounts in determining taxable
profit (or tax loss) of future periods when the carrying amount of an asset or liability is
recovered or settled.
Deductible temporary differences (DTD)
The temporary differences that will result in amounts that are deductible in determining
taxable profit (or tax loss) of future periods when the carrying amount of the asset or
liability is recovered or settled.

Note:
Some temporary differences arise when items of income or expense are included in
accounting profit in one period, but included in tax profit in another period.
The carrying amount (CA) of an item is the amount attributed to that item for
accounting purposes.

Tax base (TB)

The tax base of an item is the amount attributable to that item for tax purposes. It is
determined as follows:

i. Asset
The amount that will be deductible for tax purposes, against any taxable economic
benefits, that will flow to an entity when it recovers the carrying amount of the
asset. If the economic benefits will not be taxable, the tax base of the asset is
equal to its carrying amount.

ii. Expense
Some expenses are recognized in full for accounting purposes, but are allowed as
a deduction for tax purposes in the current and future periods. The CA is then nil
and the TB is the amount that will be allowed as a deduction in future periods.

iii. Liability
The CA, less any amount that will be deductible for tax purposes in respect of that
liability in future periods.

iv. Revenue received in advance

The CA, less any amount of revenue that will be taxable in future periods.

The relationship and effect of the differences between the CA and the TB can be
summarized as follows:

Assets and expenses CA>TB TTD DTL

Assets and expenses CA<TB DTD DTA
Liabilities and revenue received in advance CA>TB DTD DTA
Liabilities and revenue received in advance CA<TB TTD DTL

31
2.3.3 Computations

Accounting profit and taxable profit compared

Accounting profit Taxable profit
$ $
Revenue xxx Income xxx
Expenses (xxx) Allowable deductions (xxx)
Profit before tax xxx Taxable income xxx

Income tax expense

Income tax expense = Current tax expense + Deferred tax expense; or
Income tax expense = Current tax expense – Deferred tax income

Current tax expense

Current tax expense = Taxable income x Tax rate
Deferred tax expense
• Deferred tax expense = Increase in DTL
= DTL in year 2 – DTL in year 1
Where: DTL in year 2 > DTL in year 1; or
• Deferred tax expense = Decrease in DTA
= DTA in year 1 – DTA in year 2
Where: DTA in year 1 > DTA in year 2

Deferred tax income

• Deferred tax income = Decrease in DTL
= DTL in year 1 – DTL in year 2
Where: DTL in year 1 > DTL in year 2; or
• Deferred tax income = Increase in DTA
=DTA in year 2 – DTA in year 1
Where: DTA in year 2 > DTA in year 1

Deferred tax liability (DTL)

DTL = TTD x Tax rate

Deferred tax asset (DTA)

DTA = DTD x Tax rate

2.3.4 Key learning points

i. Income tax expense

The amount of income tax presented on the face of the statement of profit or loss
and other comprehensive income (income statement) is a composite figure. It

32
 consists of current tax expense plus deferred tax expense (or minus deferred tax
income).

ii. Accounting profit versus taxable profit

Profit is calculated in different ways for accounting and tax purposes. This results
in different amounts for accounting profit and taxable profit. Therefore, expected
tax based on accounting profit will be different from actual tax based on taxable
profit. The concept of ‘deferred tax’ was created to deal with this mismatch.
Deferred tax expense (or income) extinguishes, or reduces, the difference between
expected tax and actual tax.

iii. Difference between CA and TB

The difference between the CA and TB of an asset or liability means that there
will be a higher tax liability, or lower tax liability, in future periods.

2.3.5 Format for presenting financial statements

The principal requirements of IAS 1 with regard to the statement of financial position
(balance sheet), statement of profit or loss and other comprehensive income (income
statement) and statement of changes in equity are illustrated in the following four
examples.

Example 2.2

ABC Limited
Statement of financial position as at 31 December 2017
2017 2016
$ $
ASSETS
Non-current assets xxx xxx
Property, plant and equipment xxx xxx
Goodwill xxx xxx
Other intangible assets xxx xxx
Financial assets at fair value through other comprehensive income xxx xxx
Current assets xxx xxx
Inventories xxx xxx
Trade receivables xxx xxx
Other current assets xxx xxx
Cash and cash equivalents xxx xxx
Total assets xxx xxx
EQUITY AND LIABILITIES
Equity xxx xxx
Share capital xxx xxx
Other reserves xxx xxx

33
Retained earnings xxx xxx
Total liabilities xxx xxx
Non-current liabilities xxx xxx
Long-term borrowings xxx xxx
Deferred tax xxx xxx
Current liabilities xxx xxx
Trade payables xxx xxx
Short-term borrowings xxx xxx
Current tax payable xxx xxx
Total equity and liabilities xxx xxx

Example 2.3
The statement of profit or loss and other comprehensive income (income statement) can
presented using either the classification of expenses by nature method or the
classification of expenses by function method. As the statement of profit or loss and other
comprehensive income and accompanying notes prepared on the function of expense
method provides more useful and relevant information to users than the nature of expense
method, this example illustrates the function of expense method.

ABC Limited
Statement of profit or loss and other comprehensive income for the year ended 31
December 2017
2011 2010
$ $
Revenue xxx xxx
Cost of sales (xxx) (xxx)
Gross profit xxx xxx
Other income xxx xxx
Distribution costs (xxx) (xxx)
Administrative expenses (xxx) (xxx)
Other expenses (xxx) (xxx)
Finance costs (xxx) (xxx)
Profit before tax xxx xxx
Income tax expense (xxx) (xxx)
Profit for the year xxx xxx
Other comprehensive income xxx xxx
Items that will not be reclassified to profit or loss xxx xxx
Gain on property revaluation xxx xxx
Tax expense (xxx) (xxx)
Gain on financial assets at fair value through OCI xxx xxx
Tax expense (xxx) (xxx)
Items that may subsequently be reclassified to profit or loss xxx xxx
Total comprehensive income for the year xxx xxx

34
Example 2.4

ABC Limited
Statement of changes in equity for the year ended 31 December 2017
Share Revaluation Mark-to- Retained Total
capital surplus market earnings
reserve
$ $ $ $ $
Bal at 31 Dec 2016 Xxx xxx xxx xxx xxx
Total xxx xxx xxx xxx
comprehensive
income for the year
Profit for the year ----- ----- xxx xxx
Other xxx xxx xxx
comprehensive
income
Dividends (xxx) (xxx)
Issue of share Xxx ------ ----- ----- xxx
capital
Bal at 31 Dec 2017 Xxx xxx xxx xxx xxx

Example 2.5

The following trial balance was extracted from the ledger of Alpha Limited:

Trial balance at 31 December 2017

DR CR
$ $
Ordinary shares of $1.00 each 50 000
Share premium 36 000
Retained earnings on 31 December 2016 18 750
Delivery vehicles at cost 90 500
Accumulated depreciation on delivery vehicles 8 250
Office equipment at cost 7 500
Accumulated depreciation on office equipment 1 500
Land and buildings at cost 37 875
Investment at cost: 7 500 ordinary shares in Beta Limited 16 500
Sales to customers 60 250
Inventory at 31 December 2016 11 750
Purchases 15 500
Advertising 3 800
Rent – Offices 1 960
- Warehouse 990
Audit fees 1 000
Managing director’s salary 1 500

35
Directors’ remuneration 300
Salaries and wages – Offices 11 250
- Warehouse 3 750
Interest on debentures 1 050
Interest on bank overdraft 400
Cash and cash equivalents 5 925
Deferred tax on 31 December 2016 15 000
Loss on expropriation of land 1 000
Dividends received from Beta Limited 2 700
Trade payables 40 525
Proceeds on disposal of delivery vehicle 4 500
7% debentures 15 000
Provisional tax payments 7 000
Trade receivables 32 925 -------
252 475 252 475
Additional information:

1. Property, plant and equipment

- Land and buildings were revalued at $39 000 at 31 December 2017.
- During the year, a delivery vehicle which had cost $6 000 was sold for $4 500. The
accumulated depreciation on this vehicle to 31 December 2016 was $1 250. There were
no other disposals of vehicles during the year.
- Depreciation on delivery vehicles must still be provided for the current year. The details
are as follows:
$
Depreciation from beginning of year to date of disposal for vehicle sold 1 000
Depreciation on remaining vehicles 3 500
4 500
- Depreciation on office equipment must still be provided for the current year. The
depreciation charge for 2017 was $1 500.

2. Investment
The issued ordinary share capital of Beta Limited is 30 000 shares of $1.00 each. Alpha
Limited acquired the interest in Beta Limited during the current year as a strategic
investment. Upon initial recognition, the investment was designated as financial assets at
fair value through other comprehensive income. Beta Limited’s shares were quoted on
the Zimbabwe Stock Exchange at $2.30 ‘ex div’ per share on 31 December 2017.

3. Inventory
The value of inventory on 31 December 2017 was $15 750.

4. Income tax
- Taxable temporary differences (TTD) at 31 December 2017 were calculated at $48 000.
- Total income subject to income tax in terms of the Income Tax Act was $61 000.
- Allowable deductions for the year ended 31 December 2017 amounted to $43 000.
- Assume a tax rate of 30% for all forms of income.

36
5. Dividends
A dividend of $2 000 was declared on 31 December 2017.

6. Share capital
Included in ordinary share capital and share premium are 10 000 ordinary shares of $1.00
each issued at $1.50 per share during 2017.

Required:

Prepare the following financial statements, to comply with the requirements of IAS 1:
(a) Statement of profit or loss and other comprehensive income for the year ended 31
December 2017. Classify expenses by function.
(b) Statement of changes in equity for the year ended 31 December 2017.
(c) Statement of financial position as at 31 December 2017.

Suggested answer

Alpha Limited

Workings

1. Allocation of costs
Cost of Distrib - Admin. Other Finance
sales ution
$ $ $ $ $
Opening inventory 11 750
Purchases 15 500
Advertising 3 800
Rent 990 1 960
Audit fees 1 000
Managing director’s salary 1 500
Director’s remuneration 300
Salaries and wages 3 750 11 250
Interest on debentures 1 050
Interest on bank overdraft 400
Loss on expropriation of land 1 000
Depreciation 4 500 1 500
Closing inventory (15 750) ------ ------- ------ ------
11 500 13 040 17 510 1 000 1450

2. Other income
$
Investment income 2 700
Profit on sale of delivery vehicle [4 500 - (6 000 - 1 250 - 1000)] 750
3 450

37
3. Mark-to-market reserve
$
Financial assets at fair value through OCI on 31/12/11 ($2.30 x 7 500) 17 250
Fair value upon initial recognition (16 500)
Gain arising during the year 750
Tax thereon @ 30% 225

4. Revaluation surplus
$
Fair value at revaluation (31/12/17) 39 000
Carrying amount at cost (37 875)
Revaluation gain 1 125
Tax thereon @ 30% 338

5. Income tax expense

$ $
Income 61 000
Allowable deductions (43 000)
Taxable income 18 000
Current tax expense @ 30% 5 400
Deferred tax liability on 31/12/17 ($48 000 x 30%) 14 400
Attributable to components of other comprehensive income
Gain on financial assets at fair value through OCI (225)
Revaluation surplus (338)
Deferred tax liability on 31/12/16 (15 000)
Deferred tax income (1 163)
Income tax expense 4 237

6. Tax receivable/payable
$
Provisional tax payments 7 000
Current tax expense (5 400)
Tax receivable 1 600

7. Carrying amounts of property, plant and equipment

Cost/Rev Acc. Carrying
aluation depreciation amount
$ $ $
Land and buildings 39 000 --- 39 000
Office equipment 7 500 (3000)
1 4 500

Delivery vehicles 84500

2
(10500)
3 74 000

129 875 (12 375) 117 500

1. 1 500 + 1 500 = 3 000

38
2. 90 500 – 6000 = 84 500
3. 8 250 – 1 250 + 3 500 = 10 500

(a) Alpha Limited

Statement of profit or loss and other comprehensive income for the year ended 31
December 2017
$
Revenue 60 250
Cost of sales (1) (11 500)
Gross profit 48 750
Other income (2) 3 450
Distribution costs (1) (13 040)
Administrative expenses (1) (17 510)
Other expenses (1) (1 000)
Finance costs (1) (1 450)
Profit before tax 19 200
Income tax expense (5) (4 237)
Profit for the year 14 963
Other comprehensive income 1 312
Items that will not be reclassified to profit or loss 1 312
Gain on property revaluation 1 125
Gain on financial assets at fair value through OCI 750
Income tax expense relating to items that will not be reclassified (3 and 4) (563)
Items that may subsequently be reclassified to profit or loss ---------
Total comprehensive income for the year 16 275

(b) Alpha Limited

Statement of changes in equity for the year ended 31 December 2017
Share Share Revaluation Mark- Retained Total
capital premium surplus to- earnings
market
reserve
$ $ $ $ $ $
Bal at 31 Dec 2016 40 000 31000
1 ---- ---- 18 750 89 750

Total 787 525 14 963 16 275

39
comprehensive
income for the year
Profit for year ----- ----- 14 963 14963
Other 787 525 ----- 1 312
comprehensive
income
Dividends (2 000) (2 000)
Issue of share 10 000 5 000 ---- ---- ---- 15 000
capital
Bal at 31 Dec 2017 50 000 36 000 787 525 31 713 119025

1. 36 000 – ($0.50 x 10 000) = 31 000

(c) Alpha Limited

Statement of financial position as at 31 December 2017
$
ASSETS
Non-current assets 134 750
Property, plant and equipment (7) 117 500
financial assets at fair value through OCI (3) 17 250
Current assets 56 200
Inventory 15 750
Trade receivables 32 925
Tax receivable (6) 1 600
Cash and cash equivalents 5 925
Total assets 190 950
EQUITY AND LIABILITIES
Equity 119 025
Ordinary share capital 50 000
Share premium 36 000
Revaluation surplus 787
Mark-to-market reserve 525
Retained earnings 31 713
Total liabilities 71 925
Non-current liabilities 29 400
7% Debentures 15 000
Deferred tax (5) 14 400
Current liabilities 42 525
Trade payables 40 525
Dividends payable 2 000
Total equity and liabilities 190 950

40
2.4 IAS 7: Statement of cash flows
IAS 7 prescribes the basis for the presentation of statements of cash flows. Profit alone
does not always give a useful, or meaningful, picture of an entity’s operations. The
statement of cash flows provides users of financial statements with information about an
entity’s ability to generate cash and cash equivalents, as well as indicating the cash needs
of the entity. It provides historical information about cash and cash equivalents,
classifying cash flows by operating, investing and financing activities. A summary of IAS
7 is given below.

2.4.1 Objective

Information about the cash flows of an entity is useful in providing users of financial
statements with a basis to assess the ability of the entity to generate cash and cash
equivalents and the needs of the entity to utilize those cash flows. The economic
decisions that are taken by users require an evaluation of the ability of an entity to
generate cash and cash equivalents and the timing and certainty of their generation.

The objective of this standard is to require the provision of information about the
historical changes in cash and cash equivalents of an entity by means of a statement of
cash flows which classifies cash flows during the period from operating, investing and
financing activities.

2.4.2 Scope

An entity should prepare a statement of cash flows in accordance with the requirements
of this standard and should present it as an integral part of its financial statements for
each period for which financial statements are presented.

Users of an entity’s financial statements are interested in how the entity generates and
uses cash and cash equivalents. This is the case regardless of the nature of the entity’s
activities and irrespective of whether cash can be viewed as the product of the entity, as
may be the case with a financial institution. Entities need cash for essentially the same
reasons however different their principal revenue-producing activities might be. They
need cash to conduct their operations, to pay their obligations, and to provide returns to
their investors. Accordingly, this standard requires all entities to present a statement of
cash flows.

2.4.3 Benefits of cash flow information

A statement of cash flows, when used in conjunction with the rest of the financial
statements, provides information that enables users to evaluate the changes in net assets
of an entity, its financial structure (including its liquidity and solvency) and its ability to
affect the amounts and timing of cash flows in order to adapt to changing circumstances
and opportunities. Cash flow information is useful in assessing the ability of the entity to
generate cash and cash equivalents and enables users to develop models to assess and

41
compare the present value of the future cash flows of different entities. It also enhances
the comparability of the reporting of operating performance by different entities because
it eliminates the effects of using different accounting treatments for the same transactions
and events.
Historical cash flow 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.

2.4.4 Definitions

The following terms are used in this standard with the meanings specified :

Cash comprises cash on hand and demand deposits.

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

Cash flows are inflows and outflows of cash and cash equivalents.

Operating activities are the principal revenue-producing activities of the entity 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
contributed equity and borrowings of the entity.

2.4.5 Cash and cash equivalents

Cash equivalents are held for the purpose of meeting short-term cash commitments rather
than for investment or other purposes. For an investment to qualify as a cash equivalent it
must be readily convertible to a known amount of cash and be subject to an insignificant
risk of changes in value. Therefore, an investment normally qualifies as a cash equivalent
only when it has a short maturity of, say, three months or less from the date of
acquisition. Equity investments are excluded from cash equivalents unless they are, in
substance, cash equivalents, for example in the case of preferred shares acquired within a
short period of their maturity and with a specified redemption date.

Bank borrowings are generally considered to be financing activities. However, in some

countries, bank overdrafts which are repayable on demand form an integral part of an
entity’s cash management. In these circumstances, bank overdrafts are included as a
component of cash and cash equivalents. A characteristic of such banking arrangements
is that the bank balance often fluctuates from being positive to overdrawn.

42
Cash flows exclude movements between items that constitute cash or cash equivalents
because these components are part of the cash management of an entity rather than part
of its operating, investing and financing activities. Cash management includes the
investment of excess cash in cash equivalents.

2.4.6 Presentation of a statement of cash flows

The statement of cash flows should report cash flows during the period classified by
operating, investing and financing activities.

An entity presents its cash flows from operating, investing and financing activities in a
manner which is most appropriate to its business. Classification by activity provides
information that allows users to assess the impact of those activities on the financial
position of the entity and the amount of its cash and cash equivalents. This information
may also be used to evaluate the relationships among those activities.

A single transaction may include cash flows that are classified differently. For example,
when the cash repayment of a loan includes both interest and capital, the interest element
may be classified as an operating activity and the capital element is classified as a
financing activity.

(a) Operating activities

The amount of cash flows arising from operating activities is a key indicator of the extent
to which the operations of the entity have generated sufficient cash flows to repay loans,
maintain the operating capability of the entity, pay dividends and make new investments
without recourse to external sources of financing. Information about the specific
components of historical operating cash flows is useful, in conjunction with other
information, in forecasting future operating cash flows.

Cash flows from operating activities are primarily derived from the principal revenue-
producing activities of the entity. Therefore, they generally result from the transactions
and other events that enter into the determination of profit or loss. Examples of cash
flows from operating activities are:

a) cash receipts from the sale of goods and the rendering of services;
b) cash receipts from royalties, fees, commissions and other revenue;
c) cash payments to suppliers for goods and services;
d) cash payments to and on behalf of employees;
e) cash receipts and cash payments of an insurance entity for premiums and claims,
annuities and other policy benefits;
f) cash payments or refunds of income taxes unless they can be specifically identified
with financing and investing activities; and
g) cash receipts and payments from contracts held for dealing or trading purposes.

43
Some transactions, such as the sale of an item of plant, may give rise to a gain or loss
which is included in the determination of profit or loss. However, the cash flows relating
to such transactions are cash flows from investing activities.
An entity may hold securities and loans for dealing or trading purposes, in which case
they are similar to inventory acquired specifically for resale. Therefore, cash flows
arising from the purchase and sale of dealing or trading securities are classified as
operating activities. Similarly, cash advances and loans made by financial institutions are
usually classified as operating activities since they relate to the main revenue-producing
activity of that entity.

(b) Investing activities

The separate disclosure of cash flows arising from investing activities is important
because the cash flows represent the extent to which expenditures have been made for
resources intended to generate future income and cash flows. Examples of cash flows
arising from investing activities are:

a) cash payments to acquire property, plant and equipment, intangibles and other long-
term assets. These payments include those relating to capitalised development costs and
self-constructed property, plant and equipment;
b) cash receipts from sales of property, plant and equipment, intangibles and other long-
term assets;
c) cash payments to acquire equity or debt instruments of other entities and interests in
joint ventures (other than payments for those instruments considered to be cash
equivalents or those held for dealing or trading purposes);
d) cash receipts from sales of equity or debt instruments of other entities and interests in
joint ventures (other than receipts for those instruments considered to be cash equivalents
and those held for dealing or trading purposes);
e) cash advances and loans made to other parties (other than advances and loans made by
a financial institution);
f) cash receipts from the repayment of advances and loans made to other parties (other
than advances and loans of a financial institution);
g) cash payments for futures contracts, forward contracts, option contracts and swap
contracts except when the contracts are held for dealing or trading purposes, or the
payments are classified as financing activities; and
h) cash receipts from futures contracts, forward contracts, option contracts and swap
contracts except when the contracts are held for dealing or trading purposes, or the
receipts are classified as financing activities.

When a contract is accounted for as a hedge of an identifiable position, the cash flows of
the contract are classified in the same manner as the cash flows of the position being
hedged.
(c) Financing activities

The separate disclosure of cash flows arising from financing activities is important
because it is useful in predicting claims on future cash flows by providers of capital to the
entity. Examples of cash flows arising from financing activities are:

44
a) cash proceeds from issuing shares or other equity instruments;
b) cash payments to owners to acquire or redeem the entity’s shares;
c) cash proceeds from issuing debentures, loans, notes, bonds, mortgages and other short
or long-term borrowings;
d) cash repayments of amounts borrowed; and
e) cash payments by a lessee for the reduction of the outstanding liability relating to a
finance lease.

2.4.7 Reporting cash flows from operating activities

An entity should report cash flows from operating activities using either:
a) the direct method, whereby major classes of gross cash receipts and gross cash
payments are disclosed ; or
b) the indirect method, whereby profit or loss is adjusted for the effects of transactions
of a non-cash nature, any deferrals or accruals of past or future operating cash receipts or
payments, and items of income or expense associated with investing or financing cash
flows.

Entities are encouraged to report cash flows from operating activities using the direct
method. The direct method provides information which may be useful in estimating
future cash flows and which is not available under the indirect method. Under the direct
method, information about major classes of gross cash receipts and gross cash payments
may be obtained either:

a) from the accounting records of the entity; or

b) by adjusting sales, cost of sales (interest and similar income and interest expense and
similar charges for a financial institution) and other items in the statement of
comprehensive income for:

(i) changes during the period in inventories and operating receivables and payables;
(ii) other non-cash items; and
(iii) other items for which the cash effects are investing or financing cash flows.

Under the indirect method, the net cash flow from operating activities is determined by
adjusting profit or loss for the effects of:

a) changes during the period in inventories and operating receivables and payables;
b) non-cash items such as depreciation, provisions, deferred taxes, unrealized foreign
currency gains and losses, undistributed profits of associates, and non-controlling
interests (minority interests); and
c) all other items for which the cash effects are investing or financing cash flows.

Alternatively, the net cash flow from operating activities may be presented under the
indirect method by showing the revenues and expenses disclosed in the statement of

45
comprehensive income and the changes during the period in inventories and operating
receivable and payables.

2.4.8 Reporting cash flows from investing and financing activities

An entity should report separately major classes of gross cash receipts and gross cash
payments arising from investing and financing activities, except to the extent that cash
flows described below are reported on a net basis.

2.4.9 Reporting cash flows on a net basis

Cash flows arising from the following operating, investing or financing activities may be
reported on a net basis:

a) cash receipts and payments on behalf of customers when the cash flows reflect the
activities of the customer rather than those of the entity; and
b) cash receipts and payments for items in which the turnover is quick, the amounts are
large, and the maturities are short.
Examples of cash receipts and payments referred to in (a) in the above paragraph are:
a) the acceptance and repayment of demand deposits of a bank;
b) funds held for customer by an investment enterprise; and
c) rents collected on behalf of, and paid over to, the owners of properties.
Examples of cash receipts and payments referred to in (b) in the above paragraph are
advances made for, and the repayment of :
a) principal amounts relating to credit card customers;
b) the purchase and sale of investments; and
c) other short-term borrowings, for example, those which have a maturity period of three
months or less.

Cash flows arising from each of the following activities of a financial institution may be
reported on a net basis:

a) cash receipts and payments for the acceptance and repayment of deposits with a fixed
maturity date;
b) the placement of deposits with and withdrawal of deposits from other financial
institutions; and
c)cash advances and loans made to customers and the repayment of those advances and
loans.

2.4.10 Foreign currency cash flows

Cash flows arising from transactions in a foreign currency should be recorded in an

entity’s reporting currency by applying to the foreign currency amount the exchange

46
rate between the functional currency and the foreign currency at the date of the cash flow.

The cash flows of a foreign subsidiary should be translated at the exchange rates between
the functional currency and the foreign currency at the dates of the cash flows.

Cash flows denominated in a foreign currency are reported in a manner consistent with
IAS 21, The Effects of Changes in Foreign Exchange Rates. This permits the use of an
exchange rate that approximates the actual rate. For example, a weighted average
exchange rate for a period may be used for recording foreign currency transactions or the
translation of the cash flows of a foreign subsidiary. However, IAS 21 does not permit
use of the exchange rate at the statement of financial position (balance sheet) date when
translating the cash flows of a foreign subsidiary.

Unrealized gains and losses arising from changes in foreign currency exchange rates are
not cash flows. However, the effect of exchange rate changes on cash and cash
equivalents held or due in a foreign currency is reported in the cash flow statement in
order to reconcile cash and cash equivalents at the beginning and the end of the period.
This amount is presented separately from cash flows from operating, investing and
financing activities and includes the differences, if any, had those cash flows been
reported at end of period exchange rates.

2.4.11 Interest and dividends

Cash flows from interest and dividends received and paid should each be disclosed
separately. Each should be classified in a consistent manner from period to period as
either operating, investing or financing activities.

The total amount of interest paid during a period is disclosed in the statement of cash
flows (cash flow statement) whether it has been recognised as an expense in the statement
of profit or loss and other comprehensive income (income statement) or capitalised in
accordance with the treatment in IAS 23, Borrowing Costs.

Interest paid and interest and dividends received are usually classified as operating cash
flows for a financial institution. However, there is no consensus on the classification of
these cash flows for other entities. Interest paid and interest and dividends received may
be classified as operating cash flows because they enter into the determination of profit or
loss. Alternatively, interest paid and interest and dividends received may be classified as
financing cash flows and investing cash flows respectively, because they are costs of
obtaining financial resources or returns on investments.

Dividends paid may be classified as a financing cash flow because they are a cost of
obtaining financial resources. Alternatively, dividends paid may be classified as a
component of cash flows from operating activities in order to assist users to determine the
ability of an entity to pay dividends out of operating cash flows.

47
2.4.12 Taxes on income

Cash flows arising from taxes on income should be separately disclosed and should be
classified as cash flows from operating activities unless they can be specifically identified
with financing and investing activities.
Taxes on income arise on transactions that give rise to cash flows that are classified as
operating, investing or financing activities in a statement of cash flows. While tax
expense may be readily identifiable with investing or financing activities, the related tax
cash flows are often impracticable to identify and may arise in a different period from the
cash flows of the underlying transaction. Therefore, taxes paid are usually classified as
cash flows from operating activities. However, when it is practicable to identify the tax
cash flow with an individual transaction that gives rise to cash flows that are classified as
investing or financing activities, the cash flow is classified as an investing or financing
activity as appropriate. When tax cash flows are allocated over more than one class of
activity, the total amount of taxes paid is disclosed.

2.4.13 Non-cash transactions

Investing and financing transactions that do not require the use of cash or cash
equivalents should be excluded from a statement of cash flows. Such transactions should
be disclosed elsewhere in the financial statements in a way that provides all the relevant
information about these investing and financing activities.

Many investing and financing activities do not have a direct impact on current cash flows
although they do affect the capital and asset structure of an entity. The exclusion of non-
cash transactions from the statement of cash flows is consistent with the objective of the
statement of cash flows as these items do not involve cash flows in the current period.
Examples of non-cash transactions are:

a) the acquisition of assets either by assuming directly related liabilities or by means of a

finance lease;
b) the acquisition of an entity by means of an equity issue; and
c) the conversion of debt to equity.
2.4.14 Components of cash and cash equivalents
An enterprise should disclose the components of cash and cash equivalents and should
present a reconciliation of the amounts in its statement of cash flows with the equivalent
items reported in the statement of financial position.

2.4.15 Format for presenting the statement of cash flows

Cash flows can be reported using either the direct method or the indirect method. The
principal requirements of IAS 7 with regard to the statement of cash flows are illustrated
in the following three examples.

48
Example 2.6: Indirect method
ABC Limited
Statement of cash flows for the year ended 31 December 2017
$ $
Cash flows from operating activities
Profit before tax xxx
Adjustments for:
Depreciation xxx
Profit on sale of property, plant and equipment (xxx)
Investment income (xxx)
Interest expense xxx
xxx
Decrease in inventories xxx
Increase in trade receivables (xxx)
Decrease in trade payables (xxx)
Cash generated from operations xxx
Interest paid (xxx)
Income tax paid (xxx)
Dividends paid (xxx)
Net cash from operating activities xxx
Cash flows from investing activities
Purchase of property, plant and equipment (xxx)
Proceeds on sale of property, plant and equipment xxx
Interest received xxx
Dividends received xxx
Net cash used in investing activities (xxx)
Cash flows from financing activities
Proceeds from issue of shares xxx
Redemption of preference shares (xxx)
Proceeds from long-term borrowings xxx
Repayment of short-term borrowings (xxx)
Net cash from financing activities xxx
Net increase in cash and cash equivalents xxx
Cash and cash equivalents at beginning of year xxx
Cash and cash equivalents at end of year xxx

Example 2.7: Direct method

The difference between the direct and indirect methods lies in the presentation of cash
flows from operating activities. Therefore, this example only illustrates the presentation
of cash flows from operating activities.

ABC Limited
Statement of cash flows for the year ended 31 December 2017
$ $
Cash flows from operating activities

49
Cash receipts from customers xxx
Cash paid to suppliers and employees (xxx)
Cash generated from operations xxx
Interest paid (xxx)
Income tax paid (xxx)
Dividends paid (xxx)
Net cash from operating activities xxx

Example 2.8

The following information relates to Alpha limited:

Statement of financial position as at 31 December 2017

2017 2016
$ $
ASSETS
Non-current assets
Property, plant and equipment at cost 135 000 90 000
Accumulated depreciation (30 000) (20 000)
105 000 70 000
Current assets
Inventories 20 000 25 000
Trade receivables 30 000 20 000
Bank 35 000 15 000
85 000 60 000
Total assets 190 000 130 000
EQUITY AND LIABILITIES
Equity
Ordinary share capital, $1 shares 60 000 50 000
Preference share capital, $1 shares 30 000 25 000
Retained earnings 57 500 20 000
147 500 95 000
Current liabilities
Trade payables 10 000 15 000
Dividends payable 7 500 5 000
Tax payable 25 000 15 000
42 500 35 000
Total equity and liabilities 190 000 130 000

Statement of profit or loss and other comprehensive income for the year ended 31
December 2017
$
Revenue 200 000
Cost of sales (65 000)
Gross profit 135 000

50
Other expenses (55 000)
Profit before tax 80 000
Income tax expense (25 000)
Profit for the period 55 000
Other comprehensive income ---------
Total comprehensive income for the year 55 000

Additional information

1. Other expenses include depreciation and loss on sale of property, plant and equipment
amounting to $25 000 and $5 000, respectively.
2. During the year, an item of property, plant and equipment was sold for $5 000. This
had cost $25 000 and had been depreciated by $15 000.
3. There was a bonus issue of ordinary shares to ordinary shareholders during the year on
a one-for-five basis.
4. Dividends declared amount to $7 500.

Required:

(a) Prepare the statement of cash flows for the year ended 31 December 2017 that
complies with the requirements of IAS 7, using:
(i) the indirect method;
(ii) the direct method.

Comparative amounts and notes are not required.

(b) Comment on the information revealed by the statement of cash flows.

Suggested solution

(a) Alpha Limited

(i) Indirect method

Workings

1. Income tax paid

$
Balance at beginning of period 15 000
Current tax expense 25 000
40 000
Balance at end of period (25 000)
Bank (amount paid) 15 000

2. Dividends paid

51
 $
Balance at beginning of period 5 000
Recognized in statement of changes in equity 7 500
12 500
Balance at end of period (7 500)
Bank 5 000

3. Property, plant and equipment at cost

$ $
Balance b/d 90 000 Disposal at cost 25 000
Acquisition (balancing figure) 70 000 Balance c/d 135 000
160 000 160 000
4. Ordinary share capital
$
Balance at beginning of year 50 000
Bonus issue: 50 000/5x1x$1 10 000
Balance at end of year 60 000

5. Preference share capital

$
Balance at beginning of year 25 000
Balance at end of year 30 000
Issue of new shares (amount received) 5 000

Alpha Limited
Statement of cash flows for the year ended 31 December 2017
$ $
Cash flows from operating activities
Profit before tax 80 000
Adjustments for:
Loss on sale of property, plant and equipment 5 000
Depreciation 25 000
110 000
Decrease in inventory (25 000 – 20 000) 5 000
Increase in trade receivables (30 000 – 20 000) (10 000)
Decrease in trade payables (15 000 – 10 000) (5 000)
Cash generated from operations 100 000
Income tax paid (15 000)
Dividends paid (5 000)
Net cash from operating activities 80 000
Cash flows from investing activities
Purchase of property, plant and equipment (70 000)
Proceeds from sale of property, plant and equipment 5 000
Net cash used in investing activities (65 000)
Cash flows from financing activities

52
Proceeds from issue of preference shares 5 000
Net cash from financing activities 5 000
Net increase in cash and cash equivalents 20 000
Cash and cash equivalents at beginning of period 15 000
Cash and cash equivalents at end of period 35 000

(a) Alpha Limited

(ii) Direct method

Workings

The first five workings are the same as those for the indirect method.
6. Cash receipts from customers
$ $
Debtors b/d 20 000 Bank (bal. fig.) 190 000
Revenue 200 000 Debtors c/d 30 000
220 000 220 000
7. Cash paid to suppliers and employees
$ $
Inventory b/d 25 000 Creditors b/d 15 000
Bank (bal. fig.) 90 000 Cost of sales 65 000
Creditors c/d 10 000 Other expenses (1) 25 000
Inventory c/d 20 000
125 000 125 000

(1) 55 000-25 000-5 000 = 25 000

Alpha Limited
Statement of cash flows for the year ended 31 December 2017
$ $
Cash flows from operating activities
Cash receipts from customers 190 000
Cash paid to suppliers and employees (90 000)
Cash generated from operations 100 000
Income tax paid (15 000)
Dividends paid (5 000)
Net cash from operating activities 80 000
Cash flows from investing activities
Purchase of property, plant and equipment (70 000)
Proceeds from sale of property, plant and equipment 5 000
Net cash used in investing activities (65 000)
Cash flows from financing activities
Proceeds from issue of preference shares 5 000

53
Net cash from financing activities 5 000
Net increase in cash and cash equivalents 20 000
Cash and cash equivalents at beginning of period 15 000
Cash and cash equivalents at end of period 35 000

b) Comment
The statement of cash flows shows that a significant proportion of the net cash inflows
($80000) was generated from operating activities. The remainder ($5 000) was generated
through the issue of preference shares. This indicates that the business relied largely on
the re-investment of profits to finance the expansion of the business and/or to maintain
current productivity. Equity shareholders were not called upon to provide additional
funds during the year.

The net cash generated from operating and financing activities ($85 000) was used to
purchase property, plant and equipment (65 000). This can be reconciled with the net
increase in cash and cash equivalents of $20 000.

The cash generated from operations ($100 000) was used to pay the income tax and
dividends ($20 000), leaving a surplus ($80 000) which was used to finance investing
activities as stated above.

54
3.7 Questions

Question 1
What does the abbreviation ‘IASB’ stand for?

Question 2

IFRSs are a mere duplication of the Conceptual Framework for Financial reporting.
Discuss.

Question 3

‘The Conceptual Framework is neither an accounting standard, nor an accounting

interpretation. It is a much more fundamental document, one which is intended to fulfill
the lofty purpose which underpins all financial reporting.’ (Bunting, 2003)

Required:

Motivate the above statement.

Question 4

It is fundamental to the idea of financial reporting that someone is actually going to read
the financial report and make some kind of decision based on that reading. Obviously,
therefore, this reader (commonly referred to as the user) and his information needs must
be identified.
Required:
Identify the users of financial reports and outline their information needs.

Question 5

The IFRS Framework acknowledges that general purpose financial statements cannot
meet all of the information needs of all user groups all of the time, but argues that the
provision of financial statements that meet the information needs of investors will also
meet most of the information needs of the other user groups.

Required:

Discuss how the provision of general purpose financial statements that meet the
information needs of investors will also meet most of the information needs of the other
user groups.

Question 6

Beta Limited’s financial year ended on 31 December 2017. On 15 January 2018, it came
to light that a trade debtor owing $45 000 and who had been experiencing financial

55
difficulties for a number of months had been declared insolvent. The financial statements
for the year ended 31 December 2017 have not yet been prepared and the accountant does
not want to account for the $45 000 as an allowance for credit sales losses at 31
December 2017, although the amount is material. The auditors, however, insist that it
should be done.

Required:

With reference to the criteria of the IFRS Framework, explain why one should agree with
the auditors’ requirement that the valuation adjustment and expense should be reflected in
the financial statements for the year ended 31 December 2017.

Question 7

Alpha Limited has disclosed the model of motor cars driven by its directors in its
financial statements over the past few years. Explain, with reference to the qualitative
characteristics of financial statements, whether the information complies with the
requirement of usefulness.

Question 8

Delta Limited has incurred costs amounting to $150 000 during the financial year ended
31 December 2017. The costs relate to the modification of its existing software system to
make it compliant with its new operating system. The expenditure incurred will only
enable the software system to continue to perform as it did originally.

The financial director of Delta Limited has decided that, in view of the amount involved,
the costs should be capitalized at 31 December 2017.

Required:

Discuss, with reference to the criteria of the IFRS Framework, whether or not you agree
with the financial director’s decision. Assume that the amount is material.

Question 10

The trial balance of Epsilon Limited is as follows:

Trial balance at 31 December 2017

DR CR
$ $
Ordinary shares of $1.00 each 100 000
Share premium 70 000
Retained earnings on 1 January 2017 13 900

56
Deferred tax on 1 January 2017 50 000
10% Debentures 100 000
Sales 756 000
Inventory on 1 January 2017 32 000
Purchases 446 000
Sales staff salaries and commission 83 000
Administration salaries 57 000
Carriage outwards 24 000
Other expenses 45 000
Debenture interest paid 5 000
Patents at cost 100 000
Freehold premises at revaluation 200 000
Revaluation surplus 60 000
Delivery vans at cost 75 000
Accumulated depreciation on delivery vans 30 000
Office machinery at cost 35 000
Accumulated depreciation on office machinery 10 000
Financial assets at fair value through OCI 40 000
Mark-to-market reserve 11 000
Trade receivables 60 000
Trade payables 42 000
Cash and cash equivalents 36 000
Interim ordinary dividend paid 4 900 -------
1 242 900 1 242 900

Additional information:

1. Inventory
Inventory at 31 December 2017 $54 000

2. Depreciation
Depreciation for the year ended 31 December 2017 is to be provided as follows:
Delivery vans: 20% on cost
Office machinery: 20% on cost
3. Freehold premises
The freehold premises were revalued at $212 000 at 31 December 2017.

4. Financial assets at fair value through OCI

The fair value of the financial assets at 31 December 2017 was $44 000.

5. Interest
Debenture interest is payable half-yearly on 30 June and 31 December. The amount due
on 31 December 2017 has not yet been paid.

6. Patents

57
Allow for amortization of patents of $25 000 at 31 December 2017.

7. Tax
- Taxable temporary differences (TTD) at 31 December 2017 amount to $150 000.
- Total income for the year ended 31 December 2017 that is subject to income tax in
terms of the Income Tax Act amount to $750 000.
- Allowable deductions for the year ended 31 December 2017 amount to $680 000.
- Assume a tax rate of 25% for all forms of income.

8. Dividends
The directors recommended a final dividend on the ordinary shares of five (5) cents per
share on 31 December 2017.

Required:

Prepare the following financial statements, to comply with the requirements of IAS 1:
(a) Statement of profit or loss and other comprehensive income for the year ended 31
December 2017;
(b) Statement of changes in equity for the year ended 31 December 2017;
(c) Statement of financial position as at 31 December 2017.
Note:
- Classify expenses by function in the statement of comprehensive income.
- Comparatives and notes are not required.

Question 11

Distinguish between the direct and indirect methods of presenting cash flows from
operating activities.

Question 12

Suggest reasons why the profit for the period in the statement of comprehensive income
of an entity may be different from the net cash from operating activities in the statement
of cash flows.

Question 13

The following information was extracted from the financial statements of Beta Limited:

Statement of financial position as at 31 December 2017

2017 2016
$ $
ASSETS
Non-current assets

58
Property, plant and equipment at cost 290 000 200 000
Accumulated depreciation on PPE (60 000) (40 000)
Goodwill --------- 10 000
230 000 170 000
Current assets
Inventories 115 000 48 000
Trade receivables 98 000 40 000
Bank 12 000 10 000
225 000 98 000
Total assets 455 000 268 000

EQUITY AND LIABILITIES

Equity
Ordinary share capital, $1 shares 240 000 200 000
Share premium 10 000 ---------
Retained earnings 74 000 20 000
324 000 220 000
Non-current Liabilities
8% debentures 50 000 ---------
Current Liabilities
Trade payables 50 000 20 000
Current tax payable 18 000 15 000
Dividends payable 13 000 13 000
81 000 48 000
Total liabilities 131 000 48 000
Total equity and liabilities 455 000 268 000

Statement of profit or loss and other comprehensive income for the year ended 31
December 2017
$
Revenue 200 000
Other expenses (112 000)
Debenture interest (4 000)
Profit before tax 84 000
Income tax expense (17 000)
Profit for the period 67 000

Additional information:

1. No items of property, plant and equipment were disposed of during the period.
2. Other expenses include depreciation amounting to $20 000 and goodwill impairment
loss amounting to $10 000.
3. Dividends amounting to $13 000 were declared.

59
Required:

Prepare the statement of cash flows for the year ended 31 December 2017 using (1) the
indirect method and (2) the direct method. The statement of cash flows must comply with
the requirements of IAS 7. Comparative amounts and notes are not required.

60
 UNIT THREE

FINANCIAL STATEMENT ANALYSIS

3.1 Objective of financial statement analysis

The broad objective of financial statement analysis is to examine an entity’s financial
position and performance in relation to risk, with a view to evaluate the future prospects
of the firm. Financial analysis can, therefore, be seen as some form of SWOT Analysis.
The specific objectives of financial analysis are closely linked to the information needs of
the users of the financial statements. Therefore, in examining the specific objectives of
financial statement analysis, there is need to identify the different categories of users and
their information needs. The users of financial statement analysis information include
investors (current and prospective), lenders, suppliers, customers, management,
employees, auditors, financial analysts and other interested parties.

3.2 Standards of performance

Standards of performance (or standards of comparison or measures of perfomance) are

used to measure/assess the financial position and performance of an entity. Financial
statement analysis often involves comparing reported information about an entity over
different periods and comparing different entities during the same periods of time. The
standards of performance can, therefore, be categorized as internal standards and external
standards.

3.2.1 Internal Standards

Internal standards of performance are used to compare reported information about an

entity over different periods. Two common internal standards of performance are
previous periods and planned performance.

(a)Previous Periods

Comparison of current period with past periods indicates whether current financial
position and performance are better or worse than past periods, i.e. the analyst can study
the composition, size and direction of change and determine whether there has been an
improvement or deterioration in the entity’s financial position and performance over
time. By employing past periods as a standard of performance, it may be possible to
detect trends/patterns which will be useful in predicting future performance.

61
(b) Planned Performance

Comparison of actual performance with planned performance indicates whether current

financial position and performance meet budgeted financial position and performance.
Significant differences should be investigated and corrective action taken and/or plans
revised.

3.2.2 External Standards

External standards of performance are used to compare the performance of different

entities during the same periods of time. The common external standards of performance
are similar firms, industry averages, benchmarks and other acceptable norms.

(a) Similar firms within the same industry

The analyst compares the financial position and performance of one entity with those of
similar entities within the same industry at the same point in time. Such a comparison
gives insight into the relative financial position and performance of the entity and to
establish whether the entity is doing better or worse than competitors. It also helps to
identify’ any significant deviations from what is prevailing within the industry. This
standard, therefore, increases objectively as it offers an external basis for comparison.

(b) Industry averages

The analysis compares the financial position and performance of the entity with industry
averages at the same point in time. Again, such a comparison gives insight into the
relative financial position and performance of the entity. It also helps to identify any
significant deviations from any applicable industry averages. This standard, therefore,
also increases objectivity as it offers an external basis of comparison. However, industry
averages should not be treated as targets or goals. Rather, they provide general
guidelines.

(c) Benchmarks

Benchmarking is the comparison of the entity’s financial position and performance with
those of the high performers or world-class entities within the industry. Benchmarks can
be treated as targets or goals. This standard, therefore, also increases objectivity as offers
an external basis for comparison.

62
(d) Other acceptable norms

Rule of thumb is a case in point. However, the analyst should avoid using rules of thumb
indiscriminately for all industries. The analysis must be in relation to the type of business
in which the entity operates and to the entity itself.
.
3.3 Financial ratio analysis
3.3.1 Financial ratios

A financial ratio is a measure which shows the relationship between two financial figures.
It is an index or number that relates two pieces of financial data by dividing one financial
figure by the other. It is the mathematical relationship between the two pieces of financial
data.

Financial ratio analysis involves computing a financial ratio and then assessing whether
the ratio indicates a weakness or strength in the entity’s financial position and/or
performance. An assessment of the past and current financial position and performance is
useful in:

• Determining whether or not managers of the business have used the resources available
in an efficient and effective manner.
• Formulating views/opinions about the future prospects of the business, which should be
useful when making decisions.

Financial ratios are key indicators that provide the analyst/user with valuable
clues/insights concerning the financial health of the entity. By calculating ratios which
reflect key relationships, it is possible to reduce the complexity of the financial
statements to a small number of key indicators. However, ratios alone do not provide a
comprehensive analysis of the financial health of the entity. Rather, they provide a useful
starting point for further analysis by highlighting areas which require further
investigation.

A financial ratio by itself has no real significance. It is only when a ratio is compared
with some standard of performance that it can be properly evaluated. The standards of
performance by which ratios can be judged are the internal and external standards of
performance already discussed.

3.3.2 Financial ratio classification

As a financial ratio is a mathematical relationship between two financial figures, any two
amounts can be extracted and compared. However, meaningful analysis will only result if
the relationship between the two financial figures provides additional insight or
information.

63
 Financial ratios are usually classified according to the particular aspect of the business’
financial health/condition they seek to examine/assess. There is a strong interaction
between the classifications or categories such that some of the individual ratios may
belong to more than one class. The major classifications include the following:

• Profitability ratios;
• Activity ratios;
• Liquidity ratios;
• Financial leverage ratios;
• Cash flow ratios;
• Investor ratios.

One of the reasons for classifying financial ratios in this way is to group together those
ratios which might be of particular interest to a particular type of users of financial
statements. The level of importance attached to each class of ratios will depend on the
type of user and the purpose of the analysis. It is, therefore, important when conducting
financial ratio analysis to be clear for whom and for what purpose the analysis is being
undertaken.

3.3.3 Profitability ratios

Profitability ratios help assess the operating performance of the entity. They are used,
among other things:

• To assess whether the business is a worthwhile investment opportunity. Investors

require a fair return on their investment, considering the risk attached to an investment.
• To measure the performance of management.
• To determine the business’ performance relative to competitors.

Profitability ratios cover business operations for a period of time and are of two types:

• Ratios measuring profitability in relation to sales:

- Gross profit margin;
- Net profit margin.

• Ratios showing profitability in relation to investment:

- Return on assets;
-Return on capital employed;
-Return on equity.

(a) Gross profit margin (GP%)

Gross profit margin = Gross profit/Revenue x 100
Gross profit margin is also known as gross profit percentage or gross margin. It is used

64
to assess the trading performance and pricing policy of the business. It measures the
amount of gross profit earned on each dollar of revenue.

(b) Net profit margin (NP%)

Net Profit margin = Profit before interest and tax/Revenue x 100
Net profit margin is also known as net profit percentage or profit margin. It measures the
operating profit per dollar of revenue.

(c) Return on assets (ROA’)

Return on assets (ROA) is also known as Return on investment (ROI).
Return on assets = Profit before interest and tax/Total assets x 100

ROA is an input/output ratio in that it measures the output in the form of profit against
the input in the form of assets invested. It focuses on the profitability of the business as a
whole. It measures the efficiency with which the assets were used to generate profits. It
indicates the amount of profit per dollar invested in assets. ROA indicates the generation
of profits through business activities before the leverage effect of outside financing (i.e.
loans) starts increasing or decreasing the eventual return on equity.

(d) Return on capital employed (ROCE)

Return on capital employed = Profit before interest and tax/Capital employed x 100
Where: Capital employed = Shareholders’ equity + Non-current liabilities.

ROCE is also an input/output ratio. It measures management’s efficiency in the use of

capital employed in the business. It relates the profits earned to the funds employed to
generate those profits. It indicates the amount of return per dollar of capital employed in
the business. ROCE indicates to what extent a fair return was earned on capital
employed.

(e) Return on equity (ROE)

Return on Equity = Profit after tax and preference dividend/Ordinary shareholders’ equity
x 100

ROE is also an input/output ratio. It measures management’s efficiency in the use of

equity funds. It measures the rate of return the equity shareholders are earning from their
investment in the business. It indicates the amount of return per dollar of equity.

3.3.4 Activity ratios

Activity ratios are also known as efficiency ratios, asset management ratios, or turnover
ratios. They measure the efficiency with which the business utilizes its assets. They
provide useful insights into management policy and operational efficiency. Profitability is
affected by the way assets are used. The common activity ratios are:

65
• Inventory turnover ratio;
• Inventory holding period;
• Trade receivable turnover ratio;

• Trade receivables collection period;

• Trade payables turnover ratio;
• Trade payables payment period;
• Cash cycle ratio;
• Total asset turnover ratio;
• Non-current asset turnover ratio,

(a) Inventory turnover ratio

Inventory turnover ratio = Cost of sales/Average inventory
It indicates the number of times average inventory is sold during the accounting period. It
indicates the number of times average inventory generates sales during the period.

(b) Inventory holding period

Inventory holding period = Average inventory/Cost of sales x 365 days.
The inventory holding period measures the average length of time inventory spends in the
business before it is sold or before it is used in production. It indicates realisability of
inventory.

(c) Trade receivables turnover ratio

Trade Receivables turnover ratio = Credit sales/Average trade receivables
The ratio indicates the number of times trade receivables generate sales. It focuses on the
entity’s credit granting practices.

(d) Trade receivables collection period

Trade receivables collection period = Average trade receivables/Credit sales x 365days.
The ratio measures the average length of time it takes trade debtors to pay. It indicates the
average credit period allowed to trade debtors. It focuses on the entity’s debt collection
policies.

(e) Trade payables turnover ratio

Trade payables turnover ratio = Credit purchases/Average trade payables.
The ratio measures the number of times the average trade creditors grant credit to the
business.

(f) Trade payables payment period

Trade payables payment period = Average trade payables/Credit purchases x 365 days.
The ratio measures the average length of time it takes the business to pay its trade
creditors. It indicates the average credit period allowed by trade creditors.

(g) Cash Cycle

Cash cycle = Inventory holding period + Trade receivables collection period - Trade
payables payment period.

66
The ratio is also known as operating cycle or business cycle. It describes the flow of cash
out of the business and back into it again as a result of normal trading operations. It
indicates the time it takes cash to circulate through the business activities until it is once
again converted into cash.

(h) Total asset turnover ratio

Total asset turnover ratio = Revenue/Total assets
The ratio measures the efficiency with which the business is using its assets to generate
revenue. It indicates the amount. of revenue per dollar invested in assets.

(i) Non-current asset turnover ratio

Non-current asset turnover ratio=Revenue/Non-current assets.
The ratio measures the efficiency with which the business is using its non-current assets
to generate revenue. It indicates the amount of revenue per dollar invested in non-current
assets.

3.3.5 Liquidity ratios

The Liquidity of an entity is its ability to meet its obligations in the short-term. Liquidity
ratios are ratios which address the entity’s liquidity position by focusing on the
realisability of current assets and the timing of repayments of current liabilities. To assess
the liquidity of a business, two ratios are commonly used, i.e. the current ratio and acid-
test ratio. Note: The activity ratios based on the current assets and current liabilities may
also be classified as liquidity ratios.

(a) Current ratio

This ratio is also known as the working capital ratio.
Current ratio = Current assets/Current liabilities
This ratio assesses how well the business can meet its short-term financial commitments
from its current assets. It indicates the extent to which current liabilities are covered by
current assets.

(b) Acid Test Ratio

The ratio is also known as the quick ratio or liquid ratio.

Acid test ratio = (Current assets - Inventory)/Current liabilities.

This ratio measures the ability of the business to meet its short-term financial
commitments from cash and liquid assets. A liquid asset is an asset that can be converted
easily and quickly into cash with no significant loss in value.

3.3.6 Financial Leverage ratios

Financial Leverage ratios are also known as debt management ratios, gearing ratios,
solvency and risk ratios, capital structure ratios or financial structure ratios. The
relationship between the amount of fixed-return capital (i.e. preference shares and loans)

67
and ordinary shares in the capital structure is referred to as capital gearing or leverage.
The term gearing or leverage is used because employing fixed-return capital has the
effect of increasing or decreasing the return to ordinary shareholders. The use of gearing
introduces financial risk. While the use of gearing provides the opportunity for greater
returns for equity shareholders when profits are good, it also brings with it lower returns
to equity shareholders when profits are not so good. Thus, gearing ratios are used to
assess financial risk. The common gearing ratios are:

• Solvency ratio;
• Debt ratio;
• Gearing ratio;
• Debt/Equity ratio;
• Interest coverage ratio;

(a) Solvency ratio

Solvency ratio = Total assets/Total debt
Where: Total debt = Preference shares + Total liabilities
The ratio shows the entity’s ability to pay liabilities in the long term. It measures the
extent to which debt is covered by assets.

(b) Debt ratio

Debt ratio = Total debt/Total assets x 100.
The ratio measures the extent to which debt holders are financing the assets of the
business. By showing the percentage of total assets financed by debt, it indicates the
amount of debt financing for each dollar of assets.

(c) Gearing ratio

Gearing ratio = Fixed-return capital/(Equity + Fixed-return capital) x 100.
The ratio addresses the entity’s capital structure. The capital structure of a business
reflects the financing strategy adopted for financing the business activities.

(d) Debt/ equity ratio

Debt/equity ratio = Fixed-return capital/Ordinary shareholders’ equity x 100.
The ratio measures the relative contribution of debt and equity in financing the business.
It indicates the extent to which debt financing is used relative to equity financing. It
shows the amount of debt financing per dollar of equity financing.

(f) Interest coverage ratio

Interest coverage ratio = Profit before interest and tax/Interest charges.
The ratio is also known as the times interest earned ratio. It measures the entity’s ability
to meet its interest payments. It measures the amount of protection available to lenders. It
indicates the amount of profit covering each dollar of interest charges. It also sheds some
light on the business capacity to take on new debt.

68
3.3.7 Cash flow ratios

Cash flow ratios measure the ability of the entity to generate adequate cash flows from its
operating activities. The common cash flow ratios are:

• Cash flow-to-total debt;

• Repayment period;
• Quality of income.

(a) Cash flow-to-total debt ratio

Cash flow-to-total debt ratio = Cash generated from operations/Total debt.
The ratio is an indicator of financial distress.

(b) Repayment period

Repayment period (in years) = Total debt/Cash generated from operations.
The ratio measures the time it would take to repay all liabilities if all cash was used for
repayments of debt.

(c) Quality of income

Quality of income = Cash generated from operations/(Profit before interest, tax and
depreciation).
The ratio measures the difference between cash flow and profit due to the accrual
concept.
Note: The cash flow figure is obtained from the statement of cash flows.

3.3.8 Investor ratios

Investor ratios are also known as shareholder ratios. They measure performance of the
ordinary shareholders’ investment in the business. They provide measures of return and
coverage which may help in deciding whether to buy, hold or sell shares in a particular
entity. Investor ratios are of two types:

• Historical performance ratios:

- Earnings per share (EPS);
- Dividend per share (DPS);
- Dividend cover;
- Dividend payout ratio.

The historical performance ratios give an indication of the past performance and
dividend policy of the entity at the end of the financial year. Such ratios are a historical
fact and are not subject to day-to-day fluctuations.

• Present and future performance ratios:

- Price/earnings ratio (P/E ratio);

69
- Earnings yield;
- Dividend yield;

The present and future performance ratios reflect the market’s expectations of the future
performance of the entity. Ordinary shares are sensitive to expected future performance
of the entity. Thus, the prices of ordinary shares fluctuate in sympathy with expectations
of future performance of the entity.

(a) Earnings per share (EPS)

Earnings per share = Profit after tax and preference dividends/Number of ordinary shares
in issue
EPS measures the amount of profits earned by each ordinary share.

(b) Dividend per share (DPS)

Dividend per share = Ordinary share dividends/Number of ordinary shares in issue.
DPS measures the amount of dividend earned by each ordinary share.

(c) Dividend Cover

Dividend cover = Earnings per share/Dividend per share.
The ratio indicates the number of times the actual dividend can be paid out of the current
profits attributable to ordinary shareholders.

(d) Dividend payout ratio

Dividend payout ratio = Dividend per share/Earnings per share*100.
Dividend payout ratio measures the proportion of profits attributable to ordinary
shareholders that is paid as dividends. It also indicates the entity’s dividend policy.

(e) Price/earnings ratio (P/E ratio)

Price/earnings ratio = Market price per ordinary share/Earnings per ordinary share.
The ratio measures the amount that an investor has to pay per each dollar of reported
profits. It indicates the investor’s expectations concerning the future growth prospects of
the entity.

(f) Earnings yield

Earnings yield = Earnings per share/Market price share per share x 100.
The ratio measures the long-term return on the shares. It indicates the return demanded
by investors. It indicates the return that a majority shareholder can expect to earn on
shares.

(g) Dividend yield

Dividend yield = Dividend per share/Market price per share x 100.
The ratio measures the cash return in the form of dividends that the investor will earn.

70
3.4 Limitations of financial statement analysis

The usefulness of financial statement analysis largely depends upon:

• The quality of the underlying financial statements. Where the underlying

statements upon which the analysis is based are unreliable, the quality of the
analysis is undermined.

• The validity of the standards of comparison, (i.e. standards of performance)

employed. The standards used for comparison purposes must be valid for a proper
interpretation of results.

The value of financial statement analysis can be reduced considerably due to the
limitations inherent in the financial statements. The inherent weaknesses in financial
statements should be recognized when analyzing the financial position and
performance of a business as these may influence the decision making process. Some
of the limitations are discussed below:

3.4.1 Information problems

(a) Analysis of financial statements only identifies symptoms of problems, not causes of
problems. The analysis can only indicate that there may be a problem. Thus, the analysis
does not resolve problems or even reveal exactly what the problem is. The solution to the
problem is entirely in the hands of management.

(b) Financial statements mainly disclose information that can be expressed in monetary
terms. Non-financial information may be relevant to the decision to be made.

(c) Mainly quantitative information is included in the financial statements. Qualitative

matters such as management, products, markets and competition may also have an
influence on the decision of users.

(d) Information in the financial statements relates to the past, but the decisions that need
to be taken relate to the future. Thus, unless the past is a reasonable predictor of the
future, the information may have limited value. Users need to formulate views about the
future prospects of the business.

(e) Historic cost information may not be the most appropriate information for the
decision for which the analysis is being undertaken. Due to inflation, an analysis of
historic cost data may generate distorted information, as the data may bear no relation to
current market values.

(f) The information in the financial statements is summarized and is usually limited to the
minimum disclosure requirements. This may hamper an in depth analysis.

71
3.4.2 Internal Comparison Problems

(a) Effects of price changes make comparisons difficult, unless adjustments are made.

(b) The effects of changes in accounting policies on reported results have the potential to
distort information.

(c) There are problems associated with establishing a normal base year to compare other
years with.

3.4.3 External comparison problems

(a) There are problems associated with the selection of industry norms and the usefulness
of norms based on averages.

(b) Financial statements may not be comparable as a result of different entities using
different accounting policies and other subjective matters. Accounting policies used in
industry norms must also be taken into account.

(c) Financial statements may not be comparable as a result of different entities having
different operating and financial risk profiles and the impact of these on the analysis.

Example 3.1

The abridged statements of financial position of Theta Limited for the past three years are
as follows:

Statement of financial position as at 31 December 20117

2017 2016 2015
$ $ $
ASSETS
Non-current assets
Property, plant and equipment 36 450 30 300 30 000
Current assets
Inventory 51 000 36 000 24 000
Trade receivables 42 000 27 000 18 000
Bank ----- 18 000 30 000
Total assets 129 450 111 300 102 000
EQUITY AND LIABILITIES
Equity
Ordinary share capital 30 000 30 000 30 000
Retained earnings 36 450 36 300 36 000
Non-current liabilities
25% debentures 6 000 3 000 -----
Current liabilities

72
Trade payables 51 000 42 000 36 000
Bank overdraft 6 000 ----- -----
Total equity and liabilities 129 450 111 300 102 000
Required

(a) From the above data, compute the two basic liquidity ratios.
(b) Comment on the results in (a) above from the point of view of trade creditors.

Suggested solution
Theta Limited
Computation of liquidity ratios
2017 2016 2015
1. Current ratio
CA/CL 93000/57000 81000/42000 72000/36000
=1.63:1 =1.93:1 =2.00:1

2. Acid-test ratio
(CA-I)/CL 42000/57000 45000/42000 48000/36000
=0.74:1 =1.07:1 1.33:1
KEY
CA = Current assets; CL = Current liabilities; I = Inventory.

Analysis of liquidity from point of view of trade creditors

Both the current and acid-test ratios show a declining trend in liquidity over the three
year period. The acid-test ratio has declined more sharply than the current ratio. The acid-
test ratio reveals that by 2017 there were insufficient cash and liquid assets to meet short-
term obligations.

The declining trend of the liquidity ratios, especially the acid-test ratio, suggests an
increase in short-term financial risk. This should be of particular concern to trade
creditors. The trend may adversely affect the creditworthiness of the company. The
company should, therefore, seek to reverse the declining trend in liquidity in order to
retain the confidence of trade creditors.

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3.5 Questions

Question 1
Among the users of financial statement analysis information are investors, long-term
lenders and short-term lenders. Which financial ratios would each group be most
interested in, and for what reasons?

Question 2
The value of financial statement analysis can be reduced considerably due to the
limitations inherent in financial statements. Discuss the limitations of financial statement
analysis.

Question 3
Financial statement data are often used in the comparative mode, such as:
(a) Time — Series applications: Comparisons of reported information of one entity at
different points in time;
(b) Cross-sectional applications: Comparisons of reported information of one entity with
that of other entities at the same point in time.
Required:
With reference to standards of performance, motivate the above statement.

Question 4

The following are the financial statements of Jerera Limited for the past two years.

Jerera Limited

Statement of profit or loss and other comprehensive income for the year ended 31
December 2017
2017 2016
$ $
Revenue 2 646 260 2 203 930
Cost of sales (2 117 010) (1 763 140)
Gross profit 529 250 440 790
Other expenses (435 450) (357 170)
Interest payable (10 000) (10 000)
Profit before tax 83 800 73 620
Taxation (43 800) (36 420)
Profit for the year 40 000 37 200
====== =====

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Jerera Limited
Statement of financial position as at 31 December 2017
ASSETS 2017 2016
$ $
Non-current assets
Property, plant and equipment 64 010 25 190
Current assets
Inventory 254 260 202 310
Trade receivables 218 560 202 640
Bank 29 170 60 940
Total assets 566 000 491 080

EQUITY AND LIABILITIES

Equity
Ordinary share capital, 50 cents shares 50 000 50 000
Revenue reserves 147 630 122 630
Non-current liabilities
Deferred taxation 54 330 32 670
10% Debentures 100 000 100 000
Current liabilities
Trade payables 187 620 164 310
Tax payable 16 420 12 470
Dividends payable 10 000 9 000
Total equity and liabilities 566 000 491 080

Required:
a) Compute the following ratios for each of the two years:

(i) Any five profitability ratios

(ii) Two basic liquidity ratios

b) Comment on the changes between 2016 and 2017 from the point of view of the
ordinary shareholders.

Question 5

Sigma Limited is optimistic about the future economic prospects and has decided to
expand its operations. To expand, it will need to borrow funds to finance the acquisition
of property, plant and equipment.

The following data was extracted from the firm’s financial statement for the years ended
31 December 2016 and 2017

2017 2016
$ $

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Total assets 825 000 928 750
Ordinary shareholders’ equity 472 500 415 000
Long term debt 125 000 237 500
Total debt 352 500 513 750
Earnings before interest and tax 134 900 40 250
Interest charges 18 750 15 000

Required:
a) Compute five (5) relevant financial leverage ratios for the two years.

b) Comment on the financial leverage ratios calculated in (a) above from the point of
view of a prospective lender. Clearly articulate the decision the prospective lender
would most likely make and the justification thereof.

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 UNIT FOUR

BASIC MANAGEMENT ACCOUNTING CONCEPTS

4.1 Role of management accounting

Management accounting is an information system within an entity that provides
accounting and other information used by an entity’s managers in planning,
implementing and controlling an entity’s activities. It is a process that includes the
identification, measurement, accumulation, analysis, preparation, interpretation and
communication of the information needed by management to perform its functions. The
management accounting information system has, among others, three broad objectives:

• Internal routine reporting to managers for (1) cost planning and cost control of
operations and (2) performance evaluation of people and activities.
• Internal routine reporting to managers on the profitability of products, brand
categories, customers and distribution channels. This information is used in
making decisions on resource allocation, and in some cases, decisions on pricing.
• Internal non-routine reporting to managers for strategic decisions on matters such
as formulating overall policies and long-range plans, new product development,
investing in property, plant and equipment, and special orders or special
situations.

4.2 Management process

The management process is defined by the following activities: (1) planning, (2)
controlling and (3) decision-making.

4.2.1 Planning

Planning sets objectives for the entity and designs actions to achieve those objectives.
The planning decision involves choosing goals, predicting results under various
alternative ways of achieving those goals and then deciding how to attain the desired
goals. For example, a budget is a quantitative expression of a plan of action and an aid to
the coordination and implementation of the plan.

4.2.2 Controlling

Control covers both the action that implements the planning decision and the
performance evaluation of people and activities. It is the managerial activity of
monitoring a plan’s implementation and taking corrective action as needed, and is
achieved with the use of feedback. Control decisions require the comparison of actual
results with expected results and the establishment of accountability for variances from

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standards originally set. This function may require further management decisions to
ensure that the planned results are achieved, or to amend the initial plan in light of the
prevailing conditions.

4.2.3 Decision-making

Decision-making is the process of choosing from among competing alternatives. It is a

managerial function that is intertwined with planning and controlling. Managers make
planning decisions and controlling decisions. Decisions can be improved if information
about the alternatives is collected and made available to the managers. One of the major
roles of the management accounting information system is to supply information that
facilitates decision-making.

4.3 Classification of costs

To generate information relevant for different types of decisions, costs are classified into
costs for inventory valuation and profit measurement, costs for planning and decision-
making and costs for controlling and decision-making.

4.3.1 Cost objects

Cost is the cash or cash equivalent value sacrificed for goods and services that is
expected to bring a current or future benefit to the entity. A cost object is any item, such
as a product, customer, department, project or activity, for which costs are measured and
assigned. It can be a cost unit or a cost centre for which a separate measurement of cost is
desired.
A cost unit is a quantitative unit of a product or service in relation to which costs are
ascertained. A cost centre is a production or service location, function, activity, or item of
equipment whose costs may be attributed to cost units.

Costs can be divided into three broad categories, that is, costs for inventory valuation and
profit measurement, costs for planning and decision-making, and costs for controlling
and decision-making.

4.3.2 Costs for inventory valuation and profit measurement

(a) Expired and unexpired costs

An expired cost is a cost that has been consumed in the generation of revenue and has no
future revenue-producing potential and is reflected as an expense in the statement of
profit or loss and other comprehensive income. An unexpired cost is a resource which has
been acquired and which is expected to contribute to future revenue and is reflected as an
asset in the statement of financial position.

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(b) Production and non-production costs

Production costs (or product costs) are those costs that are associated with the
manufacture of goods or the provision of services. They are inventoriable costs that are
incurred in order to obtain a saleable product or service. Non-production costs (or period
costs) are those costs that are associated with the functions of marketing and
administration. They are non-inventoriable costs which are expended in the statement of
profit or loss and other comprehensive income in the period incurred, or to which they
apply, according to the accrual concept.

Production costs can be further classified as direct materials, direct labour and overheads.
Only these three cost elements can be assigned to products or services for external
financial reporting.

Direct materials are those materials that are directly traceable to the goods and services
being produced. They become part of a tangible product or are used in providing a
service.

Direct labour is the labour that is directly traceable to the goods and services being
produced. Those employees who convert raw materials into a product or who provide a
service to customers are classified as direct labour.

Overheads are all production costs other than direct materials and direct labour.

A prime cost is the sum of direct material cost and direct labour cost. A conversion cost is
the sum of direct labour cost and overhead cost.

The production and non-production costs are summarized in the example below.

Example 4.1

Total operating costs

$ $
Direct materials xxx
Direct labour xxx
Prime cost xxx
Production overheads xxx
Total production costs xxx
Marketing costs xxx
Administrative costs xxx
Total non-production costs xxx
Total operating costs xxx

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4.3.3 Costs for planning and decision-making

(a) Cost behaviour

Cost behaviour is a general term for describing whether costs change as output changes.
Knowledge of how costs will vary with different levels of activity (or volume) is essential
for decision-making. Activity or volume may be measured in terms of units of production
or sales, hours worked, patients seen or any other appropriate measure of the activity of
an entity.

Normally, the situations where cost behaviour is analyzed for planning and decision-
making are short run in nature. Over the longer term, changing prices, methods of
production and technology make any form of cost classification subject to change. In the
short run, cost behaviour forms the basis of the classification of costs into variable, fixed
and semi-variable (or mixed) costs.

(i) Fixed costs

A fixed cost is a cost that, in total, remains constant within a relevant range as the level of
activity changes. The relevant range is the range of output over which the assumed
cost/output relationship is valid. While the fixed cost remains unchanged in total, the unit
fixed cost will change because the fixed costs will be spread out over more, or less,
output.

(ii) Variable costs

A variable cost is a cost that, in total, varies in direct proportion to changes in output. For
example, doubling the level of activity will double the total variable cost. The total
variable cost varies in direct proportion to changes in output because the unit variable
cost remains constant.

(ii) Semi-variable costs

A semi-variable cost is a cost that contains both a fixed and a variable component and is,
therefore, partly affected by changes in the level of activity.

(b) Relevant and irrelevant costs and revenues

For decision-making, costs and revenues can be classified according to whether they are
relevant to a particular decision. Firstly, all decisions relate to the future and, therefore,
only future costs and revenues can be relevant to decisions. Secondly, to be relevant, a
cost or revenue must not only be a future cost or revenue, but must also change because
of the decision. Relevant costs and revenues are those costs and revenues that will change
because of the decision, while irrelevant costs and revenues are those that will not change
because of the decision. Also, relevant costs or revenues are those future costs or

80
revenues that differ across alternatives. If a future cost or revenue is the same for all
alternatives, it is irrelevant.

(c) Incremental (or differential) costs and revenues

An incremental cost or revenue is the additional cost or revenue that arises from the
production or sale of one additional group of units. Incremental costs may or may not
include fixed costs. If a fixed cost changes as a result of a decision, it represents an
incremental cost.

(d) Avoidable and unavoidable costs

Only avoidable costs are relevant to a decision. Unavoidable costs will be incurred
anyway, and will, therefore, not influence the decision. The decision rule is to accept
those alternatives that generate revenues in excess of avoidable costs.

(e) Sunk costs

Sunk costs are the costs of resources already acquired. They are a result of a decision
made in past that cannot be changed by any decision in the future. Sunk costs are,
therefore, irrelevant for decision-making.

(f) Opportunity costs

An opportunity cost is the benefit given up, lost, or sacrificed when a choice of one
course of action requires the alternative to be rejected. Opportunity costs only apply to
the use of scarce resources, for example, shortages of labour, materials and capacity. If
there is no alternative for the resource, the opportunity cost is equal to zero.

4.3.4 Costs for controlling and decision-making

Responsibility accounting is a system that measures results of each responsibility centre

according to the information managers need to operate their centres. It is a system that
measures the plans (by budgets) and actions (by actual results) of each responsibility
centre. An individual manager is held responsible for each segment’s performance.

A responsibility centre is a segment of an entity whose manager is accountable for a

specified set of activities. Each manager, regardless of level, is in charge of a
responsibility centre. The higher the manager’s level, the broader the responsibility centre
he manages. Responsibility centres are divided into four major types:

Cost centre
A responsibility centre in which a manager is responsible (i.e. accountable) only for
costs.

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Revenue centre
A responsibility centre in which a manager is responsible/accountable only for revenues.

Profit centre
A responsibility centre in which a manager is responsible/accountable for both revenues
and costs.

Investment centre
A responsibility centre in which a manager is responsible/accountable for investments,
revenues and costs.

(a) Controllable and non-controllable costs and revenues

Costs and revenues allocated to a responsibility centre should be classified according to

whether, or not, they are controllable by the manager of the responsibility centre. All
costs are controllable at some management level.

A controllable cost is a cost that is reasonably subject to regulation by the manager with
whose responsibility that cost is being identified. It is any cost that is primarily subject to
the influence of a given manager of a given responsibility centre for a given time span. If
this condition does not hold, then the cost should be classified as being non-controllable
by the manager of the responsibility centre.

(b)Cost behaviour

Classification of costs by behaviour in response to changes in the level of activity is also

important for control. Costs are classified as fixed, variable and semi-variable as already
discussed.

4.4 Cost assignment

Cost assignment is a general term that encompasses both (1) tracing costs to a cost object
and (2) allocating costs to a cost object. Costs have either a direct or an indirect
relationship to a cost object.

4.4.1 Cost tracing

Cost tracing is the assignment of direct costs to a cost object. A direct cost is a cost that is
related to a cost object and can be traced to it in an economically feasible way. Examples
of direct costs are direct materials and direct labour. Tracing uses an observable measure
of the resources consumed by a cost object to assign costs to the cost object.

4.4.2 Cost allocation

Cost allocation is the assignment of indirect costs to a cost object. An indirect cost is a
cost that is related to a cost object, but cannot be traced to it in an economically feasible

82
way. An example of an indirect cost is production overheads. Indirect costs are allocated
to a cost object using a cost allocation method based on some assumed linkage or
convenience.

4.5 Questions
Question 1

Briefly discuss the role of management accounting.

Question 2

Describe the management process.

Question 3

Classify costs in terms of:

(a) costs for inventory valuation and profit measurement;

(b) costs for planning and decision-making;
(c) costs for controlling and decision-making.

Question 4

Describe cost assignment.

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 UNIT FIVE

BUDGETING AND BUDGETARY CONTROL

5.1 Budgetary control

While the budget indicates the route that must be followed to achieve a specific goal,
budgetary control is the watch-dog which ensures that there is no deviation from the route
and that the goal is achieved in good time. This is done mainly by measuring, on a
continuous basis, the results attained against the budgeted/target results. It must be
determined whether what was planned in the budget can be carried out in practice.
Another important function of budgetary control is to establish the cause if there is a
difference between the planned and actual results, and to take the action necessary to
correct or avert in time.

One of the objectives of budgeting is to provide information to managers to be used in

controlling operations. Budgetary control is the establishment of budgets relating the
responsibilities of executives to the requirements of a policy, and the continuous
comparison of actual results with budgeted results, either to ensure by individual action
the objectives of that policy or to provide a basis for its revision

Budgetary control involves:

• Setting targets or performance standards for individuals, i.e. budget holders

• Comparing actual performance against the budget
• Expecting the budget holder to use this information to take action where
necessary to make sure that the budget is achieved
• Where necessary, changing the budget targets or performance standards

5.2 Benefits of budgeting

The benefits that can be derived from the full budgetary process are related to planning,
decision-making, coordination, authority and responsibility, communication, control and
motivation.

5.2.1 Planning

Budgeting forces managers to plan. It encourages managers to develop an overall

direction for the entity, foresee problems, and develop future policies.

5.2.2 Decision-making

Budgeting provides information that can be used to improve decision-making.

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5.2.3 Coordination

The budgeting process provides for the coordination of the activities of different divisions
of the entity to achieve organizational goals.

5.2.4 Authority and responsibility

The process of budgeting makes it necessary to define and clarify the specific areas of
responsibility and authority for each manager and each subordinate.

5.2.5 Communication

Budgets improve communication within the entity as they are formally communicated to
all employees. Also, they are an important avenue of communication between top and
middle management regarding the entity’s objectives and the practical problems of
implementing these objectives.

5.2.6 Control

The budget provides a standard for performance evaluation. Control is achieved by

comparing actual results with budgeted results on a periodic basis.

5.2.7 Motivation

The involvement of workers, middle management and top management in the preparation
of budgets and the establishment of clear targets against which to judge performance is a
motivating factor.

5.3 Problems of budgeting

1. Budgets are time consuming and expensive

Despite the advent of powerful computer networks and multi-layered models, budgeting
remains protracted and expensive. The average time consumed is between four and five
months. It also involves many people and absorbs up to 20 to 30 percent of senior
executives' and financial managers' time. Some organizations have attempted to place a
cost on the whole planning and budgeting process. Ford Motor Company figured out this
amounted to $1.2 billion per annum.

2. Budgets provide poor value to users

The perception of the value provided by the budgeting process varies widely. In one firm
it was apparent that the group board thought the budget gave them control, whereas
operating managers thought it was completely irrelevant to their needs. One of the
primary reasons that financial directors rank budgetary reform as their highest priority is
that their staffs spend too little of their time adding value. One conclusion from a 1999
global best practices study was that finance staff spent 79 percent of their time on "lower
value-added activities" and only 21 percent of their time analyzing the numbers.

85
3. Budgets fail to focus on shareholder value
Budgets focus on internally negotiated targets which tend to be incremental changes from
the previous period's outcomes. The result is a target that is inwardly comfortable to you,
yet appears outwardly difficult to your superior. There is no focus on the maximization of
customer or shareholder value.

4. Budgets are too rigid and prevent fast response

The evidence suggests that only 20 percent of firms change their budgets within the fiscal
cycle. Another survey result shows that 85 percent of management teams spend less than
one hour per month discussing strategy

5. Budgets protect rather than reduce costs

"Use it or lose it" is the manager's mantra. Not spending the budget is a cardinal sin in
most organizations. The result is that superiors invariably question why the resource is
needed and are understandably reluctant to allow it to pass into the budget for the next
period

6. Budgets stifle product and strategy innovation. "Never take risks." It is just not worth
it. If it's not in the budget, you might be exposed. Anyhow, if you did take a risk and it
worked out well, your superior probably thought of it first! And if it didn't work out, your
job might be on the line .

7. Budgets focus on sales targets rather than customer satisfaction

Though everyone wants to satisfy customers, that is not how they are measured and
rewarded. So they meet the sales target, persuade customers to buy their products, and
convince them that their slow-moving stock really is a great deal!

8. Budgets are divorced from strategy

According to a recent cover article in Fortune magazine, around 70 percent of companies
surveyed were poor at executing strategy-a massive indictment of the performance
management capabilities of budgets.

9. Budgets reinforce a dependency culture

The way to survive and prosper in a budgeting environment is to do what you're told,
meet the budget (but never beat it!).

10. Budgets lead to unethical behavior

Managing the results (also known as cooking the books) is a frequent outcome of
budgeting. Many finance managers are well versed in "managing the slack" and feeding it
into the results when needed. However, as we have seen, this practice can border on
outright fraud

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5.4 Pre-requisites of an effective budgetary control system

1. Support of Top Management

Generally budgets are prepared for one year. On the basis of the budgets, the employees
are changing their working methods, habits and even their inter-relationship also. Hence,
there may be a resistance to change on the part of employees. It leads to the preparation
of every budget with top management support.

2. Formal Organization

An employee can understand his scope of authority and responsibility with regard to
budget. In a formal organization, duties of every employee are clearly defined and
assigned. If so, they can know their authority and responsibility that are highly useful for
control through budgets.

3. Preparation by Responsible Executives

The involvement of employees in budget preparation helps the management for easy
implementation of budgets. This practice is followed subject to the approval and control
of Budget Director and Budget Committee.

4. Clear Cut Objectives

The success of budgetary control programme depends upon the clear-cut objectives of the
organization. Hence, the management before framing the objectives should take care.
Moreover, objectives are unambiguous.

5. Attainable Objectives

If the objectives are not attainable, the budgetary control system cannot succeed. On the
other hand, if the objectives are easily attainable, there is no need of special efforts and
there is no challenge to anybody. Hence, attainable objectives are framed for effective
implementation of budgetary control system.

6. Budget Committee

A budget committee is formed to prepare and implements the budgets. The budget
committee consists of functional managers of business organization. The committee
should be presided over by one of the top management personnel, to be called the Budget
Director.

7. Adequate Accounting System

Budgets are prepared on the basis of historical data. Hence, accounting records should be
properly maintained. Moreover, actual costs and revenue are periodically compared with

87
those of budgeted figures. The accounts are classified in terms of authority and
responsibility that facilitates the introduction of responsibility accounting system.

8. Periodic Reporting

There should be a proper communication in an organization for effective budgetary

control. Each employee of an organization should know about what is going on and what
has been achieved so far with regard to budget. For which, the management can make an
arrangement through which information about budget performance can be communicated
periodically. The employees can understand the variances through this system. Moreover,
it is highly useful to get communication for corrective actions.

9. Budget Education

A budget can be implemented very successfully with the active participation of line
managers and their sub-ordinates. For which, there is a need of showing interest by the
line managers and their subordinates. The budget director should take steps to create
interest among the line managers and their sub-ordinates through budget education.

The objectives of framing each budget, potentials of an organization and its employees
and techniques of budgeting are covered in the budget education. Moreover, the budget
director should create a close relationship with the line managers and their sub-ordinates
on the floor; discuss with them problems relating to the budgets and its implementation
and receive suggestions from them for improving budget procedures.

10. Appreciation Uses

Every employee of an organization should understand the uses of every budget. No one
should have the feeling that the budget is imposed on him. Nobody can participate
mechanically in the budget preparation and its administration regardless of whether he
likes it or not.

11. Limitations of Budgeting

The management should disclose not only the uses of budgets bud also the limitations of
every budgets. Everyone should realize that budget is only a managerial tool in capable
of managing itself.

5.5 Master budget

A master budget is a comprehensive financial plan for the entity as a whole. Typical, it is
for a one-year period corresponding to the financial year of the entity. It can be divided
into two components, that is, the operating budget and the financial budget.

5.5.1 Operating budget

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The operating budget consists of a budgeted statement of profit or loss, accompanied by
the following supporting schedules:

Sales budget;
Production budget;
Direct materials purchases budget;
Direct labour budget;
Overhead budget;
Selling and administrative expenses budget;
Ending finished goods inventory budget;
Cost of sales budget.

(a) Sales budget

The sales budget is a projection that describes the expected sales in units and in dollars. It
is the basis for all the other operating budgets and most of the financial budgets.

(b) Production budget

The production budget describes how many units must be produced in order to meet sales
needs and support ending inventory requirements. To compute the units to be produced,
both unit sales and units of beginning and ending finished goods inventory are needed.

Units to be produced = Expected unit sales + Units in ending inventory –

Units in beginning inventory

(c) Direct materials purchases budget

After the production schedule is completed, the budgets for direct materials, direct labour
and manufacturing overheads are prepared. The direct materials purchases budget details
the amount and cost of raw materials to be purchased in each time period. It depends on
the expected use of materials in production and the raw materials inventory needs of the
entity. Once the expected usage is computed, the purchases of materials, in units, can be
computed as follows:

Purchases = Direct materials needed for production + Desired direct materials

in ending inventory – Direct materials in beginning inventory

(d) Direct labour budget

The direct labour budget shows the total direct labour hours needed and the associated
cost for the number of units in the production budget.

(e) Overhead budget

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The overhead budget shows the expected cost of all indirect manufacturing items. Unlike
direct materials and direct labour, there is no readily identifiable input/output relationship
for overhead items. Instead, there are series of activities and related drivers.

(f) Ending finished goods inventory budget

The ending finished goods inventory budget supplies information needed for the
budgeted statement of financial position, and also serves as an important input for the
preparation of the cost of sales budget.

(g) Cost of sales budget

The cost of sales budget shows the expected cost of goods to be sold.

(h) Selling and administrative expenses budget

The selling and administrative expenses budget outlines planned expenditures for non-
manufacturing activities.

(i) Budgeted statement of profit or loss

The information in the eight schedules above is used to prepare the budgeted statement of
profit or loss. The budgeted statement of profit or loss shows the budgeted financial
performance for the budget period. It is presented in the same way as an ordinary
statement of profit or loss, except that its title specifies that it is a budgeted statement of
profit or loss.

Example 5.1

Alpha Limited produces coat racks. The projected sales for the first quarter of the coming
year and beginning and ending inventory data are as follows:

Sales in units 100 000

Unit price $15
Units in beginning inventory 8 000
Units in targeted ending inventory 12 000

The coat racks are molded and then painted. Each rack requires 2 kg of metal, which
costs $2.5 per kg. The beginning inventory of materials is 2 000 kg. Alpha Limited wants
to have 3 000 kg of metal in inventory at the end of the quarter. Each rack produced
requires 30 minutes of direct labour time, which is billed at $9.00 per hour. The standard
cost per rack is $11.00.

Required:
Prepare the following budgets for the first quarter:
(a) Sales budget;

90
 (b) Production budget;
(c) Direct materials purchases budget;
(d) Direct labour budget.

Suggested solution

Alpha Limited

(a) Sales budget for the first quarter

Units 100 000
Unit price $15.00
Sales $1 500 000

(b) Production budget for the first quarter

Sales in units 100 000
Desired ending inventory in units 12 000
Total needs 112 000
Beginning inventory in units (8 000)
Units to be produced 104 000
Standard cost per unit $11.00
Production cost $1 144 000
(c) Direct materials purchases budget for the first quarter
Units to be produced 104 000
Direct materials per unit (kg) 2.00
Production needs (kg) 208 000
Desired ending inventory (kg) 3 000
Total needs (kg) 211 000
Beginning inventory (kg) (2 000)
Materials to be purchased (kg) 209 000
Cost per kg $2.50
Total purchase cost $522 500

(d) Direct labour budget for the first quarter

Units to be produced 104 000
Labour hours per unit 0.5
Total hours needed 52 000
Cost per hour $9.00
Total direct labour cost $468 000

5.5.2 Financial budget

The financial budget consists of the cash budget, budgeted statement of financial position
and capital expenditure budget.

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(a) Cash budget

A cash budget is a statement of planned cash receipts and disbursements. The objective
of a cash budget is to ensure that sufficient cash is available at all times to meet the level
of operations that are outlined in the other budgets. It helps management to avoid
unnecessary idle cash, on the one hand, and unnecessary cash deficiencies, on the other.
An entity can avoid cash balances that are surplus to its requirements by enabling
management to take steps in advance to invest the surplus cash in short-term investments.
Alternatively, cash deficiencies can be identified in advance, and steps can be taken to
ensure that bank overdrafts will be available to meet any temporary cash deficiencies.

(b) Budgeted statement of financial position

The budgeted statement of financial position depends on information contained in the

current statement of financial position and in the other budgets in the master budget. It is
presented in the same way as the ordinary statement of financial position, except that its
title specifies that it is a budgeted statement of financial position.

(c)Capital expenditure budget

The capital expenditure budget contains the plan for acquiring non-current assets. These
assets have a time horizon that extends beyond the one-year operating period. Some of
these assets may be purchased during the coming year, while plans to purchase others
may be detailed for future periods.

Example 5.2

The following data relate to Epsilon Limited:

The opening cash balance on 1 April 2017 is expected to be $30 000.

The actual and budgeted sales are as follows:
$
February (actual) 80 000
March (actual) 90 000
April 75 000
May 75 000
June 80 000

Analysis of records shows that trade debtors settle their accounts according to the
following pattern:

60% within the month of sale;

25% the first month following that of sale;
15% the second month following that of sale.

Extracts from the purchases budget are as follows:

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 $
March (actual) 60 000
April 55 000
May 45 000
June 55 000

All purchases are on credit and past experience shows that 90% are settled in the month
of purchase and the balance settled the month after.

Wages are $15 000 per month and overheads of $20 000 per month (including $5 000
depreciation) are settled monthly.

Taxation of $8 000 has to be settled in May and the company will receive settlement of
an insurance claim of $25 000 in June.

Required:

Prepare the cash budget for the quarter ending 30 June 2017.

Suggested solution

Epsilon Limited

Workings

1. Receipts from sales

$
April
February (15% x 80 000) 12 000
March (25% x 90 000) 22 500
April (60% x 75 000) 45 000
79 500
May
March (15% x 90 000) 13 500
April (25% x 75 000) 18 750
May (60% x 75 000) 45 000
77 250
June
April (15% x 75 000) 11 250
May (25% x 75 000) 18 750
June (60% x 80 000) 48 000
78 000

2 Payments for purchases

$
April

93
Mar (10% x 60 000) 6 000
April (90% x 55 000) 49 500
55 500
May
April (10% x 55 000) 5 500
May (90% x 45 000) 40 500
46 000
June
May (10% x 45 000) 4 500
June (90% x 55 000) 49 500
54 000

Epsilon Limited
Cash budget for the quarter ending 30 June 2017
April May June Quarter
$ $ $ $
Opening balance 30 000 24 000 17 250 30 000
Cash receipts
Receipts from sales 79 500 77 250 78 000 234 750
Insurance claim ----- ----- 25 000 25 000
Total cash available 109 500 101 250 120 250 289 750
Cash disbursements
Purchases 55 500 46 000 54 000 155 500
Wages 15 000 15 000 15 000 45 000
Overheads, less depreciation 15 000 15 000 15 000 45 000
Taxation ----- 8 000 ----- 8 000
Total disbursements 85 500 84 000 84 000 253 500
Closing balance 24 000 17 250 36 250 36 250

5.6 Fixed and flexible budgets

A fixed budget is a budget prepared for a planned level of activity. A fixed budget is
prepared for planning purposes. The master budget of an entity is a fixed budget based on
a given level of activity and sales.

A flexible budget is a budget which, by recognizing different cost behaviour patterns, is

designed to change as volume of activity changes. It is a budget that can be adjusted to
allow for changes in the volume of activity. Within a flexible budget, a distinction is
made between fixed and variable costs. It can be used to evaluate actual performance, and
provide more useful variance information than a comparison of a fixed budget with actual
results would provide

Budgetary control using flexed budgets is a form of feedback control system as follows:

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 • It is similar to standard costing variance reporting
• Actual results are compared with a flexible budget based on the same volume of
activity and sales. The difference between actual results and the flexible budget
are variances
• Although it is possible to prepare flexible budgets based on absorption costing, it
is more appropriate to prepare flexible budgets using marginal costing principles

5.7 Behavioural aspects of budgeting

1. Getting Buy-In

The simplest, quickest way for management to draw up a budget is to do it top-down,

without consulting the lower ranks. This is a popular approach in corporations with
centralized decision-making, but it can cause problems. Workers and lower-level
managers may think the budget sets an unrealistic standard and resent being told to live
by it. When management solicits feedback and employee input, it takes longer.
Employees who feel they've helped set the budget, however, are more likely to make it
work.

2. Self-Interested Managers

Budgets aren't always objective, because management isn't objective. Whoever

participates in drawing up the budget may have vested interests. For example, a
department head has a stake in emphasizing her department's need for extra resources and
a bigger share of the money. That can lead to him inflating estimates of the money the
department needs or how much it contributes to the company. An effective budget-
making process has to include enough objective analysis that it can get past the human
factor.

3. Constraints and Resentment

Some employees feel a budget is a form of punishment. Managers can use budgets to
deny even reasonable requests or penalize employees for spending too much. Workers
may feel they can't do their jobs properly because of restrictions. Employees can become
even more hostile if meeting the budget is a key standard in assessing performance. An
article in "Accounting Historians Journal" says employees shackled to a bad budget are
likely to pad estimates and fudge figures to get around it.

4. Making It Work

Getting employee input in drawing up the budget can help them commit to making it
work. It also helps if managers present budgets as something they and their staff will
tackle as a team, working together. Efforts to involve employees have to be sincere,
though. A phony display of interest in the employees' view or a show of hearing their
concerns won't cut it. Employees see through those tricks, and that makes them even
more cynical about the management goals and decisions.

95
5.4 Questions
Question 1

Delta Limited expects to receive cash from sales of $45 000 in June 2018. In addition, the
firm expects to sell property worth $3 500 in June 2018. During the same month,
payments for raw materials are expected to total $10 000, direct labour payroll will be
$12 500 and other expenditures are budgeted at $14 900.

On 1 June 2018, the cash balance is expected to be $1 230.

Required:

Prepare the cash budget for June 2018.

Question 2

Sigma Limited manufactures and sells Product X. The following information relates to
first six months of 2017.

Sales in units 20 000

Selling price per unit $25
Finished goods inventory in units 2 000

Management is ready to prepare a master budget for second half-year of 2017. The
following additional information is provided:

• The selling price per unit will increase by 20% and the quantity to be sold will
decrease by 10%.
• Targeted finished goods closing inventory is 1 500 units.
• The standard cost of producing Product X is $17.75.

Required:

Prepare the following budgets for the second half-year of 2017:

(i) Sales budget
(ii) Production budget

96
 UNIT SIX

COST-VOLUME-PROFIT (CVP) ANALYSIS

8.1 Marginal costing

Marginal costing is also known as variable costing, direct costing or contribution
approach. It is an accounting system in which variable costs are charged to cost units and
the fixed costs of the period are written off in full against the aggregate contribution in
the period they are incurred. Its special value is in decision-making.

Marginal costing stresses the difference between variable and fixed costs. Only variable
manufacturing costs are assigned to the product and included in inventory valuation.
Fixed manufacturing costs are not allocated to the product, but are considered as period
costs and charged directly to the statement of income. The rationale for this is that a fixed
cost is a cost of capacity, or a cost of staying in business. Once the period is over, any
benefits provided by capacity have expired and should not be inventoried. The fixed costs
of a period are seen as expiring that period and are charged in total against the revenues
of the period.

The marginal production cost per unit is calculated as follows:

Example 8.1

Unit output cost

$
Direct material xxx
Direct labour xxx
Variable manufacturing overhead xxx
Cost per unit xxx

The marginal statement of income is presented as follows:

Example 8.2

Marginal statement of income for the period

$
Sales xxx
Variable costs
Variable cost of sales (xxx)
Variable selling and administrative costs (xxx)
Contribution margin xxx
Fixed costs

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 Fixed manufacturing costs (xxx)
Fixed selling and administrative costs (xxx)
Profit xxx

Contribution margin = Sales – Variable costs. It is the amount of revenue that is available
to contribute towards fixed costs and profit. Therefore, contribution margin = fixed cost +
profit. In other words, contribution margin is the amount of revenue remaining to cover
fixed cost and generate profit. It can be viewed as that fraction of sales that contributes to
the offset of fixed costs and the generation of profit.

8.2 Cost-volume-profit (CVP) analysis

8.2.1 Short-run planning and decision-making

CVP analysis is both a planning and decision-making tool. It is a short-term planning and
decision-making tool that applies marginal costing principles. A short-run or short-term is
normally a period of one year or less. CVP analysis is used to provide information to aid
operational decision-making with a planning focus. It explores the relationship among
costs, revenue, output levels and the resulting profit. Specifically, CVP analysis is a study
of the relationship among the following variables:

• Price of the product;

• Volume or level of activity;
• Variable cost per unit;
• Total fixed cost;
• Sales mix;
• Estimated profit.

8.2.2 Assumptions of CVP analysis

In order to avoid errors or incorrect conclusions when using CVP analysis, it is essential
to take into account the underlying assumptions of the analysis:

• Volume is the only factor that will cause costs and revenues to change, i.e. other
variables remain constant;
• A single product is sold, or there is a constant sales mix;
• Fixed costs will remain constant for the period under review;
• Profits are calculated on variable costing basis;
• The unit variable cost and selling price are constant, i.e. total costs and revenues
are linear functions of output;
• The analysis applies to the relevant range only;
• Costs can be accurately divided into their fixed and variable elements;
• The analysis only applies to a short-term time horizon.

8.2.3 Applications of CVP analysis

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CVP analysis is used to address the following issues:

• The determination of the break-even point;

• The determination of the margin of safety;
• The determination of the sales required to achieve a target profit;
• The impact of a given reduction or increase in fixed costs on the break-even
point;
• The impact of various price or cost levels on profit.

[Link] Break-even analysis

Break-even analysis is the process of determining the amount of sales (in units or dollars)
that will result in neither a profit being made, nor a loss being suffered, i.e. the point at
which the total costs equal sales, and profit equals zero. A primary requirement is that all
costs, both production and non-production, must be divided into their fixed and variable
components.

The break-even point can be determined by using either a formula or a graph. Using
formula, the break-even point can be calculated in units or in dollars as follows:

Break-even point in units = Total fixed cost/Contribution margin per unit

Where: Total fixed cost = Fixed production cost + Fixed non-production cost
Contribution margin per unit = Selling price per unit – Variable cost per unit
Variable cost per unit = Variable production cost +Variable non-production cost.

Break-even point in dollars = Total fixed cost/Contribution margin ratio

Where: Contribution margin ratio = Contribution margin per unit/Selling price per unit.
= Total contribution/Total sales
[Link] Margin of safety

The margin of safety is the difference between the planned sales volume and the break-
even sales volume. It is viewed as a measure of risk, as it helps management to assess the
vulnerability of profit to reductions in demand. It indicates by how much sales may
decrease before a company will suffer a loss.

Margin of safety = Planned sales volume – Break-even sales volume

For comparison purposes, the margin of safety can be expressed as a fraction or
percentage of planned sales volume as follows:

Margin of safety ratio = ((Planned sales volume- break- even sales volume)/planned sales
volume)* 100.

[Link] Sales required to earn target profit

Managers can use CVP analysis to determine the sales volume (in units or in dollars)
required to earn a target profit as follows:

99
Sales volume in units = (Total fixed cost+ Target profit)/Contribution margin per unit

Sales volume in dollars = (Total fixed cost + Target profit)/Contribution margin ratio.

Example 8.3

Alpha Limited manufactures and sells a single product. The following data relate to
the product for a certain period:

Planned sales volume in units 15 000

Selling price per unit $40
Variable cost per unit $15
Total fixed cost $150 000

Required:
Compute the following:

(a) the contribution margin per unit;

(b) the contribution margin ratio;
(c) the break-even point in units and in dollars;
(d) the margin of safety ratio;
(e) the sales volume in units that is required to earn a profit of $250 000.

Suggested solution

Alpha Limited

(a) Contribution margin per unit = Selling price per unit – Variable cost per unit
= $40 - $15
= $25

(b) Contribution margin ratio = (Contribution margin per unit/Selling price per
unit) x100
= ($25/$40) x 100
= 62.5%

(c) Break-even point in units = Total fixed cost/Contribution margin per unit
= $150 000/$25
= 6 000 units
Break-even point in dollars = Total fixed cost/Contribution margin ratio
= $150 000/62.5%
= $240 000

(d) Margin of safety ratio = ((Planned sales-Break-even sales)/Planned sales) x100

= ((15 000 units-6 000 units)/15 000) x 100
= 60%

100
(e) Sales volume in units = (Fixed cost + Target profit)/Contribution margin per unit
= ($150 000 + $250 000)/$25
= 16 000 units

8.3 Questions
Question 1

Beta Limited plans to sell 350 000 units of Product X during the coming year. The
following information is also available:
$
Selling price per unit 3.00
Variable cost per unit 1.80
Total fixed cost 300 000

Required:

Compute the following:

(a) the contribution margin per unit;
(b) the contribution margin ratio;
(c) the break-even volume in units and in dollars;
(d) the margin of safety in units and as a ratio;
(e) the sales volume (in units and in dollars) required to earn a profit of $60000.

101
 UNIT SEVEN

RELEVANCY COSTING AND SHORT-TERM DECISION-

MAKING

9.1 Model for making short-term tactical decisions

Tactical decision-making consists of choosing among alternatives with an immediate or
limited end in view. Although tactical decisions tend to be short-run in nature, they often
have long-term consequences. Tactical decision-making not only achieves short-run
objectives, but also serves the long-term strategic goals of the entity.

The model for making tactical decisions can be described by the following six steps:

1. Recognize and define the problem.

2. Identify alternatives as possible solutions to the problem, and eliminate alternatives
that are clearly not feasible.
3. Identify the costs and benefits associated with each alternative. Classify costs and
benefits as relevant or irrelevant, and eliminate irrelevant ones from further
consideration.
4. Total the relevant costs and benefits for each alternative.
5. Assess qualitative factors.
6. Select the alternative with the greatest overall benefit.

9.2 Relevant costing

Most tactical decisions apply relevant costing principles. The model for making tactical
decisions emphasizes the importance of identifying and using relevant costs and
revenues. Relevant costs and revenues are future costs and revenues that differ among
alternatives. All decisions relate to the future and, accordingly, only future costs and
revenues can be relevant to decisions. However, to be relevant, a cost or revenue must not
only be a future cost or revenue, but must also differ from one alternative to another. If a
future cost or revenue is the same for the alternatives under consideration, it has no effect
on the decision. Such a cost or revenue is irrelevant to the decision.

9.3 Applications of relevant costing

Applications of relevant costing include making decisions relating to outsourcing, keep-
or-drop a product, special order and sell or process further. This list is not exhaustive, and
many of the same decision-making principles apply to a variety of problems.

102
In order to avoid errors or incorrect conclusions when using relevant costing, it is
essential to take into account the underlying assumptions of the approach. These
assumptions are the same as those for CVP analysis.

9.3.1 Outsourcing decision

This is the decision to either make or buy a product. The decision depends on whether
there is excess capacity or not. If the factory is working at full capacity, some other work
would be displaced if the product currently being outsourced were to be made. Generally,
if the factory is not working at full capacity, the product should be made, provided the
variable cost is lower than the bought-in price. It is assumed that the fixed cost does not
change in the short-run.

Example 9.1
Alpha Limited is currently manufacturing Component X, producing 35 000 units
annually. The component is used in the production of several products made by the
company. The cost per unit for Component X is as follows:
$
Direct material 6.00
Direct labour 2.00
Variable overhead 1.00
Fixed overhead 3.00
Total cost per unit 12.00

Of the total fixed overhead assigned to Component X, $77 000 is direct fixed overhead
arising from the lease of production machinery and salary of a production line supervisor,
neither of which will be needed if the line is dropped. The remaining fixed overhead is
common fixed overhead.

An outside supplier has offered to sell Component X to Alpha Limited for $11 per unit.
No alternative use is available for the facilities currently being used to produce
Component X.

Required:
Determine whether Alpha Limited should make or buy Component X. Apply relevant
costing.

Suggested solution
Alpha Limited
1. Total relevant cost for Component X
Alternatives Differential cost to make
Make Buy
$000 $000 $000
Direct material ($6*35 000) 210 ----- 210
Direct labour ($2*35 000) 70 ----- 70
Variable overhead ($1*35 000) 35 ----- 35

103
Direct fixed overhead 77 ----- 77
Purchase cost ($11*35 000) ----- 385 (385)
Total relevant cost 392 385 7
2. Conclusion
The analysis shows that buying Component X is cheaper than making it by $7 000.
Therefore, the offer from the outside supplier should be accepted, i.e. Component X
should be bought and not made.

9.3.2 Keep-or-drop decision

If a firm has a range of products, one of which is deemed unprofitable, it may consider
dropping the product from its range. Generally, applying marginal costing to such a keep-
or-drop decision, the product should be dropped only if there is no contribution margin
from that product. Any contribution from that product will reduce the burden of total
fixed cost of the firm and this will result in higher overall profits than if such a product is
dropped. Relevant costing describes how information should be used to arrive at a keep-
or-drop decision. The decision requires an analysis of the revenues to be forgone and the
costs to be saved from the decision.

In a keep-or-drop decision with complementary effects, keeping or dropping a product

affects the sales of one or more of the other products produced by the firm. In making
such a decision, the differential costs and benefits of all the products produced by the
firm are relevant.

Example 9.2

Delta Limited produces three products: A, B and C. A segmented statement of income of

the firm is as follows:
Statement of income for the period
A B C Total
$ $ $ $
Sales 7 000 18 000 2 000 27 000
Variable costs (3 500) (10 000) (1 400) (14 900)
Contribution margin 3 500 8 000 600 12 100
Direct fixed cost (1 000) (3 000) (700) (4 700)
Segment margin 2 500 5 000 (100) 7 400
Common fixed cost (3 400)
Operating profit 4 000

Additional information:

Direct fixed cost includes depreciation on equipment dedicated to the product lines of
$200 for A, $1 200 for B and $300 for C. None of the equipment can be sold.

104
Required:
(a) Determine whether Product C should be dropped. Apply relevant costing.

(b) Assume that 10% of the customers for Product B (representing 10% of the sales
volume of Product B) choose to buy from Delta Limited because it offers a full range of
products, including Product C. If Product C were no longer available from Delta Limited,
these customers would go elsewhere to purchase Product B. You are required to
determine whether Product C should be dropped. Apply relevant costing.

Suggested solution

(a) Delta Limited

Note:
(i) Only differential costs and revenues of Product C are relevant.
(ii) Depreciation is not relevant since it is an allocation of a sunk cost.

1. Total relevant costs and benefits

Alternatives Differential amount to keep C
Keep C Drop C
$ $ $
Sales 2 000 ----- 2 000
Variable costs (1 400) ----- (1 400)
Contribution margin 600 ----- 600
Direct fixed cost (700-300) (400) ----- (400)
Total relevant benefit/(loss) 200 ----- 200

Note: Loss = Loss of benefit or benefit foregone.

2. Conclusion

The analysis shows that the firm will earn a benefit of $200 if Product C is kept.
Therefore, Product C should be kept.

(b) Delta Limited

1. Changes in sales induced by dropping Product C

$
Product A 7 000
Product B ($18 000 x 90%) 16 200
23 200

105
2. Changes in variable costs induced by dropping Product C
$
Product A 3 500
Product B ($10 000 x 90%) 9 000
12 500

3. Direct fixed costs with Product C

$
Product A (1 000 - 200) 800
Product B (3 000 -1 200) 1 800
Product C (700 – 300) 4 00
3 000

4. Direct fixed costs without Product C

$
Product A (1 000 – 200) 800
Product B (3 000 – 1 200) 1 800
2 600

5. Total relevant costs and benefits

Alternatives Differential
Keep C Drop C amount to
keep C
$ $ $
Sales (1) 27 000 23 200 3 800
Variable costs (2) (14 900) (12 500) (2 400)
Contribution margin 12 100 10 700 1 400
Direct fixed cost (3) (4) (3 000) (2 600) (400)
Total relevant benefit/(loss) 9 100 8 100 1 000

6. Conclusion

The analysis shows that the firm will earn a benefit of $1 000 if Product C is kept.
Therefore, Product C should be kept.

9.3.3 Special order decision

Special order decisions focus on whether a specially priced order should be accepted or
rejected. The special order usually utilizes excess capacity and is quoted at lower than
normal price. The decision to accept or reject the special order can use the contribution
approach and focus on the additional revenues and costs, or use relevant costing. Another
factor that should be considered is whether the acceptance of one order at a lower price
will lead other customers to demand a lower price as well.

106
Example 9.3

Sigma Limited has been approached by a new customer with an offer to purchase 2 300
units of Sigma Limited’s product at a price of $6.90 each. The new customer is
geographically separated from Sigma Limited’s other customers, and there would be no
effect on existing sales. Sigma Limited normally produces 12 000 units, but plans to
produce and sell 9 000 units in the coming year. The normal selling price per unit is
$[Link] cost per unit is as follows:
$
Direct material 1.75
Direct labour 2.80
Variable overhead 1.40
Fixed overhead 2.00
Total cost per unit 7.95

If Sigma Limited accepts the special order, fixed manufacturing costs will not be affected
because there is sufficient excess capacity.

Required:

Determine whether Sigma Limited should accept or reject the special order. Apply
relevant costing.

Suggested solution

Sigma Limited
1. Total relevant costs and benefits of special order
Alternatives Differential amount to accept
Accept Reject
$ $ $
Sales ($6.90*2 300) 15870 ----- 15 870
Direct material ($1.75*2300) (4025) ----- (4 025)
Direct labour ($2.80*2300) (6440) ----- (6 440)
Variable overhead($1.40*2300) (3220) ----- (3 220)
Total relevant benefit/(loss) 2 185 ----- 2 185

2. Conclusion

The analysis shows that accepting the special order would increase profits by $2 185.
Therefore, the order should be accepted.

9.3.4 Sell-or-process further decision

Joint products have common processes and common costs of production up to a split-off
point. They have relatively significant sales value and are not separately identifiable as
individual products until their split-off point. The split-off point is the point at which the

107
joint products become individually identifiable. The costs of production before split-off
point are called joint costs, i.e. common costs. Any costs beyond the split-off point are
called separable costs because they are not part of the joint process and can be
exclusively identified with individual products.

The sell or process further decision is the decision on whether to sell joint products at
split-off point, or to process them further. Joint costs are irrelevant to the decision.
Separable costs and revenue beyond the split-off point are relevant to the decision.

Example 9.4
Beta Limited produces four products, A, B, C and D, from a common input.
The joint costs for a typical quarter (i.e. a period) are as follows:
$
Direct material 95 000
Direct labour 43 000
Overhead 85 000

The sales value for each product at split-off point is as follows:

$
Product A 100 000
Product B 93 000
Product C 30 000
Product D 40 000

Management is considering processing Product D beyond the split-off point, which

would increase the sales value of Product D to $75 000. However, to process Product D
further means that the company must lease special equipment costing $15 400 per
quarter. Additional material and labour would cost $8 500 per quarter.

Required:
Determine whether the company should sell Product D at split-off point, or process it
further. Apply relevant costing.

Suggested solution
Beta Limited
1. Total relevant costs and benefits for Product D
Alternatives Differential amount to
Process Sell at process further
Further split-off
Point
$ $ $
Sales 75 000 40 000 35 000
Leasing costs (15 400) ------- (15 400)
Materials and labour (8 500) ------- (8 500)
Total relevant
benefit/(loss) 51 100 40 000 11 100

108
2. Conclusion

The analysis shows that processing Product D further would increase profits by $11 100.
Therefore, Product D should be processed further.

9.4 Questions
Question 1
Slim Limited manufactures and markets a slimming drink which they sell for $2.00 per
can. Current output is 400 000 cans per month, which represents 80% of capacity. The
firm has the opportunity to utilize the 20% excess capacity by selling their product at
$1.30per can to a supermarket chain who will sell it as an ‘own label product’.

The total costs for the last month were $560 000, of which $160 000 were fixed costs.
This represented a total cost of $1.40 per can.

Required:
Determine whether Slim Limited should accept the supermarket offer.

109
 UNIT EIGHT

OPTIMIZATION AND MARGINAL COSTING

8.1 Optimization

Optimization is a technique which determines:

• How scarce production factors should be utilized

• In a way that maximizes profit in the long-term

If alternative ways of utilization of production factors do not exist, optimization is

irrelevant. Production factors are the essentials required for the creation of wealth.
Generally, the production factors that are distinguished are:

• Natural resources
• Labour
• Capital and
• Entrepreneurship

A limiting factor is also known as a constraint, key factor or scarce resource. It is a

resource that restricts the production or sale of a product or service. When dealing with
limiting factors, the optimization techniques that may be applied are:

• Marginal costing and

• Linear programming

8.2 Marginal costing

When dealing with only one limiting factor, marginal costing techniques may be applied.
Marginal costing techniques can be used to solve optimization problems dealing with any
number of products, provided there is only one limiting factor. When a company
manufactures more than one product, management must choose the optimal product mix,
given the limiting factor found within the company.

The contribution margin approach is used to determine the optimal product mix.
However, the contribution margin per unit of each product is not the critical concern. The
correct approach is to maximize the contribution margin per unit of the limiting factor.

In order to solve optimization problems by making use of marginal costing techniques,

the following steps are followed:

110
 • From among the potential limiting factors, determine the actual limiting factor
• Calculate the contribution margin per unit for each of the products made by the
firm. Include variable selling and administrative expenses in the calculation
• Calculate the contribution margin per unit of the limiting factor for each of the
products
• Rank the products from best to worst according to their profitability as measured
by the contribution margin per unit of the limiting factor
• Determine the optimal product mix by utilizing the available resources to
manufacture products in preference of their ranking
• The maximum production of a product should be limited to its demand

The profit resulting from the manufacture and marketing of the optimal product mix can
be determined by deducting the total fixed cost from the total contribution margin.

Example 8.1

Alpha Limited produces two products, X and Y that use the same raw material input.
Product X uses 2 kg of the material per unit produced, while Product Y uses 5 kg per
unit. Currently, Alpha Limited has 16 000 kg of the material in inventory. All of the
material is imported. For the coming year, Alpha Limited plans to import an additional
8000 kg to produce 2 000 units of Product X and 4 000 units of Product Y. The
contribution margin per unit is $3.00 for Product X and $6.00 for Product Y.

Alpha Limited has, however, received information that the source of the raw material has
been shut down by trade restrictions. As a result, the company will not be able to import
the 8 000 kg it planned to use in the coming year’s production. No other source of the
raw material exists.

Required:

1. Compute the total contribution margin that the company would earn if it could
manufacture 2 000 units of Product X and 4 000 units of Product Y.
2. Determine the limiting factor.
3. Determine the optimal usage of the company’s inventory of 16 000 kg of the
material. Hence, compute the total contribution for the product mix that you
recommend.

Suggested answer

Alpha Limited

1. Total contribution margin

$
Product X ($3.00 x 2 000 units) 6 000
Product Y ($6.000 x 4 000 units) 24 000
Total contribution margin 30 000

111
2. Limiting factor
Potential limiting factor(s): Raw material (kg)
Limiting factor test
Kg
Required for the production of:
Product X (2 kg x 2 000 units) 4 000
Product Y (5 kg x 4 000 units) 20 000
Total material required 24 000
Total material available (16 000)
Shortage/(surplus) 8 000

3. Optimal production mix

Product No. of units Limiting factor Total material Contribution Total
margin per kg contribution
margin
Kg/unit Kg $ $
X 2 000 2 4 000 1.50 6 000
Y 2 400 5 12 000 1.20 14 400
20 400

112
 UNIT NINE

PERFORMANCE MEASUREMENT

9.1 Responsibility accounting

Responsibility accounting is a system that measures the plans (by budgets) and actions
(by actual results) of each responsibility centre. A responsibility centre is a segment of an
entity whose manager is accountable for a specified set of activities. The common
responsibility centres are:

• Cost centres
• Revenue centres
• Profit centres
• Investment centres

9.2 Objectives of divisionalization

• Delegation and control closer to the product

• Motivation
• Quicker decisions
• Take account of regional issues
• Exploit managerial expertise
• Divisions may be in competition
• Risk avoidance - because no diversified portfolio at division level

9.3 Advantages of divisionalization

1. Divisionalization can improve the quality of decisions made because divisional

managers (those taking the decisions) know local conditions and are able to make more
informed judgments.

2. Decisions should be taken more quickly because information does not have to pass
along the chain of command to end from top management.

3. The authority to act to improve performance should motivate divisional managers.

4. Divisional organization frees top management involvement in day-to-day operations

and allows them to devote more time to strategic planning.

5. Divisions provide valuable training ground for divisional managers to become

members of top management in future.

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9.4 Disadvantages of divisionalization

1. Danger with divisional accounting is that the business organization will divide in to
number of self-interested segments, each acting at times against the wishes and interests
of other segments.

2. It is claimed that the costs of activities that are common to all divisions such as running
the accounting department may be greater for a divisionalized structure than for a
centralized structure.

3. Top management, by delegating decision making to divisional managers, may lose

control since they are not aware of what is going on in the organization as a whole

9.5 Return on investment (ROI)

ROI is calculated as follows:

ROI = (EBIT ÷ Investment) x 100

Ideally, the earnings figure should be controllable operating profit and investment should
be controllable investment.

Advantages of ROI are:

• As a relative measure, it enables comparisons to be made with divisions or

companies of different sizes
• It is also used and well understood by external users of general purpose financial
statements
• The primary ratio splits down into secondary ratios for more detailed analysis as
follows:

➢ ROI = (EBIT ÷ Investment) x 100 = [(Sales ÷ Investment) x (EBIT ÷ Sales)]

x 100. The two secondary ratios are asset turnover ratio and net profit margin
i.e. return on sales
➢ This analysis is known as the duPont method of profitability analysis
➢ The duPont method of profitability analysis shows that ROI can be increased
by any action that:

✓ Increases revenue;
✓ Decreases costs; or
✓ Decreases investment
➢ While holding the other two factors constant

• ROI forces managers to make good use of existing capital resources and focuses
attention on managers, particularly when funds for further investment are limited

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Disadvantages of ROI are:

• Disincentive to invest :
➢ A divisional manager will not wish to make an investment which provides an
adequate return as far as the whole company is concerned if it reduces the
division’s current ROI
➢ Likewise, existing assets may unwisely be sold to improve ROI
• ROI improves with the age of the assets:
➢ As the denominator is the carrying amount of the assets which is decreased
by annual depreciation
➢ This might encourage divisions to hang on to old assets and again deter them
from investing in new assets
• The use of ROI may be dysfunctional:
➢ As corporate objectives of maximizing total shareholders’ wealth or the total
profit of the company are achieved by making decisions on the basis of ROI

9.6 Residual income (RI)

Residual income (RI) overcomes many of the disadvantages of ROI, particularly the
tendency to induce under-investment.

RI = Controllable profit – Imputed interest charge on controllable divisional investment

Where: Imputed interest charge is interest income forgone by tying up cash in divisional
investments. Is not regularly recognized by usual accrual accounting procedures

Advantages of RI are:

• It reduces the problem of under investing or failing to accept investment projects

with ROI’s greater than the overall company target but less than the division’s
current ROI
• It is more consistent with the objective of maximizing the total profitability of the
company
• It is possible to use different rates of interest for different types of assets
• The cost of financing a division is brought home to divisional managers

Disadvantages of RI are:

• It is difficult to compare divisions or companies of different sizes

• Other problems, that also apply to ROI, are:
✓ Ensuring consistent application of accounting policies in profit and asset
measurement
✓ Taking measures to reduce the potential conflict between ROI or RI and NPV
investment decisions e.g. changing depreciation methods so that ROI or RI
calculations are consistent with DCF calculations

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Question1
The Beta Division of Alpha Limited has a current investment amounting to $240 000
and controllable annual EBIT of $48 000. The division is considering the following
mutually exclusive investment projects, funds for which will be supplied by the
company:
Project A Project B Project C
$ $ $
Initial outlay 140 000 60 000 40 000
Controllable annual EBIT 35 000 20 000 8 800

Required:

(a) Compute the current ROI of the Beta Division

(b) Use ROI to determine the project proposal that would be preferred

Question 2

The following information relates to the Delta Division:

Current investment $150 000

Controllable annual EBIT $40 000
Cost of borrowing 10%

The division is considering a project proposal with an investment amounting to $10 000
and which would earn a controllable annual EBIT of $2 000.

Required:

Evaluate the project using:

(a) ROI
(b) RI

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