Topic outline
UNIT 1 : REGULATORY FRAMEWORK
Key unit competence: To be able to explain the Regulatory
Framework of Accounting
Introductory activity
Last time, the accounting was not well prepared; it was planned on each
personal understanding without respecting common rules and regulations
to conduct things in the same direction. As the time are replaced,
accounting preparation has been improved so that it was not prepared
based on a particular country’s rules and regulations but it was prepared
in the same manner through the world where the regulatory framework
exists on national and international levels.
Required: What accounting bodies should do in order to standardize
the different accounting policies and practices followed by
different business concerns?
1.1 Regulatory System
Learning Activity 1.1
Many figures in financial statements are derived from the application of
judgment in applying fundamental accounting assumptions and conventions.
This can lead to subjectivity.
Required: In attempt to deal with this subjectivity, and to achieve comparability
between different organizations, what can you develop?
In Accounting, the regulatory framework provides a set of rules and regulations
for accounting. Compliance and regulatory frameworks are sets of guidelines
and best practices. Organizations follow these guidelines to meet regulatory
requirements, improve processes, strengthen security, and achieve other
business objectives (such as becoming a public company, or selling cloud
solutions to government agencies).
Regulatory framework of accounting refers to the collection of accounting
standards, Laws, Codes, rules and regulations that are issued by
accounting bodies, government and regulatory units, which qualified accountant
must abide by. Remember, the IASB and FASB I mentioned earlier. They are
accounting standards setting bodies.
1.1.1 Introduction
Although new to the subject, you will be aware from your reading of the press
that there have been some considerable upheavals in financial reporting, mainly
in response to criticism. The details of the regulatory framework of accounting,
and the technical aspects of the changes made, will be covered later in this unit
and in your more advanced studies. The purpose of this unit is to give a general
picture of some of the factors which have shaped Financial Accounting. We
will concentrate on the accounts of limited liability companies, as these are the
accounts most closely regulated by statute or otherwise.
The following factors that have shaped Financial Accounting can be identified:
• National/local legislation
• Accounting concepts and individual judgment
• Accounting standards
• Other international influences
• Generally Accepted Accounting Principles (GAAP)
• Fair presentation
1.1.2 National/local legislation
In most countries, limited liability companies are required by law to prepare and
publish accounts annually. The form and content of the accounts is regulated
primarily by national legislation. In Rwanda, the main legislation is the Law
Governing Companies 17/2018
1.1.3 Accounting concepts and individual judgment
Many figures in financial statements are derived from the application of judgment
in applying fundamental accounting assumptions and conventions. This can
lead to subjectivity. Accounting standards were developed to try to address this
subjectivity.
Financial statements are prepared on the basis of a number of fundamental
accounting assumptions and conventions. Many figures in financial statements
are derived from the application of judgment in putting these assumptions into
practice.
It is clear that different people exercising their judgment on the same facts can
arrive at very different conclusions.
Case study
An accountancy training firm has an excellent reputation among students and
employers. How would you value this? The firm may have relatively little in the
form of assets that you can touch; perhaps a building, desks and chairs. If you
simply drew up a statement of financial position showing the cost of the assets
owned, then the business would not see to be worth much, yet its income
earning potential might be high. This is true of many service organizations where
the people are among the most valuable assets.
Other examples of areas where the judgment of different people may vary are
as follows.
• Valuation of buildings in times of rising property prices
• Research and development: is it right to treat his only as an expense?
In a sense it is an investment to generate future revenue
• Accounting for inflation
• Brands such as ‘Coca-Cola’ and ‘High Land Tea’. Are they assets in the
same way that a fork lift truck is an asset?
Working from the same data, different groups of people produce very different
financial statements. If the exercise of judgment is completely unfettered, there
will be no comparability between the accounts of different organizations. This
will be all the more significant in cases where deliberate manipulation occurs, in
order to present accounts in the most favorable light.
1.1.4 Accounting standards
In an attempt to deal with some of the subjectivity, and to achieve comparability
between different organizations, accounting standards were developed. These
are developed at both a national level (in most countries) and an international
level. The Financial Accounting syllabus is concerned with International
Financial Reporting Standards (IFRS Standards).
IFRS Standards are produced by the International Accounting Standards
Board (IASB).
Accounting is a vital part of business operations that involves managing and
reporting the financial operations of companies.
Accounting standards allow
accounting departments nationally and internationally to use similar practices
and produce similar quality accounting. If you work or plan to work in the
accounting field, it may be helpful to learn about accounting standards and why
they matter. In this article, we explain what accounting standards are, discuss
why they are important and describe how organizations use them.
Definition
Accounting standards are a set of procedures and measures that inform how
businesses conduct their accounting activities. They contain best practices for
recording, measuring and disclosing financial transactions. They apply to all
parts of a company’s activities, including revenue, expenses, noncash expenses,
assets, liabilities, equity and reporting. The primary purpose of accounting
standards is to provide accurate financial information that banks, government
agencies and investors can use when interacting with private companies.
Objectives of accounting standards
Primary objectives of accounting standards are:
• To provide a standard for the diverse accounting policies and principles.
• To put an end to the non-comparability of financial statements.
• To increase the reliability of the financial statements.
• To provide standards which are transparent for users.
• To define the standards which are comparable over all periods
presented.
• To provide a suitable starting point for accounting.
• It contains high quality information to generate the financial reports.
This can be done at a cost that does not exceed the benefits.
• For the eradication the huge amount of variation in the treatment of
accounting standards.
• To facilitate ease of both inter-firm and intra-firm comparison.
Main objective of accounting standards is to standardize the different accounting
policies and practices followed by different business concerns.
Importance of Accounting Standards
Accounting standards play a very efficient role in the whole accounting system.
Some of its important roles are discussed below:
• Brings uniformity in accounting system
• Easy comparability of financial statements
• Assists auditors
• Makes accounting informative easy and simple
• Avoids frauds and manipulations
• Provides reliability to financial statements
• Measures management performance
Relevance of accounting standards
An accounting standard is a standardized guiding principle that determines
the policies and practices of financial accounting. Accounting standards not
only improve the transparency of financial reporting but also facilitates financial
accountability. An accounting standard is relevant to a company’s financial
reporting.
Accounting standards ensure the financial statements from multiple companies
are comparable. Because all entities follow the same rules, accounting standards
make the financial statements credible and allow for more economic decisions
based on accurate and consistent information.
Generally Accepted Accounting Principles (US GAAP or GAAP)
Generally Accepted Accounting Principles refers to the standards framework,
principles and procedures used by the companies for financial accounting. The
principles are issued by Financial Accounting Standard Board (FASB). It is a set
of accounting standards that consist of standard ways and rules for recording
and reporting of the financial data, that is, balance sheet, income statement, cash
flow statement, etc. The framework is adopted by publicly traded companies
and a maximum number of private companies in the United States.
GAAP principles are updated at periodical intervals to meet with current financial
requirements. It ensures the transparency and consistency of the financial
statement. The information provided as per GAAP by the financial statement
is helpful to the economic decision makers such as investors, creditors,
shareholders, etc.
Key differences between GAAP and IFRS
The important difference between GAAP and IFRS are explained as under:
• GAAP stands for Generally Accepted Accounting Principles. IFRS is
an abbreviation for International Financial Reporting Standards.
• GAPP is a set of accounting guidelines and procedures, used by the
companies to prepare their financial statements. IFRS is the universal
business language followed by the companies while reporting financial
statements.
• Financial Accounting Standard Board (FASB) issues GAAP whereas
International Accounting Standard Board (IASB) issued IFRS (i.e
GAAP is developed by FASB whereas IFRS is developed by IASB.
• Use of Last in First out (LIFO) in inventory valuation is not permissible
as per IFRS which is not in the case of GAAP, that is, GAAP uses
LIFO, FIFO and Weighted Average Method but IFRS uses FIFO and
Weighted Average Method only.
• Extraordinary items are shown below the statement of income in case
of GAAP. Conversely, in IFRS, such items are not segregated in the
statement of income.
• Development Cost is treated as an expense in GAAP, while in IFRS, the
cost is capitalized provided the specified conditions are met.
• Inventory reversal is strictly prohibited under GAAP, but IFRS allows
inventory reversal subject to specific conditions.
• IFRS is based on principles, whereas GAAP is based on rules.
Note that as efforts are continuously made to converge these two standards, so
it can be said that there is no comparison between GAAP and IFRS. Moreover,
the differences between the two are as per a particular point of time that may
get a change in the future.
www.accounting.com/resources/gaap/
Similarities
Both are guiding principles that help in the preparation and presentation of
a statement of accounts. A professional accounting body issues them, and
that is why they are adopted in many countries of the world. Both of the two
provides relevance, reliability, transparency, comparability, understandability of
the financial statement.
Application activity 1.1
1. Mention the main objectives of the IASB when it develops IFRS
Standards.
2. Which of the following is not an objective of the accounting
standards?
a) Standardize the different accounting policies and practices
followed by different business concerns.
c) Increase the reliability of the financial statements.
b) Provide a standard for the diverse accounting policies and
principles.
d) Put an end to the non-comparability of financial statements.
e) Increase the huge amount of variation in the treatment of
accounting standards.
3. Explain the important difference between GAAP and IFRS.
4. Explain how there is subjectivity in financial statements.
5. Discuss the important roles of accounting standards in the whole
accounting system.
1.2 Structure of International Accounting Standards
Committee (IASC) Foundation
Learning Activity 1.2
Accounting standards are developed at both national and international
levels in order to raise the standard of financial reporting and eventually
bring about global harmonization of accounting standards.
Required: Mention at least two international bodies in charge of developing
these accounting standards.
1.2.1 History and structure of IASC Foundation
History of IASC Foundation
The IASC Foundation is an independent body, not controlled by any particular
Government or professional organization. Its main purpose is to oversee the
IASB in setting the accounting principles which are used by business and other
organizations around the world concerned with financial reporting.
The IASC was formed in June 1973 in London through an agreement made
by professional accountancy bodies from Australia, Canada, France, Germany,
Ireland, Japan, Mexico, the Netherlands, the UK and the USA with a view
to harmonizing the international diversity of company reporting practices.
Between its founding in 1973 and its dissolution in 2001, it developed a set of
International Accounting Standards (IAS) that gradually acquired a degree of
acceptance in countries around the world. Although the IASC came to include
some organizations representing preparers and users of financial statements, it
largely remained an initiative of the accountancy profession. On 1 April 2001,
it was replaced by the International Accounting Standards Board (IASB), an
independent standard-setting body. The IASC Foundation is the parent entity
of the International Accounting Standards Board, an independent accounting
standard-setter based in London, UK. The IASB adopted the extant corpus of
IAS which it continued to develop as International Financial Reporting Standards.
The structure of IASC Foundation
• The IASC Foundation is an independent organization having two main
bodies, the Trustees and the IASB, as well as a Standards Advisory
Council and the International Financial Reporting Interpretations
Committee.
• The IASC Foundation Trustees appoint the IASB members, exercise
oversight and raise the funds needed, but the IASB has sole responsibility
for setting accounting standards.
1.2.2 International Accounting Standards Board (IASB)
The IASB develops International Financial Reporting Standards (IFRS
Standards). The main objectives of the IFRS Foundation are to raise the
standard of financial reporting and eventually bring about global harmonization
of accounting standards. The IASB is an independent, privately funded body
that develops and approves IFRS Standards.
Prior to 2003, standards were issued as International Accounting Standards
(IAS Standards). In 2003 IFRS 1 was issued and all new standards are now
designated as IFRS Standards. Therefore, IFRS Standards encompass both
IFRS Standards, and IAS Standards still in force (eg: IAS 7).
Note: Throughout this text, we will use the abbreviation IFRS Standards to
include both IFRSs and IAS Standards.
The members of the IASB come from several countries and have a variety of
backgrounds, with a mix of auditors, preparers of financial statements, users of
financial statements and academics. The IASB operates under the oversight of
the IFRS Foundation.
The IFRS Foundation
IFRS standards are International Financial Reporting Standards (IFRS) that
consist of a set of accounting rules that determine how transactions and other
accounting events are required to be reported in financial statements. They are
designed to maintain credibility and transparency in the financial world, which
enables users, such as, investors and business operators to make informed
financial decisions or rational economic decisions with information about the
financial position, performance, profitability and liquidity of the company.
IFRS standards are issued and maintained by the International Accounting
Standards Board. Formerly, they are known as International Accounting
Standards (IAS). The standards are used for the preparation and presentation
of the financial statement that is, balance sheet, income statement, cash flow
statement, changes in equity and footnotes, etc. I FRS were created to establish
a common language so that financial statements can easily be interpreted
from company to company and country to country.
The IFRS Foundation (formally called the International Accounting Standards
Committee Foundation or IASCF) is a not for profit, private sector body that
oversees the IASB.
The objectives of the IFRS Foundation, summarized from its document IFRS
Foundation Constitution, are to:
• Develop a single set of high quality, understandable, enforceable and
globally accepted IFRS Standards through its standard-setting body,
the IASB;
• Promote the use and rigorous application of those standards;
• Take account of the financial reporting needs of emerging economies
and small-and medium-sized entities (SMEs); and
• Bring about convergence of national accounting standards and IFRS
Standards to high quality solutions.
In late 2018, the IFRS Foundation Constitution had been amended mainly
regarding the tenure terms which the Trustee Chair and Vice-Chairs may hold
their positions for, and how they can be appointed. The main four objectives
have not changed.
As at January 2019, the IFRS Foundation is made up of 22 named trustees,
who essentially monitor and fund the IASB, the IFRS Advisory Council and the
IFRS Interpretations Committee. The Trustees are appointed from a variety of
geographical and functional backgrounds.The structure of the IFRS Foundation and related bodies is shown below.
• IFRS Advisory Council
The IFRS Advisory Council (formally called the Standards Advisory Council or
SAC) is essentially a forum used by the IASB to consult with the outside world.
It consults with national standard setters, academics, user groups and a host
of other interested parties to advise the IASB on a range of issues, from the
IASB’s work program for developing new IFRS Standards to giving practical
advice on the implementation of particular standards.
The IFRS Advisory Council meets the IASB at least three times a year and putsforward the views of its members on current standard-setting projects.
• IFRS Interpretations Committee
The IFRS Interpretations Committee (formally called the International Financial
Reporting Interpretations Committee or IFRIC) was set up in March 2002 and
provides guidance on specific practical issues in the interpretation of IFRS
Standards. Note that despite the name change, interpretations issued by the
IFRS Interpretations Committee are still known as IFRIC Interpretations. In
your exam, you may see the IFRS Interpretations Committee referred to as the
IFRSIC.
The IFRS Interpretations Committee has two main responsibilities:
i. To review, on a timely basis, newly identified financial reporting issues not
specifically addressed in IFRS Standards.
ii. To clarify issues where unsatisfactory or conflicting interpretations have
developed, or seem likely to develop in the absence of authoritative
guidance, with a view to reaching a consensus on the appropriatetreatment.
Application activity 1.2
1. What is the purpose of IAS 37?
2. What is IFRS?
3. Discuss the main objectives of IFRS Foundation.
4. What are the objectives of the IFRS Foundation as they are included
in the document of the IFRS Foundation Constitution?
5. Explain the two main responsibilities of the IFRS Interpretations Committee.
1.3 International Financial Reporting Standards (IFRS
Standards)
Learning Activity 1.3
International Financial Reporting Standards (IFRS) that consist of a set
of accounting rules that determine how transactions and other accounting
events are required to be reported in financial statements.
Required: Mention any two IFRS Standards or IAS that you know.
IFRS Standards are created in accordance with due process. There are currently25 IAS Standards and 16 IFRS Standards in issue.
1.3.1 The use and application of IFRS Standards
The IFRS Standards have helped to both improve and harmonize financial
reporting around the world. The standards are used in the following ways:
• As national requirements
• As the basis for all or some national requirements
• As an international benchmark for those countries which develop
their own requirements
• By regulatory authorities for domestic and foreign companies• By companies themselves
1.3.2 Standards-setting process
The IASB prepares IFRS Standards in accordance with due process. You do
not need this for your exam, but the following diagram may be of interest.The procedure can be summarized as follows.
Current IFRS Standards
The current list is as follows. Those examinable in Financial Accounting are
marked with a *.
Conceptual Framework for Financial Reporting 2018 *
IFRS 1 First-time adoption of International Financial Reporting Standards
IFRS 2 Share-based payment
IFRS 3 * Business combinations
IFRS 4 Insurance contracts
IFRS 5 Non-current assets held for sale and discontinued operations
IFRS 6 Exploration for the evaluation of mineral resources
IFRS 7 Financial instruments: disclosures
IFRS 8 Operating segments
IFRS 9 Financial instruments
IFRS 10 * Consolidated financial statements
IFRS 11 Joint arrangements
IFRS 12 Disclosure of interests in other entities
IFRS 13 Fair value measurement
IFRS 14 Regulatory deferral accounts
IFRS 15 Revenue from contracts with customers
IFRS 16 * Leases
IAS 1 * Presentation of financial statements
IAS 2 * Inventories
IAS 7 * Statement of cash flows
IAS 8 Accounting policies, changes in accounting estimates and errors
IAS 10 * Events after the reporting period
IAS 12 Income taxes
IAS 16 * Property, plant and equipment
IAS 19 Employee benefits (2011)
IAS 20 Accounting for government grants and disclosure of government
assistance
IAS 21 The effects of changes in foreign exchange rates
IAS 23 Borrowing costs
IAS 24 Related party disclosure
IAS 26 Accounting and reporting by retirement benefit plans
IAS 27 * Separate financial statements (2011)
IAS 28 * Investments in associates and joint ventures (2011)
IAS 29 Financial reporting in hyperinflationary economies
IAS 32 Financial instruments: presentation
IAS 33 Earnings per share
IAS 34 Interim financial reporting
IAS 36 Impairment of assets
IAS 37 * Provisions, contingent liabilities and contingent assets
IAS 38 * Intangible assets
IAS 39 Financial instruments: recognition and measurement
IAS 40 Investment property
IAS 41 Agriculture
Various exposure drafts and discussion papers are currently at different stages
within the IFRS process, but these are not concern to you at this stage.
1.3.3 Scope and application of IFRS Standards
Scope
Any limitation of the applicability of a specific IFRS is made clear within that
standard. IFRS Standards are not intended to be applied to immaterial items,
nor are they retrospective. Each individual standard lays out its scope at the
beginning of the standard.
Application
Within each individual country, local regulations govern to a greater or lesser
degree, the issue of financial statements. These local regulations include
accounting standards issued by the national regulatory bodies and/or
professional accountancy bodies in the country concerned.
Application activity 1.3
1. How many IAS Standards and IFRS Standards are currently in
issue?
2. In which ways the IFRS Standards are used?
Skills Lab
Students must visit any company and analyze operating environment, they
will then discuss if the company applies any regulatory system, accounting
standards developed by International Accounting Standards Committee
(IASC) Foundation and International Financial Reporting Standards (IFRS
Standards) arising from their operations.
End unit assessment
1. Which of the following is not an objective of the IFRS Foundation?
a) To enforce IFRS Standards in most countries
b) To develop IFRS Standards through the IASB
c) To bring about convergence of accounting standards and IFRS
Standards
d) To take account of the financial reporting needs of SMEs
2. Fill in the blanks.
The IFRS…………………………………issues…………………….
……………. which aid users’ interpretation of IFRS Standards.
3. How many IAS Standards and IFRS Standards are currently in
issue?
4. The IFRS Foundation is a government-controlled body, based in the
EU. True or False?
5. The IASB is responsible for the standard-setting process. True or
False?
6. Olivier is a trainee accountant with ICPAR. One of his friends, who
works in a local supermarket, said the following: “I don’t know why
you waste your time getting qualified-everyone does whatever they
like when it comes to accounting.
Required:
List and describe the various regulations that need to be considered
when performing the financial accounting function within a business.
7. There are those who suggest that any standard-setting body is
redundant because accounting standards are unnecessary.
Required:
Discuss the statement that accounting standards are unnecessaryfor the purpose of regulating financial statements.
UNIT 2: CONCEPTUAL FRAMEWORK FOR FINANCIAL REPORTING
Key unit competence: To be able to apply the conceptual framework inpreparation of financial statements.
a) Describe the picture above and list elements of Financial
Statements
b) How to recognize and derecognize elements of FinancialStatements?
2.1 Introduction
Learning Activity 2.1
Conceptual framework Assist preparers to develop consistent accounting
policies, standard applies to particular transaction or other event, and assist
all parties to understand and interpret the standard.
Required: Why is necessary to follow a certain guidance and accountingstandards in accountant field.
2.1.1 Definition of conceptual framework
• Going concern concept
Going concern is explained in the way that the financial statements are normally
prepared on the assumption that company will continue in operation for the
foreseeable future. Hence, it is assumed that the entity has neither the intention
nor the need to enter into liquidation or to cease trading. If such an intention
or need exists, the financial statements may have to be prepared on a different
basis. If so, the financial statements describe the basis used. This concept
assumes that, when entity preparing a normal set of accounts, the business will
continue to operate in approximately the same manner for the foreseeable
future (at least the next 12 months). In particular, the entity will not go into
liquidation or scale down its operations in a material way.
The main significance of the going concern concept is that the assets should
not be valued at their ‘break-up’ value (the amount they would sell for if theywere sold off piecemeal and the business were broken up).
Example
A retailer commences business on 1 January and buys inventory of 20 washing
machines, each costing FRW 800,000. During the year they sold 17 machines
at FRW 1,000,000 each. How should the remaining machines be valued at 31
December in the following circumstances?
i) They are forced to close down their business at the end of the year and
the remaining machines will realize only FRW 600,000 each in a forced
sale
ii) They intend to continue their business into the next year.
Answer
i) If the business is to be closed down, the remaining three machines must
be valued at the amount they will realize in a forced sale, i.e. 3*FRW
600,000 = FRW 1,800,000.
ii) If the business is regarded as a going concern, the inventory unsold at 31
December will be carried forward into the following year, when the cost of
the three machines will be matched against the eventual sale proceeds in
computing that year’s profits. The three machines will therefore be valued
at cost, 3*FRW 800,000 = FRW 2,400,000.
If the going concern assumption is not followed, that fact must be
disclosed, together with the following information.
i) The basis on which the financial statements have been prepared Accruals
ii) The reasons why the entity is not considered to be a going concern
• Accrual basis.
The effects of transactions and other events are recognized when they occur
(and not as cash or its equivalent is received or paid) and they are recorded in
the accounting records and reported in the financial statements of the periods
to which they relate.
The accruals basis is not an underlying assumption, the Conceptual Framework
for Financial Reporting makes it clear that financial statements should be
prepared on an accruals basis. Entities should prepare their financial statements
on the basis that transactions are recorded in them, not as the cash is paid
or received, but as the revenues or expenses are earned or incurred in the
accounting period to which they relate.
According to the accruals assumption, in computing profit revenue earned must
be matched against the expenditure incurred in earning it. This is also known
as the matching convention.
Example
Accrual basis KAMARIZA purchases 20 T-shirts in her first month of trading
(May) at a cost of FRW 5,000 each. She then sells all of them for FRW 10,000
each.
KAMARIZA has therefore made a profit of FRW 100,000, by matching the
revenue (FRW 200,000) earned against the cost (FRW 100,000) of acquiring
them. All of KAMARIZA’s sales and purchases are on credit and no cash has
been received or paid.
If, however, KAMARIZA only sells 18 T-shirts, it is incorrect to charge her
statement of profit or loss with the cost of 20 T-shirts, as she still has two T-shirts
in inventory. Therefore, only the purchase cost of 18 T-shirts (18*FRW 5,000
= FRW 90,000) should be matched with her sales revenue (18 units*FRW10,000 = FRW 180,000), leaving her with a profit of FRW 90,000.
However, if KAMARIZA had decided to give up selling T-shirts, then the going
concern assumption no longer applies and the value of the two T-shirts in the
statement of financial position is their break-up valuation, not cost. Similarly, if
the two unsold T-shirts are unlikely to be sold at more than their cost of FRW
5,000 each (say, because of damage or a fall in demand) then they should
be recorded on the statement of financial position at their net realizable value
(i.e. the likely eventual sales price less any expenses incurred to make them
saleable) rather than cost. This shows the application of the prudence concept.
The Conceptual Framework views prudence as a component of neutrality, whichis a characteristic of faithful representation.
Prudence is described as:
The exercise of caution when making judgments under conditions of uncertainty.
The exercise of prudence means that assets and income are not overstated and
liabilities and expenses are not understated, as an accountant, it is important
to exercise caution when making accounting estimates. In the example above,
the concepts of going concern and accruals are linked. Since the business is
assumed to be a going concern, it is possible to carry forward the cost of theunsold T-shirts as a charge against profits of the next period.
• The business entity concept
Financial statements always treat the business as a separate entity. It is crucial
that you understand that the convention adopted in preparing accounts (the
business entity concept) is always to treat a business as a separate entity from
its owner(s). This means the transactions of the owner should never be mixed
with the business’s transactions. This applies whether or not the business isrecognized in law as a separate legal entity.
2.1.2. The objective of general purpose of financial reporting
The objective of general-purpose financial reporting its to provide financial
information about the reporting entity that is useful to existing and potential
investors, lenders and other creditors in making decision relating to providing
resources to the entity. Those decisions involve decision about:
a) Buying, selling or holding equity and debt instrument
b) Providing or settling loans and other forms of credit
c) Exercising rights to vote on, or otherwise influence, management’sactions that affect the use of the entity’s economic resources.
The decisions described depend on the returns that existing and potential
investors, lenders and other creditors expect, for example, dividends, principal
and interest payment or market price increases. Investors, lenders and other
creditors’ expectation about returns depend on their assessment of the amount,
timing and uncertainty of (the prospects for) future net cash inflows to the entity
on their assessment of management’s stewardship of the entity’s economic
resources. Existing and potential investors, lenders and other creditors need
information to help them make those assessments.
Application activity 2.1
1) Explain the objective of financial statements
2) Explain 5 elements of Financial Statements as per IAS1.
3) Briefly explain (4) different users of the Financial information andtheir needs in the Financial information.
2.2 Qualitative characteristics of useful financial information
Learning Activity 2.2
Financial Accounting states that accounting source documents must
contain information that is certain and trusted.Required: Explain when information is certain and trusted.
2.2.1 Two fundamental qualitative characteristics
For financial reporting purposes, fundamental qualitative characteristics are two;
• Relevance
Only relevant information can be useful. Information should be released on a
timely basis to be relevant to users.
Relevant financial information is capable of making a difference in the decisions
made by user. Financial information is capable of making a difference in decisions
if it has predictive value, confirmatory value or both.
The predictive and confirmatory roles of information are interrelated. Information
on financial position and performance is often used to predict future position
and performance and other things of interest to the user, eg likely dividend,
wage rises. The manner of showing information will enhance the ability to make
predictions, eg by highlighting unusual items.
The relevance of information is affected by its nature and materiality.
• Materiality
Information is material if omitting it or misstating it could influence decisions
that the primary users of general-purpose financial reports make on the basis
of those reports which provide financial information about a specific reporting
entity.
Information may be judged relevant simply because of its nature. In other cases,
both the nature and materiality of the information are important. An error which
is too trivial to affect anyone’s understanding of the accounts is referred to as
immaterial.
In preparing accounts, it is important to assess what is material and what is not,so that time and money are not wasted in the pursuit of excessive detail.
Determining whether or not an item is material is a very subjective exercise.
There is no absolute measure of materiality. It is common to apply a convenient
rule of thumb (for example, material items are those with a value greater than 5%
of net profits). However, some items disclosed in the accounts are regarded
as particularly sensitive and even a very small misstatement of such an item
is taken as a material error. An example, in the accounts of a limited liability
company, is the amount of remuneration (salaries and other rewards) paid todirectors of the company.
The assessment of an item as material or immaterial may affect its treatment
in the accounts. For example, the statement of profit or loss of a business
shows the expenses incurred grouped under suitable captions (administrative
expenses, distribution expenses etc); but in the case of very small expenses,
it may be appropriate to lump them together as ‘sundry expenses’, because a
more detailed breakdown is inappropriate for such immaterial amounts.
In assessing whether or not an item is material, it is not only the value of the itemwhich needs to be considered. The context is also important.
a) If a statement of financial position shows non-current assets of FRW
2,000 million and inventories of FRW30 million an error of FRW
200,000 in the depreciation calculations might not be regarded as
material. However, an error of FRW 20 million in the inventory valuation
would be material. In other words, the total of which balance the errorforms, must be considered.
b) If a business has a bank loan of FRW 50 million and a FRW 55 million
balance on bank deposit account, it will be a material misstatement if
these two amounts are netted off on the statement of financial position
as ‘cash at bank FRW 5 million. In other words, incorrect presentation
may amount to material misstatement even if there is a very small oreven no monetary error.
2.2.2 Faithful representation
Faithful representation: Financial reports represent economic phenomena
in words and numbers. To be useful, financial information must not only
represent relevant phenomena but must faithfully represent the substance of
the phenomena that it purports to represent. To be a faithful representation,
information must be complete, neutral and free from error
A complete depiction includes all information necessary for a user to understand
the phenomenon being depicted, including all necessary descriptions and
explanations.
A neutral depiction is without bias in the selection or presentation of financial
information. A neutral depiction is not slanted, weighted, emphasized or
otherwise manipulated to increase the probability that financial information will
be received favorably or unfavorably by users.
Neutrality is supported by the exercise of prudence. Prudence is the exercise
of caution when making judgments under conditions of uncertainty
Free from error means there are no errors or omissions in the description of
the phenomenon and the process used to produce the reported information
has been selected and applied with no errors in the process. In this context free
from error does not mean perfectly accurate in all respects.
Prudence was removed from the 2010 Conceptual Framework as it was
deemed to be implied within the depiction of neutrality, and that the term was
being interpreted in different ways. However, it was felt that the exercise of
prudence, along with understanding the substance of the transitions, ratherthan the pure legality of them, was required to be explicitly stated.
2.2.3 Enhancing qualitative characteristics
• Comparability
Comparability is the qualitative characteristic that enables users to identify and
understand similarities in, and differences among items
Information about a reporting entity is more useful if it can be compared with
similar information about other entities and with similar information about the
same entity for another period or date.
Consistency, although related to comparability, is not the same. Consistency
refers to the use of the same methods for the same items (ie consistency of
treatment) either from period to period within a reporting entity or in a single
period across entities.
The disclosure of accounting policies is particularly important here. Users
must be able to distinguish between different accounting policies in order to
be able to make a valid comparison of similar items in the accounts of different
entities.
Comparability is not the same as uniformity. Entities should change
accounting policies if those policies become inappropriate.
Corresponding information for preceding periods should be shown to
enable comparison to be made over time.
• Verifiability
Verifiability helps assure users that information faithfully represents the economic
phenomena it purports to represent. It means that different knowledgeable
and independent observers could reach consensus, although not necessarily
complete agreement, that a particular depiction is a faithful representation.
Information that can be independently verified is generally more decision-useful
than information that cannot.
• Timeliness
Timeliness means having information available to decision-makers in time to be
capable of influencing their decisions. Generally, the older information is the less
useful it is Information may become less useful if there is a delay in reporting it.
There is a balance between timeliness and the provision of reliable information.
If information is reported on a timely basis when not all aspects of the transaction
are known, it may not be complete or free from error. Conversely, if every detail
of a transaction is known, it may be too late to publish the information because
it has become irrelevant. The overriding consideration is how best to satisfy the
economic decision-making needs of the users.
• Understandability
Understandability classifying, characterizing and presenting information clearly
and concisely makes it understandable financial reports are prepared for users
who have a reasonable knowledge of business and economic activities and who
review and analyses the information diligently.
Some phenomena are inherently complex and cannot be made easy to understand.
Excluding information on those phenomena might make the information easier
to understand, but without it those reports would be incomplete and therefore
misleading. Therefore, matters should not be left out of financial statements
simply due to their difficulty, as even well-informed and diligent users may
sometimes need the aid of an adviser to understand information about complex
economic phenomena.
• Reliability
Reliable information is the information free from material error and bias and can
be depended upon by users. The following factors contribute to reliability:
i) Faithful representation
ii) Substance over form
iii) Neutrality
iv) Prudencev) Completeness
Application activity 2.2Explain qualitative characteristics of financial information
2.3 Elements of financial statements
Learning Activity 2.3
ABC company ltd produce and sell the following items water, Juice and
Milk, it has invested money in purchasing the asset, including premises and
motor vehicles, some transactions are by cash, bank and others on credit, in
the second year of trading it has enjoyed an increased number of customer.
But accountant is not aware of the documents to be prepared at the end
of the year.
What kind of financial statement that accountant should prepare at the endof the year.
2.3.1 Conceptual Framework of Financial statements
The Conceptual Framework outlined the following elements of financialstatements:
A process of sub-classification then takes place for presentation in the financial
statements, eg assets are classified by their nature or function in the business
to show information in the best way for users to take economic decisions.
• Statement of Financial position
The elements affecting financial position are assets, liabilities and equity
i. Assets
Asset is a present economic resource controlled by the entity as a result of
past events. An economic resource is a right that has the potential to produce
economic benefits. Assets are usually employed to produce goods or services
for customers; customers will then pay for these. Cash itself renders a service
to the entity due to its command over other resources
The economic benefits can come in various forms, including:
a) Cash flows, such as returns on investment sources
b) Exchange of goods, such as by trading, selling goods, provision of services
c) Reduction or avoidance of liabilities, such as paying loans.
ii. Liabilities
Liability is a present obligation of the entity to transfer an economic resource as
a result of past events.
For a liability to exist, three criteria must all be satisfied:
a) The entity has an obligation
b) The obligation is to transfer an economic resource
c) The obligation is a present obligation that exists as a result of past events
Obligation- A duty or responsibility that the entity has no practical ability to
avoid, an essential characteristic of a liability is that the entity has an obligation.
A present obligation exists as a result of past events if the entity has already
obtained economic benefits or taken an action, and as a consequence, the entity
will or may have to transfer an economic resource that it would not otherwisehave had to transfer.
It is important to distinguish between a present obligation and a future
commitment. A management decision to purchase assets in the future doesnot, in itself, give rise to a present obligation.
Example
Consider the following situations in each case do we have an asset or liability
within the definitions given by the Conceptual Framework? Give reasons for
your answer.
a) Mucyo Ltd has purchased a patent for FRW 20,000,000. The patent
gives the company sole use of a particular manufacturing process
which will save FRW 3,000,000 a year for the next five years.
b) Kalisa Ltd paid René Gatera FRW 10,000,000 to set up a car repair
shop, on condition that priority treatment is given to cars from the
company’s fleet.
c) Deals on Wheels Ltd provides a warranty with every car sold.
Answer
a) This is an asset, an intangible one. There is a past event, control and
future economic benefit (through cost savings)
b) This cannot be classified as an asset. Kalisa Ltd has no control over
the car repair shop and it is difficult to argue that there are ‘future
economic benefits’.
c) The warranty provided constitutes a liability; the business has taken
on an obligation. It would be recognized when the warranty is issuedrather than when a claim is made:
iii. Equity
Equity is the residual interest in the assets of the entity after deducting all
its liabilities or Equity represents the net assets owned by the owners (the
shareholders).
Thought equity is defined above as a residual, but it may be sub-classified in
the statement of financial position. This will indicate legal or other restrictions on
the ability of the entity to distribute or otherwise apply its equity. Some reserves
are required by statute or other law, eg for the future protection of creditors.
The amount shown for equity depends on the measurement of assets and
liabilities. It has nothing to do with the market value of the entity’s shares.
• Statement of financial performance
The elements affecting financial performance are income and expenses.
Profit is used as a measure of performance or as a basis for other measures
(e.g: earnings per share). It depends directly on the measurement of income
and expenses, which in turn depend (in part) on the concepts of capital and
capital maintenance adopted.
The elements of income and expense are therefore defined as below:
i. Income
‘Increases in assets, or decreases in liabilities, that result in increases in equity,
other than those relating to contributions from holders of equity claims.’
Revenue arises in the course of ordinary activities of an entity. ‘Increases in
assets’ include those arising on the disposal of non-current assets. The definition
of income also includes unrealized gains, e.g on revaluation of marketable
securities
ii. Expenses
Expense stand for decreases in assets, or increases in liabilities, that result
in decreases in equity other than those relating to distributions to holders of
equity claims.’ Expenses include losses as well as those expenses that arise in
the course of ordinary activities of an entity. Losses will include those arising on
the disposal of non-current assets. The definition of expenses will also include
unrealized losses, e.g the fall in value of an investment.
Income and expenses can be presented in different ways in the statement of
profit or loss and other comprehensive income, to provide information relevant
for economic decision making. For example, income and expenses which relate
to continuing operations are distinguished from the results of discontinued
operations.
2.3.2 Recognition and derecognition of element of financial statement
Recognition of element of financial statement
Only items that meet the definition of an asset, a liability or equity are recognized
in the statement of financial position. Similarly, only items that meet the
definition of income or expenses are recognized in the statement(s) of financial
performance. However, not all items that meet the definition of one of those
elements are recognized
Recognition
The process of capturing for inclusion in the statement of financial position or
statement(s) of profit or loss and other comprehensive income an item that
meets the definition of one of the elements of financial statements
• An asset,
• Liability,
• Equity,
• Income
• Expense.
An asset or liability should be recognized if it will be both relevant and provide
users of the financial statements with a faithful representation of the transactions
of that entity. The Conceptual Framework takes these fundamental qualitative
characteristics along with the definitions of the elements of the financial
statements as the key components of recognition.
Previously, recognition of elements would have been affected by the probability
of whether the event was going to happen and the reliability of the measurement.
The International accounting standards Board (IASB) has revised this as they
believed this set too rigid criteria as entities may not disclose relevant information
which would be necessary for the user of the financial statements because of
the difficulty of estimating both the likelihood and the amount of the element.
Even if an item is not recognized, then the preparers of the financial statements
should consider whether, in order to meet the faithful representation requirement,
there should be a description in the notes to the financial statements.
• Assets
An asset is recognized in the balance sheet 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. The economic benefits contribute, directly or
indirectly, in the form of cash or cash equivalents.
Even though many assets are in physical form, such as machinery, the physical
form is not essentials. For example, patents and intellectual property are assets
controlled by the entity and have future economic benefits.
• A liability
Liability is recognized in the balance sheet 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. For example, accounts payables are present obligations,
which will result in an outflow of resources embodying economic benefit.
• Income
Income is recognized in the income statement when an increase in future
economic benefit related to an increase in an asset or a decrease of a liability
has arisen that can be measured reliably. In effect, the recognition of income
occurs simultaneously with the recognition of increases in assets or decreases
in liabilities. For example, when a sale is made, it results in a net increase in
assets (cash). Income includes both revenues and gains, such as from sale of
assets that are not a part of the normal business activity.
• Expenses
Expense is recognized when a decrease in future economic benefit related to a
decrease in an asset or an increase of a liability has arisen that can be measured
reliably. In effect, the recognition of expenses occurs simultaneously with the
recognition of an increase in liabilities or a decrease in assets. For example, the
depreciation of an asset decreases the asset and the expense is recognized.
Expenses include both expenses and losses.
Derecognition of elements of financial statement
Derecognition is the removal of all or part of a recognized asset or liability from
an entity’s statement of financial position. Derecognition normally occurs when
that item no longer meets the definition of an asset or liability.
The Conceptual Framework considers derecognition to be a factor when the
following occurs:
• Loss of control or all or part of the recognized asset
• The entity no longer has an obligation for a liability. The International
accounting standards boards (IASB) has brought these concepts of
recognition and derecognition into the Conceptual Framework so that
they can be revisited when visiting new standards or revising existing
ones.
Derecognition of Property, Plant, and Equipment-PPE
Property, Plant, and Equipment is derecognized (that is, the cost and any related
accumulated depreciation are removed from the accounting records) when it
is sold or when no future economic benefit is expected. To account for the
disposal of a PPE asset, the following must occur.
If the disposal occurs part way through the accounting period, depreciationmust be updated to the date of disposal by
A loss arises whenever the carrying amount of the asset is greater than the
proceeds received. A gain results when the carrying amount is less than anyproceeds received.
2.3.3 Measurement of elements of financial statements
Measurement is the process of determining the monetary amounts at which
the elements of the financial statements are to be recognized and carried
in the balance sheet and income statement. This involves the selection of theparticular basis of measurement.
i. Cost Model
After recognition, the asset should be carried in the Statement of Financial
Position at:
a) Cost
b) Less Accumulated Depreciationc) Less Accumulated Impairment Losses.
ii. Revaluation Model
After recognition, an asset, whose fair value can be measured reliably, should
be carried at a revalued amount. The revalued amount is the fair value of the
asset at the date of revaluation less subsequent accumulated depreciation and
impairment losses
The fair value of property is based on its market value, as assessed by a
professionally qualified value. The fair value of plant and equipment is usuallytheir market value, determined by appraisal.
If there is no market-based evidence of fair value because the asset is of a
specialized nature and is rarely sold, then the fair value of that asset will have
to be estimated using an income or a depreciated replacement cost approach.
All revaluations should be made at such a frequency that the carrying amount
does not differ materially from the fair value at the Statement of Financial Positiondate.
If an item of property, plant and equipment is revalued, then the entire class of
property, plant and equipment to which the asset belongs shall be revalued.
Treatment of revaluation surplus
If an asset is revalued upwards:
Debit: Asset
Credit; Revaluation Surplus
With the amount of the increase
However, if the revaluation gains reverse a previous revaluation loss, which was
recognized as an expense, then the gain should be recognized in the income
statement (but only to the extent of the previous loss of the same asset). Any
excess over the amount of the original loss goes to the Revaluation Surplus.
Example:
GJ Limited has land in its books with a carrying value of FRW 14 million. Two
years ago, the land was worth FRW 16 million. The loss was recorded in the
Income Statement. This year the land has been valued at 20 million FRW.
Dr Land FRW 6 million
Cr Income statement FRW 2 million
Cr Revaluation surplus FRW 4 million
Treatment of revaluation deficit
Debit: income statement
Credit; asset
With the amount of the decrease
However, the decrease should be debited directly to the revaluation surplus to
the extent of any credit balance existing in the revaluation surplus in respect of
that asset.
Example:
G J Limited has land in its books with a carrying value of FRW 20 million. Two
years ago, the land was worth FRW 15 million. The gain was credited to the
Revaluation Surplus. This year the land has been valued at FRW 13 million.
Dr Income statement FRW 5 million
Dr Revaluation surplus FRW 2 million
Cr Land FRW 7 Million
Note that the Revaluation Surplus is part of owners’ equity.
A number of different measurement bases are employed to different degreesand in varying combinations in financial statements. They include the following:
a. Historical cost.
Assets are recorded at the amount of cash or cash equivalents paid or the fair
value of the consideration given to acquire them at the time of their acquisition.
Liabilities are recorded at the amount of proceeds received in exchange for
the obligation, or in some circumstances (for example, income taxes), at the
amounts of cash or cash equivalents expected to be paid to satisfy the liability
in the normal course of business.
b. Current cost.
Assets are carried at the amount of cash or cash equivalents that would have to
be paid if the same or an equivalent asset was acquired currently.
Liabilities are carried at the undiscounted amount of cash or cash equivalents
that would be required to settle the obligation currently.
c. Realizable (settlement) value.
Assets are carried at the amount of cash or cash equivalents that could currently
be obtained by selling the asset in an orderly disposal.
Liabilities are carried at their settlement values; that is, the undiscounted
amounts of cash or cash equivalents expected to be paid to satisfy the liabilities
in the normal course of business.
d. Present value.
Assets are carried at the present discounted value of the future net cash inflows
that the item is expected to generate in the normal course of business. Liabilities
are carried at the present discounted value of the future net cash outflows
that are expected to be required to settle the liabilities in the normal course
of business. The measurement basis most commonly adopted by entities in
preparing their financial statements is historical cost. This is usually combined
with other measurement bases.
For example, inventories are usually carried at the lower of cost and net realizable
value, marketable securities may be carried at market value and pension liabilitiesare carried at their present value.
2.3.4 Presentation and disclosures of financial statement
A reporting entity communicates information about its assets, liabilities, equity,
income and expenses by presenting and disclosing information in its financial
statements.
Effective communication of information in financial statements makes that
information more relevant and contributes to a faithful representation of an
entity’s assets, liabilities, equity, income and expenses.
It also enhances the understandability and comparability of information infinancial statements.
Effective communication of information in financial statements requires:
• Focusing on presentation and disclosure objectives and principles
rather than focusing on rules.
• Classifying information in a manner that groups similar items and
separates dissimilar items
Just as cost constrains other financial reporting decisions, it also constrains
decisions about presentation and disclosure. Hence, in making decisions about
presentation and disclosure, it is important to consider whether the benefits
provided to users of financial statements by presenting or disclosing particularinformation are likely to justify the cost of providing and using that information.
Classification
Classification is the sorting of assets, liabilities, equity, income or expenses on
the basis of shared characteristics for presentation and disclosure purposes.
Such characteristics include—but are not limited to the nature of the item, its
role (or function) within the business activities conducted by the entity, and howit is measured.
Classifying dissimilar assets, liabilities, equity, income or expenses together can
obscure relevant information, reduce understandability and comparability and
may not provide a faithful representation of what it purports to represent.
• Classification of assets and liabilities
Classification is applied to the unit of account selected for an asset or liability.
However, it may sometimes be appropriate to separate an asset or liability into
component that have different characteristics and to classify those components
separately. That would be appropriate when classifying those componentsseparately.
For example, it could be appropriate to separate an asset or liability into current
and non-current components and to classify those components separately.
Offsetting
Offsetting occurs when an entity recognizes and measures both an asset and
liability as separate units of account, but groups them into a single net amount in
the statement of financial position. Offsetting classifies dissimilar items together
and therefore is generally not appropriate.
Offsetting assets and liabilities differs from treating a set of rights and obligations
as a single unit of account
• Classification of equity
To provide useful information, it may be necessary to classify equity claims
separately if those equity claims have different characteristics.
Similarly, to provide useful information, it may be necessary to classify components
of equity separately if some of those components are subject to particular legal,
regulatory or other requirements. For example, in some jurisdictions, an entity
is permitted to make distributions to holders of equity jurisdictions, an entity is
permitted to make distributions to holders of equity. Separate presentation or
disclosure of those reserves may provide useful information.
• Classification of income and expenses
Classification is applied to: components of such income and expenses if those
components have different characteristics and are identified separately. For
example, a change in the current value of an asset can include the effects of
value changes and the accrual of interest. It would be appropriate to classify
those components separately if doing so would enhance the usefulness of the
resulting financial information.
• Profit or loss and other comprehensive income
Income and expenses are classified and included either:
a) in the statement of profit or loss or
b) Outside the statement of profit or loss, in other comprehensive income.
The statement of profit or loss is the primary source of information about an
entity’s financial performance for the reporting period. That statement contains
a total for profit or loss that provides a highly summarized depiction of the entity
of the financial performance for the period. Many users of financial statements
incorporate that total in their analysis either as a starting point for that analysisor as the main indicator of the entity’s financial performance for the period.
The statement of profit or loss is primary source of information about an entity’s
financial performance for the period, all income and expenses are, in principle,
included in that statement. However, in developing standards the board may
decide in exceptional circumstance that income or expenses arising from a
change in the current value of an asset or liability are to be statement of profit or
loss providing more relevant information, or providing more faithful representationof the entity’s financial performance for that period.
2.3.5 The reporting entity
A reporting entity is an entity that is required, or chooses, to prepare financial
statements
A reporting entity can be a single entity or a portion of an entity can comprise more
than one entity. A reporting entity is not necessarily a legal entity. Sometimes one
entity (parent) has control over another entity (subsidiary). If a reporting entity
comprises both the parent and its subsidiaries, the reporting entity’s financial
statements are referred to as ‘consolidated financial statements.
If the reporting entity is the parent a reporting a lone, the reporting entity’s
financial statements are referred to as “unconsolidated financial statements”
If a reporting entity comprises two or more entities that are not all linked by
a parent-subsidiary relationship, the reporting entity’s financial statements arereferred to as ‘combined financial statements
2.3.6 Concepts of capital and capital maintenance concepts of capital
a. Concepts of capital
A financial concept of capital is adopted by most entities in preparing their
financial statement. Under a financial concept of capital, such as invested
money or invested purchasing power, capital is synonymous with the net asset
or equity of the entity.
Under physical concept of capital, such as operating activity, capital is regarded
as productive capacity of the entity based on for example, units of output per day.
The selection of the appropriate concept of capital by an entity should be based
on the needs of the users of its financial statements. Thus, a financial
concept of capital should be adopted if the users of financial statement are
primarily concerned with maintenance of nominal invested capital or thepurchasing power of invested capital.
If, however, the main concern of the users is with the operating capability of the
entity, physical concept of capita should be used.
The concept chosen indicates the goal to be attained in determining profit,
even though there may be some measurement difficulties in making the conceptoperational.
b. Concepts of capital maintenance
The concept of capital gives the following concepts of capital maintenance:
Physical capital maintenance: under this concept a profit is earned only if
the physical productive capacity (operating capacity) of the entity (resources
or funds needs to achieve that capacity) at the end of the period exceeds the
physical productive capacity at the beginning of the period, after excluding any
distributions to, and contributions from, owners during the period.
Financial capital maintenance: under this concept a profit is earned only if
financial (or money) amount of net assets at the end of the period exceeds the
financial (or money) amount of net assets at the beginning of the period after
excluding any distribution to, and contribution from owners during the period.
Financial capacity maintenance can be measured in their normal monetary units
or units of constant purchasing power.
The concept of capital maintenance is concerned with how an entity defines the
capital that it seeks to maintain.
It provides the linkages between the concept of capital and the concept of profit
because it provides the point of reference by which profit is measured, it is
prerequisite for distinguishing between an entity’s return on capital and its return
of capital, only in flow of assets in excess of amount needed to maintain capital
may be regarded as profit and therefore as a return on capital. Hence, profit is
the residual amount that remains after expenses (including capital maintenance,
adjustment, where appropriate) have been deducted from income. If expenses
exceed income the residual amount is loss.
The principal difference between the two concepts of capital maintenance is
the treatment of the effects of changes in the prices of assets and liabilities of
the entity. In general terms, an entity has maintained its capital if it has as much
capital at the end of the period as it had at the beginning of the period
Any amount over and above that required to maintain the capital at the beginning
of the period is profit.
Example of the physical concept of capital:
An entity is established on 1 January 2022 with 20,000 ordinary shares at FRW
1,000 each.
It then buys FRW 20,000,000 worth of stock, which they sold it during the year
for FRW 25,000,000.
At the end of the year the purchase price of the stock increased on FRW
23,000,000.
Required: Compute profit using capital maintenance concept
Using the physical capital maintenance concept, the profit for the reporting
period is: FRW 2,000,000 i.e FRW 25,000,000 - FRW 23,000,000.
If the financial capital maintenance concept is used, the profit for the year is:
FRW 5,000,000, but if the company paid out the FRW 5,000,000 profit to
shareholders, it would be unable to buy the same stock again as the purchase
price arisen.
Note: Most entities use the financial capital maintenance concept as it is the
easiest to apply because it uses actual prices paid for goods, rather than
making adjustments.
Investors prefer to use the financial capital maintenance concept as they
allow them to assess increasing and maximizing the returns they get on theirinvestment.
Application activity 2.3
a) Fill in the blanks.
i) The elements affecting Financial position are:…..., ………... and
………...
ii) The elements affecting financial performance are …………. and
……………….
iii) ………………. .is a present economic resource controlled by the
entity as a result of past events. An economic resource is a right that
has the potential to produce economic benefits.
iv) ……………………is a present obligation of the entity to transfer an
economic resource as a result of past events.
v) ……………. is the residual interest in the assets of the entity after
deducting all its liabilities?
b) Explain derecognition as used in accounting
c) Explain when to recognize the elements of statements of financial performance
Skills Lab
Visit small business located near the school and request for a trial balance.
From the trial balance select elements to appear in financial performanceand element to appear in financial position.
End unit assessment
1. Making an allowance for receivables is an example of which concept?
a) Accruals
b) Going concern
c) Materiality
d) Fair presentation
2. What does ‘relevance’ mean in the context of financial statements?
3. Based on Conceptual Framework, identify the fundamental
characteristics and the enhancing qualitative characteristics of
financial statements.
4. An obligation may be recognized when:
a) The obligation is fulfilled
b) When an obligation meets the definition of a liability
c) When it is probable that economic benefits will be received
d) When the obligation can be faithfully represented, even if it is
irrelevant to a user
5. An entity is established on 1 January 2022 with 40,000ordinary
shares at FRW 2,000 each. They then bought FRW 40,000,000
worth of stock, which generated sales during the year of FRW
50,000,000. At the end of the year the purchase price of the stock
increased on FRW 46,000,000. Calculate profit under financial
capital maintenance concept and physical capital maintenance concept.UNIT 3 : ACCOUNTING FOR TANGIBLE NON-CURRENT ASSETS
Key unit competence: To be able to measure and record tangible non current assets
Introductory activity
Observe the above picture and answer the following questions:
Based on International Accounting Standard (IAS) 16,
1) Why is it necessary to account for tangible fixed assets? Justify
your answer.
2) What is the meaning of carrying amount of fixed asset?3) What is Residual value of tangible fixed asset?.
3.1 Determination of the cost for non-current assetsLearning Activity 3.1
Required:
Is it necessary to recognize for this new asset in the books of ALLERUALTD? If yes, what is the meaning of recognition of intangible fixed asset?
3.1.1 International Accounting Standard (IAS) 16
IAS 16 covers keys aspect of accounting for property, plant and equipment.
This represents the bulk of items which are “tangible non-current assets”.
• Objective
IAS 16 Property, Plant and Equipment outlines the accounting treatment for
most types of property, plant and equipment. The Standard addresses the
recognition, measurement and disclose of all property, plant and equipment
pertaining to the entity.
• Scope
Property, plant and equipment are tangible assets that:
i. Are held for use in the production or supply of goods or services, for rental
to others, or for administrative purposes.
ii. Are expected to be used during more than one period
Carrying amount is the amount at which an asset is recognized in the
statement of financial position after deducting any accumulated depreciationand accumulated impairment losses.
IAS 16 should be followed when accounting for property, plant and equipment
unless another international accounting standard requires a different treatmentIAS 16 does not apply to the following:
a) Biological assets related to agricultural activity, apart from bearer
biological assets
b) Mineral rights and mineral reserves, such as oil, gas and non
regenerative resources
c) Property, plant and equipment classified as held for sale.
However, the standard applies to property, plant and equipment used to develop
these assets.
A bearer biological asset is living plant that:
a) Is used in the production or supply of agricultural produce
b) Is expected to bear produce for more than one period; and
c) Has a remote likelihood of being sold as agricultural produce, exceptfor incidental scrap sales?
• Recognition
In this context, recognition simply means incorporation of the item in the
business’s accounts, in this case as a non-current asset. The recognition of
property, plant and equipment depends on the two criteria:
i. It is probable that future economic benefits associated with the asset will
flow to the entity;
ii. The cost of the asset to the entity can be measured reliably.
Cost is the amount of cash or cash equivalents paid or the fair value of the
other consideration given to acquire an asset at the time of its acquisition orconstruction.
Property, plant and equipment can amount to substantial amounts in financial
statements, affecting the presentation of the company’s financial position and
the profitability of the entity, through depreciation and also if an asset is wronglyclassified as an expense and taken to profit or loss.
First criterion: Future economic benefits
The degree of certainty attached to flow of future of economic benefits must
be assessed. This should be based on the evidence available at the date of initial
recognition (usually the date of purchase). The entity should be assured that it
will receive the rewards attached to the asset and it will incur the associated
risks, which will only be the case when the rewards and risks have actuallypassed to the entity. Until then, the asset should not be recognized
Second criterion: cost measured reliably
It is generally easy to measure the cost of an asset as the transfer amount on
purchase, i.e what was paid for it. Self-constructed assets can also be measured
easily by adding together the purchase price of all the constituent parts (labor,material etc.) paid to external parties.
3.1.2 Measurement
• Initial measurement
Once an item of property, plant and equipment qualifies for recognition as anasset, it will initially be measured at cost
i. Components of cost
The standard lists the components of the cost of an item of Property, plant and
equipment.
a) Purchase price, less any trade discount or rebate
b) Import duties and non-refundable purchase taxes
c) Direct attributable costs of bringing the asset to working condition for
its intended use, eg:
– The cost of site preparation
– Initial delivery and handling costs
– Installation costs
– Testing (net of any proceeds on the sale of items produced)
– Professional fees (architects, engineers)
Initial estimate of unavoidable cost of dismantling and removing the asset
and restoring the site on which it is located
IAS 16 provides guidance on directly attributable costs included in the
cost of an item of property, plant and equipment.
a) The cost bringing the asset to the location and working conditions
necessary for it to be capable of operating in manner intended by
management, including those costs to test whether the asset is
functioning properly.
b) They are determined after deducting the net proceeds from selling any
items produced when bringing the asset to its location and condition.
Income and related expenses of operations that are incidental to the
construction or development of an item of property, plant and equipment should
be recognized in profit or loss.
The following costs will not be part of the cost of property, plant and
equipment unless they can be attributed directly to the asset’s acquisition, or
bringing it into its working condition:
– Administration and other general overhead costs
– Start-up and similar pre-production costs
– Initial operating losses before the asset reaches planned performance
All of these will be recognized as an expense rather than an asset.
In the case of self-constructed assets, the same principles are applied as
for acquired assets. If the entity’s normal course of business is to make these
assets and sell them externally, then the cost of the asset will be the cost of
its production. This also means that abnormal costs (wasted material, labor or
downtime costs) are excluded from the cost of the asset. An example of a selfconstructed asset is when a building company builds its own office.
ii. Subsequent expenditure
The recognition criteria apply to subsequent expenditure as well as costs
incurred initially. There are no separate criteria for recognizing subsequent
expenditure. For example, if a shop building is extended to include a new café
as revenue source, then this meets the criteria of probable future economic
benefits, and so should be recognized as property, plant and equipment.
However, if the shop building is maintained or repaired, it does not enhance the
future economic benefits, it merely sustains the existing economic benefits and
therefore the costs must be expensed.
iii. Exchanges of assets
IAS 16 specifies that exchange of items of property, plant and equipment,
regardless of whether the assets are similar, are measured at fair value, unless
the exchange transaction lacks commercial substance or the fair value
of neither of the assets exchanged can be measured reliably. If the acquired
item is not measured at fair value, its cost is measured at the carrying amountof the asset given up.
• Measurement subsequent to initial recognition
The standard offers two possible treatments here, essentially a choice between
keeping an asset recorded at cost of revaluing it to fair value
i. Cost model. Carry the asset at its cost less depreciation and any
accumulated impairment loss.
ii. Revaluation model. Carry the asset at a revalued amount, being its fair at
the date of the revaluation less any subsequent accumulated depreciation
and subsequent accumulated impairment losses. The revised IAS 16
makes clear that the revaluation model is available only if the fairvalue of the item can be measured reliably.
Revaluations
The market value of land and buildings usually represents fair value, assuming
existing use and line of business. Such valuations are usually carried out by
professionally qualified valuers
In the case of plant and equipment, fair value can also be taken as market
value. Where a market value is not available, however, depreciated replacement
cost should be used. There may be not market value where types of plant and
equipment are sold only rarely or because of their specialised nature (i.e they
would normally only be sold as part of an ongoing business).
The frequency of valuation depends on the volatility of the fair values of
individual items of property, plant and equipment, the more volatile the fair value,
the more frequently revaluations should be carried out. Where the current fair
value is very different from the carrying amount then a revaluation should be
carried out.
Most importantly, when an item of property, plant and equipment is revalued,
the whole class of assets to which it belongs should be revalued.
All the items within in class should be revalued at the same time, to prevent
selective revaluations of certain assets and avoid disclosing a mixture of costs
and values from different dates in the financial statements. A rolling basis of
revaluation is allowed if the revaluations are kept up to date and the revaluationof the whole class is completed in a short time.
Accounting for revaluations
How should any increase in value be treated when a revaluation takes place?
The debit will be the increase in value in the statement of financial position, but
what about the credit? IAS 16 requires the increase to be credited to other
comprehensive income and accumulated in a revaluation surplus (ie part of
owner’s equity), unless there was previously a decrease on the revaluation ofthe same asset.
DEBIT Carrying amount (statement of financial position)
CREDIT Other comprehensive income (revaluation Surplus)
Reversing a previous decrease in value
If the asset has previously suffered a decrease in value that was charged to profit
or loss, any increase in value on subsequent revaluation should be recognized
in profit or loss to the extent that it reverses the previous decrease. The amount
of the reversal is not necessarily the same as the amount of previous decrease-
the cumulative effect of differences in depreciation charged to profit or loss
as a result of the previous decrease must be considered. Any excess is then
recognized in other comprehensive income and accumulated in a revaluationsurplus.
Example
ABC Ltd has an item of land carried in its books at FRW 13 million as at 31
March 2018. Two years previously, at 31 March 2016, a slump in land values
led the company to reduce the carrying amount from FRW 15 million. This was
taken as an expense in profit or loss. There has been a surge in land prices in
the current year and the land is now worth FRW 20 million.Account for revaluation in the current year ending 31 March 2018.
Answer
The double entry is:
The case is similar for a Decrease in value on revaluation. Any decrease should
be recognized as an expense, except where it offsets a previous increase taken
as a revaluation surplus in owners’ equity. Any decease greater than the previousupwards increase in value must be taken as an expense in the profit or loss.
Example:
Let us simply swap round the example given above. The original cost was FRW
15 million, revalued upwards to FRW 20 million two years’ ego, for the period
ending 31 March 2016. The value has now fallen to FRW 13 million as of 31
March2018.Account for the decrease in value.
Remember that IAS 16 requires the initial increase here to be credited to other
comprehensive income and accumulated in a revaluation surplus (i.e part of
owners’ equity), therefore the increase in 31 march 2016 will be taken to other
comprehensive income and held in the revaluation surplus.
Once the value decreases, the original increase in value must be reversed
and any amounts over and above that should be taken to the statement of profit
or loss.
Revaluation of depreciated assets
There is a further complication when a revalued asset is being depreciated. As
we have seen, an upward revaluation means that the depreciation charge will
increase. Normally, a revaluation surplus is only realized when the asset is sold.
However, when it is being depreciated, part of that surplus is being realized as
the asset is used.
The amount of the surplus realized is the difference between depreciation
charged on the revalued amount and the (lower) depreciation which would have
been charged on the asset’s original cost. This amount can be transferred
to retained (realized) earnings but NOT through profit or loss.
Example:
KBG Ltd bought an asset for FRW 10 million at the beginning of 2016. It had
a useful life of 5 years. On January 2018 the asset was revalued to FRW 12
million. The expected useful life has remained uncharged (i.e three years remain).
Account for the revaluation and state the treatment for depreciation from 2018
onwards.
On 1st January 2018 the carrying amount of the asset has changed to FRW 12
million. Up to 1 January 2018, the company has depreciated the asset by FRW
4 million (FRW 10 million/5years*2) to reflect that the asset has been realized
through use. This means that the carrying amount was therefore FRW 6 million
(FRW 10 million- FRW 4 million), which is credited to other comprehensive income.
Due to the increased value, it appears that none of the asset’s original cost has
been used up in the past two years; therefore, we must also reverse theaccumulated depreciation:
The new depreciation is FRW 4 million compared to depreciation on the original
cost of 10m÷5= FRW 2m. So each year, the extra FRW 2 million can be treatedas part of the revaluation surplus that has become realized:
This is the movement on owners’ equity only and it will be shown in the statement
of changes in equity it is not an item in profit or loss.
Complex assets
For very large and specialized items, an apparently single asset should be
broken down into its composite parts. This occurs where the different parts
have different useful lives and different depreciation rates are applied to each
part, e.g an aircraft, where the body and engines are separated as they havedifferent useful lives.
Example
A company purchases an aircraft for FRW 330,000 million. Show how the asset
should be accounted for at the end of the first financial year if the following is alist of its component parts:
Answer
Depreciation at the end of the first year, in which 150 flights totaling 400 hourswere made, would then be:
Retirements and disposals
When an asset is permanently withdrawn from use, or sold or scrapped,
and no future benefits are expected from its disposal, it should be derecognized
from the statement of financial position.
Gain or losses are the difference between the estimated net disposal proceeds
and the carrying amount of the asset. They should be recognized as income orexpense in profit or loss.
Derecognition
An entity is required to derecognize the carrying amount of an item of
property, plant or equipment that it disposes of on the date the criteria for the
sale in IFRS 15 Revenue from contracts with customers would be met. Thisalso applies to parts of an asset.
Application activity 3.1
An equipment was purchased from England at CIF Mombasa value of
FRW 10,000,000. Transportation fees to Kigali Magerwa costs FRW
1,500,000; imports duties and fees amounted to FRW 1,900,000. The
installation cost was FRW 2,000,000 while trial runs and commissioning
amounted to FRW 2,600,000.
Required: Determine the original cost for that equipment
3.2 Compute depreciation charge and carrying amount
Learning Activity 3.2
A machine was bought at a cost of FRW 6,500,000; total non-refundable
taxes paid on the purchase transaction amounted to FRW 1,500,000 while
the installation cost was FRW 2,000,000. The scrap value is estimated atFRW 256,000 at the end of the estimated lifetime of 4 years.
Required: Based on the above information explain the following terms:
a) Capital expenditure
b) Depreciationc) Residual value
d) Useful life
Capital and Revenue Expenditure
Capital expenditure is money spent by a business on the purchase of fixed
assets for use in the business and not for immediate resale, or on their alteration
or improvement; it includes any costs of delivering or installing fixed assets, andthe legal costs of buying a non-current asset.
Revenue expenditure is money spent on the running expenses of a business:
that is, maintenance of fixed assets, the cost of administering the business and
selling and distributing goods, and the cost of stock of goods acquired withintention of resale.
Differences between capital and revenue expenditure
Depreciation
Depreciation accounting is governing by IAS 16 property, plant and equipment.These are some of IAS 16 definitions concerning depreciation.
Depreciation is the systematic allocation of the depreciable amount of an asset
over its estimated useful life. Depreciation for the accounting period is chargedas an expense to net profit or loss for the period either directly or indirectly.
Depreciable assets are assets which:
• Are expected to be used during more than one accounting period
• Have a limited useful life
• Are held by an entity for use in the production or supply of goods and
services, for rental to others, or administrative purposes.
Useful life is one of two things:
• The period over which a depreciable asset is expected to be used by
the entity; or
• The number of production or similar units expected to be obtained fromthe asset by the entity.
Depreciable amount of a depreciable asset is the historical cost or other
amount substituted for cost in the financial statement, less its estimated residual
value.
An amount substituted for cost’ will normally be a current market value after a
revaluation has taken place.
Residual value is the net amount which the entity expects to obtain for an
asset at the end of its useful life after deducting the expected costs of disposal.
If an asset’s life extends over more than one accounting period, it earns profits
over more than one period. It is a non-current asset.
With the exception of land, every non-current asset eventually wears out over
time. Machines, cars and other vehicles, fixtures and fittings, and even buildings
do not last forever. When a business acquires non-current asset, it will have
some idea about how long its useful life will be, and it might decide what to do
with it.
• Keep on using the non-current asset until becomes completely worn
out, useless and worthless.
• Sell off the non-current asset at the end of its useful life, either by
selling it as a second hand item or as scrap.
Since a non-current asset has a cost, and a limited useful life, and its value
eventually declines, it follows that a charge should be made in profit or loss to
reflect the use that is made of the asset by the business. This charge is calleddepreciation.
The need to depreciate non-current assets arises from the accruals
assumption. If money is expended in purchasing an asset, then the amount
expended must at some time be charged against profits. If the asset is one
which contributes to an entity’s revenue over a number of accounting periods it
would be inappropriate to charge any single period (e.g the period in which the
asset was acquired) with the whole of the expenditure. Instead, some method
must be found of spreading the cost of the asset over its estimated useful life.
It is worth mentioning here two common misconceptions about the purpose
and effects of depreciation:
• It is sometimes thought that the carrying amount of an asset is equal to
its net realizable value and that the object of charging depreciation is to
reflect the fall in value of an asset over its life. This misconception is the
basis of a common, but incorrect, argument which says that freehold
properties need not be depreciated in times when property values arearising.
It is true that historical cost statements of financial position often give a misleading
impression when a property’s carrying amount is much below its market value,
but in such a case it is open to a business to incorporate a revaluation into
its books, or even to prepare its accounts based on current costs. This is a
separate problem from that of allocating the property’s cost over successiveaccounting periods.
• Another misconception is that depreciation is provided so that an
asset can be replaced at the end of its useful life. This is not the
case :
– If there is no intention of replacing the asset, it could then be argued
that there is no need to provide for any depreciation at all.
– If prices are rising, the replacement cost of the asset will exceed theamount of depreciation provided.
There are situations where, over a period, an asset has increased in value, i.e its
current value is greater than the carrying amount in the financial statements. You
might think that in such situations it would not be necessary to depreciate the
asset. The standard states, however, that this is irrelevant, and that depreciation
should still be charged to each accounting period, based on the depreciableamount, irrespective of a rise in value.
An entity is required to begin depreciating an item of property, plant and
equipment when it is available for use and continue depreciating it until it isderecognized even if it is idle during the period.
Useful life
The following factors should be considered when estimating the useful life of
depreciable asset.
• Expected physical wear and tear
• Obsolescence
• Legal or other limits on the use of the assets
Once decided, the useful life should be reviewed at least every financial year end
and depreciation rates adjusted for the current and future periods if expectations
vary significantly from the original estimates. The effect of the changes shouldbe disclosed in the accounting period in which the change takes place.
The assessment of useful requires judgment based on previous experience with
similar assets or classes of asset. When a completely new type of asset is
required (through technological advancement or through use in producing a
brand new product or service) it is still necessary to estimate useful life, eventhough the exercise will be much difficult.
Land and buildings are dealt with separately when it comes to depreciation,
even when they are acquired together, because land normally has unlimited life
and is therefore not depreciated. In contrast buildings do have a limited life and
must be depreciated. Any increase in the value of land on which a building isstanding will have no impact on the determination of building; useful life.
Review of useful life
A review or the useful life of property, plant and equipment should be carried out
at least each financial year end and the depreciation charge for the current
and future periods should be adjusted if expectations have changed significantly
from previous estimates. Changes are changes in accounting estimates and areaccounted for prospectively as adjustments to future depreciation.
Example:
ABC Ltd acquired a non-current asset on 1 January 2002 for FRW 800,000.
It had no residual value and a useful life of ten years. On 1 January 2005, the
remaining useful life was reviewed and revised to 4 years.What will be the depreciation charge for 2005?
Residual value
In most cases the residual value of an asset is likely to be immaterial. If
it is likely to be of any significant value, that value must be estimated at the
date of purchase or any subsequent revaluation. The amount of residual value
estimated based on the current situation with other similar assets, used in the
same way, which are now at the end of their useful lives. Any expected costs ofdisposal should be offset against the gross residual value.
Depreciation methods
Consistent is important. The depreciation method selected should be applied
consistently from period to period unless altered circumstances justify a charge.
When the method is changed, the effect should be quantified and disclosedand the reason for the change should be stated.
Various methods of allocating depreciation to accounting periods are available,
but whichever is chosen must be applied consistently to ensure comparability
from period to period. Change of policy is not allowed simply because of theprofitability situation of the entity.
Depreciation methods were covered extensively in senior 5. The most common
accepted methods of allocating depreciation are straight-line method and
reducing balance method.
Under straight-line method, the depreciable amount is charged in equal
installments over the asset’s expected useful life. This method is best when
the business enjoys the benefits of the asset in equal measure over the asset’s
useful life. It is useful where there is an estimated realizable or scrap value after
a set period, for example, a van may be used by a business for four years, but
with the aim of selling it back to the motor company for an agreed amount of
money after that time.
Under the reducing balance method, the annual depreciation charge is a fixed
percentage of the carrying amount, as at the end of the accounting period.
Examples include machinery which has a higher productivity in the earlier years
of its usage.
The reducing balance method should be used when it is considered fair to
allocate a greater proportion of the total depreciable to the earlier years and a
lower amount in the later years, on the assumption that the benefits obtained by
the business from using the asset decline over time. Examples would includecomputer hardware or production machinery that gets less efficient as it ages.
Review of depreciation method
The depreciation method should also be reviewed at least at each financial
year end and, if there has been a significant change in the expected pattern of
economic benefits from the assets, the method should be changed to suit this
changed pattern. When such a change in depreciation method takes place the
change should be accounted for as a change in accounting estimate and the
depreciation charge for the current and future periods should be adjusted.
Impairment of carrying amounts of non-current assets
An impairment loss is the amount by which the carrying amount of an asset
exceeds its recoverable amount.
An impairment loss should be treated in the same way as revaluation
decrease i.e the decrease should be recognized as an expense. However, arevaluation decrease (impairment loss) should be charged directly against any
related revaluation surplus to the extent that the decrease does not exceed the
amount held in the revaluation surplus in respect of that same asset.
A reversal of an impairment loss should be treated in the same way as a
revaluation increase, i.e a revaluation increase should be recognized as an
income to the extent that it reverses a revaluation decrease or an impairment
loss of the same asset previously recognized as an expense.
Disclosure
The standard has a long list of disclosure requirements, for each class of
property, plant and equipment.
• Measurement bases for determining the gross carrying amount (if more
than one, the gross carrying amount for that basis in each category)
• Depreciation method used
• Useful lives or depreciation rates used
• Gross carrying amount and accumulated depreciation (aggregated
with accumulated impairment losses) at the beginning and end of the
period
• Reconciliation of the carrying amount at the beginning and end of the
period showing:
– Additions
– Disposals
– Acquisitions through business combinations
– Increases/decreases during the period from revaluations and from
impairment losses
– Impairment losses recognized in profit or loss
– Impairment losses reversed in profit or loss
– Depreciation
– Net exchange differences (from translation of statements of e foreign
entity)
– Any other movements
The financial statements should also disclose the following:
• Any recoverable amounts of property, plant and equipment
• Existence and amounts of restrictions on title, and items pledged as
security for liabilities
• Accounting policy for the estimated costs of restoring the site
• Amount of expenditures on account of items in the course of construction
• Amount of commitments to acquisitions
• Accounting policy disclosing the valuation bases used for determining
the amounts at which depreciable assets are stated.
IAS 16 also requires the following to be disclosed for major class of depreciable
asset:
Revalued assets require further disclosures:
• Basis used to revalue the assets
• Effective date of the revaluation
• Whether an independent valuer was involved
• Nature of any indices used to determine replacement cost
• Carrying amount of each class of property, plant and equipment that
would have been included in the financial statements had the assets
been carried at cost less accumulated depreciation and accumulated
impairment losses
• Revaluation surplus, indicating the movement for the period and any
restrictions on the distribution of the balance to shareholders.
The standard also encourages disclosure of additional information, which the
users of financial statements may find useful:
• The carrying amount of temporarily idle property, plant and equipment
• The gross carrying amount of any fully depreciated property, plant and
equipment that is still in use
• The carrying amount of property, plant and equipment retired from
active use and held for disposal
• The fair value of property, plant and equipment when this is materiallydifferent from the carrying amount
Application activity 3.2The following information relates to BGM LTD:
On Feb 2013, an additional equipment was bought at a cost of FRW
2,500,000. Due to expansion in the market for serviced plots, another
equipment, was bought on 24th June 2013 at a cost of FRW 3,750,000.
On Feb 2013, an additional equipment was bought at a cost of FRW
2,500,000. Due to expansion in the market for serviced plots, another
equipment, was bought on 24th June 2013 at a cost of FRW 3,750,000.
However, an equipment which had been acquired at a cost of FRW
2,000,000 on 7th April2010 and was expected to have a useful life of
5years and a scrap value of FRW 125,000 could not cope up with bigger
projects efficiently, as a result on 5 July 2013, management disposed it off
at FRW 750,000.
Another equipment which was bought on 20th May 2010 at a cost of FRW
4,000,000 and was expected to have a residual value of FRW 250,000 at
the end of tenth year broke down was disposed of at FRW 1,750,000 on3 September 2013.
The company’s policy is to charge full depreciation in the year of purchase
and none at all in the year of sale (disposal).
The company followed straight line method of depreciation but changed
to charge depreciation at rate of 10% on cost for the equipment which
was available by the end of 31 December 2013. All transactions were by
cheque.
Required:
Prepare the following accounts as at 31 December 2013:
a) Equipment A/C
b) Equipment disposal A/Cc) Accumulated depreciation-equipment A/C
End unit assessment
1) KABALISA Ltd acquired a building in KIGALI on 1st January 2011 for
FRW 200 million. The building was judged to have a useful life of 50
years. On 31 December 2013, the property was revalued at FRW 210
million. On January 2016 the property was independently valued atFRW 170 million, the useful life was unchanged.
Required
Calculated the effect of the property on the statement of profit or loss forthe year ended 31st December 2016.
2) The following information was got from the balance sheet of GASABOTOURS as at 31 December 2021
SOYDM: Sum of Years Digits method
All transactions were by cheque. It is the company’s policy to charge a full
year’s depreciation in the year of purchase and none in the year of disposal.
All motor vehicles that are not disposed by 31December 2022 should be
depreciated by 20% on cost. The company’s financial year runs from 1January to 31 December.
Required:
i. Motor vehicles A/C
ii. Motor vehicles Accumulated depreciation A/Ciii. Motor vehicles disposal A/C
UNIT 4 : INTANGIBLE ASSETS
Key unit competence: To be able to measure and record intangibleassets
Introductory activity
Coca cola, Microsoft and Google are examples of the products that have
given the world their best and they are biggest trade mark since their
registration. The good reputation built over the years was catalyzed by
innovation and advertisements in big tournaments or events streamlined
through world class media.
What do you think these trademarks are in their books of accounts?
a) Company’s name
b) Asset
c) Equityd) Revenue
4.1 Introduction
Learning Activity 4.1
Required: Analyze the above picture and answer the following questions:
1) What does the picture demonstrate?2) Is a computer software an intangible asset ? Justify your answer.
4.1.1 Objective and scope
• Objective
The objective of this Standard is to prescribe the accounting treatment
for intangible assets that are not dealt with specifically in another Standard.
This Standard requires an entity to recognize an intangible asset if, and only
if, specified criteria are met. The Standard also specifies how to measure
the carrying amount of intangible assets and requires specified disclosuresabout intangible assets
• Scope
This standard shall be applied in accounting for intangible assets
except:
i. Intangible assets that are within the scope of another standard
ii. Financial assets
iii. Recognition and measurement of exploration and evaluation assets
iv. Expenditure on the development and extraction of minerals, oil, natural gas
and similar non-regenerative resources.
Note: If another Standard prescribes the accounting for a specific type
of intangible asset, an entity applies that Standard instead of this Standard.
a) This Standard applies to, among other things, expenditure on
advertising, training, start-up, and research and development activities.
Research and development activities are directed to the development
of knowledge. Therefore, although these activities may result in an
asset with physical substance (e.g: a prototype), the physical element
of the asset is secondary to its intangible component, i.e the knowledgeembodied in it.
b) Rights held by a lessee under licensing agreements for items such as
motion picture films, video recordings, plays, manuscripts, patents and
copyrights are within the scope of this Standard
Intangible assets that contain physical subsistence
Some intangible assets may be contained in or on a physical substance such as
a compact disc (in the case of computer software), legal documentation (in thecase of a license or patent) or film.
In determining whether an asset that incorporates both intangible and tangible
elements should be treated under IAS 16 Property, Plant and Equipment or as
an intangible asset under this Standard, an entity uses judgement to assess
which element is more significant. For example, computer software for a
computer-controlled machine tool that cannot operate without that specific
software is an integral part of the related hardware and it is treated as property,
plant and equipment. The same applies to the operating system of a computer.
When the software is not an integral part of the related hardware, computersoftware is treated as an intangible asset.
4.1.2 Definition and criteria to recognize intangible assets
• Definition
The following terms are used in this Standard with the meanings specified therein
i. Intangible assets: Intangible assets are non-current assets with no
physical substance, but which can be recognized in the statement of
financial position if they meet certain criteria.
ii. Amortization: is the decrease in the value of intangible asset due to its
use.
iii. Asset: is a resource controlled by an entity as a result of past events and
from which future economic benefits are expected to flow to the entity.
iv. Carrying amount is the amount at which an asset is recognized in the
statement of financial position after deducting accumulated amortization
and accumulated impairment losses thereon.
v. Depreciable amount is the cost of an asset, or other amount substituted
for cost less its residual amount
vi. Research is the original and planned investigation undertaken with
the prospect of gaining new scientific or technical knowledge and
understanding.
vii. Development is the application of reach findings or other knowledge
to a plan or design for the production of the new or improved materials,
products or system before start of commercial production or use
viii. Fair value is the price that would be received to sell an asset or paid to
transfer a liability in an orderly transaction between market participants at
measurement date
ix. Impairment loss: is the amount which the carrying amount of an asset
exceeds its recoverable amount
x. Residual value of intangible assets: is the estimated amount that an
entity would currently obtain from disposal of the asset, after deducting
the estimated costs of disposal.
xi. Useful life: Useful life is the period over which an asset is expected tobe available for use by an entity.
• Criteria necessary to recognize intangible assets
The intangible asset is recognized if the following three criteria are fully met
i. The intangible asset should be identifiable
Intangible asset is identifiable when
a) It is separable, i.e is capable of being separated or divided from the
entity and sold, transferred, licensed, rented or exchanged, either
individually or together with a related contract, identifiable asset or
liability, regardless of whether the entity intends to do so
b) Arises from contractual or other legal rights, regardless of whether
those rights are transferable or separable from the entity or from other
rights and obligations
ii. Intangible asset is controlled by entity
An entity controls an intangible asset if the entity has the power to obtain the
future economic benefits flowing from the underlying resource and to restrict
the access of others to those benefits.
iii. Intangible asset has expected future economic benefits
An item can only be recognized as an intangible asset if economic benefits
are expected to flow in the future from ownership of the asset. This economic
benefit could be revenue from the sale of products or services, cost savings, orother benefits resulting from the use of that intangible asset by the entity.
4.1.3 Exchange of asset
How to determine value of the exchanged asset?
If one intangible asset is acquired by way of exchanged for another, the cost of
the intangible asset is measured at fair value unless:
• The exchange transaction lacks commercial substance i.e no way to
determine market value ; or
• The fair value of neither the asset received nor the asset given up can
reliably be measured.
If the acquired asset is not measured at fair value, its cost is measured atthe carrying amount of the asset given up.
Example
Kigali Education Board is government business enterprises that comply with
IFRS and IAS for reporting purpose.
On 01 January 2021, Kigali education board (KEB) decides to acquire Clients’
Management System (CMS) that will serve as client management information
system. With this system, the clients can register, request service, and pay
through the system. Despite the need of the system, the management had no
funds to finance it and they decided to exchange one of their motor vehicles into
this system. The cost of this given up motor vehicle was FRW 20 million while its
accumulated depreciation as of 01 January 2021 was FRW 4 million. Because
the system was new in Rwanda, Kigali Education Board failed to determinemarket value of that system.
Required: Determine the value that will be assigned to this Client Management
System in KEB’s books of account
Answer
IAS 38 provides that if the acquired asset through exchange is not measured
at fair value, its cost is measured at the carrying amount of the asset given up.
Therefore, the fact that Kigali Education Board failed to determine fair value
of the system, the carrying amount of the given-up asset which is now motor
vehicle will serve the basis to determine initial value of the system.
Therefore, the value to be assigned to this Client Management System is FRW
16 million deemed to be carrying amount of motor vehicle, computed as follows
FRW 20 million – FRW 4 million.
4.1.4 Types of intangible assets
• Goodwill
Goodwill is an intangible asset that arises when one company acquires another.
Things like the value of a company name and brand, customer loyalty, or even
good employee retention are examples of a goodwill asset. You can calculate a
rough estimate of a goodwill asset by using this formula:
Goodwill= P - (A - L)
P = Purchase price of the target company
A = Fair market value of assets
L = Fair market value of liabilities
Goodwill acquired always makes it on to a balance sheet and will show up on a
separate line than other intangible assets.
• Brand equity: This represents a well-recognized brand with ability
to boost profit of the company. With good brand, the customers are
willing to order and buy goods from you at highest price compared to
similar product in the same industry
• Intellectual properties: Example of intellectual properties
includes: Copyrights, patents, franchises.
• Licensing: This is another type of intangible assets whereby a company
could buy license to use formula or software to make sales
• Customer lists
A strong customer lists is an asset to the company that own it, because
this is a tool that can increase company’s profit
Application activity 4.1
Highland Ltd is a company that manufactures ink for big printers. During the
year that ended 31 December 2021, the company acquired multisystem
machine that will be used to produce the ink for new developed SPC360SN
card printer. The machine requires software to operate and the software
was successfully installed in the machine at cost of FRW 50 million. The
machine could not operate without that software.
The FRW 50 million cost incurred to buy software will be treated
as part of
a) IAS 38-Intangible assets
b) IAS 16-Property plant and Equipment
c) IFRS 16-Leased) None of the above
4.2 Measurement of Intangible asset
Learning Activity 4.2
4.2.1 Internally generated goodwill
In some cases, expenditure is incurred to generate future economic benefits, but
it does not result in the creation of an intangible asset that meets the recognition
criteria in this Standard. Such expenditure is often described as contributing to
internally generated goodwill. Internally generated goodwill is not recognized as
an asset because it is not an identifiable resource (ie it is not separable nor does
it arise from contractual or other legal rights) controlled by the entity that can be
measured reliably at cost.
How does internally generated goodwill arise?
In some instance, entity believes that the difference between fair value of entity’s
net assets and its carrying amount could represent goodwill.
However, that is wrong interpretation because the Differences between the fair
value of an entity and the carrying amount of its identifiable net assets at any time
may capture a range of factors that affect the fair value of the entity. Therefore,
such differences do not represent the cost of intangible assets controlled bythe entity
4.2.2 Initial measurement and subsequent measurement
• Initial measurement
Intangible assets are initially recognized at cost. This is either the purchase
price, or the internally generated cost (see research and development later in
this unit).
• Subsequent measurement
After initial recognition, the Standard allows two methods of valuation forintangible assets. The entity shall choose either:
i. Cost model and
ii. Revaluation model
The methods used for subsequent measurement of intangible assets areexplained below
a) Cost Model
This method applies when an intangible asset is carried at its cost, less any
accumulated amortization and less any accumulated impairment losses.
Computation of accumulated amortization is shown in learning outcome 4.2.3of this book.
b) Revaluation model
The revaluation model allows an intangible asset to be carried at a revalued
amount, which is its fair value at the date of revaluation, less any subsequent
accumulated amortization and any subsequent accumulated impairment losses.
The standard states that there will not usually be an active market in an intangible
asset; therefore, the revaluation model will usually not be available. For example,
although copyrights, publishing rights and film rights can be sold, each has a
unique sale value. In such cases, revaluation to fair value would be inappropriate.
A fair value might be obtainable however for assets such as fishing rights orquotas or taxi cab licenses.
Treatment of Valuation surplus and deficit
Where an intangible asset is revalued upwards i.e fair value exceed carrying
amount, the amount of the revaluation should be credited directly to equityunder the heading of a revaluation surplus (other comprehensive income).
Example
The intangible asset that cost FRW 10 million was revalued on 31 December
2022 at FRW 8 million. The accumulated amortization at the date of revaluation
was FRW 4 million.
Required: Show how the above transaction will be treated in books of accounts
Answer: If the intangible asset is revalued, the first step you compute carrying
amount of the revalued intangible asset at revaluation date. The carrying amountin this case is, FRW 6 million
Where the carrying amount of an intangible asset is revalued downwards, the
amount of the downward revaluation should be recognized in profit or loss,
unless the asset has previously been revalued upwards in which case the
revaluation decrease should be first charged against any previous revaluation
surplus in respect of that asset.
Example: In our example above, let assume that the intangible asset was
revalued at FRW 5 million. Therefore, this implies revaluation decrease asrevalued amount falls short to carrying amount. The deficit is FRW 1 million
4.2.3 Useful life of intangible asset and amortization method
1. What is useful life of intangible asset
Useful life is the period over which an asset is expected to be available for use
by an entity
An entity should assess the useful life of an intangible asset, which may be finite
or indefinite. An intangible asset has an indefinite useful life when there is no
foreseeable limit to the period over which the asset is expected to generate net
cash inflows for the entity.
Many factors are considered in determining the useful life of an
intangible asset, including:
• Expected usage
• Typical product life cycles
• Technical, technological, commercial or other types of obsolescence
• The stability of the industry; expected actions by competitors
• The level of maintenance expenditure required
• Legal or similar limits on the use of the asset, such as the expiry dates
of related leases
2. Amortization of intangible assets
An intangible asset with a finite useful life should be amortized over its expected
useful life. Amortization is calculated in the same way as depreciation for tangible
assets.
When shall entity start and cease to compute amortization of intangible
asset?
Amortization should start when the asset is available for use while amortization
should cease at the earlier of the date the asset is classified as held for sale in
accordance with IFRS 5
The residual value of an intangible asset with a finite useful life is assumed to be
zero unless a third party is committed to buy the intangible asset at the end of
its useful life or unless there is an active market for that type of asset (so that its
expected residual value can be measured) and it is probable that there will be amarket for the asset at the end of its useful life
4.2.4 Intangible assets with indefinite useful lives
An intangible asset with an indefinite useful life should not be amortized. (IAS
36 requires that such asset is tested for impairment at least annually). However,
the appropriateness of deeming the useful life of the asset as indefinite should
be reviewed each year. If the useful life of the asset is deemed to be finite rather
than indefinite this may indicate that the asset may be impaired and it should betested for impairment.
4.2.5 Disposal/retirements of intangible assets
a) When to derecognize intangible asset in the accounts
An intangible asset shall be derecognized
• On disposal
• When no future economic benefits are expected from its use or disposal.
b) Treatment of gain or loss on disposal
The gain or loss arising from the derecognition of an intangible asset shall be
determined as the difference between the net disposal proceeds, if any, and
the carrying amount of the asset. It shall be recognized in profit or loss when theasset is derecognized.
Application activity 4.2
Mahoro supermarket has development expenditure of RWF5 million. Its
policy is to amortized development expenditure at 5% per annum using
straight line method. Accumulated amortization brought forward is
RWF500,000
What is the charge in the statement of profit or loss for the year’s
amortization?
a) FRW 250,000
b) FRW 225,000
c) FRW 500,000d) FRW 4,500,000
4.3 Internally generated intangible assets
Learning Activity 4.3
List some examples of activities that might be included in either research ordevelopment
4.3.1 Research and development cost
• Criteria to recognize internally developed intangible asset
To assess whether an internally generated intangible asset meets the criteria for
recognition, an entity classifies the generation of the asset into:
i. research phase; and
ii. development phase.
a. Research phase
Research activities by definition do not meet the criteria for recognition under
IAS 38. This is because, at the research stage of a project, it cannot be certain
that future economic benefits will probably flow to the entity from the project.
There is too much uncertainty about the likely success or otherwise of the
project. Research costs should therefore be written off as an expense as they
are incurred.
b. Development
Development costs may qualify for recognition as intangible assets provided
that the following strict criteria can be demonstrated.
– The technical feasibility of completing the intangible asset so that it will
be available for use or sale.
– Its intention to complete the intangible asset and use or sell it.
– Its ability to use or sell the intangible asset.
– There will be future economic benefits for the entity. The entity should
demonstrate the existence of a market for the output of the intangible
asset or the intangible asset itself or the usefulness of the intangible
asset to the business.
– The availability of technical, financial and other resources to complete
the development and to use or sell the intangible asset.
– Its ability to reliably measure the expenditure attributable to the intangibleasset during its development.
Note: If an entity cannot distinguish the research phase from the development
phase of an internal project to create an intangible asset, the entity treats the
expenditure on that project as if it were incurred in the research phase only.
• Cost of an internally generated intangible asset
The cost of an internally generated intangible asset is the sum of expenditure
incurred from the date when the intangible asset first meets the recognition
criteria. The IAS 38 prohibits reinstatement of expenditure previously recognizedas an expense.
The cost of an internally generated intangible asset comprises all directly
attributable costs necessary to create, produce, and prepare the asset to be
capable of operating in the manner intended by management.
Examples of directly attributable costs are:
i. Costs of materials and services used or consumed in generating the
intangible asset;
ii. Costs of employee benefits (salaries-wages) arising from the generation
of the intangible asset;
iii. Fees to register a legal right; andiv. Amortization of patents and licenses that are used to generate the
intangible asset
The following are not components of the cost of an internally
generated intangible asset:
a) Selling, administrative and other general overhead expenditure unless
this expenditure can be directly attributed to preparing the asset for use
b) Identified inefficiencies and initial operating losses incurred before the
asset achieves planned performance; and
c) Expenditure on training staff to operate the asset.
• Recognition of an expense
Expenditure on an intangible item shall be recognized as an expense when it is
incurred unless:
i. It forms part of the cost of an intangible asset that meets the recognition
criteria
ii. The item is acquired in a business combination and cannot be recognized
as an intangible asset. If this is the case, it forms part of the amount
recognized as goodwill at the acquisition date
• Past expenses not to be recognized as an asset
Expenditure on an intangible item that was initially recognized as an expenseshall not be recognized as part of the cost of an intangible asset at a later date.
Learning Activity 4.3
Igicuruzwa Ltd is developing a new production process. During 2020,
expenditure incurred was RWF1,000,000 of which RWF900,000 was
incurred before 1 December 2020 and RWF100,000 between 1 December
2020 and 31 December 2020. Igicuruzwa Ltd can demonstrate that, at 1
December 2020, the production process met the criteria for recognition as
an intangible asset. The recoverable amount of the know-how embodied inthe process is estimated to be RWF500,000
Required: How should the expenditure be treated?
Skills Lab
Visit local business center and try to identify or choose one company/
business with a good reputation compared to others and discuss on how
that reputation will increase value of the business when its acquisition happen
End unit assessment
1. A business buys a patent for RWF50 million. It expects to use the
patent for the next ten years, after which it will be valueless.
Required: Calculate the amortization charge for each year and
show the double entry to record it.
2. What do you think intangible assets is?
a) Non-current asset
b) Current asset
c) Revenue expenditure
d) Deferred expenditure3. Explain the accounting treatment of internally generated goodwil
UNIT 5: ACCOUNTING FOR PROVISIONS, CONTINGENT LIABILITIES AND CONTINGENT ASSETS
Key unit competence: To be able to ensure that the appropriate
recognition rules and measurement bases are
applied to provisions
Introductory activity
A manufacturer company of Mercedes-Benz car, follows accounting
standards developed at both national and international levels so that its
business runs very well. Units of cars purchased are covered by a standard
three-year warranty, whereby the company will replace any defective cars.
The customer does not have to pay for this three-year warranty. At the
end of the last year 31 December 2019, some amount representing a
liability of uncertain timing or amount was made. During this year another
amount was paid for the cost of replacing cars under warranty. At the end
of this year, the company estimated that amount of liability of uncertain
timing o r amount beyond the cost of replacing was needed.
REQUIRED: At the end of year 31 December 2020, what type of
account used to record the cost of replacing cars under warranty? How
this warranty should be recorded in financial statement?
5.1. Provisions
Learning Activity 5.1
A manufacturer of a technical equipment sells goods with a standard
warranty under which customers are covered for the cost of repairs of any
manufacturing defect that becomes apparent within the year of purchase.
What account that will appear in statement of financial position of a
manufacturer?
A provision should be recognized:
• When an entity has incurred a present obligation
• When it is probable that a transfer of economic benefits will be required
to settle it
• When a reliable estimate can be made of the amount involved
5.1.1 Objective and scope
Objective
The objective of IAS 37 Provisions is to ensure that appropriate recognition
criteria and measurement bases are applied to provisions, contingent liabilities
and contingent assets and that sufficient information is disclosed in the notes to
the financial statements to enable users to understand their nature, timing and
amount. The standard aims to ensure that only genuine obligations are dealtwith in the financial statements.
Scope
IAS 37 covers provisions arising from other accounting standards, but excludes
obligations and contingencies arising from financial instruments covered under
IAS 39 and IFRS 9 and insurance contracts covered under IFRS 4.
5.1.2 Definitions
IAS 37 Provisions, Contingent Liabilities and Contingent Assets views a
provision as a liability
‘A provision is a liability of uncertain timing or amount.’
‘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.’
IAS 37 distinguishes provisions from other liabilities, such as trade payables
and accruals. This is on the basis that for a provision there is uncertainty about
the timing or amount of the future expenditure.
While uncertainty is clearly present in the case of certain accruals, the uncertainty
is generally much less than for provisions.
An estimate is still required for an accrual but it is more reliable than provision.
Provision is only made for future expenses, whereas accrual is for both costs
and revenue.
The provisions are expected and uncertain, whereas accrual is certain, probable,
and easily foreseen. Accrual and provision are made before the reports of the
company are reported.
Example of an accrual
If a company has a savings account that earns interest, the interest that has
been earned but not yet paid would be recorded as an accrual on the company’s
financial statements.
Examples of provisions include bad debts, depreciation, doubtful debts,
guarantees (product warranties), income taxes, inventory obsolescence,
pension, restructuring liabilities and sales allowances. Often provision amounts
need to be estimated.
IAS 37 states that a provision should be recognized (which simply means
‘included’) as a liability in the financial statements when all three of the following
conditions are met.
• An entity has a present obligation (legal or constructive) as a result of
a past event.
• It is probable (that is more than 50% likely) that a transfer of economic
benefits will be required to settle the obligation.
• A reliable estimate can be made of the obligation.
What do we mean by a legal or constructive obligation? An obligation means
in simple terms that the business owes something to someone else. A legal
obligation usually arises from a contract and might, for example, include
warranties sold with products to make good any repairs required within a
certain time frame. A constructive obligation arises through past behavior
and actions where the entity has raised a valid expectation that it will carry
out a particular action. For example, a constructive obligation would arise if a
business which doesn’t offer warranties on its products has a history of usually
carrying out free small repairs on its products, so that customers have come to
expect this benefit when they make a purchase.
5.1.3 Provisions: Ledger accounting entries
When a business first sets up a provision, the full amount of the provision should
be debited to the statement of profit or loss and credited to the statement of
financial position as follows.
DEBIT Expenses (statement of profit or loss)
CREDIT Provisions (statement of financial position)
In subsequent years, adjustments may be needed to the amount of the provision.
The procedure to be followed then is as follows.
a) Calculate the new provision required.
b) Compare it with the existing balance on the provision account (that is the
balance b/f from the previous accounting period).
c) Calculate increase or decrease required.
i. If a higher provision is required now:
DEBIT Expenses (statement of profit or loss)
CREDIT Provisions (statement of financial position)
With the amount of the increase
ii. If a lower provision is needed now than before:
DEBIT Provisions (statement of financial position)
CREDIT Expenses (statement of profit or loss)
With the amount of the decrease
Example
A business has been told by its lawyers that it is likely to have to pay FRW
10,000,000 damages for a product that failed. The business duly set up a
provision at 31 December 2017. However, the following year, the lawyers found
that damages were more likely to be FRW 50,000,000.
Required
How is the provision treated in the accounts at
a) 31 December 2017?
b) 31 December 2018?
Answer
a) The business needs to set up provision as follows.
FRW’000 FRW’000
DEBIT Damages (SPL) 10,000
CREDIT Provision (SOFP) 10,000
Extract from statement of profit or loss
FRW’000
Expenses
Provision for damages 10,000
Extract from statement of financial position
FRW’000
Non-current liabilities*
Provision for damages 10,000
*Because it is uncertain when the amount relating to the provision will be paid,
or indeed if it definitely will be paid, it is classified as a non-current liability.
b) The business needs to increase the provision.
FRW’000 FRW’ 000
DEBIT Damages (SPL) 40,000
CREDIT Provision (SOFP) 40,000
Do not forget that the provision account already has a balance brought forward of
FRW 10,000,000 so we only need to account for the increase in the provision.
Extract statement of profit or loss
FRW’000
Expenses
Provision for damages 40,000
Extract from statement of financial position
Non-current liabilities FRW’000
Provision for damages (10,000,000 + 40,000,000) 50,000
5.1.4 Measurement of provisions
The amount recognized as a provision should be the best estimate of the
expenditure required to settle the present obligation at the end of the reporting
period. The estimates will be determined by the judgment of the entity’s
management supplemented by the experience of similar transactions. If the
provision relates to just one item, the best estimate of the expenditure will be
the most likely outcome.
When a provision is needed that involves a lot of items (for example, a warranty
provision, where each item sold has a warranty attached to it), then the provision
is calculated using the expected value approach. The expected value approach
takes each possible outcome (ie the amount of money that will need to be paid
under each circumstance) and weights it according to the probability of that
outcome happening. This is illustrated in the following example.
Warranty provisions are also covered under IFRS 15 Revenue from contracts
with customers. IFRS 15 will affect any warranty where there is a specific
contract between the customer and the seller, for example, where the customer
has paid for an extended warranty (over and above the standard manufacturer’s
warranty).
Here, we are only concerned with standard warranties where the organization
may be expecting a certain percentage of faults and therefore set aside a sum
of money to cover such costs.
Example
Garanti Ltd sells goods with a standard warranty under which customers are
covered for the cost of repairs of any manufacturing defect that becomes
apparent within the first six months of purchase. The company’s past experience
and future expectations indicate the following pattern of likely repairs. The
customer does not have to pay for these warranties.
Calculate the warranty provision that should be included in Garanti Ltd’s
financial statements
Answer
Garanti Ltd should provide on the basis of the expected cost of the repairs
under warranty. The expected cost is calculated as (75% × FRW 0 million) +
(20% × FRW 1.0 million) + (5% × FRW 4.0 million) = FRW 0.4 million, that is,
FRW 400,000.
Garanti Ltd should include a provision of FRW 400,000 in the financial
statements.
Application activity 5.1
1. What are the three conditions necessary for the recognition of a
provision as a liability?
2. What are provisions of IFRS?
3. Mention the difference between provision and accrual.
4. What are the examples of IAS 37 provision?
5. How can a provision be recognized in accordance with IAS 37?
6. An entity sells goods with a warranty covering customers for the cost
of repairs of any defects that are discovered within the first two months
after purchase. Past experience suggests that 80% of the goods sold
will have no defects, 15% will have minor defects and 5% will have
major defects. If minor defects were detected in all products sold the
cost of repairs would be FRW 30,000; if major defects were detected
in all products sold, the cost would be FRW 150,000.
Required: What amount of provision should be made?
7. An entity has to rectify a serious fault in a piece of equipment that it had
sold to a customer. The individual most likely outcome is that the repair
will succeed at the first attempt at a cost of FRW 50,000, but there is
a chance that a further attempt will be necessary, increasing the total
cost to FRW 80,000.
Required: What amount of provision should be made?
8. The company’s lawyer has advised that it is likely to have conscience
to pay FRW 5,000,000 money compensation for defective
equipment. The company respects the lawyer’s advice and sets up
a provision on 31 December 2020. Therefore, the lawyer discovers
that damages are more likely to be FRW 25,000,000 the following
year. You are asked to show how the provision is treated in the
accounts at:
i) 31 December 2020.
ii) 31 December 2021.
5.2 Contingent Liabilities and Contingent Assets
Learning Activity 5.2
During 2018, KEZA Ltd borrowings from Twisungane Co. Ltd were
guaranteed. At that time KEZA’s financial situation was good. During 2020,
the financial situation of KEZA Ltd was deteriorated due to Covid-19
negative effects. On 31 November 2020 KEZA Ltd makes its declaration
for protection from its creditor.
Required: Show accounting treatment required in the KEZA Ltd financial
statements at the end of the both years.
A contingent liability must not be recognized as a liability in the financial
statements. Instead, it should be disclosed in the notes to the accounts, unless
the possibility of an outflow of economic benefits is remote. A contingent asset
must not be recognized as an asset in the financial statements. Instead, it should
be disclosed in the notes to the accounts if it is probable that the economic
benefits associated with the asset will flow to the entity.
5.2.1 Contingent Liabilities
Contingent liabilities are defined as follows.
IAS 37 defines a contingent liability as:
• ‘a possible obligation that arises from past events and whose existence
will be confirmed only by the occurrence or non-occurrence of one or
more uncertain future events not wholly within the control of the entity;
or
• a present obligation that arises from past events but is not recognized
because:
– It is not probable that a transfer of economic benefits will be required
to settle the obligation; or
– The amount of the obligation cannot be measured with sufficient
reliability.’
As a general rule, probable means more than 50% likely. If an obligation is
probable, it is not a contingent liability – instead, a provision is needed.
If the obligation is remote, it does not need to be disclosed in the accounts.
Contingent liabilities should not be recognized in financial statements
but they should be disclosed in the notes.
The required disclosures are:
• A brief description of the nature of the contingent liability
• An estimate of its financial effect
• An indication of the uncertainties that exist
• The possibility of any reimbursement
5.2.2 Contingent assets
IAS 37 defines a contingent asset as a possible asset that arises from past
events and whose existence will be confirmed only by the occurrence or non
occurrence of one or more uncertain future events not wholly within the control
of the entity’.
A contingent asset must not be recognized in the accounts, but should be
disclosed if it is probable that the economic benefits associated with the asset
will flow to the entity.
A brief description of the contingent asset should be provided, along with an
estimate of its likely financial effect.
If the flow of economic benefits associated with the contingent asset becomes
virtually certain, it should then be recognized as an asset in the statement of
financial position, as it is no longer a contingent asset.
For example, a company expects to receive damages of FRW 1,000,000 and this
is virtually certain. An asset is recognized. If, however, the company expects to
probably receive damages of FRW 1,000,000, a contingent asset is disclosed.
5.2.3 IAS 37 flow chart
You must practice the questions below to get the hang of the IAS 37 rules on
contingencies. But first, study the flow chart, taken from IAS 37, which is a good
summary of its requirements.
Example
During 2019 Umuhigo Ltd gives a guarantee of certain borrowings of Ubuhinzi
Ltd, whose financial condition at that time is sound. During 2020, the financial
condition of Ubuhinzi Ltd deteriorates and at 30 June 2020 Ubuhinzi Ltd files
for protection from its creditors.
What accounting treatment is required in the financial statements of Umuhigo
Ltd:
a) At 31 December 2019?
b) At 31 December 2020?
Answer
a) At 31 December 2019
There is a present obligation as a result of a past obligating event. The obligating
event is the giving of the guarantee, which gives rise to a legal obligation.
However, at 31 December 2019 no transfer of economic benefits is probable
in settlement of the obligation.
No provision is recognized. The guarantee is disclosed as a contingent liability
unless the probability of any transfer is regarded as remote.
An appropriate note to the accounts would be as follows.
Contingent liability
The company has given a guarantee in respect of the bank borrowings (currently
FRW 5 million) of Ubuhinzi Ltd. At the reporting date, Ubuhinzi Ltd was sound
and it is unlikely that the company will be required to fulfil its guarantee.
b) At 31 December 2020
As above, there is a present obligation as a result of a past obligating event,
namely the giving of the guarantee.
At 31 December 2020 it is probable that a transfer of economic benefits will be
required to settle the obligation. A provision is therefore recognized for the best
estimate of the obligation.
Application activity 5.2
1. What are contingent liabilities according to IAS 37?
2. What is the treatment of contingent liabilities in the financial
statements?
3. How shall a contingent asset be recognized in the financial
statements in line with IAS 37?
4. What is the proper treatment of contingent asset?
5. Why are contingent assets not recognized?
6. (a) Twihangirumurimo Co. Ltd issued a one-year guarantee for on
equipment that it sells to its customer. At the company’s year end,
the company is being sued by one of its customers for refusing to
repair equipment within the guarantee period.
Twihangirumurimo Co. Ltd is of the view that the fault is not covered
by the guarantee as it believes that it has arisen because the customer
incorrectly followed the instructions on using the equipment.
Twihangirumurimo Co. Ltd’s lawyer has advised that it is more likely
than not that they will be found liable. This would result in the company
being forced to repair the equipment plus pay legal expenses amounting
to approximately FRW 20,000,000.
(b)The company also manufactures another line of equipment which
it sells to wholesalers. The company sold 2,000 items of this type this
year, which also has a one-year guarantee if the equipment fails. Based
on past experience, 10% of items sold are returned for repair. In each
case, 40% of the items returned are able to be repaired at a cost of
FRW 100,000, while the remaining 60% need significant repair at a
cost of FRW 300,000.
Required: Discuss the accounting treatment of the above situations.
5.3 Disclosure in Financial Statements
Learning Activity 5.3
Kundumurimo Co. Ltd is a manufacturer of Cellular Phone TECHNO. Cellular
Phones purchased on 1 January 2020 are covered by a standard one-year
warranty. A condition is that the company will replace any defective Cellular
Phones. The customer does not have to pay for this one-year warranty. Until
the end of the year 2020 different provisions was made including the cost
of replacing Cellular Phones under warranty.
a) The possibility of an outflow of economic benefits is not recognized
as the liability in financial statement of Kundumurimo Co. Ltd,
where this liability is included?
b) How do you call this liability?
IAS 37 requires certain items for provisions and contingent assets and liabilities
to be disclosed in the financial statements.
5.3.1 Disclosures for Provisions
Disclosures required in the financial statements for provisions fall into two parts.
• Disclosure of details of the change in carrying amount of a provision
from the beginning to the end of the year, including additional provisions
made, amounts used and other movements.
• For each class of provision, disclosure of the background to the making
of the provision and the uncertainties affecting its outcome, including:
i) A brief description of the nature of the provision and the expected timing
of any resulting outflows relating to the provision
ii) An indication of the uncertainties about the amount or timing of those
outflows and, where necessary to provide adequate information, the major
assumptions made concerning future events
iii) The amount of any expected reimbursement relating to the provision
and whether any asset that has been recognized for that expectedreimbursement.
Example
Umukino Ltd is a manufacturer of golf tees. Tees purchased are covered by a
standard three-year warranty, whereby the company will replace any defective
tees. The customer does not have to pay for this three-year warranty.
At the end of last year on 31 March 20X6, a provision of FRW 150 million was
made. During this year, FRW 75 million was paid for the cost of replacing tees
under warranty. At the end of this year, the company estimated that a provision
of FRW 135 million was needed.
Provide the following for the year ended 31 March 20X7:
a) Accounting entrees to record the movement in the warranty provision
b) How the warranty provision should be disclosed in the financial
statements?c) The general ledger account for the warranty provision
Non-current liabilities
Warranty provision 135
Below is an example of how the warranty provision might be disclosed in thenotes to the financial statements.
Note X: Provisions
Warranty provision
FRW M
At 1 April 2016 150
Increase in the provision during the year 60
Amounts used during year (75)
At 31 March 2017 135
The warranty provision relates to estimated claims on those products sold in
the year ended 31 March 2017 which come with a three-year warranty. The
expected value method is used to provide a best estimate. It is expected thatthe expenditure will be incurred in the next three years.
The table above is essentially a T-account, as set out below.
5.3.2 Disclosures for Contingent Liabilities
Unless remote, disclose for each contingent liability:
• A brief description of its nature, and where practicable
• An estimate of the financial effect
• An indication of the uncertainties relating to the amount or timing of any
outflow• The possibility of any reimbursement
5.3.3 Disclosures for Contingent Assets
Where an inflow of economic benefits is probable, an entity should disclose:
• A brief description of its nature, and where practicable• An estimate of the financial effect
Application activity 5.3
1. Rwanda Tourism Company (RTC) is a company registered in 2012
to facilitate foreign tourism coming in Rwanda to visit different place.
During the year that ended 30 June 2020, 10 customers booked to visit
Rwanda as they were motivated by Visit Rwanda promotion. However, due
to Covid-19 outbreak, all of these 10-tourists failed to travel to Rwanda
because of flight restrictions. Toward the end of fiscal year, RTC received
refund request from those customers but no payment made till end of year
which resulted into court case. The legal advisor of the company estimated
that RTC would pay damaged totaling FRW 50 million but it is not remote.
Required: Explain disclosure requirement per IAS 37 in respect of the
above pending legal case.
2. What is IAS 37 disclosure requirements?
3. What is disclosed for a contingent asset?
4. During the year to 31 December 2021, customer started legal
proceedings against company, claiming that one of the food products
that it manufactures had caused several members of his family to
become seriously ill. The company’s lawyers have advised that thisaction will probably not succeed.
Required: Should the company disclosure this in its financial statements?
5. Turwanyubukene Co. Ltd planted at Gakiriro is manufacturing MUVERO
used for cooking. The company gives promise to the customer that
the defective MUVERO will be replaced and MUVERO purchased
are covered by a standard five months’ warranty. Three months after
purchase, at the end of last year on 31 December 2021, a provision
of FRW 3 million was made. During this year, FRW 1.5 million was
paid for the cost of replacing MUVERO under warranty. The company
estimated that a provision of 2.5 million was needed at the end of this year.
At the end of year on 31 December 2022, you are asked to provide
the following:
i. Accounting entrees to record the movement in the warranty provision.
ii. How the warranty provision should be disclosed in the financial
statements?iii. The general ledger account for the warranty provision.
Skills Lab
Students must visit any company and analyze operating environment, they
will then discuss if the company has any provision, contingent liability andcontingent asset arising from their operations.
End unit assessment
1. A company is being sued for FRW 10 million by a customer. The
company’s lawyers reckon that it is likely that the claim will be upheld.
Legal fees are currently FRW 5 million.
How should the company account for this?
2. Given the facts in 1 above, how much of a provision should be made
if further legal fees, relating to the case, of FRW 2 million are likely to
be incurred in the future?
a) FRW 10 million
b) FRW 5 million
c) FRW 15 million
d) FRW 12 million
3. A company has a provision for warranty claims b/f of FRW 50 million. It
does a review and decides that the provision needed in future should
be FRW 40 million. What is the effect on the financial statements?
Statement of profit or loss Statement of financial position
a) Increase expenses by FRW 5 m Provision FRW 50 m
b) Increase expenses by FRW 5 m Provision FRW 45 m
c) Decrease expenses by FRW 5 m Provision FRW 50 m
d) Decrease expenses by FRW 5 m Provision FRW 45 m
4. A contingent liability is always disclosed on the face of the statement
of financial position.
True or False?
5. How does a company account for a contingent asset that is not
probable?
a) By way of note
b) As an asset in the statement of financial position
c) It does nothing
d) Offset against any associated liability
6. A company provides a two warranty on all their sales of technical
equipment. During 2019, they made sales of 200,000 units of technical
equipment at the value of FRW 20 million. History has shown that 5%
of all sales will require repairs, averaging FRW 100 each and 1% of all
sales will need to be replaced at a cost of FRW 200 each.
What is the journal entry to reflect the warranty to be provided on the
current year sales?
7. Bazizane Ltd is preparing its financial statements for the year ended
31 December 2016. A number of issues must be accounted for before
they can be finalized.
The following circumstances have arisen during the year:
i) Bazizane Ltd has a machine that needs regular overhauls every year
in order to be allowed to operate. Each overhaul costs FRW 5 million.
ii) Bazizane Ltd has set up a new division to produce a product for
which the market is still small. It expects this division to run at a loss
for two years.
iii) Bazizane Ltd sells goods with a one-year warranty. Customers are
not required to pay additional amounts for the warranty. Goods may
require minor or major repairs during the warranty period. If all of the
goods sold during the year to 30 December 2016 were to require
minor repairs, the total cost would be FRW 50 million. If all of the
goods sold required major repairs the cost would be FRW 120
million. In any year Bazizane Ltd expects 5% of goods sold to bereturned for major repairs and 16% to be returned for minor repairs.
Required
a) Which of circumstances (i) to (iii) above will give rise to a provision
and why?
b) What amount should be shown as a warranty provision in the
statement of financial position of Bazizane Ltd at 31 December 2016?
8. What is the difference between a trade payable, an accrual, a provision
and a contingent liability and how will they each appear in the financialstatements?
UNIT 6 : PREPARATION OF FINANCIAL STATEMENTS FOR A LIMITED LIABILITY COMPANY
Key unit competence: To be able to prepare financial statements for alimited liability
Introductory activity
Read the following information and answer the question that follows
for the year ended 31st March 2010 from the financial records of Watt
Limited:
Distribution Costs FRW 5,470; Interest Costs FRW 647; Cost of Sales
FRW 18,230, Sales FRW 44,870; Income Tax Expense FRW 1,617;
Administrative Expenses FRW 9,740; an asset originally cost FRW 10
,000 and was revalued to FRW 15,000
a) Which financial statement to be prepared by Watt Limited?
b) Which parts of that statement of Watt Limited?c) What income statement and other comprehensive?
6.1. Statement of comprehensive income
Learning Activity 6.1
KEZA is accountant of ABC ltd she has been prepared well ledger and
trial balance the next step is to be sure if they obtain net profits or net loss
for the period.
Required:
1. Which financial statement KEZA is going to prepare?2. Give five examples of elements included in this financial statement.
6.1.1 Trading and Profit or loss account
Objective and scope
As well as covering accounting policies and other general considerations
governing financial statements, IAS 1 Presentation of Financial Statements gives
substantial guidance on the form and content of published financial statements.
IAS 1 gives guidance on the format and content of all of these, apart from thestatement of cash flows, which is covered by IAS 7.
The entity should identify each component of the financial statements very
clearly. IAS 1 also requires disclosure of the following information in a prominent
position. If necessary it should be repeated wherever it is felt to be of use to the
readers in their understanding of the information presented.
After extracting a trial balance, the next step is to determine the amount of profit
or loss that the business has made during the trading period. This is done bypreparing two accounts namely:
There are basically two formats that are used to prepare a trading account.
• Horizontal• Vertical format
Horizontal T-formatABC limited trading account for the year ending ……./……./……../
(Vertical format)
ABC Limited (name of company) trading account for the yearended………./…../…../
Trading account
• Trading account is an account which is prepared to determine the gross
profit or gross loss of the business concern. It shows the revenues from
sales, the cost of those sales or goods sold and the gross profit from
for the specific period ended. It is prepared after the preparation of the
trial balance. Trading account is where the value of the gross profit or
gross loss is determined by deducting the cost of goods sold from net
sales i.e Gross Profit = Net Sales – Cost of Sales, or Gross Loss=
Cost of Goods Sold - Net Sales.
• Profit and loss Account where the value of net profit or Net loss is
calculated by deducting total operating expenses from the gross profitsi.e Gross profit – total expenses.
Items found in a trading account.
i. Sales: Refer to the value of goods which were bought for resale and have
been sold by the business. It is revenue earned from goods sold. They are
entered in the trading account for the purpose of calculating gross profit or loss.
ii. Sales return: Value of goods that were previously sold but have been
returned to the business.
iii. Net sales = Sales – Return inwards/ Sales Return
iv. Opening stock: Unsold goods in the business available at the beginning
of the new trading period.
v. purchases: Goods bought by the business for resale
vi. Purchases return: Goods previously bought by the business for sale
but have been sent back to the suppliers. This value is treated in the
trading account and it is subtracted from the purchases to get the net
purchases i.e.
Net purchases = purchases – return outwards/purchase returns
vii. Carriage in wards: refers to the cost of transporting the goods or bring
the goods up to the premises. It forms part of the goods bought henceadded to purchases the trading account.
viii. Warehouse wages: These are payments made directly for purchases
activity. Only wages paid directly for purchases in trading account to
determine the gross profit or gross loss. Net purchases = Purchases +Carriage Inwards +Wages -Purchases Return.
ix. Closing stock: Goods not sold by the business at the end of a trading
period. It’s included in the trading account and it is subtracted from thegoods available for sale to get cost of sales.
Cost of Goods Sold (CoGS) = Cost of Goods Available for Sale
(CoGAS) – closing stock.
Operating expenses (to be found in Profit and Loss Account):
These are the expenses incurred by the business on services that help in the
normal operation and running of the business. Such expenses include; transport,
electricity, rent insurance/premium, carriage outwards, salaries, water bills,
postage, discount allowed, advertising, communication, depreciation and bad
debts. In the profit and loss account the total operating expenses are subtractedfrom the total income or gross income to get net profit or net loss
Operating expenses fall into three major categories, namely:
i. Administrative expenses: comprising of office salaries and wages,
office rent and rates, office lighting, electricity and power, office stationery,
telephones, insurances, etc.
ii. Selling and distribution expenses: comprising of motor running
expenses, advertising, showroom, salesman salaries, carriage on sales etc.
iii. General and financial expenses: comprising of interest charges on
loan, and overdraft, bank charges, discount allowed, sundry or generalexpenses, etc.
Managers’ salaries
The salary of a sole trader or a partner in a partnership is not a charge to the
statement of profit or loss but is an appropriation of profit. The salary of a manager
or member of management board of a limited liability company, however, is an
expense in the statement of profit or loss, even when the manager is a shareholderin the company. Management salaries are included in administrative expenses.
Taxation
Taxation affects both the statement of financial position and the statement of
profit or loss. All companies pay some kind of corporate taxation on the profits
they earn, which we will call income tax in line with the terminology in IAS 1, but
which you may find called ‘corporation tax’
Note that because a company has a separate legal personality, its tax is included
in its accounts. An unincorporated business would not show personal income
tax in its accounts, as it would not be a business expense but the personal affairof the proprietors.
i. The charge for income tax on profits for the year is shown as a deductionfrom profit for the year.
ii. In the statements of financial position, tax payable to the Government is
generally shown as a current liability, as it is usually due within 12 monthsof the year end.
iii. For various reasons, the tax on profits in the statement of profit or loss and
the tax payable in the statement of financial position are not normally thesame amount
Example
A company has a tax liability brought forward of FRW 15,000. The liability is
finally agreed at FRW 17,500 and this is paid during the year. The company
estimates that the tax liability based on the current year’s profits will be FRW20,000.
Prepare the tax liability account for the year.
Inter-relationship of statement of profit or loss and statement of
financial position
When we were dealing with the financial statements of sole traders, we
transferred the profit for the year to the capital account. In the case of limited
liability companies, the profit for the year is transferred to retained earnings in
the statement of changes in equity.
The closing balance of the accounts in the statement of changes in equity isthen transferred to the statement of financial position.
Gains on property revaluation
Gains on property revaluation arise when a property is revalued. The revaluation
is recognized in the other comprehensive income part of the statement of profit
or loss and other comprehensive income and shown in the statement of changesin equity as a movement in the revaluation surplus.
For example, an asset originally cost FRW 10 million and was revalued to FRW
15 million. The gain on the revaluation is recognized in the statement of profit
or loss and other comprehensive income (in the other comprehensive incomesection) and then shown as a movement in the revaluation surplus
Illustration
IDC Ltd has share capital of 400,000 ordinary shares of FRW 10 each and
200,000 5 per cent preference shares of FRW 10 each.
The net profits for the first three years of business ended 31 December are:
2014, FRW 10,967,000; 2015 FRW 4,864,000; and 2016 FRW 15,822,000.
Transfers to reserves are made as follows: 2014 nil; 2015, general reserve,
FRW 10,000; and 2016, fixed assets replacement reserve, FRW 22,500.
Dividends were proposed for each year on the preference shares at 5 per cent
and on the ordinary shares at: 2014, 10 per cent; 2015, 12.5 per cent; 2016,15 per cent.
Corporation tax, based on the net profits of each year, is 2014 FRW 410,000;
2015 FRW 525,000; 2016 FRW 630,000Required: Prepare profit or loss account IDC Ltd
6.1.2 Presentation of statement of profit or loss and other
comprehensive income
We have considered just the statement of profit or loss. However, IAS 1 requires
entities to include a statement of profit or loss and other comprehensive income,
either as a single statement or as two separate statements:
Statement of profit or loss and a statement of other comprehensive
income
The statement of profit or loss and other comprehensive income takes the
statement of profit or loss and adjusts it for certain gains and losses. At Financial
Accounting level, this just means gains on revaluations of property, plant and
equipment.
The idea is to present all gains and losses, both those recognized in profit or
loss (in the statement of profit or loss) as well as those recognized directly in
equity, such as the revaluation surplus (in other comprehensive income).
IAS 1 gives the following suggested format for a statement of profit or loss andother comprehensive income
ABC CO
Statement of profit or loss and other comprehensive income forthe year ended 31 December 2012
Or
Statement of profit or loss and other comprehensive income for theyear ended 31 December 20x8 Extract
Other comprehensive income:
Gain on property on revaluation
Total comprehensive income = Profit for the year + other
comprehensive income =
Format of a trading account
Note:
• A reference to other comprehensive income means the last three lines
in the statement above. However, a reference to statement of profit
or loss and other comprehensive income means the whole statement
shown above.
• At the Financial Accounting level, the only items of other comprehensive
income are gains on revaluations of property, plant and equipment.
• Income statement is a financial statement that reports a company’s
financial performance over a specific accounting period. Financial
performance is assessed by giving a summary of how the business
incurs its revenues and expenses through both operating and nonoperating activities.
Illustration
ABC ltd company trial balance on 31/12/2019
Notes:
a) Closing inventory FRW 8,000
b) Depreciation on plant and machinery at 15% buildings 10%
c) Provision for doubtful receivables FRW 500
d) Insurance prepaid FRW 50
e) Outstanding rent
f) An asset (land) originally cost FRW 15 million and was revalued toFRW 20 million.
Required:
i) To Prepare a statement of profit or loss and other comprehensive incomefor the year ended 31 December 2019
Answer:
Vertical formatABC ltd Company trading account on 31/12/2019
Answer:
Vertical format
i) Statement of profit or loss and other comprehensive income for the yearended 31 December 2019.
Application activity 6.1
ABC Ltd has share capital of 400,000 ordinary shares of FRW 10 each
and 200,000 5 per cent preference shares of FRW 10 each.
The net profits for the first three years of business ended 31 December
are: 2014, FRW 10,967,000
2015 FRW 14,864,000; and 2016 FRW 15,822,000.
Transfers to reserves are made as follows: 2014 nil; 2015, general reserve,
FRW 100,000; and 2016, fixed assets replacement reserve, FRW 225,000.
Dividends were proposed for each year on the preference shares at 5 per
cent and on the ordinary shares at: 2014, 10 per cent; 2015, 12.5 per
cent; 2016, 15 per cent.
Corporation tax, based on the net profits of each year, is 2014 FRW
410,000; 2015 FRW 525,000; 2016 FRW 630,000
Required: Prepare profit or loss account ABC Ltd at ended 31 Decemberare: 2015, 2016
6.2 Statements of Financial Position
Learning Activity 6.2
ABC Company is closing its Financial period and they need to know the
company’s Financial Position. As a hired accountant,
You are asked to:
1. Tell which statement that shows the Financial Statements of abusiness and its elements.
6.2.1 Presentation of statement of financial position
ABC CompanyStatement of financial position as
6.2.2 Element of statement of Financial position
The statement of financial position makes use of accounting equation concepts:
Assets = Capital+ liabilities
The statement of financial position is also prepared according to the businessentity convention/concept, that a business is separate from its owners.
Assets
The assets are exactly the same as those we would expect to find in the account
of a sole trader.
The only difference is that the detail is given in notes. Only the totals are shownon the face of the statement of financial position.
Equity
Capital reserves usually have to be set up by law, whereas revenue reserves
are appropriations of profit. With a sole trader, profit was added to capital.
However, in a limited company, share capital and profit have to be disclosed
separately share capital, reserve, retained earnings, dividends, because profit
is distributable as a dividend but share capital cannot be distributed. Therefore,any retained profits are kept in the retained earnings reserve.
Liabilities
Liabilities are split between current and non-current
Users of financial statements need to be able to identify current assets and
current liabilities in order to determine the company’s financial position. Where
current assets are greater than current liabilities, the net excess is often called
‘working capital’ or ‘net current assets.
Each entity should decide whether it wishes to present current/non-current
assets and current/ non-current liabilities as separate classifications in the
statement of financial position. This decision should be based on the nature of the
entity’s operations. Where an entity does not choose to make this classification,
it should present assets and liabilities broadly in order of their liquidity.
In either case, the entity should disclose any portion of an asset or liability which
is expected to be recovered or settled after more than 12 months. For example,
for an amount receivable which is due in installment over 18 months, the portiondue after more than 12 months must be disclosed.
Current assets
An asset should be classified as a current asset when it is:
– Expected to be realized in, or is held for sale or consumption in, the
entity’s normal operating cycle
– Held primarily for the purpose of being traded
– Expected to be realized within 12 months after the reporting date
– Cash or a cash equivalent which is not restricted in its use all other
assets should be classified as non-current assets.
All other assets should be classified as non-current assets
Non-current assets include tangible, intangibles operating and financial assets
of a long –term nature. Other term with the same meaning can be used (“fixed”
“long-term”).
The term operating cycle of an entity is the time between the acquisition of
asset for processing and their realization in cash or cash equivalent. Current
assets therefore include assets (such as inventories and trade receivables) that
are sold or realized as part of the normal operating cycle. This is the case evenwhere they are not expected to be realized within 12 months.
Current liabilities
A liability should be classified as a current liability when it is:
– Expected to be settled in the entity’s normal operating cycle
– Due to be settled within 12 months of the reporting date– Held primarily for the purpose of being traded
All other liabilities should be classified as non-current liabilities.
The categorization of current liabilities is very similar to that of current assets.
Thus, some current liabilities are part of the working capital used in the normal
operating cycle of the business (i.e trade payables and accruals for employee
and other operating costs). Such items will be classed as current liabilities even
where they are due to be settled more than 12 months after the reporting date.
There are also current liabilities which are not settled as part of the normal
operating cycle, but which are due to be settled within 12 months of the
reporting date. These include bank overdrafts, income taxes, other non-trade
payables and the current portion of interest-bearing liabilities. Any interest
bearing liabilities that are used to finance working capital on a long-term basis,
and that are not due for settlement within 12 months, should be classed asnon-current liabilities.
Example:
From the example 6.2.2.1 Present statement of financial position of ABC limitedCompany for the ended 31 December 2019 in vertical format.
Statement of financial position of ABC Limited Company for the ended31 Dec 2019
Application activity 6.2
The following balances were extracted from the book of KASAYA limitedas at 30 September 2010 in FRW”000”
Additional information:
1. The balance on corporation tax account represents an over provision
of tax for the previous year.
tax expenses for the current year is estimated at FRW 3 million.
2. On the 15 September 2010 the directors of the company proposed
to pay the dividend due to the ordinary preference shareholders
and also to pay a final dividend of FRW 2 million to the ordinary
shareholders.
3. A building whose net book value is 5million is to be revalued to FRW9 million.
Required:
Prepare Statement of financial position for the year ended 30 September 2010
6.3. Statement of changes in equity
Learning Activity 6.3
There are two businesses A&B which are operating in Kamonyi District
where A is a Sole trader and B is a company. There are showing you their
Financial Statements.
Required: To Differentiate statement of sole trader from Statement of
financial position of company based on element of owners’ equity?
6.3.1 Presentation statement of changes in equity
IAS 1 requires an entity to provide a statement of changes in equity. The
statement of changes in equity shows the movements in the entity’s equity for
the period.
The statement of profit or loss and other comprehensive income is a straight
forward measure of the financial performance of the entity, in that it shows all
items of income and expense recognized in a period. It is then necessary to link
this result with the results of transactions with owners of the business, such as
share issues and dividends. The statement making the link is the statement of
changes in equity.
The statement of changes in equity simply takes the equity section of the
statement of financial position and shows the movements during the year. The
bottom line shows the amounts for the current statement of financial position.
As we saw above, the total comprehensive income for the year is split between
the gains on revaluation of property, which is credited to the revaluation surplus,
and the profit for the year, which is credited to retained earnings.An example statement of changes in equity is shown below
6.3.2 Elements of statement of changes in equity
ABC co statement of changes in equity for the year ended 31 December 2012
Dividends paid during the year are not shown on the statement of profit or lossaccount, they are shown in the statement of changes in equity.
Example 1:
Opening balances of all equity account
Share capital FRW 5000,000
Retained earnings FRW 2,350,000
Accumulated other comprehensive income FRW 650,000
Preliminary financial data:
Revenue was FRW 15,000,000 and expenses were FRW 8,500,000 for the
year.
A cash dividend of FRW 500,000 was declared and paid in the current year.
The other comprehensive income for the year is FRW 900,000Prepare and present statement changes in equity for the year.
Application activity 6.3
The published accounts of XYZ Co, the profit for the period is FRW
350,000. The balance of retained earnings at the beginning of the year is
FRW 50,000. If dividends of FRW 250,000 were paid, what is the closing
balance of retained earnings?
a) FRW 400,000
b) FRW 150,000
c) FRW 50,000d) FRW 100,000
6.4 Statement of cash-flow
Learning Activity 6.4
Analyze the above picture and answer the question follow:
a) Is there the movement of money? Explain
b) List two examples of each movement of money
The standard gives the following definition, the most important of which are
cash and cash equivalents.
– 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 toan 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 capital and borrowings of theentity.
6.4.1 Presentation of a statement of cash flows
IAS 7 requires statements of cash flows to report cash flows during the period
classified by operating, investing and financing activities.
The manner of presentation of cash flows from operating, investing and financing
activities depends on the nature of the enterprise.
By classifying cash flows between different activities in this way, users can see
the impact on cash and cash equivalents of each one, and their relationshipswith each other. We can look at each in more detail.
Component of cash flow:
1. Operating activities:
This is perhaps the key part of the statement of cash flows because it shows
whether, and to what extent, companies can generate cash from their operations.
It is these operating cash flows which must, in the end, pay for all cash outflows
relating to other activities, ie paying loan interest, dividends and so on.
Most of the components of cash flows from operating activities will be those
items which determine the net profit or loss of the enterprise, i.e they relate tothe main revenue-producing activities of the enterprise.
The standard gives the following as examples of cash flows from operating
activities.
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 servicesd) Cash payments to and on behalf of employees
Certain items may be included in the net profit or loss for the period which do
not relate to operational cash flows; for example, the profit or loss on the sale of
a piece of plant will be included in net profit or loss, but the cash flows will beclassed as investing.
2. Investing activities
The cash flows classified under this heading show the extent of new investment
in assets which will generate future profit and cash flows.
The standard gives the following examples of cash flows arising from investing
activities
a) Cash payments to acquire property, plant and equipment, intangibles
and other non-current assets, including those relating to capitalized
development costs and self-constructed property, plant and equipment
b) Cash receipts from sales of property, plant and equipment, intangibles
and other non-current assets
c) Cash payments to acquire shares or loan notes of other entities
d) Cash receipts from sales of shares or loan notes of other entities
e) Cash advances and loans made to other parties
f) Cash receipts from the repayment of advances and loans made toother parties
3. Financing activities
This section, of the statement of cash flows shows the share of cash which the
entity’s capital providers have claimed during the period. This is an indicator of
likely future interest and dividend payments. The standard gives the following
examples of cash flows which might arise under these headings.
a) Cash proceeds from issuing shares
b) Cash payments to owners to acquire or redeem the entity’s shares
c) Cash proceeds from issuing loans, bonds, mortgages and other short-
or long-term borrowings
d) Cash repayments of amounts borrowed
e) Cash payments by a lessee for the reduction of the outstanding liabilityrelating to a lease
Reporting cash flows from operating activities
a) Direct method: disclose major classes of gross cash receipts and
gross cash payments
b) Indirect method: net 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
a. Using the direct method:
There are different ways in which the information about gross cash receipts
and payments can be obtained. The most obvious way is simply to extract theinformation from the accounting records.
Example
ABC Ltd had the following transactions during the year:
a) Purchases from suppliers were FRW 19,500,000 of which FRW
2,550,000 was unpaid at the year end. Brought forward payables
were FRW 1,000,000.
b) Wages and salaries amounted to FRW 10,500,000 of which FRW
750,000 was unpaid at the year end. The accounts for the previous
year showed an accrual for wages and salaries of FRW 1,500,000.
c) Interest of FRW 2,100,000 on a long-term loan was paid in the year.
d) Sales revenue was FRW 33,400,000, including FRW 900,000
receivables at the year end. Brought forward receivables were FRW400,000.
Required:To calculate the cash flow from operating activities using the direct method
B. Using the indirect method
This method is undoubtedly easier from the point of view of the preparer of the
statement of cash flows. The net profit or loss for the period is adjusted for the
following.
a) Changes during the period in inventories, operating receivables and
payables
b) Non-cash items, eg depreciation, provisions, profits/losses on the
sales of assets
c) Other items, the cash flows from which should be classified underinvesting or financing activities
a) Depreciation is not a cash expense, but is deducted in arriving at the
profit figure in the statement of profit or loss. It makes sense, therefore,
to eliminate it by adding it back.
b) By the same logic, a loss on a disposal of a non-current asset (arising
through under-provision of depreciation) needs to be added back and
a profit deducted.
c) An increase in inventories means less cash – you have spent cash on
buying inventory.
d) An increase in receivables means the company’s receivables have not
paid as much, and therefore there is less cash.
e) If we pay off payables, causing the figure to decrease, again we haveless cash.
• 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 (IAS 7,
A financial institution shows interest paid and interest and dividends received as
operating cash flows, because its business model is based around generatingreceipts of interest and dividends.
For entities that are not financial institutions:
a) Interest paid should be classified as an operating cash flow or a
financing cash flow.
b) Interest received and dividends received should be classified as
investing cash flows.
c) Dividends paid by the entity may be classified as a financing cash
flow, showing the cost of obtaining financial resources or alternatively
as an operating cash flow, so that users can assess the entity’s abilityto pay dividends out of operating cash flows. (IAS 7
• 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 bespecifically identified with financing and investing activities
• The advantages of cash flow accounting
a) Survival in business depends on the ability to generate cash. Cash
flow accounting directs attention towards this critical issue.
b) Cash flow is more comprehensive than ‘profit’ which is dependent on
accounting conventions and concepts.
c) Creditors of the business (both long and short term) are more
interested in an enterprise’s ability to repay them than in its profitability.
While ‘profits’ might indicate that cash is likely to be available, cash
flow accounting gives clearer information.
d) Cash flow reporting provides a better means of comparing the results
of different companies than traditional profit reporting.
e) Cash flow reporting satisfies the needs of all users better.
i) For management, it provides the sort of information on which decisions
should be taken (in management accounting, ‘relevant costs’ to a decision
are future cash flows). Traditional profit accounting does not help with
decision making.
ii) For shareholders and auditors, cash flow accounting can provide a
satisfactory basis for stewardship accounting.
iii) As described previously, the information needs of creditors andemployees will be better served by cash flow accounting.
a) Cash flow forecasts are easier to prepare, as well as more useful, than
profit forecasts.
b) They can in some respects be audited more easily than accounts
based on the accruals concept.
c) The accruals concept is confusing, and cash flows are more easilyunderstood.
ILLUSTRATION 1
The following are balance sheets of Neema private ltd for the years ended 31stDec 2003 and 2004 respectively Neema private company.
Balance sheet/ statement of financial position as at 31st Dec 2003
NEEMA PRIVATE LTD
Balance sheet/ Statement of Financial Position as at 31st Dec 2004
Additional information:
i. A piece of land was sold in July 2004 for FRW 610,000 and investment in
October 2004 for FRW 175,000
ii. Some motor vehicle was bought in 2004 for FRW 520,000. No furniture
was bought or sold during the year.
Required: To prepare a statement of Cash Flow to explain the change in cash
Solution
Adjustments:
a) Gain on disposal (land) = 610,000-(1,500,000-1,200,000) =
610,000-300,000=310,000
b) Loss on disposal (investment)= 200,000-175,000= 25,000
c) Depreciation on furniture= 100,000-40,000=60,000
or NBV for 2nd year-NBV for 1st year= 3,400-2,800=600x100=60,000
a) Depreciation on Motor Vehicle= 520,000-(880,000-550,000) =190,000
NEEMA PRIVATE LTDSTATEMENT CASH FLOW (INDIRECT METHOD)
ILLUSTRATION 2
The following information is extracted from the financial statement of AMANI ltdon 31/12/2016:
You are required to prepare a statement of Cash Flow
6.4.2 Notes to financial statement
Note to financial information are included in a set of financial statement
to give users extra information.
Notes to financial statements provide more details for the users of the accounts
about the information in the statement of profit or loss and other comprehensive
income, the statement of financial position, the statement of cash flows and the
statement of changes in equity.
For example, the statement of financial position shows just the total carrying
amount of property,
Plant and equipment owned by an entity. The notes to the financial statements
then break down this total into the different categories of assets, the cost, any
revaluation, the accumulated depreciation and the depreciation charge for the year.
A reconciliation to the opening and closing amount at the beginning and end of
the period, asShown below:
As well as the reconciliation above, the financial statements should disclose the
following.
i) An accounting policy note should disclose the measurement bases used
for determining the amounts at which depreciable assets are stated, along
with the other accounting policies.
ii) For each class of property, plant and equipment:
For each class of property, plant and equipment: IAS 16
– Depreciation methods used
– Useful lives or the depreciation rates used
– Total depreciation allocated for the period
– Gross amount of depreciable assets and the related accumulated
depreciation at the beginning and end of the period
iii) For revalued assets:
For revalued assets:
a) Effective date of the revaluation
b) Whether an independent valuer was involved
c) Carrying amount of each class of property, plant and equipment that
would have been included in the financial statements had the assets
been carried at cost less depreciation
d) Revaluation surplus, indicating the movement for the period and
any restrictions on the distribution of the balance to shareholders.
Intangible non-current assets
A reconciliation of the carrying amount of intangible assets at the beginning andend of the period, as shown below
As well as the reconciliation above, the financial statements should disclose the
following
– The accounting policies for intangible assets that have been adopted.
– For each class of intangible assets (including development costs),
disclosure is required of the following:
The method of amortization used: IAS 38
a) The useful life of the assets or the amortization rate used
b) The gross carrying amount, the accumulated amortization and the
accumulated impairment losses as at the beginning and end of the period
c) The carrying amount of internally generated intangible assets
d) The line item(s) of the statement of profit or loss in which anyamortization of intangible assets is included
Contingent liabilities
Disclose for each contingent liability:
i) A brief description of its nature; and where practicable
ii) An estimate of the financial effect
iii) An indication of the uncertainties relating to the amount or timing of any
outflowiv) The possibility of any reimbursement
Contingent assets
Where an inflow of economic benefits is probable, an entity should disclose:
i) A brief description of its nature; and where practicableii) An estimate of the financial effect.
Inventories
Inventories are valued at the lower of cost and NRV. Cost is determined using
the first in, first out (FIFO) method. NRV is the estimated selling price in theordinary course of business, less the costs estimated to make the sale.
6.4.3 Company accounts for internal purposes
The large amount of information in this unit so far has really been geared towards
the financial statements companies produce for external reporting purposes. In
particular, the IFRS Standards discussed here are all concerned with external
disclosure. However, companies to produce financial accounts for internal
purposes.
It will often be the case that financial accounts used internally look very similar
to those produced for external reporting for various reasons.
a) The information required by internal users is similar to that required
by external users. Any additional information for managers is usually
provided by management accounts.
b) Financial accounts produced for internal purposes can be used for
external reporting with very little further adjustment.
It remains true, nevertheless, that financial accounts for internal use can follow
whichever format manager wishes.
They may be more detailed in some areas than external financial accounts
(perhaps giving breakdown of sales and profits by region or by product), but
may also exclude some items.
For example, the taxation charge and dividend may be missed out of thestatement of profit or loss.
EXAMPLE
The accountant of ABC Ltd has prepared the following trial balance as at 31December 2017
Notes
1. Sundry expenses include FRW 9,000 paid in respect of insurance for
the year ending 1 September 2018. Light and heat does not include
an invoice of FRW 3,000 for electricity for the three months ending 2
January 2018, which was paid in February 2018. Light and heat alsoincludes FRW 20,000 relating to salespeople’s commission.
3. The net assets of ABC Ltd were purchased on 3 March 2017. Assets
were valued as follows. FRW’000
All the inventory acquired was sold during 2017. The investments were still held
by ABC at 31.12.2017.
4. The property was acquired some years ago. The buildings element of the
cost was estimated at FRW 100,000 and the estimated useful life of the
assets was 50 years at the time of purchase. As at 31 December 2017
the property is to be revalued at FRW 800,000.
5. The plant which was sold had cost FRW 350,000 and had a carrying
amount of FRW 274,000 as at 1 January 2017. FRW 36,000 depreciations
are to be charged on plant and machinery for 2017.
6. The loan stock has been in issue for some years. The FRW 0.5 ordinary
shares all rank for dividends at the end of the year.
7. The management wish to provide for:
1. Loan stock interest due
2. A transfer to general reserve of FRW 16,000
3. Audit fees of FRW4,000
8. Inventory as at 31 December 2017 was valued at FRW 220,000 (cost).9. Taxation is to be ignored.
Required:
Prepare the financial statements of ABC Co as at 31 December 2017, including
the statement of financial position, the statement of profit or loss and other
comprehensive income, and the statement of changes in equity. No other notes
are required.
SOLUTION:
1. Normal adjustments are needed for accruals and prepayments (insurance,
light and heat, loan interest and audit fees). The loan interest accrued iscalculated as follows.
Illustration
1. Which of the following is not a component of financial statements?
a) Statement of Financial Position
b) Cashbook
c) Statement of Profit or Loss D Statement of Changes in Equity
2. The following trial balance was extracted from the books of accounts ofKWESA LTD for the year ended 20 June 2021:
The following additional information is relevant for the preparation of financial
statements
1. The loan was obtained from Cogenenk Plc. ON 1stseptemeber 2020
at an annual rate of 16.5% and the interest was not yet settled as at
30thJune 2021.
2. Depreciation, Staff meals and staff salaries and wages are to be allocated
to both selling and Distribution and administrative expenses in the ration
of 30% to 70% respectively.
3. The following rate will be applicable in the depreciation of the followingassets:
– Buildings 5% straight line
– Furniture and fittings 25% reducing balance– Vehicles 20% reducing balance
4. The buildings were revalued at 30 June 2021 at FRW 3.2 billion
5. Income tax expense is to be charged at 30% of the profit
6. On 1st January 2021, the company acquired a new ERP software worth
FRW 543.5 million with a definitive useful life of 10 years. This software
has not been recorded in the financial statements.
Required: In accordance with IAS, Prepare:
a) Statement of profit or loss and comprehensive incomes of KWESA
LTD for the year ended 30 June 2021b) Statement of financial position of KWESA LTD as at 30 June 2021
KWESA LTD STATEMENT OF FINANCIAL POSITION AS AT 30 JUNE 2021
Application activity 6.4
The following is a summarized balance sheet of MURENZI Ltd as at 31st
March 2014, together with the comparative figures relating to the previous year.
iv) Capital raising operations
a) During the year ended 31 March 2015 there was a right issue of
FRW 1 ordinary shares for every 8 held, being issued at a price
of FRW 1.20 per fully paid share.
b) There was an issue of FRW 300,000 10% debenture stock. Bothof these issues were fully subscribed.
NOTE: the trading profit was arrived at after charging the FRW 201,000
debenture interest.
Required:
Prepare the statement OF Cash Flow for MURENZI Ltd for the year ended
31 March 2015
2. What must include in note to financial statement for property, plantand equipment: IAS 16
Skills Lab
Students in small groups prepare financial statements of a limited liability
company from case studies.
Through a case study, students conduct a field visit to see how financial
statements are prepared in a selected limited liability company and presentwhat they have observed.
End assessment
1. According to IAS 1, which of the following items must appear on
the face of the statement of profit or loss and other comprehensive
income?
i) Tax expense
ii) Revenue
iii) Cost of sales
iv) Profit or loss
a) (iv) only
b) (ii) and (iv)
c) (i), (ii) and (iv)
d) (ii) and (iii)
2. According to IAS 1, which of the following items make up a complete
set of financial statements?
i) Statement of changes in equity
ii) Statement of cash flows
iii) Notes to the accounts
iv) Statement of financial position
v) Statement of profit or loss and other comprehensive income
vi) Chairman’s report
a) All of the items
b) (i), (ii), (iv) and (v)
c) (i), (ii), (iii), (iv) and (v)
d) (iii), (iv) and (v)
3. Which of the following items are non-current assets?
i) Land
ii) Machinery
iii) Bank loan
iv) Inventory
a) only
b) (i)and (ii)
c) (i), (ii) and (iii)
d) (ii), (iii) and (iv)
4. How is a bank overdraft classified in the statement of financial position?
a) Non-current asset
b) Current asset
c) Current liability
d) Non-current liability
5. The following account balances were extracted from the books of XYZ
LTD, a company owning a computer store in Nyarugenge, at the endof her financial year 30 June 2020:
The inventory at the end of the year was valued at FRW 8,800
You are required to prepare (For Internal Purpose):
a) XYZ’s Statement of Profit or Loss for the year ended 30 June
2020 (10 Marks)b) XYZ’s Statement of Financial Position as at 30 June 2020
UNIT 7 : EVENTS AFTER THE REPORTING PERIOD
Key unit competence: To be able to assess the events that require
the entity to adjust the amount shown in the financial statements.
Introductory activity
Imagine that the end of your reporting period is 31st December 2022,
your accountants finish the closing works on 31st January 2023, the
board of directors authorizes them for issue on 15th February 2023 and
the shareholders approve them on 28th February 2023. By definition, you
need to consider everything that happens between 31st December 2022
and 15th February 2023 as an event after the reporting period.
Ok, but what if the earthquake happens on 16th February 2023 and
destroys your building? Well, that is the event after the reporting period
for sure, but not under the definition of IAS 10, because it falls outsidethose two important dates.
1. Why do accountants adjust the accounts after the reporting period?
2. What is the impact of adjustments on the financial statements of a
company?
7.1. Objective and scope of the International Accounting
Standard 10 (IAS 10)Learning Activity 7.1
One of the accounting purposes is to report the accounting information to
various users, including internal and external. After reporting, some eventsmay occur and adjustments may be done.
1. In which range these adjustments must be done?
Events after the reporting period are the events which could be favorable or
unfavorable, that occur between the reporting period and the date that thefinancial statements are authorized for issue.
7.1.1 Objective of the International Accounting Standard 10
(IAS 10)
The financial statements are significant indicators of a company’s success
or failure. It is important therefore, that they include all the informationnecessary for an understanding of the company’s position.
7.1.2 Scope of the International Accounting Standard 10 (IAS 10)
The International Accounting Standard 10 (IAS 10) deals with the events after
the reporting period, which may affect the performance and financial position
of a company at the reporting date. It addresses the criteria that must be met in
order to adjust the financial statements and all disclosures that must be made
regarding events after the reporting period date.
Application activity 7.1
a) Why do businesses consider adjustments after reporting period?
b) Is it necessary to adjust all events that occur between the reportingperiod and that of authorization for issue? Why?
7.2. Events that require adjustments and events that do not
require adjustments.
Learning Activity 7.2
After the reporting period, a given number of events may occur and, some
of them affect the accounts included in the financial statements while others
are not, reason why accountants must consider all of these events.a) Why do accountants adjust accounts?
7.2.1 Events that require adjustments
Events that require adjustments are the events that provide further evidence
of conditions that existed at the reporting date should be adjusted for in the
financial statements.
The standard requires adjustment of assets and liabilities in certain circumstances;
an entity shall adjust the amounts recognized in its financial statements to reflect
adjusting events after the reporting period.
Examples include additional evidence which becomes available after the
reporting date is where a customer goes bankrupt, thus confirming that the
trade account receivable balance at the year-end is irrecoverable.
Other examples include:
• Evidence of a permanent diminution in property value prior to the year end,
• Sale of inventory after the end of the reporting period for less than its
carrying at the year-end;
• Insolvency of a customer with a balance owing at the year-end;
• Amounts received or paid in respect or insurance claims which were in
negotiation at the year end
• Determination after the year end of the sale or purchase price of assets
sold or purchased before the year end;
• Evidence of a permanent diminution in the value of a long-term
investment prior to the year end
• Discovery of fraud or errors that show that the financial statements are
incorrect.
The standard states that, where operating results and the financial position have
deteriorated after the reporting date, it may be necessary to reconsider whether
the going concern assumption is appropriate in the preparation of the financialstatements.
7.2.2 Events that do not require adjustments
Events which do not affect the situation at the reporting date should not be
adjusted, but should be disclosed in the financial statements. The entity shall
not adjust the amounts recognized in its financial statements to reflect non
adjusting events after the reporting period.
Example given by the standard of such an event is where the value of an
investment falls between the reporting date and the date the financial statements
are authorized for issue. The fall in value represents circumstances during the
current period, not condition existing at the previous reporting date, so it is not
appropriate to adjust the value of the investment in the financial statements.
Disclosure is an aid to users, however, indicating unusual changes in the state
of assets and liabilities after the reporting date.
Other examples include the following:
• Acquisition or disposal of subsidiary after the year end;
• Announcement of a plan to discontinue an operation;
• Major purchases and disposals of assets;
• Destruction of a production plant by fire after the end of the reporting period
• Announcement of commencing implementation of a major restructuring;
• Share transactions after the end of the reporting period;• Litigation commenced after the end of the reporting period.
Illustration
KANYANA Company Ltd faces the court case for selling contaminated foods to
KABANYANA its customers. KANYANA Company Ltd denied all claims and no
provision was made in its financial statements at 31st December 2021.
On 2nd February 2022, the court awards KABANYANA FRW 1,000,000
damages against KANYANA Company Ltd. The financial statements have not
yet authorized for issue at that date.
Therefore, this adjusting event must be reflected in the financial statement at
31st December 2021.
KANYANA Company Ltd needs to create a provision for the damages because
the present obligation existed at 31st December 2021 (they sold contaminated
food prior that date)
The adjusting entries are as under:
Dr: Legal costs in profit or loss 1,000,000Cr: provision against legal cost 1,000,000
Application activity 7.2
a) Distinguish the events that require the adjustments from the events
that do not require adjustments after the reporting period
b) Give three examples of events that require adjustments and three
ones that do not require adjustments after the reporting period
c) State whether the following events occurring after the reporting
period require an adjustment to the assets and liabilities of the
financial statements:
– Purchase of an investment
– A change in the rate of tax, applicable to the previous year
– An increase in pension benefits– Losses due to fire
– An irrecoverable debt suddenly being paid
– The receipt of proceeds of sales or other evidence concerning the
net realizable value of inventory
– A sudden decline in the value of property held as a long-term asset
d) A debtor who owed FRW 500,000 to the business by the end of the
financial year is declared bankrupt by the court before the statements
are authorized for issue.
Required:
• State if this event requires adjustment or not. Explain your position• Make journal entries for this bankruptcy
7.3. Information to be disclosed in the notes
Learning Activity 7.3
Accounting information users always need to be informed about the
performance and the financial position of their business. Sometimes, there
are events that occur after reporting period and do not require adjustments.
1. In which way are the shareholders informed how their business is
especially about the events which are not included in the financial
statements?
Notes to the financial statements disclose the detailed assumption made by
accountants when preparing a company’s income statement, balance sheet,
statement of change of financial position or statement of retained earnings. The
notes are essential to fully understanding these documents.
These notes include important factors that were used in preparing the statement,
information such as cash or accrual accounting procedures, valuation methods
for inventory, reporting of events, intangible assets and contingent liabilities.
These notes are used to disclose important information that explains how
accountants applied Generally Accepted Accounting Principles (GAAP) in theirreporting of the company.
Importance of disclosed information
Full disclosure of relevant information by businesses helps investors make
informed decisions. It decreases the sentiment of mistrust and speculation
and increases investor confidence as they feel fully prepared to make investmentdecisions with transparency in information at hand.
7.3.1 Dividends
A dividend is the distribution of a company’s earnings to its shareholders and is
determined by the company’s board of directors
Proposed dividend (which must be distributed among shareholders of the
company during a financial year which will be paid in the next financial year), or
declared dividend (dividend that has been authorized by the board of directors,
but not yet paid to investors), are not recognized as a liability in the accounts atthe reporting date, but are disclosed in the notes to the accounts.
7.3.2 Disclosures
Accounting disclosure notes are included in the footnotes to an entity’s financial
statements. These notes reveal certain important facts about an entity’s finances
that are not shown elsewhere in the financial statements. These disclosure notes
disclose facts and situations that are considered “material” and are done either
as a requirement or in good faith.
If there is a known merger or acquisition occurring in the near future, it would
be in the best interest of the shareholders to reveal this fact in a disclosure
note. Essentially, any time there is a major event or important fact related to a
company’s financial health that is not included anywhere else in the financial
statements, this item should be reported via an accounting disclosure note.
The following requirements are given for material events after the reporting
period which do not require adjustment. If disclosure of events occurring after
the reporting period is required by this standard, the following information
should be provided:
• The nature of the events
• An estimate of the financial effect, or a statement that such an estimatecannot be made.
Application activity 7.3
1. What is the importance to the shareholders to disclose information?
2. Which organ is in charge of determining the dividend to be distributedto the shareholders within the business?
Skills Lab
Students in small groups analyze events after reporting period from case
studies. Through a case study, students conduct a field visit to school
bursar office, check how the events after reporting period are treated and
their effects on the financial statements prepared just at the end of thereporting period.
End unit assessment
1. The controller of UBWIZA Ltd Company is preparing the financial
statement for the year ended 30th June 2018 and has identified the
following transactions/events which happened after the end of the
reporting period but before the date when the financial statements are
authorized for issue:
a) The production of a factory has been suspended since 15th July
2018 due to a succession of power cuts. Sales orders of FRW
60,000,000 received in May 2018 with a planned production and
delivery in August 2018 could not be fulfilled. According to the
terms of the sale contracts, UBWIZA Ltd Company agreed to
compensate the counterparty by 25% of the contract price for
breach of contract;
b) A customer informed UBWIZA Ltd Company on 3rd July 2018
that all the goods delivered to the customer’s warehouse on 25th
June 2018 were not produced in accordance with the agreed
specification. UBWIZA Ltd Company reproduced the order and
shipped the replacement goods to the customer on 10th July 2018.
The invoice of FRW 32,000,000 issued on 25th June 2018 has
not been cancelled and the customer paid it when they confirmedthe acceptance of the replacement goods.
Required:
Explain how the above transactions/events should be dealt in the financial
statements of UBWIZA Ltd Company for the year ended 30 June 2018
2. The following material events take place after reporting date of 31st
December 2021 and before the financial statements for KIRABO Ltd
are approved:
i) KARABO Company, a major customer of KIRABO Ltd, went into
liquidation. KIRABO Ltd was advised that it is highly unlikely to receive
any of the outstanding debt of FRW 150,000,000 owed by KARABO
Company at the year end
ii) A fire occurred in the warehouse of KIRABO Ltd and stock costing
FRW 75,000,000 was destroyed.Adjustments are made in the financial statements as required by IAS
Required
What is the effect on profit for the year in the financial statement at 31st
December 2021 of making the required adjustments?
a) Reduction of FRW 150,000,000
b) Reduction of FRW 75,000,000
c) Reduction of FRW 225,000,000d) No effect on profit
UNIT 8 :CONSOLIDATED FINANCIAL STATEMENTS
Key unit competence: To be able to consolidate financial statements
Introductory activity
Companies frequently refer to the use of aggregate reporting of the
entire firm when using the term “consolidation” in the company’s financial
reporting.
1. What are the financial statements that are important for the financial
reporting of group companies?
8.1. Introduction to consolidated financial statements
Learning Activity 8.1
There are few fundamental strategies to expand business operations, like
purchasing a foreign company or its shares, launching altogether a new
company, forming a joint venture with someone else
1. Define the following terms;
i) A parent Company
ii) A subsidiary Company
iii) A group
8.1.1 An overview on Groups and consolidation
This topic discusses issues in relation to group accounting and the provisions
of the IFRSs that give guidance on how to disclose items in the financial
statements. It gives important definitions and explains the need for consolidation
and how relevant consolidated financial statements are for the users. One of the
IFRSs that guide consolidation process is IFRS 10, the objective of IFRS 10
‘Consolidated Financial Statements’ is to establish principles for preparation
and presentations of consolidated financial statements when an entity controls
one or more other entities.
The need to develop an IFRS to deal specifically with issues of consolidated
accounts arose due to inherent weaknesses in IAS 27. While recognizing that
the basic model for consolidated accounts was fine in IAS 27, inconsistency in
applying the provisions of IAS 27 necessitated the need for a single combined
model that meets the needs of both those preparing financial statements andthe end users of financial information in a consistent manner.
Non-controlling interest: Equity in a subsidiary not attributable, directly or
indirectly.
IFRS 10 establishes principles for presenting and preparing consolidated
financial statements when an entity controls one or more other entities. IFRS 10:
• Requires an entity (the parent) that controls one or more other entities
(subsidiaries) to present consolidated financial statements;
• Defines the principle of control, and establishes control as the basis for
consolidation;
• Sets out how to apply the principle of control to identify whether an
investor controls an investee and therefore must consolidate the investee;
• Sets out the accounting requirements for the preparation of consolidated
financial statements; and
• Defines an investment entity and sets out an exception to consolidating
particular subsidiaries of an investment entity.
Consolidated financial statements are financial statements that present the
assets, liabilities, equity, income, expenses and cash flows of a parent and its
subsidiaries as those of a single economic entity.
Consolidation means presenting the results, assets and liabilities of a group ofcompanies as if they were one company.
Example
There are two companies, Mukungu and Shaiga. Mukungu owns 70% of the
shares in Shaiga. Mukungu has a land worth 120 FRW million. Shaiga has
buildings worth RWF100 million. Keep in mind that consolidation refers to thepresentation of the results of two or more businesses as if they were one.
Answer
You add together all the values of the land and buildings to get the values of the
assets. In group accounts take the share for Mukungu plus the share for Shaiga
and this is how is done;
FRW120 Million + FRW 100 million=FRW 220 Million. So, this what is
consolidation?
Intra-group debts
a) Suppose Mukungu has receivables of FRW 60 Million and FRW40
million for shaiga. Shaiga owes Mukungu 4Million (included in his
receivables).
Consolidation = FRW 60Million + FRW40 Million-FRW 4Million= FRW96Million.
This implies that, figures as treated as for one company. What Shaiga owes
Mukungu is there internal matters.
b) Suppose Mukungu has FRW50Million payables and Shaiga has
FRW30Million payables still Shaiga owes Mukungu FRW 5Million
payables.
Consolidation payables =50Million+30Million-5Million= 75Million
The total receivables and payables show that correct figure in the books of
Mukungu company.
From the above we conclude that Mukungu controls Shaiga and mukungu’s
directors have the right to control shaiga as a subsidiary company. In this case,
the total assets for the company is equal to FRW 220Million.
From the above activity FRW 142,000 Million is the total non-current assets ofMukiza ltd.
8.1.2 Subsidiary
A subsidiary is an entity controlled by another entity.
There are relevant IFRS standards for consolidation;
ISA 27 Separate Financial statements
ISA 28 Investments Associates and joint ventures
IFRS 3 Business Combination
IFRS 10 Consolidated Financial Statements
ISA 27 consolidated and separate financial statement is set out to enhance
the relevance, reliability and comparability of information provided by the parent
company in its separate financial statements and in its consolidated financial
statements where it has entities under control.
It outlines the conditions under which consolidated financial statements are
necessary, how to account for the changes in the ownership and how to account
for the loss of control. Additionally, it specifies disclosure rules pertaining to the
connection between the parent company and its subsidiaries.
The standard applies to a group of entities under control of a parent and to
associate and joint ventures where they elect, or are required to present separate
financial statements.
ISA 28 Investment in associates
ISA 28 outlines the accounting treatment of investment in associates which also
provides specifics on how to apply the equity method to account for investmentsin associates and joint ventures.
IFRS 3 Business combinations
When a parent company acquires control of a business, the accounting rules
for goodwill on acquisition and non-controlling interests are outlined in IFRS
3 Business combinations. It also establishes what information must be made
available to financial statement users.
IFRS 10 Consolidated financial statements
When an entity controls one or more other entities, IFRS 10 consolidated
financial statements specifies the guidelines for production and presentation
of consolidated financial statements. It provides controls as the foundation for
consolidation, mandates that the parent entity presents consolidated financialstatements and defines the principle of control.
Definitions
Although some of the concepts will be covered in greater depth later, they are
helpful now because they offer you a general idea about consolidation.
Control: when an investor is exposed to, has a claim to, variable returns as
a result of its participation with an investee and has power to influence those
returns due to that power over investee, the investor is said to have control over
the investee.
Power: Existing rights that allow the present to control the essential activities.
Subsidiary: is an entity that is controlled by another entity known as the parent
Parent: is an entity that control one or more entities
Group: is a parent and all of its entities (subsidiaries)
Consolidated Financial Statements: The financial statements of a group
in which the assets, liabilities, equity, income, expenses and cash flows of the
parent company and the subsidiaries are presented as of those of a singleeconomic entity.
Non-Controlling interest: The equity in subsidiary that is not directly or
indirectly related to the parent company. Please refer to IFRS 10
A trade or investment: is a stake kept foe wealth accumulation in the stockof another company is not an affiliate or subsidiary.
Investments in subsidiaries
You should be able to tell from the definitions above the concept of control.
The parent or the holding company will often control the majority of ordinary
shares in the subsidiary company (to which normal voting rights are attached).
There are circumstances, however, when the parent company owns merely
minority of the voting rights in the subsidiary, yet the parent still have control
over the subsidiary. For example, when the parent company own more than
a half of the company’s voting rights i.e more than 50%, control is typically
considered to exist until it can be demonstrated that such ownership does not
constitute control but these situations will be rare.
What about the circumstances in which this ownership criterion is absent?
Below examples illustrate instances in which control even exists when a parent
owns just 50% or less of the voting entity.
• By agreement with other investors, the parent has control over more
than 50% of the voting rights.
• By statute or agreement, the parent has the authority to control the
entity’s financial and operational policies.
• The parent has the authority to control or dismiss the majority of the
board of directors
• At the board of directors meeting, the parent has the power to vote forthe majority of votes.
For example:
kawu co has invested its share in the following companies;
Name of the company Equity shares Non-equity shares held
Koco co 70% Nil
Koba co 35% 90%Kabu co 48% 25%
Kawu co has appointed five out of seven directors of Kabu co
Which of the above investments is considered as subsidiary in the consolidated
accounts of Kawu co group?
Answer
Let’s examine each invest in turn to see if the control exists and if so, whether
they should be treated as a subsidiary in accounting terms.
Koco co –By looking at the equity shares, Kawu has more than 50% (i.e. 70%)
so, it is a subsidiary
Koba co- has less than 50 % of equity shares, despite having majority of non
equity shares (these do not give voting power) Kawu co does not have control,
so it is not a subsidiary
Kabu co- has less than 50% of equity shares you may incorrectly conclude that
it doesn’t have control over Kabu co but because it appointed five directors out
of seven, it has the voting right, thus its decision will impact on the returns of thecompany. In conclusion therefore, Kabu co is a subsidiary.
8.1.3 Associates and trade investments
Associate is a business that is partially owned by the parent company. A parent
company will hold minority or non-controlling interests. A corporation in which
another has sizeable portion of voting shares, typically, 20-50% in accounting
and business valuation. Associates are accounted in the consolidated statementsof a group using equity method.
Investment in Associates
Investment in associates is less than investment is subsidiary but more than a
simple trade investment. Here the key criterion is the significant influence.
Significant influence means the ability to influence the investee’s financial and
operational policy decisions without having sole or shared control over those
decisions. Similar to control, considerable influence can be assessed based on
who holds voting rights (which are typically linked common shares) in the entity.
According to IAS 28, unless it can be demonstrated clearly that this is not the
case it can be assumed that an investor has significant control over the entity
if they hold 20% or more of the voting power of the entity. If the investor owns
less than 20% of the entity’s voting power, significant influence can generally
be assumed to not exist unless proven differently.
The existence of significant influence by an entity is usually evidenced in one or
more of the following ways:
a) Representation on the board of directors or equivalent governing body
of the investee;
b) Participation in policy-making processes, including participation in
decisions about dividends or other distributions;
c) Material transactions between the entity and its investee;
d) Interchange of managerial personnel; ore) Provision of essential technical information.
Equity method
For investments in associates, IAS 28 mandates the use of the equity method of
accounting (often known as “equity accounting”) (with certain exceptions, butthese are beyond the scope of this syllabus).
Trade investments
A trade investment is a simple investment in the shares of another entity that is
not an associate or a subsidiary.
Trade investments are simply shown as investments under non-current assets inthe consolidated statement of financial position of the group
8.1.4 Content of consolidated financial statements
Consolidated financial statements present the results of the group; they do not
replace the separate financial statements of the individual group companies.
Consolidated financial statements do not replace parent or subsidiary individual
statements. Consolidated financial statements are issued to the shareholders
of the parent company and provide information for those shareholders on all the
companies controlled by the parent company.
Most of the parent companies present their own individual accounts and their
group accounts in a single package. The package typically comprises the
following.
Parent Company financial statements, which will include investments in
subsidiary undertaking’ as an asset in the statement of financial position, and
income from subsidiaries (dividends) in the statement of profit and loss andother comprehensive income
Consolidated statement of financial position
Consolidated statement of profit and loss and other comprehensive income
Note: The other comprehensive income elements of the consolidated financialstatements will not be covered in this unit.
Application activity 8.1
Mukiza ltd own 60 %of Ruzinda ltd. Mukiza has non-current assets of FRW
100 Million and Ruzinda has non-current assets of FRW70Million.Required: Calculate the consolidated non-current assets
8.2 Consolidated Financial statements
Learning Activity 8.2
During the consolidation process, a
parent company has to compile financial reports from the subsidiaries.
Required: What are the procedures of consolidated statement of financialposition?
8.2.1 Consolidated Statement of Profit or Loss
The main principle of equity accounting states that whether or not as associate,
GARU ltd, pays its gains as dividends, the investing business MURT ltd, should
account for its portion of those gains. MURT ltd accomplishes this by including
the group’s portion of GARU Ltd’s post tax profit in the consolidated earnings.
Take note of the distinction between this method and consolidating the financial
performance of a subsidiary firm. If MURT ltd owned 100% of GARU ltd, it
would be entitled to all of GARU Ltd’s sales revenues, cost of sales, etc.
Using the equity accounting, sales revenues, cost of sales and other financial
measures for associate are not combined with those of the group instead the
profit after tax of associate is merely added to the group profit in the form of thegroup share.
8.2.2 Consolidated statement of financial position (Balance sheet)
In this lesson we are going to learn about the statements of financial position
also known as the Balance sheet.
Consolidated financial statements are financial statements of a group presented
as those of a single economic entity (IFRS 10). When a parent company issues
consolidated financial statements, it should consolidate all subsidiaries, both
domestic and foreign. The first step in any consolidation is to identify the
subsidiaries using the definitions as set out in IFRS 10.
Consolidated financial position includes investments in associate’s amount that
must be declared at the cost at the moment the associate was acquired.
This amount will arise or fall annually in proportion to the group’s portion of theconnected company’s post-acquisition retained reserve growth or decline.
Basic steps
The following are the procedures for consolidated statements of financial
position;
• In the individual statements of the parent company and each subsidiary,
items that appear as an asset in one company and a liability in another
should be cancelled out.
• After cancellation, add together the remaining assets and liabilitiesthrough the group.
Items to be cancelled may include;
• The assets, investment or shares in subsidiary in the parent company’s
statement of financial position will be matched with the share capital in
the subsidiaries’ accounts.
• Any intra-group trading needs to be cancelled accordingly. E.g the
parent company records a receivable for selling goods to its subsidiary
and the subsidiary likewise recording a payable relating to the parent
company. This means that there is a trading between a parent andsubsidiary company (trading group).
ExampleStatement of financial position as at 31 December 2021
Consolidated statement of financial position as at 31 December 2021
Intra-group trading
We are going to look the consolidated financial statements specifically on intra
group trading explain what it is and have examples.
If intra-group trading transactions are undertaken at cost, there would be no issue
in dealing with profits due to intra-group trading. However, with each company
in a group being a separate trading entity, other group companies are treated
in the same way as any other outside customer. In this case, if a company is
selling say a parent company to a subsidiary company or a subsidiary company
to another, their selling prices should be the same as they say to outsiders.
In the consolidated statement of financial position, the only profits recognized
should be those earned by the group in providing goods or services to outsiders.
Inventory should also be valued at cost to the group.
Scenario
GAGA ltd (subsidiary) buys goods at one price and sells them at a higher price
to kaka ltd (a parent company). The accounts of GAGA ltd will properly include
the profit earned on sales to KAKA ltd. KAKA Ltd’s statement of financial position
will also include inventories at their cost of purchase from GARU ltd.
The problem arising from the above transaction
1. Although GAGA ltd makes a profit as soon as it sells goods to KAKA
ltd, the group does not make a sale or achieve a profit until an outside
customer buys the goods from KAKA ltd. This is because the inventories
are still in the group until they get an outsider to come and buy goods.
2. Any purchases from GAGA ltd which remain unsold by KAKA ltd at the
end of the year will be included in KAKA Ltd’s inventory. Their value in the
statement of financial positions will be at their cost to KAKA ltd, which isnot the same as their cost to the group.
EXAMPLE
GAGA ltd buys goods for FRW 5,000 and sells to its parent company KAKA ltd
for FRW 7,000. The goods are in KAKA Ltd’s store at the end of the year and
appear in KAKA Ltd’s statement of financial position at FRW 7,000.
In this case GAGA ltd made a profit of FRW 2,000 as it bought goods on FRW
5,000 and sold them to KAKA ltd a parent company at FRW 7,000. This will
be recorded in GAGA Ltd’s individual account. Let’s see how to record in an
intra- group
Consolidated financial statement for intra-group company
Cost of the group FRW 5,000
External sales
Closing stock at the cost to the group FRW 5,000
Profit or loss to the group
Because the group account is overstated by FRW 2,000 from KAKA ltdindividual statement of financial position, it must be cancelled.
Consolidation adjustment
Dr Cr
Group retained earnings 2,000Group inventory 2,000
Steps to follow when you have non-controlling interest
1. Intra-group sales and purchases should be eliminated
2. Any unrealized profit is eliminated by trading to the cost of sales
3. I f the subsidiary made the sale; the figure for the subsidiary’s net profit
used to non-controlling interest must be adjusted for the unrealized profit.
4. If the parent made a sale, there will be no effect on the non-controllinginterest.
Example
KAKA ltd acquires 75% of the ordinary shares of the GAGA ltd, which it has
owned since GAGA Ltd’s incorporation. The summarized statements of profit
or loss of the two companies for the year ending 31 December 2021 are given
below. GAGA ltd sold goods to KAKA ltd for FRW8, 000. It has bought these
goods for FRW 6,000. 40% of these goods remained in KAKA Ltd’s inventoryat 31 December 2021.
Goodwill arising on consolidation
Goodwill is simply reputation of the business. Goodwill is recognized only
when it has been acquired for the value consideration and represents advance
payment made by the acquirer for the future economic benefit.
On consolidation, goodwill is reported as an intangible asset in consolidated
group balance sheet. One of the simplest methods of calculating goodwill is by
subtracting the fair market value of a company’s net identifiable assets from theprice paid for ....
Example
Muko ltd buys all the shares of 50,000 FRW 1,000 of Musi ltd at 80 million in
by using cheque. The following is the statement of financial position before theacquisition of Musi ltd.
Statement of financial position as at 31 December 2021
NOTE: Since MUKO Ltd bought 50,000 shares at FRW 1,000 and paid 80
Million which is above the value of the shares, the difference (the premiumamount) is the goodwill. In this case, 30 Million is goodwill
Application activity 8.2
1) Why do parent companies need to prepare consolidated financial
statements?
2) Outline their limitations of financial statement
3) Mucyo Co ltd acquired 100% of Mukama Co ltd at a cost of FRW
100M. On the date of acquisition, the fair value of the identifiable
assets of Mukama Co ltd was FRW 75M.Required: Calculate the goodwill arising on acquisition.
End unit assessment
1. The following statements of financial position were extracted from the
books of two companies-GIKI LTD and KAWU LTD at 31 December 2020
GIKI LTD acquired all of the share capital of KAWU LTD one year ago. The
retained earnings of KAWU LTD stood at FRW 2,000,000 on the day of
acquisition. Goodwill is calculated using the fair value method and there
has been no impairment of goodwill since acquisition.
Required: Prepare the consolidated statement of financial position of GIKILTD as at 31 December 2020.
UNIT 9 : FINANCIAL STATEMENTS ANALYSIS
Key unit competence: To be able to analyze financial statements for anentity
Introductory activity
JWZ is a partnership business of lawyers operating its activities in
Bugesera District. The business accountant prepared all needed financial
statements for the year ended 31 December 2022 horizontally. Some
users of financial statements information are trying to convince him not to
use the horizontal format and the accountant is trying to explain to themthat there are different forms of financial statement analysis.
You are asked:
1. What is financial Statement analysis?2. What are the formats of Financial Statements?
9.1. Introduction to financial statement analysis
Learning Activity 9.1
An Audit conducted in Rwanda, in 2022 revealed that some businesses are
not preparing financial statements. Asking them why, some answered that
they do have enough knowledge on financial statements and thus they do
not know about the financial statements analysis. As an accountant student,
your asked to help them about:
a) Explain the term financial Statements analysis?
b) What is involved in Financial statements analysis?c) What are the advantages of financial statements analysis?
Financial Statement consists of Statement of Financial Position, Financial reports
and other financial reports which are to be framed according to applicable
financial reporting framework and auditor and various other analysts analyze
the financial statements and give their report on the same but this analysis has
certain limitations because of volatile industry, business conditions, and otherfactors.
9.1.1 Introduction
Financial statements are prepared and presented, in accordance with generally
accepted accounting principles, to give readers an overview of the financial
results and condition of a business. However, it is the analysis of financial
statements that gives true representation of what is going on inside the company.
It is necessary to analyses the numbers in the statements to get a true and clear
picture of the company. The financial statements are analyzed with the help of
different tools such as comparative statements, common size statements, ratioanalysis, trend analysis and funds flow analysis.
Financial statement analysis (or financial analysis) is the process of reviewing and
analyzing a company’s financial statements to make better economic decisions.
These statements include the income statement, balance sheet, statement ofcash flows, a statement of retained earnings.
9.1.2 Meaning of financial statements analysis
Financial statement analysis is a method or process involving specific
techniques for evaluating risks, performance, financial health, and future
prospects of an organization.
Financial statement analysis (or financial analysis) is the process of reviewing and
analyzing a company’s financial statements to make better economic decisions.
These statements include the income statement, balance sheet, statement ofcash flows, a statement of retained earnings.
Financial statement analysis is one of the most fundamental practices in financial
research and analysis. In layman’s terms, it is the process of analyzing financialstatements so that decision-makers have access to the right data.
Financial statement analysis is also used to take the pulse of a business.
Since statements center on a company’s key financial details, they are useful
for evaluating activities. This is essential to understanding the firm’s overallperformance.
Financial statement analysis involves:
• Assessment of the firm’s past, present and future financial condition
• Finding out a firm’s financial strengths and weaknesses
• Comparison through time (Trend)
• Comparison among companies (industrial analysis)
Advantages of a financial statement Analysis
• To meet their financial reporting obligations and to assist in strategic
decision-making, firms prepare financial statements. However, “the
information provided in the financial statements is not an end in itself as
no meaningful conclusions can be drawn from these statements alone.”
Firms employ financial analysts to read, compare and interpret the data
as necessary for quantitative analysis and decision- making.
• Financial analysis determines a company’s health and stability.
• The data gives you an intuitive understanding of how the company
conducts business
• Stockholders can find out how management employs resources and
whether they use them properly.
• Governments and regulatory authorities use financial statements to
determine the legality of a company’s fiscal decisions and whether the
firm is following correct accounting procedures
• Government agencies, such as the Internal Revenue Service, use
financial statement analysis to decide the correct taxation for thecompany.
Financial statements
Measures of financial performance and position are developed from a firm’s
financial information organized into 3 main statements:
– Statement of Profit or Loss
– Statement of Financial Position– Statement of Cash Flow
According to IFRS, a complete set of financial statements comprises the
following:
– Statement of financial Position
– Statement of Profit or Loss
– Statement of changes in equity
– Statement of cash flow– Accounting policies and notes
Entities are encouraged to furnish other related financial and non-financial
information in addition to the financial statements. The statement of changes
in equity reflects information about the increase or decrease in net assets orwealth.
Importance of Statement of Financial Position
The statement of Financial Position helps to know the three origins of economic
resources used by a firm:
• Contribution of shareholders or owners
• Long, medium and short term liabilities
• Internal financing (retained earnings and reserves)
Succinctly, sources of capital used by a business are:
• Personal resources
• Borrowings from friends or banks
• Trade credits• Bank overdraft
The Statement of Financial Position helps to know the use of economic resources
which are:
• Fixed assets (Fixed capital)
• Current assets (Stocks, receivables, cash)
Structural equilibrium of the enterprise
The structural equilibrium is based on the following general principles:
1. Owner’s equity should be greater than liabilities.
2. Capital employed (owner’s equity plus long term liabilities) should cover
the fixed assets and part of current liabilities.
3. Current liabilities should be invested only into current assets and basicallyin cash and receivables so to be easily reimbursed.
Application activity 9.1
As an accountant student:
a) What do you understand by financial statements analysis?
b) Is it necessary to have financial statement Analysis? Justify your answer
9.2 Uses of financial statement analysis
Learning Activity 9.2
Your classmates of senior six Accounting are discussing about preparation
of financial statements. They are not aware and asked you to:
Explain the key measures in determining the financial strength of the
business?
Final accounts or financial Statements are outputs of an accounting system,
they are prepared at the end of the financial year, hence the name final accounts.
However, interim financial statements can be prepared before the end offinancial year.
External users of accounting information (Banks, shareholders or investors,
creditors, donors, funding agencies, government, competitors and general
public) are more interested in final accounts or financial statements than booksof accounts.
Final accounts are prepared from trial balance after end year adjustments
are incorporated. The types of financial statements prepared vary from one
organization to another depending upon its nature and size among other factors.
However, the major financial statements prepared by profit making organizationsfor disclosure purpose are:
• Statement of profit or Loss
• Statement of Financial Position
The income statement should be prepared before the balance Sheet/Statement
of Financial Position because the ending figure after subtracting expenses from
incomes (net profit or net Loss) connects the income statement/Statement of
Profit or Loss and statement of financial Position, thus, there are two accounts
that are in both final accounts:
• Closing stock• Net profit/Loss
9.2.1 Statement analysis for different users
The users of information can be divided into two:
• Internal users: who are parties within the organization e.g. the
management or the employees.
• External users: who on the other hand, are parties outside the
organization e.g. the shareholder, creditors, government, customers,etc.
Stakeholders including current and potential investors, creditors, customers,
employees, government, bankers and stock exchanges all have an interest in the
financial performance (and other aspects) of a company. Financiers and credit
providers are concerned about the financial performance and creditworthiness
of a company, especially before providing any loans or securities. Stakeholderswill have enhanced confidence in a company if it has strong ratios compared
The need for financial analysis
Financial statements are prepared for decision-making purposes. Good decision
making is driven by effective analysis and interpretation of financial statements
(also referred to as financial analysis). Analysis provides a meaningful conclusion
by drawing a meaningful relationship between the various items of the two
financial statements:
• the profit and loss account or income statement
• the balance sheet or statement of financial position.
These are the indicators of profitability and financial soundness of a businessentity for a given period.
Interested parties and managers
Different parties are interested in financial statements and their analysis for
various reasons. As discussed above, they provide useful financial information to
external and internal users in making financial decisions. For example, investors
want to know the earning capacity of the business, the wellbeing of the business
and its future prospects. Understanding the company’s financial position andrecent performance helps management direct the business.
Shareholders entrust the board of directors with the responsibility for managing
the resources entrusted to them by giving it direction and providing both control
and strategy. The board employs managers to implement their strategic visionand to help ensure the investments of owners are maximized.
Owners put mechanisms in place to monitor managerial behavior. For example,
the UK Corporate Governance Code provides guidelines that require directors
to conduct business with integrity, responsibility and accountability. An
obligation of stewards or the directors is to provide relevant and reliable financialinformation, including analysis of financial statements using various techniques.
Key financial indicators
The purpose of financial analysis is to assess the financial strength and weakness
of the business by assessing the efficiency and performance of an entity. The
key measures in determining the financial strength of the business are as listedbelow.
• Profitability: the main objective of a business and its management
(the agent) is to earn a satisfactory return on the funds invested by
the investors or shareholders. Financial analysis ascertains whether
adequate profits are being earned on the capital invested. It is also useful
to understand the earning capacity of a business, its wellbeing and its
prospects, including the capacity to pay the interest and dividends.
• Trend of achievements: analysis can be done through the comparison
of financial statements with previous years, especially trends regarding
various expenses, purchases, sales, gross profits and net profit. Users
can compare the value of assets and liabilities, and forecast the future
prospects of the business.
• Growth potential of the business: financial analysis indicates the
growth potential of the business.
• Comparative position in relation to similar businesses: financial
analysis helps the management to study the competitive position of their
firm in respect of sales, expenses, profitability and capital utilization.
• Overall financial strength and solvency of the entity: analysis
helps users make decisions by determining whether funds required
for the purchase of new machines and equipment are provided from
internal sources or received from external sources, and whether it hassufficient funds to meet its short-term and long-term liabilities.
9.2.2 Analysis of income statement and balance sheet
Tools of financial statements analysis
• Comparative financial statement
• Common size financial statements
• Trend percentages analysis
• Ratio analysis, cash flow statement analysis etc.
What Is Horizontal Analysis?
Horizontal analysis is used in financial statement analysis to compare historical
data, such as ratios, or line items, over a number of accounting periods.
Horizontal analysis can either use absolute comparisons or percentage
comparisons, where the numbers in each succeeding period are expressed as
a percentage of the amount in the baseline year, with the baseline amount being
listed as 100%. This is also known as base-year analysis.
Horizontal analysis shows the changes between years in the financial data in
both FRW and percentage form
Illustration1
Norique Ltd had the following sales and operating income in FY 2016 and FY2017 (amounts are in FRW millions).
The change calculated shows that the sales have increased by FRW 9,910
million in FY 2017, with the corresponding increase in the operating income byFRW 990 million.
A better trend analysis is provided by the change in percentage, calculated as:
Percent change = (Current period amount – Base period amount) ÷ Base
period amountPercentage change for Norique Ltd is as follows.
The above calculations show sales have increased by 11% from FY2016 to
FY2017, whereas operating income has increased by 14.6%. This requiresfurther investigation.
Illustration2.
Clover Corporation’s balance sheets for the year endedDecember 31
Sales increased by 8.3%, yet net income decreased by 21.9%
There were increases in both cost of goods sold 14.3% and operating expenses
2.2%. These increased costs more than offset the increase in sales, yielding an
overall decrease in net income.
Vertical analysis or Common size statements
Trend Analysis
Trend percentages state several years’ financial data in terms of a base year,which equals 100 percent
Working:
The base year is 2007, and its amounts will equal 100%.
2008 amount/2007 amount*100%
(290,000/275,000) *100%=105%
(198,000/190,000) *100%=104%(92,000/85,000) *100%=108%
By analyzing the trends for Berry Products, we can see that cost of goods sold
is increasing faster than sales, which is slowing the increase in gross margin.
Vertical analysis is a proportional analysis where each item of financial
statement is shown as a percentage of base items. Usually, line items in the
income statement are shown as a percentage of sales, while line items in the
balance sheet are shown as a percentage of the total assets. It helps to provide
a greater understanding of how sales revenue is being consumed within the
business, thus requiring further investigation if the level of activity is not as
expected
Vertical analysis: focuses on the relationships among financial statement
items at a given point in time.
In Income statements, all items usually are expressed as a percentage of sales.
In Balance sheets, all items usually are expressed as a percentage of total
assets.
Common-size financial statements are particularly useful when comparing datafrom different companies.
Interpreting Horizontal and Vertical Analyses
There are several interpretations that can come out of Horizontal analysis, the
following are examples:
Under horizontal analysis,
• Increase in total asset may mean company growth
• Increase in company’s inventory and fixed asset may be due to
expending business by opening new stores, branches, etc. However,
increase in inventory may also mean weakness because as a general
rule, retail companies are in business to sell, not hold, inventory. When
we see a build-up in inventory we know that the company is facing a
soft business environment. We cannot generate cash unless we sell
inventory.
• Significant Decrease in cash position from one period to another may
be a warning sign since the cash weakening hurt the liquidity of the
company.
• A comparative analysis on income statement reveals an increase/
decrease in income/expense from one year to another and this would
explain a decrease or increase in the resulting net income.
Under vertical analysis:
• Under balance sheet any other item is expressed as a percentage of
asset, so important figure is gauged depending on how much they are
compared to total asset for example: A higher % of debt may mean a
highly leveraged company and Vice versa.
• Under income statement important figures are determined depending
on how much they are compared to sales; for e.g. if COGS and
operating expenses are important compared to sale, one can evaluate
the effectiveness of management looking at how well the management
controls operating expenses and COGS. The increase in % of COGS
or Operating expense as compared to sales may mean an adversesituation given that it would worsen the net income.
9.2.3 Limitations of financial analysis
• The cost principle is used to prepare financial statements. Financial
data is not adjusted for price changes or inflation/deflation.
• Companies may have different fiscal year ends making comparison
difficult if the industry is cyclical.
• Diversified companies are difficult to classify for comparison purposes
• Financial statement analysis does not provide answers to all the users’questions. In fact, it usually generates more questions!
Other limitations
The analysis is based on past and present data and conditions: The
analysis of the auditor and various analysts are based on past data and present
conditions and results. They compare the past data with the present position
and if there is the improvement they will issue the positive reports and otherwise
the qualified report, but they do not consider the future plans of the enterprise
and future economic and market conditions as these conditions can change
at any point of time due to unpredictable nature. The report which shows the
favorable points is based on conditions which can be changed hence it is not
necessary that report will always show the points in the future also.
Reliability of the data presented: Auditor and various analyst make reliability
on the reports and financial statements presented by the management of the
enterprise and they only verify the figures on test check bases but in the world of
competition everyone wants to attract the investors and hence one can do the
same by window dressing of accounts and showing the better position of the
company. Hence the reports issued by independent third parties are subject to
the limitation of reliability and transparency by management.
Valuation by different methods of accounting policies and estimates:
The valuations made by management like valuation of inventory, valuation of
Fixed assets, valuation of investments, etc. are based on different methods
and accounting policies and estimates by the management. And the auditor or
financial analyst cannot question on the method or policy adopted unless being
not acceptable by law. The different methods and estimates show different
results and accordingly different financial positions.
Change in accounting methods enforced by law: There are situations
when an enterprise is following one accounting method for years and suddenly
the law changes and enterprise have to change the accounting policies or
methods as required by law. Hence because of different accounting policies
from past periods it is not justifiable to compare the statement with the past
data. Analysts and auditor while analyzing should keep this limitation in mind.
Inflationary effects are being ignored: As inflation is increasing day by day
and it affects every business organization which results into rise in expenses and
probably a decrease in profits. With this, too every investor, analyst or auditor
make the comparison of the current position with the past data but they should
also keep that limitation in mind that the time value of money changes.
Limitations of methods application for analysis: Every analyst whether
the auditor or the market analyst analyzes and make reports based on the
experience and skills of the analyst and we must take this fact in mind that the
experience and skill of analysts is not the same in any manner. Hence the reports
issued by them are subject to limitation as it is based on personal judgments of
the analyst.
The Reports of the Analysis should not create the assessment of
managerial Ability: On the basis of the reports issued by an analyst, the
people or some stock analyst question the management about their inability
to bring the company at the industry standards and forget the truth that it is
based on market conditions, situations, the response from buyers, the attitude
of employees, credit worthiness etc. hence one should keep the fact in mind
that unfavorable result doesn’t mean the poor managerial or performance ability.
Change of business conditions: The market is highly unpredictable, the
market situations and conditions can change at any point of time, sometimes
results into recession sometimes favorable conditions. Hence being an analyst,
one should make clear that the reports are subject to the current conditions and
which may or may not be the same all the time and can change in the future, theunfavorable conditions can turn into favorable and vice versa.
Application activity 9.2
a) Disco LLP has finalized its quarterly results for Q1 FY 2018. The team
has also included the previous years’ financials. Can you determine thehorizontal trends?
End unit assessment
1. What do you understand about horizontal analysis?
2. Which of the following statement describes horizontal analysis?
a) A statement that shows items appearing on it in percentage and
dollar form.
b) A side-by-side comparison of two or more years’ financial
statements.
c) A comparison of the account balances on the current year’s
financial statements.
d) None of the above.
Let’s take the above information from the comparative income statements
of Clover Corporation for this year and last year.Determine the vertical trend.
UNIT 10: INTERPRETATION OF FINANCIAL STATEMENTS
Key unit competence: To be able to interpret financial statements using
ratios for an entity
Introductory activity
Observe the above picture and answer to the following questions:
1. What do you think is the interpretation of financial statements?
2. What is a financial ratio?
3. What is the purpose of financial ratios?4. What are the broad categories of accounting ratios?
10.1. Introduction to financial statements interpretations
Learning Activity 10.1
Lois ltd company is a Company operating its business in Kigali city from
2019. At the end of the financial period ended 31st December 2021,
the owners hired the new accountant to present the business’s financial
statements. After preparing the financial statements, the owners asked the
accountant to explain the meaning of his results and he was not able to give
the real answer. The owners of Lois ltd company want you to help them tounderstand well the meaning of their financial statements results.
a) Which tool are you going to use to understand the Financial10.1.1 Meaning of interpretation of financial statements
Statements results?
b) What is the purpose of financial statement interpretation?c) What is the Importance of ratio method?
Financial statements should be clear and understandable to enable users make
sound decision and judgments. They should also show corresponding figures
for the preceding period to afford comparison and analysis.
Depending on the need and the accounting knowledge of the users, the
financial statements may not fully serve the required needs, however simple
they may appear to the accountant. It is therefore the duty of the accountant to
analyze and interpret the special language to non-accounting users so that they
may make the best use of financial statements to suit their special needs. The
accountant translates the information contained in the financial statements into
a form which is more helpful and can easily be understood by users.
In order to translate financial statements to users, some yardsticks or bases or
identifiable economic relationships are used. The commonly used yardsticks in
analyzing and interpreting financial statements are as follows:
• Annual or inter-period
The analysis of financial statements is based on the results achieved by the
business enterprise during a previous accounting period. This is only possible iffinancial statements show corresponding figures for the preceding period.
Inter-firm comparison
The results of the firm and results of other closely related firms operating
within the same industry for the current period, also help in analyzing the firm’s
performance.
• Standards and budgets
The management establishes standards and budgets upon which the
performance of the business is measured. The financial statements are therefore
analyzed based on these standards.
Tools of financial analysis
There are several tools used in analyzing financial statements. These include:
i. Ratio analysis: Liquidity, profitability, Solvency, operating or activity
ii. Comparative financial statements (variations in %)
iii. Common size statement
iv. Trend ratios or trend analysis (changes in % from base year)
v. Statement of changes in working capital
vi. Funds flow and cash flow analysis
vii. Graphicsviii. Charts
10.1.2 Meaning and purpose of accounting ratios
Definition of ratio
Ratio can be defined as a proportional relationship between two significant
values (or significant magnitudes). It is an arithmetical relationship between
given items normally expressed as a fraction or a percentage or the numerical or
arithmetical relationship between two figures. It is expressed where one figureis divided by another.
Ratio analysis
Ratio analysis is one of the powerful tools of financial analysis which deals
with calculation and interpretation of ratios. It can be defined as the process of
ascertaining the financial ratios that are used for indicating the ongoing financialperformance of a company using a few types of ratios.
Ratio analysis helps the analysts to make quantitative judgment with regard to
concern’s financial position and performance.
Ratio can be expressed:
• As a pure ratio e.g 1:2
• As a decimal value, such as 0.10
• As an equivalent percent, such as 10%
• As a decimal number, especially when they are more than 1.
Objectives/purpose of financial ratios/ financial statements
interpretation
Use of ratios enable items appearing in financial statements to be translated and
interpreted using any suitable basis such as the past record of the business.
Comparison of the firm with other competitive business of the same nature, is
also possible by use of ratio analysis.
In analyzing the financial statements of a business, ratio analysis has the following
objectives:
• Measure the profitability and adequacy of the profits of the business
enterprise. In this regard, users of financial statements would be able
to determine:
a) Whether the profits earned by the business are rising or declining
over time and whether such profits are adequate to cover the cost
of sales and operating expenses, yet still leave a balance for the
proprietors.
b) Whether the firm’s profits are stable over time
c) The position of the firm’s profits as compared to the average annual
profits earned by competitors and similar firms operating in the same
industry.
• Measure the worth of a business to its owners or equity holders. In this
regard, users would be able to determine:
a) The return on equity or shareholders’ funds tied up in the business
b) If the satisfaction that the current earnings are per share is realistic
c) How realistic the current market price is for the firm’s shares.
• Measure the liquidity, financial strength and the survival ability of the
business. In this regard, the users of financial statements would be able
to determine:
a) The ability of the business to pay its short term debts as they fall
due, without having to sell the whole undertaking
b) The financial stability of the business
c) The ability of the enterprise to withstand a fall in the value of its
assets before the creditors’ position is prejudiced
d) The ability of the business to generate enough revenue to cover
financial charges and leave a sufficient balance over for dividends,
expansion and provision to finance a loan capital repayment.
• Measure the productivity of the assets and how efficient management
utilizes the economic resources placed at its disposal. In this regard,
the users would like to know:
a) The extent of asset utilization and extent to which management uses
all available resources to generate sales.
b) The collection period of accounts from credit customers
c) How fast the business turns over its stock and the ability of
management to control the investment in stock.
d) The average period of time taken to pay debts of the business
especially to settle accounts of creditors.
• Measure the solvency, defensive and survival position of the business.
Users would be able to determine:
a) The extended to which the firm’s assets are financed through
borrowing and its extent of trading on equity, i.e. using shareholders’
funds.
b) The level of the cushion of security of creditors
c) The gearing or leverage into the capital structure of the business, in
other words, the relationship between capital and capital investedby the ordinary shareholders.
Importance of ratio method
Ratio method permits:
• To follow the evolution and progress of the financial situation of an
enterprise
• To set or to establish regularly the relationship between two values or
two subjects
• To analyze and interpret the information extracted from the financial
statements
• To compare an enterprise (financial position) with another (or industry)
in the same sector.
• To know the actual financial situation of an enterprise.
• It provides a basis for making future business policies.
• It is used in evaluating the business and shares by investing on stockexchange.
The users of financial ratios
Users of financial statements include owners -who are managers, owners –who
are shareholders, managers, government, creditors, potential buyers, suppliers,
customers, employees and general public.
Each of these users has their own requirement of information. Financial
statements may meet some. Financial statements provide information that is
historical, summarized and highly selective.
• Internal Managers: To evaluate the performance of the business as
compared to the previous years or other firms in the same trade.
• Existing and prospective shareholders: to make the investments
decisions on the basis of return on their investments.
• Bank Managers and creditors: To make the decisions for providing
loans and credit facilities.
• Security analysts: use financial ratios to compare the strengths and
weaknesses in various companies. If shares in a company are traded
in a financial market, the market price of the shares is used in certainfinancial ratios. Etc
Source of data for financial ratios
Values used in calculating financial ratios are taken from the balance sheet,
income statement, statement of cash flows or (sometimes) the statement of
retained earnings. These comprise the firm’s accounting statements or financialstatements.
Notes: The comparison of a firm’s ratios with other similar firms’ ratios, or
with industry figures, is known as A cross sectional analysis.
Whereas the comparison of the firm’s own results in time is called Time seriesanalysis.
Application activity 10.1
1. You are hired as an accountant of any local company, appreciate the
need of financial ratios method in your work.
2. An accountant of your local company is not understanding why different
users’ need its financial ratios and he/she is persisting offering them.
You are asked to help him/her knowing some users of accountinginformation and why each of them needs that information.
10.2 Broad categories of ratios, their calculation and their
interpretation.Learning Activity 10.2
From the above figure,
a) What are the broad categories of ratio analysis?
b) Give examples to each category of ratio analysis.
Financial ratios are categorized according to the financial aspect of the business
which the ratio measure. There are broadly classified into five categories:
• Liquidity/working capital ratios measure the availability of cash to
pay debt
• Activity ratios measure how quickly a firm converts non-cash assets
to cash assets.
• Debt ratios measure the firm’s ability to repay long-term debt.
• Profitability ratios measure the firm’s use of its assets and control of
its expenses to generate an acceptable rate of return.
• Market ratios measure investor response to owning a company’sstock and also the cost of issuing stock.
10.2.1 Liquidity ratios
Liquidity: It is the ability of a business to pay its debts as they fall due and to
meet unexpected expenses within a reasonable settlement period. It is also an
indicator of a firm’s ability to generate enough cash to remain in existence.
Liquidity Ratios, also called working capital ratios. Those are the ratios that
attempt to indicate the ability of a business to meet its debts as they become due.
A business that has satisfactory liquidity will have sufficient funds, normally
referred to as working capital to pay creditors at the required time. This is vital
to ensure that good business relationships are maintained
The liquidity ratios include:
c) Current ratio (or working capital ratio): It measures currentassets against current liabilities.
This ratio shows whether the business is able to pay back its current liabilities
using only its current assets. The analysis of this ratio can be completed by theanalysis of facility of current assets to be turned into cash.
Interpretation: It is best for this ratio to be about 2 (or 2:1) i.e the current
asset must at least be twice as high as current liabilities. The rule says that the
current ratio should meet current liabilities at least twice. If the actual current
ratio is less than the standard ratio (current) of two to one (2:1), the conclusion
is that the concern does not enjoy sufficient liquidity and will not be able to meetits short-term obligations and vice-versa.
d) Quick ratio (or Acid test ratio): The Acid test or quick ratio takes
into account only those current assets that are cash or can be changedvery quickly into cash.
This ratio shows whether there are enough liquid assets to be able to pay
current liabilities quickly. It is dangerous if this ratio is allowed to fall to a very
low figure. The analysis of this ratio should be completed by the comparison
analysis between collection period and payment period. Collection period
should precede repayment period. It is an acid test of solvency and measureson how quickly current assets can be converted into cash.
Is a more refined current ratio which exclude amount of stock of the firm. Stocks
are excluded for two basic reasons:
i) They are valued on historical cost basis
ii) They may not be converted into cash very quickly
Interpretation: On average, a liquidity ratio 1:1 is considered adequate.
However, the most appropriate acid test ratio will definitely depend on thenature of the business.
c) Cash ratio/absolute ratio/ super quick ratio: Indicates the cash
available to pay the liabilities. This is a refinement of acid test ratio
indicating the ability of the firm to meet its current liabilities from its
most liquid resources. It is more refined since it assumes that debtors
may not pay their accounts on time and stock will take time to convertinto cash.
Absolute assets mean cash in hand, cash at bank and readily marketable
securities.
Interpretation: Actual absolute liquid ratio is compared to the standard of 1:2,
(the standard absolute liquid ratio is fixed at 1:2, because for the payments of
quick liabilities, besides 100% cash available from the absolute liquid assets,
a good amount of cash may also come from other current assets like bills
receivable
d) Inventory to working capital ratio
Inventory/ stock: Refers to the closing stock of raw materials, work in progress
(semi-finished goods) and finished goods.
Working capital: The difference between current assets and current liabilitiesor excess of current assets and current liabilities.
The use of this ratio is to indicate that there is overstocking or understocking.
Interpretation: As per the standard, inventory to working capital ratio, the
inventories should not absorb more than 75% of working capital. As such,
a low inventory to working capital ratio (a ratio of less than 75%) indicates
understocking and so, a high liquid position. While a high inventory indicates
overstocking, and so a low liquid position.
Illustration 1.
Let’s assume that the balance sheet of Diane on 31/12/2011 shows thefollowing:
As this ratio is greater than 1, it means that the working capital is positive, the
long financing covers all fixed assets and one part of current liabilities. It is goodsituation.
Determine the liquidity ratios studied knowing the sales values for period was
FRW 20,000
10.2.2 Activity / efficiency ratios/performance ratios/turn
over ratios
Activity or efficiency ratios measure the effectiveness of the firms use of
resources (assets) to generate sales/turnover and so profit.
These ratios compare revenue figures with capital figures and may be used
in addition to the return on capital percentage to measure the management’s
efficiency in using available assetsa) Stock turnover ratio/Inventory turnover ratio
Every business should operate both to keep its stock to as low a figure as
possible without losing profitability, and to sell its goods as quickly as possible.
The stock turnover ratio measures how well the firm is managing to do these
things and indicates the velocity with which goods move out of the business. In
other words, it indicates the number of time the average stock of finished goods
is turned over or sold during a year.
Interpretation: a stock turnover of 8 times a year is considered ideal. As such,
a stock turnover of 8 times or more than 8 times indicates that more sales are
affected. i.e. the business is expanding, thus there is effective management of
inventory. On the other hand, a stock turnover of less than 8 times means that theconcern has accumulated useable goods. i.e. the business is not prosperous.
Illustration1
Gross profit for product A: FRW 5 with Stock Turnover of 8
The total gross profit: 5 x 8 = FRW 40
If the stock turnover ratio goes up to 10. The gross profit will be 5 x 10 = FRW 50
Note: Average of stock is found by adding opening stock and closing stock anddividing the sum by two.
Illustration 2
Given that: Opening stock: 300 units at FRW 200 per unit
Purchase account: 2 000 units for FRW 450 000Closing stock: 100 units for FRW 24 000
Determine the:
i. Stock turnover ratio
ii. Inventory conversion periodValue of opening stock: 200 x 300 = FRW60 000
The stock is renewed more of 11 times during the year, after 32 days.
c) Debtors to sales ratio or Debtors’ collection period or Debtors
ratio:
Also called Average collection period (Number of days receivable), thisratio assesses how long it takes for debtors (On average) to pay what they owe.
This ratio is better to judge the quality of the debtors. In short, it indicates the
average period of credit allowed to debtors. It gives the number of days that
debtors (on average) take to pay up; it is debt period.
Interpretation: if the actual period of credit is more than normal period of
credit or ideal period of credit is 30 days, the indication is that credit is not
efficient. On the other hand, if the actual period of credit allowed is less than the
normal period of credit or ideal period of credit, the indication is that the credit
collection is efficient.
Note: Here, the closing balance of debtor’s figure is always used because the
operating balance figure relates to the previous year’s sales. By multiplying by
12 or 52 we may arrive at the credit period in months or weeks.
Two main reasons for the firm to make certain that the debtors pay their accounts
on time:
– The longer a debt is owed, the more likely it will become a bad debt.
– Any payment can be used in the firm as soon as it is received, and so
this increases profitability; it can help reduce expenses. E.g. it wouldreduce a bank overdraft.
d) Creditors to purchases ratio or Creditors’ payment period orCreditor ratio:
e) Cash turnover ratio
Cash, for this purpose, means cash in hand, cash at bank and readily realizable
investment. Turnover refers to total annual sales (i.e., cash sales plus creditsales.
Use: this ratio indicates the extent to which cash resources are efficiently utilized
by the firm. It is also helpful in determining the liquidity of the concern.
Interpretation: the standard or ideal cash turnover ratio of 10:1. As such, a
cash turnover ratio of 10:1 or more indicates the effective utilization of the cash
resources of the enterprise. On the other hand, a cash turnover ratio of less than
10:1 suggests that cash resources of the enterprise are not effectively utilized.
f) Assets turnover ratio: (This ratio is also called Asset efficiency
ratios) and indicates the efficiency or inefficiency in the use of total
resources or assets of the concern. In other words, it is a measure ofthe overall performance of the business.
Interpretation: A total assets turnover ratio of 2 times or more indicates that
the assets of the concern have been utilized effectively. On the other hand, a
total assets turnover ratio of less than 2 times indicates that the assets of theconcern have been under-utilized.
g) Working capital turnover ratio or sales to working capital ratio
Working capital is the excess of current assets over current liabilities.Turnover means net sales. i.e. total sales less sales returns.
Use: this ratio indicates the efficient or inefficient utilization of the working
capital of an enterprise.
Interpretation: there is no standard or ideal working capital turnover ratio.
Though there is no standard working capital ratio, one can say that a high
working capital turnover ratio indicates the efficiency and a lower working capital
turnover ratio indicates the inefficiency of the management in the utilization ofworking capital.
h) Sales to net worth ratio or owned Turnover ratio
Use: This ratio is a good index of the utilization of the owner’s funds. It also
indicates over trading (i.e. too much of sales in relation to owners’ capital) or
under- trading (i.e. low sales in relation to owners’ capital). In short, it is a guide
in the proper administration of capital.
Interpretation: if the volume of sales in relation to net worth is reasonable, the
indication is that the owners ‘funds have been effectively utilized.
i) Noncurrent assets turnover ratio (Sales/Fixed Assets ratio): This
ratio indicates as to what extent the fixed assets of a concern have
contributed to sales. In other words, it indicates as to what extent thefixed assets have been utilized.
Interpretation: The standard or ideal fixed assets turnover ratio is 5 times.
So, a fixed assets ratio of 5 times or more indicates better utilization of fixed
assets turnover ratio of less than 5 times is an indicator of underutilization
of fixed assets.j) Current assets turnover ratio
Use: This ratio indicates the contribution of current assets to sales.
Interpretation: There is no standard or ideal current assets turnover ratio. Yet
the inference is that high current assets turnover ratio is an indication of the
better utilization of current assets. On the other hand, the low current assets
turnover ratio suggests that the current assets have not been utilized effectively.
k) Account Receivables/debtors turnover ratio/ debtors velocity
Debtor turnover ratio is the ratio which indicates the relationship between
debtors and sales. It is also the ratio which indicates the number of times thedebts are collected in a year.
Debtors or accounts receivables, for this purpose, is sundry debtors plus
bills receivable. Further, debtors, here mean gross debtors (i.e. debtors before
deducting bad debts and reserve for doubtful debts). Sales here, mean net
credit sales (credit sales-sales returns)
Use: this ratio indicates the extent to which debts have been collected in time.
It also indicates the liquidity of the concern
l) Account payable/creditors turnover ratioThis ratio indicates the rate at which the debt is paid to creditors.
Illustration 3
The following information was extracted from IDI’s books for the year ended X:
Sales accounts: FRW 700 000 Purchases account: FRW 550 000
Opening stock: FRW 100 000 Closing stock: FRW 80 000
Debtors account: FRW300 000 Creditors account: FRW 250 000Total Assets: FRW 900 000 Total of noncurrent assets: 60% of Assets
10.2.3 Gearing / leverage/ capital structure ratios / long
term solvency ratios
These ratios measure the extent to which the firm is financed by liabilities. They
are used to measure long term structure of the company position and its financial
risk. Financial risk is the probability that the firm may not be able to pay its debtsas and when they fall due.
Solvency ratio measure the ability of a company to pay its long term debt and
the interest on that debt.
Solvency versus Liquidity
Liquidity is a measure of the firm’s ability to pay short-term debt whereas
Solvency measure of the firm’s ability to pay all debt, particularly long-term debtand is a measure of the firm’s long-term survival.
It expresses the relationship between the proportions of fixed interest capital
to share capital. A high proportion means a highly geared business (company).
This will mean that shareholders can get more income if the additional loan
capital brings more profit than the interest. This on the other hand means that
the dividends of ordinary shareholders will be fluctuating a lot. It also means that
the company highly depends on non-owners to supply capital.b) Debt ratio (or Debt to Assets ratio)
Measures the proportion of the total assets financed by liabilities. In other words,
this ratio indicates to what extent the liabilities of a firm can be covered by its
economic resources. The higher the ratio, the higher the financial risk
c) Solvency ratioSolvency ratio is a ratio between total assets and total liabilities of a concern.
Uses: The solvency ratio is a measure of the solvency of a concern means the
ability of a concern to meet its total liabilities out of its total assets.
Interpretation: Though no standard ratio, solvency ratio has been established,
one can say that the higher the ratio, the stronger the financial position of theconcern and the lower the ratio the weaker is its financial position.
d) Debt to equity ratio or Leverage ratio
Interpretation: the standard ratio: 2:1. If the debt is less than two times the
equity, the logical conclusion is that the financial structure of the concern is
sound and so the risk of the long term is relatively less and vice-versa.e) Capital structure ratio
A higher CNCAR indicates that it is easier to meet the business debt and credit
commitment
g) Proprietary/equity/Net worth ratio
Net worth means the excess of total assets over total liabilities. It means
owners’ funds. Total assets include all realizable assets that are all tangible
assets and intangible assets if they can be realized. But goodwill cannot be
included since it cannot be realized before the liquidation of the concern. It iscalculated as follows:
Uses of Net Worth ratio: it indicates the proportion between owned capital
and loaned capital. It is also an index of the amount proprietor invested on total
assets.
Interpretation: The higher the proprietary ratio, the stronger is the financial
position of the concern and vice versa. Generally, a ratio of 5:1 is considered
ideal.
h) Fixed assets to Net Worth ratio
Fixed assets refer to assets which are used in the enterprise permanently.
However, they do not include investments on security. Again, fixed assets mean
Net fixed assets i.e. fixed assets at cost less depreciation.Net worth means owner’s fund
Use: It indicates to what extent the owners have invested funds in the fixed
assets, which constitute the main structure of the business.
Interpretation: the ideal fixed assets to Net Worth ratio for an industrial
undertaking is 67%. That is to mean the fixed assets should not constitute
more than 67% or 2/3 of the owner’s funds. If the fixed assets are more that,
the owner’s funds are mostly sunk in the fixed assets and current assets arefinanced out of loaned funds.
i) Current assets to Net worth ratio
This ratio indicates the proportion of current assets financed by the owners.
Interpretation: The higher ratio indicates the proportion of current assets
financed by the owners.
j) Fixed assets Ratio
It is the ratio between fixed assets and capital employed. Capital employedmeans owner’s funds plus long term loans plus deposits and debentures.
Use: this ratio indicates how the fixed assets of concern have been financed.
Interpretation: the fixed assets ratio should not be more than 1. The standard
ratio is 0.67.
k) Fixed charges cover ratio
It is the ratio between net profit and fixed charges and income tax. Fixed profit for
this purpose means net profit before deducting fixed charges and income tax.Fixed charges mean interests on long term loans and deposits and debentures.
This ratio indicates as to how many times the net profit of the concern covers its
fixed charges. It indicates whether the business would earn sufficient profits topay the interest charges periodically.
l) Dividend coverage ratio
This is the ratio between disposable profit and dividend. Disposable profit
means net profit after deducting interest on long-term borrowings and incometax. In short, it means final net profit available for dividend.
Use: this ratio indicates the ability of the concern to maintain the dividend on
shares in the future.
Interpretation: if the dividend declared is adequately covered by the disposable
profit, the indication is that there is sufficient amount of retained profit and so,
slight variations in profits in the future will not disturb the amount of dividend in
the future and vice –versa. i.e. The higher the number of times the better for theenterprise.
Illustration 1
The list of accounts balance of MMM is given in the following table
1. Calculate the Gearing/ leverage / capital structure ratios
(Sales 5,000,000 FRW; Purchases: 1,000,000 FRW, Closing stock600,000 FRW)
Illustration 2
The following is the Balance sheets (In FRW) of Maria
Required: Calculate the Gearing/ leverage / capital structure ratio
10.2.4 Profitability ratios
These are ratios which measure the profitability of a concern. In other words,
there are ratios which reveal the effect of the business transactions on the
profit position of an enterprise and indicate how far the enterprise has beensuccessful in its aim.
i) Gross profit margin
This is the ratio of profits to sales. It assesses the business level and adequateof profits earned and their stability. The gross profit margin is expressed as:
Gross profit is the profit that a concern earns on its trading. In other words, it
is the excess of the net sales over the cost of goods sold.
Sales refer to total sales, i.e. cash sales plus credit sales, but they represent net
sales, i.e. total sales minus sales returns.
Use: this ratio discloses the gross result of trading or the overall margin within
which a business undertaking must limit its operating expenses to earn sufficient
profit.
Interpretation: the actual gross profit ratio is compared with gross profit ratio
of the previous years and those of other concerns carrying on similar business,
when it is high, it is indication of good results and vice-versa.ii) Net profit ratio
Net profit means final balance of operating and non-operating incomes after
meeting all expenses. Sales means total sales, but net sales i.e. total sales
minus sales returns
Use: this ratio indicates the quantum of profit earned by a concern.
Interpretation: A high net profit ratio indicates that the profitability of the
concern is good. On the other hand, a low net ratio indicates that profitability is
poor.iii) Operating ratio or operating cost ratio
Operating cost refers to all expenses incurred for operating or running a
business. It comprises cost of goods sold plus operating expenses and selling
and distribution expenses. Sales refer to net sales. i.e. total sales minus sales
returns.
Use: the operating ratio indicates the efficiency of the management in the
conduct of the business.
Interpretation: a low operating ratio is an indication of an operating efficiency
of the business.
iv) Expenses ratio
Expenses ratios are ratios which supplement the information given by the
operating cost ratio. They are the ratios between expenses and sales. Some ofthe important expenses ratios are:
Interpretation:
a) A low factory ratio is an indication of the economy and the efficiency
in the manufacturing operations of the firm. On the other hand, a
high factory expenses ratio is an indication of the inefficiency in the
manufacturing process of the enterprise.
b) A low administrative expense ratio is an indication of the economy and
the efficiency in the general administration of the concern and viceversa.
c) A low selling and distribution expenses and vice versa.
v) Operating profit ratio
Operating profit ratio is the excess of net sales over the operating cost.
Alternatively, it is the net profit plus non-operating expenses minus operatingincomes.
Interpretation: The standard o ideal operating profit ratio of 10% or more is an
indication of the operating efficiency of the business, and vice-versa.
vi) Return on total Resources ratio
Return, here, means net profit after taxes, i.e. final profit.
Total resources or total assets mean all realizable assets, including intangible,if they are realizable.
Use: This ratio measures the productivity of the total resources or assets of a
concern. In other words, it indicates the profitability of the business.
Interpretation: a return of 10% is normally considered as an ideal ratio. As such,
if the actual ratio is 10% or more, it is an indication of the higher productivity of
the resources on the other hand, a return of less than 10% is an indication of
lower productivity of the resources.
vii) Returns on capital employed (ROCE) or Return on Investment
Ratio (ROI)
ROCE or ROI is the ratio between return on capital employed and capitalemployed
Return on capital employed means operating profit or net profit before
deducting interests and taxes
Capital employed refers to total long-term funds employed in the business.
This ratio indicates the overall profitability of the business. Since it reveals the
productivity of the capital employed in the business. Capital employed here
means investments made outside the business-fictious assets.
Interpretation: the standard or ideal return on capital employed ratio is about
16%. So if the actual ratio is equal to or more than 16% it is an indication of
higher productivity of the capital employed.
Use: this ratio is the measure of the productivity.viii) Return On Equity Ratio (ROE)
Net worth here means all types of share capital + accumulated resources and
profits-all losses and fictious assets.
Use: This ratio is a measure of the productivity of shareholders’ funds. It also
gives the shareholders an idea of the return on their funds. It is also useful for
inter-firm and inter-industry comparisons.
Interpretation: the standard or ideal net profit to net worth ratio is about 13%or
more. It is an indication of good return on shareholders’ funds it influences the
market price of the equity shares.ix) Return on Equity Capital ratio or Net profit to Equity Capital
Net profit: Net profit after deducting taxes and preference dividends or net
profit available for equity shareholders.
Equity capital is interpreted in two ways. Some authors take equity capital to
mean only equity share capital. Other take equity shareholders’ funds (i.e. equity
share capital plus all accumulated reserves and profits minus all losses andfictious assets.
Use: this ratio is a measure of the productivity of equity capital. It is a satisfactory
measure of the profitability of the eEnterprise from the point of view of equityshareholders.
Interpretation: there is no standard or ideal net profit to equity capital ratio.
So, the actual net profit to equity capital ratio is compared with those othersimilar concern and the productivity of equity capital is determined.
x) Debt-service coverage ratio (DSCR)
1. In corporate finance, it is the amount of cash flow available to meet annual
interest and principal payments on debt, including sinking fund payments.
2. In government finance, it is the amount of export earnings needed to meet
annual interest and principal payments on a country’s external debts.
3. In personal finance, it is a ratio used by bank loan officers in determining
income property loans.
This ratio should ideally be over 1. That would mean the property is generatingenough income to pay its debt obligations. In general, it is calculated by:
A DSCR of less than 1 would mean a negative cash flow. A DSCR of less
than 1, say .95, would mean that there is only enough net operating income to
cover 95% of annual debt payments.
For example, in the context of personal finance, this would mean that the
borrower would have to delve into his or her personal funds every month to keep
the project afloat. Generally, lenders frown on a negative cash flow, but some
allow it if the borrower has strong outside income.
Debt-service refers to the cash that is required for a particular time period to
cover the repayment of interest and principal on a debt.
Sinking funds: a means of repaying funds that were borrowed through a bondissue.
IllustrationThe following are the Final accounts for two similar types of business:
Balance Sheets (in FRW)
You are required to calculate:
a) Gross margin rate
b) Gross mark-up ratio
c) Salaries expenses to sale ratio
d) Net margin ratio
e) Net mark-up ratio
f) Electricity expense to sales ratio
g) Return on Equity ratio
h) Return on Assets
i) Return on Fixed assets
j) Return on Capital Employed ratio (ROCE)Solution
10.2.5 Shareholders ratios/growth and valuation ratios/
defensive and survival ratiosi) Earnings per share (EPS)
Use: the EPS ratio assesses the relationship of operating profit after tax, interest
on loan capital and preference dividend, to the number of shares issued as fully
paid up. It shows the amount of earnings applicable to a share of ordinary equity.
Interpretation: the more the earning per share, the better is the performance
and the future prospects of the company. Higher earnings per share suggest
the possibility of more cash dividend or bonus shares and a rise in the market
price of share.ii) Dividend per share (DPS)
The higher the ratio, the more profitable the enterprise.
iii) Dividend yield
Use: this is the ratio of dividend paid by the business enterprise per share to the
market price per each share of the business.
Interpretation: the actual dividend yield ratio of the company in question
should be compared with the dividend yield ratios of other similar companies.
If the dividend yield ratio of the company in question is more than that of other
similar companies, it is an indication to the investor that it is worth investing on
the shares of the company in the question.iv) Price earnings ratio (P/E ratio)
This ratio assesses the ongoing financial performance of company from year to
year. It shows the profit earning capacity of a business. It indicates the number
of times the earning per share is covered by its market price. It is very useful toan investor for predicting the market price of shares at some future date.
Interpretation: the higher the price earnings ratio, the better are the chances
of appreciation in the market price of share.v) Dividend payout ratio/ payout ratio
Use: it throws light on the chance of appreciation, in the price of the shares.
Interpretation: a low payout ratio indicates that only a small portion of the
earning of the company has been used for dividend and the major portion of
the earnings is retained for ploughing back and vice versa. A low payment ratio
suggests that there are good chances of appreciation in the prices of shares.
vi) Preference Dividend cover
Use: the EDC indicates the number of times the equity dividend paid is covered
by the profits available for equity shareholders. It indicates the degree of certainty
of declaration of equity dividend in future years also.
Interpretation: the standard equity dividend cover is two times. As such, if the
equity dividend cover is more, the indication is that there is a greater degree of
certainty that equity dividend will be declared in the future years also; and vice versa.
Limitations of ratio analysis
Ratio analysis is not foolproof. There are many problems in trying to identify
trends and make comparisons. Below are just a few.
• Information problems
– The base information is often out of date, so timeliness of information
leads to problems of interpretation.
– Historical cost information cost information may not be the most
appropriate information for the decision for which the analysis is being
undertaken.
– Information in published accounts is generally summarized information
and detailed information may be needed.
– Analysis of accounting information only identifies symptoms, not causes,
and is therefore of limited use.
• Comparison problems: trend analysis
– Effects of price changes make comparisons difficult unless adjustments
are made.
– Impacts of changes in technology on the price of assets, the likely
return and the future markets.
– Impacts of a changing environment on the results reflected in the
accounting information.
– Potential effects of changes in accounting policies on the reported
results
– Problems associated with establishing a normal base year with which
to compare other years.
• Comparison problems: across companies
– Selection of industry norms and the usefulness of norms based on
averages
– Different firms having different financial and business risk profiles and
the impact on analysis.
– Different firms using different accounting policies
– Impacts of the size of the business and its comparators on risk, structure
and returns.
– Impacts of different environments on results, eg different countries orhome-based versus multinational firms.
Application activity 10.2
1) The ratio has increased in 2018 compared to 2017 because we
have increased the length of time allowed for customers to pay their
invoices. The statement above could explain a decrease in which of
the following ratios?
i. The receivables collection period
ii. The gearing ratio
iii. Interest cover
iv. The payables payment period2) The following information for Christian Ltd is available
Christian Ltd purchased new non-current assets during the year
Required: calculate and comment on ROCE for Christian Ltd
Skills Lab
Carry out a visit in any company, ask for their financial statements and
interpret them based on different categories of financial ratios.
End unit assessment
Given below is a range of financial ratios for two companies that bothoperates nearby your school:
Required: Comment upon what the ratios indicate about each business
One of the businesses is a supermarket and the other is jeweler who
supplies some goods on credit to long standing customers. Identify whichbusiness.
2. The following are summarized financial statements of DAMIAN
Limited:
DAMIAN LimitedStatement of Profit or Loss for the year ended 31 October
Balance sheet as at 31 October
Note:
1. 80% of the sales are no credit2. The stock as at 31 October 2001 was valued at FRW 13,000,000
REQUIRED:
Calculate two ratios for each classification identified below for the financial
years ended 31 October 2021 and 2022:
i) Profitability
ii) Liquidity ratios
iii) Gearing ratiosiv) Activity ratios
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