Introduction of the Accounting Equation

The statement of financial position reflects the accounting equation. It reports a company’s assets, liabilities, and owner’s (or stockholders’) equity at a specific point in time. Like the accounting equation, it shows that a company’s total amount of assets equals the total amount of liabilities plus owner’s (or stockholders’) equity.

Every business transaction will have an effect on a company’s financial position. The financial position of a company is measured by the following items:

1.     Assets (what it owns)

2.     Liabilities (what it owes to others)

3.     Owner’s Equity (the difference between assets and liabilities)

The accounting equation (or basic accounting equation) offers us a simple way to understand how these three amounts relate to each other. The accounting equation for a sole proprietorship is:

Assets = Liabilities + Owner’s Equity

The accounting equation for a corporation is:

Assets = Liabilities + Stockholders’ Equity

Assets are a company’s resources—things the company owns. Examples of assets include cash, accounts receivable, inventory, prepaid insurance, investments, land, buildings, equipment, and goodwill. From the accounting equation, we see that the amount of assets must equal the combined amount of liabilities plus owner’s (or stockholders’) equity.

Liabilities are a company’s obligations—amounts the company owes. Examples of liabilities include notes or loans payable, accounts payable, salaries and wages payable, interest payable, and income taxes payable (if the company is a regular corporation). Liabilities can be viewed in two ways:

(1) as claims by creditors against the company’s assets, and 
(2) a source—along with owner or stockholder equity—of the company’s assets.

Owner’s equity or stockholders’ equity is the amount left over after liabilities are deducted from assets:

Assets – Liabilities = Owner’s (or Stockholders’) Equity.

Owner’s or stockholders’ equity also reports the amounts invested into the company by the owners plus the cumulative net income of the company that has not been withdrawn or distributed to the owners.

If a company keeps accurate records, the accounting equation will always be “in balance,” meaning the left side should always equal the right side. The balance is maintained because every business transactionaffects at least two of a company’s accounts. For example, when a company borrows money from a bank, the company’s assets will increase and its liabilities will increase by the same amount. When a company purchases inventory for cash, one asset will increase and one asset will decrease. Because there are two or more accounts affected by every transaction, the accounting system is referred to as double entry accounting.

A company keeps track of all of its transactions by recording them in accounts in the company’s general ledger. Each account in the general ledger is designated as to its type: asset, liability, owner’s equity, revenue, expense, gain, or loss account.

REPORTING CASH FLOWS FROM OPERATING ACTIVITIES (USING INDIRECT METHOD)

The cash from operating activities is the ‘cash generated from operations’ less interest and tax actually paid in the year.

There are two ways of getting to ‘cash generated from operations’, the direct method and the indirect method.

With the indirect method, we start with Profit before tax, and then have to make some adjustments for:

A. Non cash items, eg depreciation, provisions, profits/losses on the sale of assets

B. Changes during the period in inventories, receivables and payables

C. Other items, the cash flows from which should be classified under investing or financing activities 

PROFORMA

Cash flows from operating activities                           $

Profit before taxation                                                    x

Adjustment for:

            Depreciation                                                    x         

            Foreign Exchange Loss                                    x

            Loss on Disposal of asset                                x

            Interest Expenses (net)                                    x

            Profit on disposal of asset                              (x)        

            Investment Income                                        (x)

                                                                                 x

            Decrease in inventories                                  x

            Increase in Trade Receivables                      (x)

            Decrease in Trade Payables                         (x)

Cash generated from operations                                 x

Interest Paid                                                             (x)

Income tax paid                                                        (x)

Net cash from operating activities                               x

IFRS 9 FINANCIAL INSTRUMENTS

IFRS 9 deals with recognition and measurement of Financial Assets. An entity recognise  financial asset on its Sttatement of Financial Postion.

The three classification of financial assets are measured at fair value under IFRS 9, as follows:

Debt instruments

A debt instrument will be measured at amortised cost or FVTPL. A debt instrument generally must be measured at amortised cost if both the ‘business model test’ and the ‘contractual cash flow characteristics test’ are satisfied.

Business model test: The objective of the entity’s business model is to hold the financial asset to collect the contractual cash flows (rather than have the business model objective to sell the instrument prior to its contractual maturity to realise its fair value changes). 

Contractual cash flow characteristics test: The contractual terms of the financial asset give rise on specified dates to cash flows that are solely payments of principal and interest on the principal amount outstanding.

Equity investments
Under IFRS 9 all equity investments held must be measured at either:

1. fair value through profit or loss, or

2. fair value through other comprehensive income.

Gains and losses arising on equity investments are recognised in profit or loss (i.e. they are measured at FVTPL) unless the entity irrevocably designates at initial recognition that they should be recognised in other comprehensive income (i.e. designating them as at FVTOCI). Designation at FVTOCI is not permitted if the equity investment is held for trading.

Non-Current Asset Held for Sale [IFRS 5]

A non-current asset (or disposal group) should be classified as held for sale if its carrying amount will be recovered principally through a sale transaction rather than through continuing use.

A number of detailed criteria must be met:

(a) The asset must be available for immediate sale in its present condition.

(b) Its sale must be highly probable

-committed to a plan to sell

-active programme to locate a buyer

-marketed for sale at a price that is reasonable)

(c) The sale should be expected to take place within one year from the date of classification.

Measurement of assets held for sale

A non-current asset (or disposal group) that is held for sale should be measured at the lower of its carrying amount and fair value less costs to sell. Fair value less costs to sell is equivalent to net realisable value. An impairment loss should be recognised where fair value less costs to sell is lower than carrying amount. Note that this is an exception to the normal rule. IAS 36 Impairment of assets requires an entity to recognise an impairment loss only where an asset's recoverable amount is lower than its carrying value. Recoverable amount is defined as the higher of net realisable value and value in use. IAS 36 does not apply to assets held for sale. Non-current assets held for sale should not be depreciated, even if they are still being used by the entity.

Presentation

Non-current assets and disposal groups classified as held for sale should be presented separately under current assets in the statement of financial position.

Definition:

Fair value: the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm's length transaction.*

Costs to sell: the incremental costs directly attributable to the disposal of an asset (or disposal group), excluding finance costs and income tax expense.

Recoverable amount: the higher of an asset's fair value less costs to sell and its value in use.

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

LIST OF IASs/IFRSs

List of useful International Accounting Standards (IASs)/ International Financial Reporting Standards (IFRSs)
FINANCIAL STATEMENTS OF SINGLE ENTITY
A.    Presentation of Published Financial Statements
        IAS 1 (revised) Presentation of Financial Statements
        IAS 34: Interim financial reporting
B.    Accounting for tangible non-current assets
        IAS 16: Property, Plant and Equipment
        IAS 23: Borrowing Costs
        IAS 36: Impairment of Assets
        IAS 40: Investment Property
        IAS 20: Accounting for Government Grants and Disclosure of Government Assistance
C.    Intangible assets and goodwill
        IAS 38: Intangible Assets
        Goodwill (IFRS 3)
D.    Revenue Recognition
        IAS18: Revenue
E.    Inventories and Construction Contracts
        IAS 2: Inventories
        IAS 11: Construction Contracts
F.    Accounting for leases
        IAS 17: Leases
G.   Accounting for Taxation
       IAS 12: Income Taxes
H.   Financial Instruments
       IAS 32: Financial Instruments: Presentation
       IFRS 7: Financial Instruments: Disclosures
       IFRS 9: Financial Instruments
I.     Earnings Per Share
       IAS 33: Earnings per share
J.    Statement of Cash Flows
       IAS 7: Statement of Cash Flows
K.   Reporting Financial Performance
       IAS 8: Accounting policies, Changes in Accounting Estimates and errors
       IAS 10: Events after the reporting period
       IFRS 5 : Non-Current Assets held for sale and Discontinued Operations
L.   Provisions and Contingencies
      IAS 37: Provisions, Contingent Liabilities and Contingent Assets
GROUP FINANCIAL STATEMENTS
The Consolidated Statement Of Financial Position 
      IFRS 10: Consolidated Financial Statement
      IFRS 3: Business Combinations (revised)
      IAS 28: Investments in Associates

Working for Property, Plant and Equipment [IAS 16] RELEVANT TO ACCA QUALIFICATION PAPER F7

		$000	$000
A	Land
	Carrying amount 01/09/2011	XXX
	Revaluation reserve	XXX
	Revalued amount 31/08/2012		XXX
B	Leased Property
	Carrying amount 01/09/2011	XXX
	Revaluation reserve	XXX
	Revalued amount 31/08/2012	XXX
	Amortization	(XXX)
	Carrying amount 31/08/2012		XXX
C	Plant and Equipment
	Carrying amount 01/09/2011	XXX
	Depreciation for the year	(XXX)
	Carrying amount 31/08/2012		XXX
D	Leased Plant (under Finance Lease)
	Fair value	XXX
	Depreciation for the year	(XXX)
	Carrying amount 31/08/2012		XXX
		Total	XXX

IAS 17 LEASES (Key Notes)

Definition of lease types:

Finance lease-lease that transfers substantially all the risks and rewards to the lessee

Operating lease-any other lease

Indicators of Finance Lease

The main indicator is that the lease term is for the major part of the useful economic life of the asset. And the indicators are:

-          at the beginning of the lease, the present value of the minimum lease payments is approximately equal to the fair value of the asset

-          The lease transfers ownership of the asset to the lessee by the end of lease term  

-          The lessee has the option to buy the asset at a price expected to be lower than fair value at the time the option is exercised

-          The lease asset is of specialized nature

Substance over form

Accounts are generally required to reflect commercial substance (reflects the financial reality of the transaction) rather than legal form (legal reality of the transaction).

IAS 17 deals with the accounting for finance lease which follow the definition of an asset in the IASB Framework for the Preparation and Presentation of Financial Statements: “an asset is a resource controlled by the entity as a result of the past events and from which future economic benefits are expected to flow the entity”. Ownership is not necessary, control is the essential feature.

 IAS 17 thus argues that an asset leased under a finance lease must be recorded as an asset and corresponding liability in the lessee’s accounting records.

ACCOUNTING ENTRIES

A.      Finance Lease

01.   At the beginning of the lease

Dr. Non-Current Asset

Cr. Finance Lease Liability

Initial recording-

NCA: at the fair value (or, if lower, the present value of the minimum lease payment)

Finance Lease Liability: liability for finance leases spilt between current liabilities and non-current liabilities

02.   At the end of each period of the lease

Dr. Depreciation expenses (Income Statement)

Cr. Non-current Asset-accumulated depreciation

(NCA should be depreciated over the shorter of the useful life and the lease term)

03.   As each rental paid

Dr. Interest Expenses (Income Statement)

Cr. Finance Lease Liability

(with the finance charge)

Dr. Finance Lease Liability

Cr. Bank/Cash

(with the rental payment)

B.      Operating Lease

Only rental payment under operating leases are charged to the income statement on straight-line-basis over the term of the lease  

Note: If a finance lease asset is incorrectly treated as an operating lease it will have the following effects on the financial statements:

- assets understated so Return on capital employed will be overstated

- liabilities understated so gearing understated

- little effect on income statement (profit will be overstated)

IAS 11 CONSTRUCTION CONTRACTS

DEFINITION

IAS 11 defines a construction contract as: a contract specifically negotiated for the construction of an asset or a combination of assets that are closely interrelated or interdependent in terms of their design, technology, and function for their ultimate purpose or use.

IAS 11 TREATMENT

Where possible, IAS 11 applies the accruals concept to the revenue earned on a construction contract. If the outcome of a project can b reasonably foreseen, then the accruals concept is applied by recognising profit on uncompleted contracts in proportion to the percentage of completion, applied to the estimated total contract profit. If, however, a loss is expected on the contract, then an application of prudence is necessary and the loss will be recognised immediately.

OUTCOME CAN BE RELIABLY MEASURED

IAS 11 only allows revenue and contract costs to be recognised when the outcome of the contract can be predicted with reasonable certainty. This means that it should be probable that the economic benefit attached to the contract will flow to the entity. If a loss is calculated, then the entire loss should be recognised immediately. If a profit is estimated, then revenue and costs should be recognised according to the stage that the project has completed. There are two ways in which stage of completion can be calculated, and, in the exam, it is important to determine from the question scenario which method the examiner intends you to use, either the:

  work certified method (sometimes referred to as the sales basis)

work certified to date / contract price

   cost method

                        costs incurred to date / total contract costs

Step approach

Step 1: Set up extracts of the financial statements and a working paper.

Step 2: Determine at W1 whether a profit or loss is expected on the contract.

Step 3: In this example a profit will be calculated, so determine the accounting policy from the question and calculate the stage of completion.

Step 4: Calculate how much profit should be shown this year from the stage of completion and include it in the income statement extract.

Step 5: ‘Build’ up the income statement. If it is a work-certified accounting policy, then the work certified for the year should be taken to the revenue line. If it is a cost-basis accounting policy, then the costs incurred should be taken to the cost of sales line.

Step 6: Depending on what approach was taken at step 5, you are now in a position to

find the balancing figure to complete the income statement.

Step 7: Calculate the asset or liability outstanding on the construction contract.

OUTCOME CANNOT BE RELIABLY MEASURED

In following prudence, where an outcome cannot be reliably measured, any costs incurred during the financial year should be expensed immediately and revenue recognised as equivalent to the contract costs expected to be recoverable.

WHAT IS INCLUDED IN CONTRACT REVENUE AND COSTS?

Contract revenue will be the amount agreed in the initial contract, plus revenue from variations in the original contract work, plus incentive payments and claims that can be reliably measured, such as contract revenue which can be valued at the fair value of received or receivable revenue. Contract costs are to include costs relating directly to the initial contract plus costs attributable to general contract activity, plus costs that can be specifically charged to the customer under the terms of the contract.

Framework for the preparation and presentation of financial statements

IAS 1 PRESENTATION OF FINANCIAL STATEMENTS

The objective of IAS 1 (revised 1997) is to prescribe the basis for presentation of general purpose financial statements based on International Financial Reporting Standards. [IAS 1.2]

Objective of Financial Statements The objective of general purpose financial statements is to provide information about the financial position, financial performance, and cash flows of an entity that is useful to a wide range of users in making economic decisions. To meet that objective, financial statements provide information about an entity's: [IAS 1.7]

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

Components of Financial Statements A complete set of financial statements should include: [IAS 1.8]

• a statement of financial position at the end of the period,
• a statement of comprehensive income for the period,
• a statement of changes in equity for the period
• statement of cash flows for the period, and
• notes, comprising a summary of accounting policies and other explanatory notes.

Fair Presentation and Compliance with IFRSs

·         The financial statements must "present fairly" the financial position, financial performance and cash flows of an entity. Fair presentation requires the faithful representation of the effects of transactions, other events, and conditions in accordance with the definitions and recognition criteria for assets, liabilities, income and expenses set out in the Framework. The application of IFRSs, with additional disclosure when necessary, is presumed to result in financial statements that achieve a fair presentation. [IAS 1.13]

·         IAS 1 requires that an entity whose financial statements comply with IFRSs make an explicit and unreserved statement of such compliance in the notes. Financial statements shall not be described as complying with IFRSs unless they comply with all the requirements of IFRSs (including Interpretations). [IAS 1.14]

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

·         IAS 1 acknowledges that, in extremely rare circumstances, management may conclude that compliance with an IFRS requirement would be so misleading that it would conflict with the objective of financial statements set out in the Framework. In such a case, the entity is required to depart from the IFRS requirement, with detailed disclosure of the nature, reasons, and impact of the departure. [IAS 1.17-18]