Arsi University

College of Business and Economics

Department of Accounting and Finance

Key note module on Financial Accounting

and Reporting courses

Prepared by:
1. Abebe Teka
2. Bekalu Anteheh
3. Wubshet Ayanew
4. Asaminew Desalign
5. Zerihu Getachew

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 THEMATC AREA I

FINANCIAL ACCOUNTING AND REPORTING

Courses (Subjects)
1. Fundamentals of Accounting I
2. Fundamentals of Accounting II
3. Intermediate Financial Accounting I
4. Intermediate Financial Accounting II
5. Advanced Financial Accounting I
6. Advanced Financial Accounting II

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 COURSE: FUNDAMENTALS OF ACCOUNTING I

Learning outcomes

 Understand the role of accounting in business, Explain the accounting equation and its elements
 Understand the steps in accounting cycles, know the rule of double entry systems, Complete
worksheets and prepare financial statements
 Understand the accounting for merchandizing businesses and its applications Compare the
manual & computerized accounting systems
 Understand internal control mechanisms over cash & receivables, Apply accounting principles
and control of cash and receivables

1. Accounting Defined
As a financial information system, accounting is defined as a process of identifying measuring, recording
and communicating economic events of an organization (business or non- business) to interested users of
the information.

1.2. The Roe (Importance) of Accounting and Users of Accounting Information

1.2.1. Importance of accounting
The main purpose of accounting is to provide financial information to be used for decision-making. For
instance, Business executives and managers need the financial information provided by the accounting
system to help them plan and control the activities of the business. Outsiders such as bankers, potential
investors, and labour unions and others also need accounting information.

In short the goal of the accounting system is to provide useful information to decision makers.
Thus, accounting is the connecting link between decision makers and business operations.
1.2.2. Users of Accounting Information

Today‘s accountants focus on the ultimate needs of those who use accounting information, whether the
users are inside or out side the business. Accounting is not an end by itself. The information that
accounting provides allows users to make ―reasonable choices among alternative uses of scarce resources
in the conduct of business‖

The people who use accounting information basically fall in to two categories:
1. External Users, and
2. Internal Users
1) External Users: External Users of accounting information are parties, which are not directly
involved in running the business enterprise. These include lenders, shareholders (stock holders),
suppliers, employees and their Unions, government (regulatory bodies) and others. External users

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 rely (depend on) accounting information to help them make better decisions in trying to achieve their
goals.
- The area of accounting aimed at serving external users is called Financial Accounting. Its main
objective is to provide to external users information through financial statements.
Each external user has its own specified information-need depending up on the decisions to be made. That
is to say, all external users do not have the same intentions (objectives) when they use the information.

In the following paragraphs we well try to discuss how some external users use accounting information.

a) Lenders / Creditors

Creditors lend money or other resources to an organization. Lenders include banks, mortgage and finance
companies. Lenders look for information to help them assess the ability of borrowers to repay their debts.

b) Share- holders (Stockholders)

Shareholders have legal control over part or all of a corporation. When it comes to a corporation,
shareholders are not directly involved in the management of the corporation. However, as owners, they
have claims over the properties of the organization. Financial reports help to answer shareholders‘
questions such as:

- what is the income of the organization for the current and past periods?

- are the properties adequate to meet business plan?

- will the business continue to be profitable in the future?

c) Employees and labour Unions

Employees and labor unions are interested in judging the fairness of their wages and assessing future job
prospects. They also use accounting reports as evidence to ask for bonuses, when the organization is
successful.

d) Government

The Inland Revenue Authority requires organizations to prepare financial reports, in order to compute
taxes.

2) Internal Users: These are persons that are directly involved in managing and operating an
organization. They include managers and other important decision makers. The internal role of
accounting is to provide information to help improve the efficiency and effectiveness of an
organization.
1.2.3. Business transactions and the accounting equation
Business transactions are economic events that should be recorded because they affect the financial
position of the business enterprise. These businesses transactions are the raw materials of accounting
reports, as cotton is a raw material for a textile factory.

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A transaction can be an exchange (such as the purchase or sale of property, payment or
collection of a loan etc.) between two or more parties. A transaction can also be an event that
has the same effect as an exchange transaction but doesn‘t involve an exchange transaction.
Some examples of ―non exchange‖ transactions are losses from fire, flood; physical wear and
tear on equipment; donation of property and so forth.
For a given transaction to qualify to be recorded it has:

1 To be related to the business enterprise

2 To be measurable in terms of money
3 To be completed / happened/ action.
1.2.4. Assets, Liabilities and Owner’s Equity
If you have noticed, in any organization you will find properties such as a building, furniture, land,
vehicles and the like. Such properties owned by business enterprises are referred to as Assets. To buy
these assets, businesses get money from two sources: investments made by owners or amounts
borrowed from creditors. Therefore, both owners and creditors have a claim over the assets of the
business enterprise. The claims or rights of owners are referred to as Equities. If the assets owned by
a business amount to Birr 50,000 the equities in the assets must also amount to Birr 50,000. The
relationship between the two may be stated in the form of an equation, as follows:

Economi c Re source s = cl ai ms ove r the re source s

Asse ts = Equi tie s.

Equity may be subdivided in to two principal types: the rights of creditors and the rights of owners. The
rights of creditors represent debts of the business and are called Liabilities. The rights of owners are
called Owners’ Equity (capital).

Assets=equities

Equities = Liability (Creditors equity) + Owner‘s equity

This equation can be written as:

Assets= liability + Owner’s Equity

2. ACCOUNTING CYCLE FOR SERVICE GIVING BUSINESS

2.1. Accounting Cycle: It is the procedure for analyzing, recording, summarizing, and reporting
the transactions of a business. The sequence of this cycle can be summarized in the following
exhibit.

EXHIBIT 1: The Sequence of Accounting Cycle

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 Exchange Transactions (Businesses enter into exchange transactions signaling the beginning of the
accounting cycle)

Step 1: Identify and analyze Transactions.

ye Transaction

Step 2: Record the transaction in a journal (Journalizing)

Step 3: Summarize the effects of transactions

I. Posting Journal entries

II. Preparing a trial balance

Step 4: Prepare Reports

I. Adjusting Entries
II. Financial statements
III. Closing Entries

Step 1: Identify and analyze the transactions

The first step in the accounting cycle is to identify and identify all transaction made during accounting
period, including expenses, debt payments, sales or service revenues and cash received from customers.
During this initial stage, companies go through every transaction that affects their financials, though this
should be ongoing steps for companies that are continuously creating customer invoices, buying
inventory, paying bills, making payrolls and collecting cash.

Step 2: Record the transaction in a journal (Journalizing)

When a business transaction takes place, source documents will be obtained and recorded. The
accounting record in which a transaction is initially recorded is known as a journal. The journal is
therefore referred to as ―The book of original entry‖.

The Journal commonly used to record all types of transactions is the General Journal. This Journal
includes the following parts, entered step by step.

 The date of the transaction

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  The title of the account debited
 The title of the account credited
 The amount of debit and credit
 Brief explanation of the entry or reference to the source document.

Look at the following General Journal and notice where each of the above information is found.

Journal page

Date Description P.R Debit Credit

Year
Month day Debited account title XXX XX
Credited account title X XX XX
Explanation

However, in order to record transaction in the journal you must understand the rules of debit and credit.
The general rule will be expanded as follows.

Debit side Credit side

-Increase in assets -Decrease in assets
-Increase in expenses -Decrease in expenses
-Decrease in capital -Increase in Liabilities
-Decrease in liabilities -Increase in liabilities
-Decrease in revenue -Increase in revenue.

Step 3: Summarize the effects of transactions

I. Posting
Once transactions have been analyzed and recorded in a journal, it is necessary to classify and group all similar
items. This is accomp lished by the bookkeeping procedure of posting all the journal entries to appropriate accounts.
Posting is the process of transferring the information is called posting.
II. Trial Balance
After the posting phase is completed, we have to verify the equality of the debit and credit balances. This
is done through the use of the ‗Trial Balance‘. A trial balance is a two column listing of the accounts in
the ledger and their balance to make sure that the total of debit balances equals the total of credit balances

Step 4: Prepare Reports

I. Adjusting Entries

The accrual basis of accounting – Under this method revenues are reported in the period in which they
are earned, and expenses are reported in the period in which they are incurred. For example, revenue will
be recognized as services are provided to customers or goods sold and not when cash is collected. Most
organizations use this method of accounting and we will apply this method in this course.

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Adjustments are dated as the last day of the year. The accounting year here – we assume, runs from
January 1- December 31.

The realization principle requires that revenue be recognized and recorded in the period it is earned. And
the matching principle stresses that in order to measure income; expenses incurred to produce revenues
must be matched (associated) with the revenue generated in the same accounting period.

Adjusting entries: Entries required at the end of each accounting period to recognize, on an accrual basis,
revenues and expenses for the period and to report proper amounts for asset, liability, and owners‘ equity
accounts.

Thus, adjusting entries help in achieving the goals of accrual accounting – which states recording
revenues when it is earned and recording expenses when the related goods and services are used, i.e.
when expenses are incurred.

Types of adjusting entries

A business may need to make a dozen or more adjusting entries at the end of each accounting period. The
exact number of adjustments will depend up on the nature of the company‘s business activities. But, all
adjusting entries fall in to two general categories known as deferrals and accruals.

A. Adjusting entries for deferrals

Definition: - The word ―defer‖ means to delay or post pone. In accounting, Deferrals are the delay (or
postponement) in the recognition of an expense already paid or revenue already received.

Deferred items consist of adjusting entries involving data previously recorded in accounts. These entries
involve the transfer of data already recorded in asset and liability accounts to expense and revenues
accounts.

Types of Deferrals

1. Prepayments (Deferred Expenses)

Companies often make advance expenditures that benefit more than one period, before receiving the
service. Such expenditures that are made before receiving the service are called Prepaid Expenses or
Deferred Expenses. An example would be the payment of an insurance premium for the next 18 months.
Theoretically, every resource acquisition is an asset, at least temporarily. At the initial point of payment,
the total advance payment is an asset not an expense to the business enterprise paying in advance

2. Deferred revenue (Unearned revenue)

Amounts received before the actual earning of revenues are known as unearned revenues. They arise
when customers pay in advance of the receipt of goods or services. Because the company has received
cash but has not yet given the customer the purchased goods or services, the unearned revenues are in fact

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liabilities. That is, the company must provide something in return for the amounts received. For example,
a building contractor may require a deposit before proceeding on construction of a house. Upon receipt of
the deposit, the contractor has unearned revenue, a liability. The contractor must construct the house to
earn the revenue. If the house is not built, the contractor will be obligated to repay the deposit.

B. Adjusting entries for accruals.

Definition: an accrual is the recognition of revenue or an expense that has arisen but has not yet been
recorded. The word ―accrue‖ means to accumulate or grow in size. In accounting, an accrual is the
recognition of revenue or an expense that has accumulated overtime but has not yet been recorded. In
order to report a company‘s financial position and profitability accurately, the accruals should be
recognized (recorded) in the accounting period in which they occur.

Types of accruals

As you can notice from the definition, we have basically two types of accruals in accounting. These are:
1. Accrued Expense / Accrued Liability/. 2. Accrued Revenue /Accrued Assets/

1. Accrued Expense / Accrued Liability/.

Accrued expenses refer to expenses that are incurred but are both unpaid and unrecorded. When we say
the expense is incurred; it means, ―the service has been received but the payment for it has not yet been
made.‖ Since the incurred expense is not paid there is a sense of a liability, hence the name accrued
liability.

2. Accrued Revenue (Accrued Assets)

Accrued revenues are revenues for which a service has been performed or goods delivered but for which
no entry has been recorded. That is, the revenues have been earned but not both yet recorded and
received. Any revenues that have been earned but not recorded during the accounting period call for an
adjusting entry that debits an asset account (specifically a receivable) and credits a revenue account.

II. Financial Statements

After the effect of the individual transactions has been determined, the essential information is
communicated to users at certain intervals. The accounting reports, which communicate this information,
are called financial statements. Financial statements are said to be the central features of accounting
because they are the primary means of communicating important accounting information to users.

The major financial statements used to communicate accounting information about a business are:

- Statement of profit or loss and Other Comprehensive Income

- Statement of financial position

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 - Statement of change in Equity
- Statement of cash flows (will be discussed in senior courses)

III. Closing Entries

Some of the accounts in the ledger are temporary accounts used to classify and summarize the
transactions affecting capital (owner‘s equity). These accounts will be closed after financial statements
are prepared. That is, their balances will be transferred to the Capital account. The temporary accounts
that have to be closed are revenue, expense and withdrawal accounts.

Steps in closing:

1. Closing revenue accounts - Debit each revenue account by its balance and credit the ‗Income
Summary‘ account by the total revenue for the period. Note: Income summary is an account used to
close revenue and expense accounts. This account will immediately be closed to the capital account
at the end of the closing process.
2. Closing expense accounts – Debit the income summary account by the total of expenses for the
period and credit each expense account by its balance.
3. Closing the income summary account – Income summary will be closed to the
capital account. The balance of this account depends on the nature of operation; credit if result is
profit and debit if result is loss.
4. Closing Withdrawal – Debit the owners equity account by the total of drawings for the period and
credit.

Exercise:

The following transactions were completed by Adama Photographic Studio during the month of
January 2022

1. Mr. Abdi (The owner) took Birr 250,000 from his personal savings and deposited it to Awash Bank
by the name of his business.
2. Purchased Photographic Equipment for Birr 50,000 on cash.
3. Paid Birr 40,000 for Awash Insurance Company to buy an insurance policy for Two months
4. Purchase Supplies of Birr 10,000 on account
5. Provide services to customers on account birr 25,000.
6. Paid Birr 30,000 & Br. 2000 as a salary and utility for the month
7. Received cash from customers on account Birr 15,000
8. Provide services to customers on cash birr 65,000.
9. Paid creditors o Account Br. 1000
10. Withdraw Birr 10,000 for personal use

Required

I. Journalize the above transaction

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 II. Post the transaction to the ledger
III. Prepare unadjusted trial balance

Additional information

 At the end of the month 1/3 of the insurance policy were expired
 The amount of supply on hand on January 31 is Br. 7000
 Depreciation on Photographic equipment is Br. 10,000

IV. Prepare adjusting entries for the above transaction

V. Prepare adjusted trial balance
VI. Prepare the necessary financial statements
VII. Prepare closing entries

3. ACCOUNTING FOR MERCHANDISE BUSINESS

A merchandising business buys goods in finished form for resale to customers. A merchandising business
sells tangible goods to its customers. These can be goods ranging from television sets, cars, office table
and chair (furniture), to chewing gums, toothbrushes and various stationeries. These goods that a
merchandising company sells to its customers are called merchandise inventory. (A customer is an
individual or a firm to whom a business sells its products.) One final thing that you should know about a
merchandising business is that a merchandising company does not produce the goods that it sells. Instead,
it buys these goods from manufacturers, which produce the goods using raw materials. The following
diagram can help you to better visualize the flow of goods from a manufacturer to the final consumer:

3.1. The periodic and the perpetual inventory systems

The value of goods (merchandise) on hand at the end of the year for resale would be reported on the
Balance Sheet as one asset as described above. This means that we need to open a separate ledger account
in which to record merchandise inventory information. The two alternatives in dealing with this account
are:

 To update this account every time goods are bought and sold (continuously = perpetually) or
 To update this account only at the end of the period (periodically).

3.1.1. Periodic Inventory System

Under this system, as the name periodic suggests, the inventory account is updated only
periodically i.e., only at the end of a period. When goods are bought, a temporary purchases
account is debited instead of the inventory account itself. Likewise, when goods are sold
revenue is recorded, but the fact that there is a reduction in merchandise inventory is not
recognized. This is because the Merchandise Inventory account is not credited every time goods
are sold. Therefore, if one wants to know the cost of goods on hand, it is a must that a physical
inventory be conducted first. The account doesn‘t reflect the value of goods on hand because it
was not up dated when merchandise

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3.1.2. Perpetual Inventory Systems

A perpetual inventory system continuously records the amount o f inventory on hand (perpetual
or continuous). Under this system, the merchandise inventory account is debited or credited
every time (goods) are bought or sold. When an item is sold, its cost is recorded in a separate
cost of goods sold account in addition to recording sales.

The cost of merchandise on hand can be looked up from the merchandise Inventory account any time,
without conducting a physical inventory.

3.2. Accounting cycle for me rchandising business (Recording purchases and sales
transactions)

3.2.1. Recording Sales

 Recording Cash Sales

When merchandise is sold on cash, the Cash account is debited and the revenue account Sales is
credited.

Example –On January 14. 2001,Geda Electronics sold goods for Birr 20,000. Record the transaction.
Answer: January 14, Cash……………………..20,000
Sales…………………………20,000

 Recording Credit Sales- The Accounts Receivable account is debited when goods are sold on
account (for credit).

Example: Ika sold goods worth Birr 35,000 on account on January 15, 2001. Record the transaction.
Answer: January 15. Accounts Receivable……………..35,000
Sales…………………………35,000

3.2.2. Recording Deductions from Gross Sales

I. Sales Discounts (Cash discount)

Sales Discounts are deductions from invoice price to customers who pay early when goods are
sold on credit. How much discount is given usually depends on the credit terms. These terms
(agreements) are usually stated on the invoice. The most frequently used terms are stated below:

 n/30‖ or ―Net 30‖ – means there is no discount even if the customer pays before the payment
date.
 2/10, n/30 –means the due date of the payment is after 30 days of the sale. But if the customer
pays with in 10 days she will get a 2% discount.

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  2/EOM, n/60- means the normal due date is with in 60 days of the sale but the customer will
get a 2% discount if she pays before the end of month of sale.

The following form of journal entry will be made to record sales discount.

Sales Discounts ………... xxxx

A/R……………….. xxxx

II. Sales Returns and Allowances

Customers can return merchandise they have bought if they find it to be defective or of the wrong model,
or unsatisfactory for a variety of reasons. A sales return is merchandise returned by a buyer. The buyer
would be paid back her money if she has already paid. A sales allowance is a deduction from the original
invoice price when the customer keeps the merchandise but is dissatisfied.

The following entry will be made to record sales return and allowance

Sales Returns and Allowances ………xxxx

A/R………………………………….xxxx

Net sales = Gross sales – (Sales discount + Sales return and allowance)

3.3. Recording Purchase

Under the periodic inventory system a merchandising company uses the Purchases account to record the
cost of goods bought for resale to customers.

Example: Nile Company bought goods worth Birr 43,000 from Saba Co., which is based in Addis Ababa,
on account on January 4, 2001, terms 20/10, n/30. Record the transaction.

January 4: Purchases …………………..43,000

Accounts payable…………………..43,000

3.3.1. Deductions from gross purchase

i. Purchase Discounts

A merchandising company can buy goods under credit terms that permit it to get a discount if it pays
within a specified period of time. The deduction from the original purchase price is recorded in a separate
contra Purchase account called Purchase Discounts.

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Example: IKA Company bought goods worth Birr 50,000 from Gibir Company on account on January 14,
2001, terms 1/10,n/60. Ika Company paid on January 24, 2001. Record the transactions on both dates.

Solution: Jan. 14. Purchases………………..50,000

A/P…………………............……50,000

Jan. 24. A/P…………………….. …50,000

Purchase Discounts …….......500

Cash…………………….......... 49,500

ii. Purchase Returns and allowances

A purchase return occurs when a buyer returns merchandise to a seller. A purchase allowance is a
reduction on the price of goods bought for dissatisfaction on the side of the buyer. Both purchase returns
and purchase allowances are recorded in a contra purchase account called Purchase Returns and
Allowances.

Example: In the previous example for IKA Company, a portion of the goods worth birr 5,000 bought on
January 14 from Gibir Company were of the wrong size. Gibir Company acknowledged this and gave
IKa Company a 5% price allowance on January 17. What should IKA Company record on January 17?

Solution:

January 17 A/P…………………………………250

Purchase Returns and Allowance……250

Thus, Net Purchase = Purchase – (Purchase discount + Purchase return and allowance)

3.3.2. Transportation cost:

Once merchandise has been bought it has to be moved from the seller‘s place to the buyer‘s
place. A third party comes in to the scene here: the transportation company who moves the goods
between the two places.

So, the question is who is going to pay to the freighter (transportation) company. Who covers the
transportation costs depends on the agreement between the buyer and seller. The agreements are
usually stated in either of the following two terms:

1. FOB Destination – means ―free on board at destination ―. That is, since the destination of the goods
is the buyer‘s place, it is free at destination means transportation cost is paid when the goods are

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 loaded. It simply means the seller pays transportation cost. FOB Destination means goods are
shipped to their destination (to the buyer) with out transportation charge to the buyer.
2. FOB shipping Point –means ―free on board at shipping point‖. That is, goods are loaded (on a
truck or train) or shipped free of charge. It is, therefore, the buyer, which pays to the transportation
company when the goods reach the buyer (their destination) briefly, when the terms are FOB
Shipping Point the buyer pays transportation costs. Transportation costs paid by a buyer of
merchandise increase the cost of merchandise. They are recorded in a separate Transportation-In
account that is used to record freight costs incurred in the acquisition of merchandise.

3.3.3. Summary of Important Relationships on the Income State ment

1. Net sales = Gross sales- (Sales Discounts + Sales Returns and allowances)
2. Net purchases = Purchases – (Purchase Disc. + Purchase Return & allowance)
3. Total cost of Purchase = Net purchase + Transportation In
4. Cost of goods sold = Beg inventory + Total cost of purchase –Ending inventory
5. Gross profit = Net sales – Cost of goods sold
6. Net Income = Gross Profit – operating (i.e., selling & administrative) expenses.

4. CASH AND RECEIVABLES

4.1.Meaning of Cash

Cash includes money on deposit in banks and other items that a bankwill accept for immediate
deposit. Money on deposit in banks includes checking and saving accounts. Other items such as
ordinary checks received from customers, money orders, coins and currency and petty cash also
are included as cash. Banks do not accept postage stamps, travel advances to employees, notes
receivable or post-dated checks as cash.

4.1.1. Characteristics of cash

The following are some of the characteristics of cash:

a) Cash is used as medium of exchange

b) Cash is the most liquid asset
c) Cash is mostly affected by business transactions
d) Cash is used to measure the value of other assets
e) Cash is mostly exposed to embezzlements

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4.1.2. Inte rnal control over cash

The need to safeguard cash is crucial in most businesses because cash is mostly exposed to
embezzlement. Firms address this problem through the internal control system. An internal
control system is a set of policies and procedures designed to protect assets, provide accurate
accounting records and evaluate performances.

A sound internal control system for cash increases the likely hood that the reported values for
cash are accurate.

Inte rnal control for cas h should include the following procedures:

a) The individuals who receive cash should not also disburse (pay) cash
b) The individuals who handle cash should not access accounting records
c) Cash receipts are immediately recorded and deposited and are not used directly to make
payments.
d) Disbursements are made by serially numbered checks, only upon proper authorization by
someone other than the person writing the check
e) Bank accounts are reconciled monthly.
4.2.Receivables

Receivables are claims of various types by an entity for future receipts of cash originating from
normal business or other types of transactions. Transactions leading to the occurrence of
receivables include:

4.2.1. Classification of receivables

Receivables can be broadly classified into Trade Receivables and Non-trade Receivables.

 Trade Receivables describe amounts owed to the company for goods and services sold in the
normal course of business. Accounts Receivable and Notes Receivable are the typical
examples of trade receivables.
 Non-trade Receivable arise from many other sources, such as advance to employees, interest
receivables, rent receivables and loan to affiliated companies.
4.2.2. Inte rnal control over receivables

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The principles of internal control are required by organizations to safeguard their assets from any kind of
error and misconduct. These control procedures should apply on receivables because they are one of the
asset elements for the organization. For example, the individual responsible for sales should be separate
from the individual accounting for the receivables and approving credit. By doing so, the accounting and
credit approval functions serve as independent checks on sales. Separation of responsibility for related
functions reduces the possibility of errors and misuse of funds.

Adequate control over Accounts Receivable begins with the approval of the sales by a responsible
company official or the credit department, after the customer‘s credit rating has been reviewed. Likewise,
adjustments of Account Receivable, such as for sales return and allowance, and sales discount, should be
authorized or reviewed by a responsible party. Effective collection procedure should also be established
to ensure timely collection of receivables and to minimize losses from uncollectible accounts.

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COURSE: FUNDAMENTALS OF ACCOUNTING II
Learning outcomes

 Explain & apply different inventory costing methods

 Internalize the current Ethiopian payroll systems
 Understand the accounting for Partnership form of businesses in Ethiopia
 Analyze the formation, operations & management procedures of share companies in
Ethiopia

1 INVENTORIES
1.1.1. Meaning of Inventories

Inventories are asset items held for sale in the ordinary course of business or goods that will be
used or consumed in the production of goods to be sold. They are mainly divided into two major:
 Inventories of merchandising businesses
 Inventories of manufacturing businesses

i. Inventories of merchandising businesses are merchandise purchased for resale in the

normal course of business. These types of inventories are called merchandise
inventories.
ii. Inventories of manufacturing businesses manufacturing businesses are businesses that
produce physical output. They normally have three types of inventories. These are:

 Raw material inventory

 Work in process inventory
 Finished goods inventory

1.1.2. Inventory Costing Methods

One of the most important decisions in accounting for inventory is determining the per unit costs assigned
to inventory items. When all units are purchased at the same unit cost, this process is simple since the
same unit cost is applied to determine the cost of goods sold and ending inventory. But when identical
items are purchased at different costs, a question arises as to what amounts are included in the cost of
merchandise sold and what amounts remain in inventory. A periodic inventory system determines cost of
merchandise sold and inventory at the end of the period. We must record cost of merchandise sold and
reductions in inventory as sales occur using a perpetual inventory system. How we assign these costs to
inventory and cost of merchandise sold affects the reported amounts for both systems.

There are four methods commonly used in assigning costs to inventory and cost of merchandise sold.
These are:

i. FIFO (First-in first-out) iii. Weighted average

ii. LIFO (Last-in first-out) iv. Specific identification

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 i. First-in, First-out (FIFO)
This method of assigning cost to inventory and the goods sold assumes inventory items are sold in the
order acquired. This means the cost flow is in the order in which the expenditures were made. So, to
determine the cost of ending inventory, we have to start from the most recent purchase and continue to the
next recent. Because the first purchased items (old purchases) are the first to be sold they are used
(included) in the computation of cost of goods sold.
ii. Last-in first-out (LIFO)

This method of assigning cost assumes that the most recent purchases are sold first. Their costs are
charged to cost of goods sold, and the costs of the earliest purchases are assigned to inventory. The c ost
flow is in the reverse order in which expenditures were made.
In calculating the cost of goods sold, we will start from the earliest purchases.

iii. Weighted Average Method

This method of assigning cost requires computing the average cost per unit of merchandise available for
sale. That means the cost flow is an average of the expenditures.
To calculate the cost of ending inventory, we will calculate first the cost per unit of goods available for
sale

Average cost per unit = Cost of goods available for sale

Number of Units available for sale
Then the weighted average unit cost is multiplied by units on hand at the end of the period to calculate the
cost of ending inventory. Also, the same average unit cost is applied in the computation of cost of goods
sold.

iv. Specific Identification Method

When each item in inventory can be directly identified with a specific purchase and its invoice, we
can use specific identification (also called specific invoice pricing) to assign costs. This method is
appropriate when the variety of merchandise carried in stock is small and the volume of sales is
relatively small. We can specifically identify the items sold and the items on hand.

Exercise:

Beza Company began the year and purchased merchandise as follows:

Item Unit Unit Cost Total
Jan-1 Beginning inventory 80 units Br. 60 = Br. 4,800
Feb. 16 Purchas 400 units 56 = 22,400
Sep.2 Purchase 160 units 50 = 8,000
Nov. 26 Purchase 320 units 46 = 14,720
Dec. 4 Purchase 240 units 40 = 9,600
Total 1200 units Br. 59, 520

Assume based on physical count, the ending inventory at the end of accounting period consists of 300
units.

Required:

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Apply FIFO, LIFO and weighted average methods, and compute the cost of ending inventories and the
cost of goods sold using

2 ETHIOPIAN PAYROLL SYSTEM

Learning outcomes

 Internalize the current Ethiopian payroll systems

2.1.1. Definition of Payroll: - Refers to the total amount paid to employees of a firm as a
compensation for the services rendered to the firm for a certain period of time

2.1.2. Components of payroll in Ethiopia

A. Employees Number
B. Employees Name
C. Earnings (Gross Earnings) – money earned by an employee(s) of a firm from various sources. It
may include:
I. Basic Salary: – Is a flat monthly salary of an employee for carrying out the normal work
of employment
II. Allowances: – money paid monthly to an employee for special reasons, which may
include Position allowance, House allowance, Desert allowance, House, Hardship
allowance, Transportation allowance and other allowance
III. Overtime earnings: - is income from overtime work done during a specific payroll
period.

 Overtime work is the work performed by an employee beyond the regular working hours or
days. Over time earning depends on the duration of over time work done.
 To determine the over time income, first we have to compute the Regular Hourly rate or the
ordinary Hourly Rate. This is the payment per hour for regular or normal working hours. It is
determined as follows.
BsicSalary
Reg ular Ho urly Rate (RHR) =
Re gularworkinghours

 A worker who works over time shall be entitled to the following overtime payments in addition to
his/her normal salary.

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1. In the case of works performed between 6 (six) O‘clock in the morning (6 A.M) and 10 (ten) O‘clock
in the evening (10PM), the employee is entitled to be paid at the rate of one and one quarter (1 ¼)
multiplied by the regular hourly Rate.
Overtime Rate = 1.25 x RHR (Regular Hourly Rate)

2. In the case of night works performed between 10 (ten) O‘clock in the evening (10P.M) and 6 (Six)
O‘clock in the morning (6 A‘M), the employee is entitled to be paid at the rate of 1 ½ multiplied by
the regular Hourly rate
Over time Rate =1.5 x Regular Hourly Rate

3. In the case of works performed on weekly rest day, the employee is entitled to be paid at the rate of
2(two) Multiplied by regular Hourly rate.
Overtime Rate = 2x Regular Hourly Rate

4. In the case of works performed on public holidays, the employee is entitled to be paid at the rate of 2
(two) and one half (2 ½) multiplied by regular hourly rate
Overtime Rate = 2.5 x Regular Hourly Rate

Thus, Gross Earnings = Bsasic Salary + Allowance + Overtime +Other earnings

D. Deductions: - are subtractions made from the total (gross) earnings of an employee. Some of
these deductions are mandatory and others are permitted (authorized) by the employee
him/herself (voluntary deductions).
1- Mandatory deductions
(a) Employee Income tax: - is a mandatory deduction from earnings, which is required (authorized)
by the government. The Ethiopian employment income tax rate is a progressive income tax that
charges higher rates for higher earnings.

In Ethiopia, income tax is deducted from an employee whose earning exceeds Br 600. According to this
proclamation, the tax rates and the respective income range are shown in the following table:
Employment Income Tax Rate (in %) Deduction
(Per month) (in Birr)
Over Birr To Birr
0 600 0% -
601 1,650 10 % 60.00
1,651 3,200 15 % 142.50
3,201 5,250 20 % 302.50
5,251 7,800 25 % 565.00

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 7,801 10,900 30 % 955.00
Over 10,900 35 % 1500.00

(b) Pension contribution

In Ethiopia, Permanent employees of government organizations are required to pay or contribute 7% of

their basic salary to their pension plan. This amount is withheld by the employer from each employee on
every payroll data and latter paid to social security authority. The employer is also required to contribute
to employees‘ pension plan 11% of the basic salary of every permanent government employee. Therefore,
the total contribution to the pension trust fund is equal to 18% of the employee’s basic salary.

2. Voluntary deductions (Other deductions) - are deductions permitted or authorized by the

employee him/self, which includes: Contribution to credit association, Contributions to idir and the like,
Bank loan (repayment of loan), Health and life insurance, Donation to charitable organizations, Absentees,
Penalty and others - Like court order, fines, etc.

E) Net pays (Take home pay): is the difference between the gross earning of an employee and the
total of the deductions.

Net pay = Gross Earning – Total deductions

4. PARTNERSHIP IN ETHIOPIA

4.1. Definition of Partnership in Ethiopia: A general partnership is a business

organization consisting of partners who are each jointly and severally liable with the
partnership itself for the obligations of the
4.2. Characteristics of a partnership
4.3. Accounting for Partnership in Ethiopia

i. Formation of a partnership

Memorandum of Association: The Ethiopian commercial code, article 185 states that the memorandum
of association to be drawn by partners shall contain the following points.
1. the firm-name;
2. the head office and branches, if any;
3. the name, address and nationality of each partner;
4. the business purpose of the firm;
5. The amount of cash contribution of each partner, in the case of in-kind contributions,
their value and method of valuation;
6. Where there is a partner contributing skill, the services required from him;

22
 7. The share of each partner in the profits and losses, and mode of allocation of profits;
8. The manager and agent, if any, of the partnership, and powers and duties of the manager
9. The period of time for which the partnership has been established; other particulars
determined by the law or agreement of the partners.

Up on formation of a partnership a separate journal entry is made for the initial investments
of each partner as follows:
 the various assets contributed by a partner are debited to the proper asset accounts
 if liabilities are assumed by the partnership, the appropriate liability accounts are credited
 the partner‘s capital account is credited by the net amount(assets - liabilities)

ii. Allocation (Division) of Profits and Losses

 Unless otherwise agreed, every partner shall have an equal share in the profits and
losses, irrespective of the nature and amount of contribution he made to the
partnership.
 If the agreement specifies only either the share in the profits or losses, such
agreement shall apply equally to the share of profits and losses.

iii. Dissolution of a partnership

A. Admission of a partner

In the absence of a contrary provision in the memorandum of association, unanimous consent of

the partners is required to admit an outsider into the partnership.

B. Withdrawal of a partne r

 Transfer of Shares to Another Partner

Unless there is a contrary provision in the memorandum of association of the partnership, a
partner is entitled to transfer his share to another partner.
 Paying out a Partner Leaving
Where a partner leaves a partnership without transferring his share to another partner or a third
party and the partnership continues, he shall receive payment fixed by the agreement of the
partners.

Where there is no agreement concerning the matter, the amount money to be paid to the partner
who has left the partnership shall be determined taking into account contributions paid to the
partnership, his share of surplus assets left after settlement of the debts of the partnership or
accumulated profits and profits from dealings outstanding at the time of his departure.

iv. Liquidation of a partnership

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Liquidation is the process of breaking-up and discontinuing a partnership business. It is an end to the
business both economically and legally
Liquidation of a partnership involve four steps:
a. Asset realization-converting non cash assets in to cash
b. Recognizing gains/losses and distributing among each partners based on their profit or loss
sharing ratios
c. Payment of all liabilities
d. Distributing cash to the partners according to the final balances in their capital accounts

5. SHARE COMPANIES IN ETHIOPIA

5.1. Definition of Share Company
A share company is a company whose capital is fixed in advance and divided into shares and
whose liabilities are met only by the assets of the company. The obligation of the shareholders
shall be limited to making the contribution they pledged to make to the company.

5.2. FORMATION OF SHARE COMPANY IN ETHIOPIA

5.3. MANAGEMENT OF SHARE COMPANIES IN ETHIOPIA

5.3.1. The Board of Directors (Article 296)

 A company shall have not less than three or more than thirteen directors who shall be
elected by the shareholders. Two-thirds of members of the board of directors may not
play a role in the day-to-day management of the affairs of the company.
 Persons who are not shareholders may be elected as members of the board of directors.
However, the number of non-shareholder directors may not exceed one-thirds of the total
membership of the board of directors.
 Where the memorandum of association does not clearly specify the number of directors,
the meeting of subscribers shall decide the number of directors to be appointed.

5.3.2. Powers of the Board of Directors (Article 324)

 The board shall have such powers as are given to it by law, the memorandum of
association and resolutions passed at general meetings of shareholders.
 The memorandum of association shall specify whether the directors are jointly
responsible as managers and agents of the company or whethe r one only of the directors
is responsible for this purpose.
 Directors authorized to act as agents for the company may exercise in its name their
powers as agents. Any restriction on their powers shall not affect third parties acting in
good faith.

5.3.3. Liability of Directors to the Company (Article 325)

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  Directors shall be jointly and severally liable to the company for damages caused by failure to
carry out their duties. Directors shall bear the burden of proof for showing that they have exercised
due care and diligence.

5.4. GENERAL MANAGER AND SECRETARY

5.4.1. General Manager

 A company shall have a general manager appointed by the board of directors. The general
manager shall be accountable to the board of directors.
 The board may revoke the appointment of the general manager; The general manager shall have no
right to be reinstated as a general manager even where he has been dismissed without good cause;
however, the board may reappoint him.
 The general manager is an employee of the company; he may be a member of the board of
directors; He may not be the chairperson of the board.

Powers and Duties of the General Manager

1. The general manager is responsible for the general day-to-day management of the company. In the
absence of a provision to the contrary in the memorandum of association, he represents it in its
dealings with third parties.
2. Without prejudice to the generality of Sub-Article of this Article he shall have the duties that follow:
a) Sign and transfer negotiable instruments especially commercial instruments, transferable
securities and documents of title to goods;
b) Discharge responsibilities entrusted to him by the memorandum of association;
c) Discharge responsibilities entrusted to him by the board of directors and implement its decisions;
d) Preparation of annual work plan and budget of the company and implementing the same upon
approval by the board of directors; and
e) Hiring, managing and firing the employees of the company, as necessary.

5.4.2. Secretary
 A company shall have a secretary; the hiring and firing of the secretary shall be approved by the
board of directors upon the recommendation of the general manager.
 The secretary shall be accountable to the general manager.

Powers and Duties of the Secretary

A company`s secretary shall have the following powers and duties:

1. Organize and keep information and records of the company;

2. Provide reports and other necessary information promptly to concerned body;
3. Provide information to shareholders and third parties;
4. Organize meetings of shareholders and members of the board of directors;
5. prepare, organize and keep minutes; and
6. Carry out other tasks assigned to him by the general manager and memorandum of association.

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 COURSE: INTERMEDIATE FINANCIAL ACCOUNTING

1. Introduction to Financial Accounting and the Conceptual Frame

work
1.1 INTRODUCTION
Fair presentation of financial affairs is the essence of accounting theory and practice. With the increasing
size and complexity of business enterprises and the increasing economic role of government, the
responsibility placed on accountants is greater today than ever before. If accountants are to meet this
challenge, they must have a logical and consistent body of accounting theory to guide them. This
theoretical structure must be realistic in terms of the economic environment and must be designed to meet
the needs of users of financial statements.

Financial statements and reports prepared by accountants are vital to the successful working of society.
Creditors, Economists, investors, business executives, labor leaders, bankers, and government officials all
rely on these financial statements and reports as fair and meaningful summaries of day-to-day business
transactions In addition, these groups are making increased use of accounting as a base for forecasting
future economic trends.

1.2 The International Accounting Standards Board (IASB)

The International Accounting Standards Board (Board) is the standard-setting body of the IFRS
Foundation. Selected, overseen and funded by the IFRS Foundation, the Board has complete
responsibility for technical matters, including the preparation and issuing of IFRS Standards. The
Trustees of the IFRS Foundation are responsible for governance and oversight. A Monitoring Board
provides a formal accountability link between the Trustees and public authorities.

1.2.1 What is IFRS?

IFRS is a globally recognized set of Standards for the preparation of financial statements by business
entities.

IFRS is a set of globally accepted standards for financial reporting allowed primarily by listed
entities in over 144 countries across the world.
The overriding requirement of IFRS is for the financial statements to give a fair presentation (or
a true and fair view).
IFRS are referred to as being principles-based standards which Provides core principles
(objectives) with minimum guidance.They are also more loosely framed, allowing for
professional judgment to be applied
Benefits of IFRS

 Credibility of local market to foreign investors

 More cross-border investment
 Comparability across political boundaries

26
  Facilitates global education and training
 Facilitates raising capital abroad
 One set of books + easier consolidation
 Better understanding of financial statements from business partners abroad
 G20 , WB , IMF , International Organization of Securities Commissions and International
Federation of Accountants
1.1.2 The IASBs Conceptual Framework for financial reporting

Conceptual Frame work is a statement of generally accepted theoretical principles which form the frame
of reference for financial reporting. It sets out the concepts that underlie the preparation and presentation
of financial statements.

Why is a conceptual framework necessary?

First, to be useful, standard setting should build on and relate to an established body of concepts and
objectives. A soundly developed conceptual framework should enable the development and issuance of a
coherent set of standards and practices built upon the same foundation.

Second, a conceptual framework should increase financial statement users‘ understanding of and
confidence in financial reporting.

Third, such a framework should enhance comparability among the financial statements of different
companies. Similar events should be similarly accounted for and reported; dissimilar events should not
be.

Fourth, new and emerging practical problems should be solved more quickly by referring to an existing
framework of basic theory

The Conceptual Framework distinguishes between fundamental and enhancing qualitative

characteristics, for analysis purposes. Fundamental qualitative characteristics distinguish useful financial
reporting information from information that is not useful or that is misleading.

Enhancing qualitative characteristics distinguish more useful information from less useful information.

a. FIRST LEVEL
OBJECTIVES OF FINANCIAL STATEMENTS

The objective of financial statements is to provide information about the financial position (balance
sheet), performance (income statement), and changes in financial position (cash flow statement) of an
entity; this information should be useful to a wide range ofusers for the purpose of making economic
decisions, focusing on users who cannot dictatethe information they should be getting.

The objective of general-purpose financial reporting is to provide financial information about the
reporting entity that is useful to existing and potential investors, lenders, and other creditors in making
decisions about providing resources to the entity.

b. SECOND LEVEL

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  QUALITATIVE CHARACTERISTICS OF FINANCIAL REPORTING
1. The fundamental qualitative characteristics
If financial information is to be useful, it must be relevant and faithfully represent what it purports to
represent (i.e. fundamental qualities). Financial information without both relevance and faithful
representation is not useful, and it cannot be made useful by being more comparable, verifiable, timely or
understandable.

 Relevance: Relevant information is capable of making a difference in the decisions made by users. It
is capable of making a difference in decisions if it has predictive value , confirmatory value or both.
 Predictive value (input to predict future cash flows): Accounting information should be helpful
to external decision makers by increasing their ability to make predictions about the outcome of
future events. Decision makers working from accounting information that has little or no
predictive value are merely speculating.
 confirmatory value (confirm/disconfirm prior cash flow expectations): Accounting information
should be helpful to external decision makers who are confirming past predictions or making
updates, adjustments, or corrections to predictions.
 Materiality: Materiality is an entity specific aspect of relevance based on the nature or
magnitude, or both, of the items to which the information relates in the context of an individual
entity‘s financial report. Consequently, an entity need not apply its accounting policies to
immaterial items; and disclose immaterial information.
 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 phenomena that it purports to represent.
 Completeness: A complete depiction includes all information necessary for a user to understand
the phenomenon being depicted, including all necessary descriptions and explanations.
 Neutrality: Accounting information must be free from bias regarding a particular view point,
predetermined result, or particular party. Preparers of financial reports must not attempt to induce
a predetermined outcome or a particular mode of behavior (such as to purchase a company‘s
stock). Accounting information cannot be selected to favor one set of interested parties over
another. It should be factual and truthful this means that information must not be manipulated in
any way in order to influence the decisions of users.
 Free from error: Free from errormeans there are no errors or omissions in the description of the
phenomenon and no errors made in the process by which the financial information was produced.
It does not mean that no inaccuracies can arise, particularly where estimates have to be made
2. Enhancing qualitative characteristics
 Timeliness: means available to decision makers before it loses its capacity to influence their
decisions. Accounting information should be timely if it is to influence decisions, like the news of the
world; state financial information has less impact than fresh information.
 Understandability: Classifying, characterizing and presenting information clearly and concisely
make it understandable. Some phenomena are inherently complex and cannot be made easy to
understand. Excluding information about those phenomena from financial reports might make the
information in those financial reports easier to understand. However, those reports would be
incomplete and therefore potentially misleading.

28
Financial reports are prepared for users who have a reasonable knowledge of business and economic
activities and who review and analyses the information diligently. At times, even well-informed and
diligent users may need to seek the aid of an adviser to understand information about complex economic
phenomena.

 Verifiability: - Verifiability pertains to maintenance of audit trials to information source documents

that can be checked for accuracy. It also pertains to the existence of alternative information sources
as backing. Verification implies a consensus and implies that independent measures using the same
measurement methods would reach substantially the same conclusions.
 Comparability: Information should be presented in a consistent manner over time and in a consistent
manner between entities to enable users to make significant comparisons. 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 another date.Users‘ decisions
involve choosing between alternatives, for example, selling or holding an investment, or investing in
one reporting entity or another.
 ELEMENTS OF FINANCIAL STATEMENTS
An important aspect of the theoretical structure is the establishment and definition of the basic categories
of items to be included in financial statements. At present, accounting uses many terms that have peculiar
and specific meaning in the language of business. One such term is asset. Is it something we own? If the
answer is yes, can we assume that any asset leased would never be shown on the balance sheet? Is it
anything of value used (or for which there is a right to use) by the enterprise? If the answer is yes, then
why the management of the enterprise should not be reported as an asset? It seems necessary, therefore,
to develop a basic definitional framework for the elements of accounting. Such definitions provide
guidance for identifying what to include and what to exclude from the financial statements.

SFAC No.6 defines 10 elements of financial statements as follows:

1. Assets
Assets are probable future economic benefits obtained or controlled by a particular entity as a result of
past transactions or events. They have three essential characteristics:

a) They embody a future benefit that involves a capacity, singly or in combination with other
assets to contribute directly or indirectly to future net cash flows.
b) The entity can control access to the benefit
c) The transaction or event-giving rise to the entity‘s right to, or control of, the benefit has
already occurred (result of past transactions).
2. Liabilities
Liabilities are probable future sacrifices of economic benefits arising from present obligations of a
particular entity to transfer assets or provide services to other entities in the future as result of past
transactions or events. They have three essential characteristics.

a) They embody a duty or responsibility to others that entails settlement by future transfer or use of
assets, provision of services or other yielding of economic benefits, at a specified or determinable
date, on occurrence of a specified event, or on demand.
b) The duty or responsibility obligates the entity, leaving it little or no discretion to avoid it.

29
 c) The transaction or event obligating the entity has already occurred.
3. Equity
Equity is the residual (ownership) interest in the assets of an entity that remains after deducting its
liabilities. While equity in total is a residual, it includes specific categories of items, for example, types of
share capital, contributed surplus and retained earnings

4. Income
Income: Increase in economic benefits during the accounting period in the form of inflows or
enhancements of assets or decreases of liabilities those results in increases in equity, other than those
relating to contribution from equity participants.

5. Expenses
Expenses: decrease in economic benefits during the accounting period in the form of outflows or
depletions of assets or incurrence of liabilities those results in decreases in equity, other than those
relating to distribution to equity participants.

THIRD LEVEL: recognition, measurement and disclosure concepts

Recognition: The process of incorporating in the statement of financial position or statement of profit or
loss and other comprehensive income an item that meets the definition of an element and satisfies the
following Criteria for recognition:

 it is probable that any future economic benefit associated with the item will flow to or from the
entity; and
 the item has a cost or value that can be measured with reliability
Measurement: The process of determining the monetary amounts at which the elements of the financial
statements are to be recognized and carried in the statement of financial position and statement of profit
or loss and other comprehensive income.

Disclosure to compliance with IFRS: Most importantly, financial statements should present fairly the
financial position, financial performance and cash flows of an entity. Compliance with IFRS is
presumed to result in financial statements that achieve a fair presentation.

IAS 1 stipulates that financial statements shall 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 Conceptual Framework.

The following points made by IAS 1 expand on this principle.

(a) Compliance with IFRS should be disclosed

(b) All relevant IFRS must be followed if compliance with IFRS is disclosed

(c) Use of an inappropriate accounting treatment cannot be rectified either by disclosure of accounting
policies or notes/explanatory material

30
IAS 1 states what is required for a fair presentation.

 Selection and application of accounting policies

 Presentation of information in a manner which provides relevant, reliable, comparable and
understandable information
 Additional disclosures where required

Summary of conceptual frame work for financial reporting

31
1.4 IFRS Based financial statements (IAS 1)
1.4.1 STATEMENT OF PROFIT OR LOSS AND RELATED INFORMATION

The Statement of profit or loss (SPL) is the report that measures the success of company operations for
a given period of time. (It is also often called the statement of income or statement of earnings.) The
statement of income includes revenues, gains, expense and losses recognized by the firm for a specified
period of time.

Elements of the SPL

Net income results from revenue, expense, gain, and loss transactions.

 The two major elements of SPL

Income: Increases in economic benefits during the accounting period in the form of inflows or
enhancements of assets or decreases of liabilities that result in an increase in equity, other than those
relating to contributions from equity participants.

The definition of income includes both revenues and gains. Revenues arise from the ordinary activities of
a company and take many forms, such as sales, fees, interest, dividends, and rents. Gains represent other
items that meet the definition of income and may or may not arise in the ordinary activities of a company.
Gains include, for example, gains on the sale of long-term assets or unrealized gains on trading securities.

Expenses:

Decreases in economic benefits during the accounting period in the form of outflows or depletions of
assets or incurrence‘s of liabilities that result in decreases in equity, other than those relating to
distributions to shareholders.

The definition of expenses includes both expenses and losses. Expenses generally arise from the ordinary
activities of a company and take many forms, such as cost of goods sold, depreciation, rent, salaries and
wages, and taxes. Losses represent other items that meet the definition of expenses and may or may not
arise in the ordinary activities of a company. Losses include losses on restructuring charges, losses re lated
to sale of long-term assets, or unrealized losses on trading securities

Specific elements of SPL include:

1. Sales or Revenue Section. Presents sales, discounts, allowances, returns, and other related
information. Its purpose is to arrive at the net amount of sales revenue.
1. Cost of Goods Sold Section.
Shows the cost of goods sold to produce the sales revenue

Gross Profit: Revenue less cost of goods sold.

2. Selling Expenses. Reports expenses resulting from the company's efforts to make sales.
3. Administrative or General Expenses: Reports expenses of general administration.
5. Other Income and Expense. Include most other transactions that do not fit into the revenues and
expenses categories provided above. Items such as gains and losses on sales of long-lived assets,

32
impairments of assets, and restructuring charges are reported in this section. In addition, revenues such as
rent revenue, dividend revenue, and interest revenue are often reported.

6. Financing Costs.
A separate item that identifies the financing cost of the company, hereafter referred to as interest expense.

7. Income Tax.
A short section reporting taxes levied on income from Continuing Operations. A company's results before
any gain or loss on discontinued operations. If the company does not have any gain or loss on
discontinued operations, this section is not reported and this amount is reported as net income.

8. Discontinued Operations.
Gains or losses resulting from the disposition of a component of a company

Net Income: The net results of the company's performance over a period of time

9. Non-Controlling Interest: Presents an allocation of net income to the controlling shareholders

and to the non-controlling interest (also referred to as minority interest).
10. Earnings per Share: portions of net income retained for the purpose of reinvestment is allocate for
the outstanding number of common share.
Statement of profit or loss
A recommended format is as follows:

XYZ
Statement of profit or loss and other comprehensive income
For the year ended 31 December 20X2
$
Revenue……….……………………………………………………….…XX
Cost of sales ………………………………………………..……….…. (XX)
Gross profit …………………………………………………………...…XX
Distribution costs……………………………………………………… (XX)
Administrative expenses ……………………………………………….(XX)
Profit from operations ……………………………………………..….XX
Finance costs …………………………………………………………. (XX)
Investment income……………………………………………………...XX
Profit before tax……………………………………………………….. XX
Income tax expense…………………………………………………….(XX)
Profits for the year…………………………………………………… .XXX
Other comprehensive income
Gain/loss on revaluation (PPE and intangible assets)…………………………..…....XX
Gains and losses arising from translating a foreign operation……………………….XX
Gains and losses on re-measuring of financial assets held -for-sale……..………….XX
Gains and losses on hedging instruments……………………………………… …..XX
Total comprehensive incomes for the year ……………………………….……….XXX
Comprehensive Income

33
All changes in equity during a period except those resulting from investments by owners and
distributions to owners Includes, all revenues and gains, expenses and losses reported in net
income, and all gains and losses that bypass net income but affect equity.
Companies generally include in income all revenues, expenses, and gains and losses recognized during
the period. These items are classified within the income statement so that financial statement readers can
better understand the significance of various components of net income. Changes in accounting principle
and corrections of errors are excluded from the calculation of net income because their effects relate to
prior periods.

In recent years, use of fair values for measuring assets and liabilities has increased. Furthermore,
possible reporting of gains and losses related to changes in fair value has placed a strain on income
reporting. Because fair values are continually changing, some argue that recognizing these gains and
losses in net income is misleading. The IASB agrees and has identified a limited number of transactions
that should be recorded directly to equity. One example is unrealized gains and losses on non-trading
equity securities.

These gains and losses are excluded from net income, thereby reducing volatility in net income due to
fluctuations in fair value. At the same time, disclosure of the potential gain or loss is provided.
Companies include these items that bypass the income statement in a measure called comprehensive
income. Comprehensive income includes all changes in equity during a period except those resulting
from investments by owners and distributions to owners. Comprehensive income, therefore, includes the
following: all revenues and gains, expenses and losses reported in net income, and all gains and losses
that bypass net income but affect equity. These items non-owner changes in equity that by pass the
income statement are referred to as other comprehensive income.

Companies must display the components of other comprehensive income in one of two ways: (1) a
single continuous statement (one statement approach) or (2) two separate but consecutive statements of
net income and other comprehensive income (two statement approaches). The one statement approach is
often referred to as the statement of comprehensive income. The two statement approach uses the
traditional term income statement for the first statement and the comprehensive income statement for the
second statement.

1.4.2 STATEMENT OF FINANCIAL POSITION

Statement of Financial Position, also known as the Balance Sheet, presents the financial position of an
entity at a given date. It is comprised of three main components: Assets, liabilities and equity.

The balance sheet provides economic information about an entity‘s resources (assets), claims
against those resources (liabilities) and the remaining claim accruing to the owners (owners‘
equity).
Statement of financial position is basically a historical statement, because it shows the
cumulative effect of past transactions and events.
Elements of the Statement of Financial Position

34
  Asset: Resource controlled by the entity as a result of past events and from which future
economic benefits are expected to flow to the entity.
 Liability: 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.
 Equity: Residual interest in the assets of the entity after deducting all its
1. Assets

Property, plant, and equipment: are tangible long-lived assets used in the regular operations of the
business. These assets consist of physical property such as land, buildings, machinery, furniture, tools,
and wasting resources (minerals). With the exception of land, a company either depreciates (e.g.,
buildings) or depletes (e.g., oil reserves) these assets.

Long-term investments: often referred to simply as investments, normally consist of:

 Investments in securities, such as bonds, ordinary shares, or long-term notes

 Investments in tangible assets not currently used in operations, such as land held for speculation.

Intangible assets: lack physical substance and are not financial instruments. They include patents,
copyrights, franchises, goodwill, trademarks, trade names, and customer lists. A company writes off
(amortizes) limited-life intangible assets over their useful lives.

Financial assets: result from financial instruments or contracts of the business such as; Cash, Cash
equivalent and receivables

Cash and cash equivalents: Cash. Cash is generally considered to consist of currency and demand
deposits (monies available on demand at a financial institution). Cash equivalents are short-term highly
liquid investments that will mature within three months or less. Most companies use the caption ―Cash
and cash equivalents,‖ and they indicate that this amount approximates fair value.

Investment property: is property (land or a building – or part of a building – or both) held (by the owner
or by the lessee under a finance lease) to earn rentals or for capital appreciation or both.

Inventories: Inventories consist of goods owned by a business and held either for use in the manufacture
of products or as products awaiting sale.

Prepaid expenses: advance payments of a company

Agricultural activity: is the management by an enterprise of the biological transformation of biological

assets for sale into agricultural produce or into additional biological assets

 Biological assets. Living plants and animals.

 Agricultural produce. The product of the entity‘s biological assets, for example, milk and
coffee beans
2. Liabilities

Non-current liabilities are obligations that a company does not reasonably expect to liquidate within the
longer of one year or the normal operating cycle. Instead, it expects to pay them at some date beyond that

35
time. The most common examples are bonds payable, notes payable, some deferred income tax amounts,
lease obligations, and pension obligations.

Current liabilities are the obligations that a company generally expects to settle in its normal operating
cycle or one year, whichever is longer. This concept includes:

1. Payables resulting from the acquisition of goods and services: accounts payable, salaries and wages
payable, income taxes payable, and so on.

2. Collections received in advance for the delivery of goods or performance of services, such as unearned
rent revenue or unearned subscriptions revenue.

3. Other liabilities whose liquidation will take place within the operating cycle or one year, such as the
portion of long-term bonds to be paid in the current period, short term obligations arising from purchase
of equipment, or estimated liabilities, such as a warranty liability.

Financial liabilities: liabilities resulted from contractual obligations of firms

3. Owner’s Equity
The owners‘ equity in a business enterprise is the residual interest in assets, after liabilities have
been deducted.
Owners‘ equity for a corporation is called stockholders‘ equity; the most commonly reported
sources are:
Capital Stock It is the firm‘s stated or legal capital. It is the par value of the issued or
outstanding preferred and common stock of the corporation and represents the amount that is not
available for dividend declarations. Legal capital is specified by state law and the articles of
incorporation (the charter) of the corporation.
Contributed capital in excess of par (or stated value) If reports the value of assets received by
the corporation above the par (or stated value) of the capital stock given in exchange. These
amounts usually arise when the corporation sells its stock above par (or the stated amount per
share) or issues stock dividends. Sometimes called additional paid- in capital or premium on
stock, it is considered legal capital in most instances.
Retained Earnings It is essentially corporations‘ accumulated net earnings, fewer dividends
paid out, since the company‘s inception. In many corporations, retained earnings are the largest
amount in the owners‘ equity section.

STATEMENT OF RETAINED EARNINGS

A statement of retained earnings often presented as a supplement to the financial statements. The
purpose of statements of retained earnings is to reconcile the beginning and ending balances of
retained earnings, showing all changes in retained earnings, d uring the accounting period, and to
provide connecting link between the income statement and the balance sheet.
The ending balance of retained earnings is reported on the balance sheet as one element of
owners‘ equity. Major components of a statement of retained earnings are:

36
 1. Net income or loss for the period
2. Dividends
Stock dividends and
Cash dividends
Disclosure of cash dividends per share also is made in the statement of retained earnings.
The format of the statement of retained earnings is presented below:
MATY Corporation
Statement of Retained Earnings
For the year ended Decembe r 31, 2018
Retained earnings, beginning of the year--------------------------- -- ---------Br. xxx
Add: Net income ----------------------------------------------------------------------xxx
Subtotal --------------------------------------------------------------------------------- xxx
Less: Cash dividends on preferred stock -----------------------------Br. xxx
Cash dividends on common stock ----------------------------------xxx (xxx)
Retained Earnings, end of year ---------------------------------------------------------xxxx
Earnings per share . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .XXX
1.4.3 STATEMENT OF CHANGE IN EQUITY
A financial statement that lists the beginning and ending balances of each equity account and
describes all the changes that occurred during the year.

MATY CORPORATION
Statement of Stockholders’ Equity
For the year ended Dec. 31, 2018
Capital stocks
preferred stock - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - xx
common stock - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - xx
additional paid in capital in excess of par- - - - - - - - - - - - - - - - - - - - - xx
retained earnings beginning of year- - - - - - - - - - - - - - - - - - - - xx
add: net income - - - - - - - - - - - - - - - - - - - - - - - - - - - - xx
Less: cash dividends
preferred stock dividend- - - - - - - - - - - - - - - - - - - - - - (xx)
common stock dividend- - - - - - - - - - - - - - - - - - - - - - - (xx)
subtotal - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - xx
retained earnings ending- - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - -xx
total stock holders‘ equity- - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - XXX

37
38
 2. FAIR VALUE MEASUREMENT AND IMPAIRMENT
Part I: Fair value measurement
2.1 Objectives and scope

 Sets out in a single IFRS a framework for measuring fair value and the required disclosures.
 IFRS 13 Fair Value Measurement applies when another IFRS requires or permits either :
◦ Fair value measurements, and/or
◦ Disclosures about fair value measurements.
Exclusions:

 The measurement and disclosure requirements of IFRS 13 do not apply to:

◦ Share-based payment transactions within the scope of IFRS 2 Share-based Payment,
◦ Leasing transactions within the scope of IAS 17 Leases,
◦ Measurements that appear similar to fair value, but which are not the same, such as: Net
realisable value in IAS 2 Inventories, Value in use in IAS 36 Impairment of Assets.
Definition

 IFRS 13 does not establish which items are to be measured and/or disclosed at fair value, these
requirements being included in other IFRSs
 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 the measurement date.
 This definition of fair value is sometimes referred to as an ‗exit price‘.
 As per the definition, the fair value of an asset is:
 the price that would be received to sell an asset (exit price)
 in an orderly transaction (not a forced sale/liquidation)
 between market participants (market-based view, independent buyers & sellers-not
related parties)
 at the measurement date (current price)
 Market participant perspective: consequently, the entity‘s intention to hold an asset is not relevant
when measuring fair value.
Characteristics of fair value

 a market value (not entity-specific value)

 an exit value
 reflects all changes that market participants factor into pricing at the measurement date
 requires judgement to measure (especially Level 3 measurements)
 determine the appropriate valuation technique/s and inputs that market participants would
use when pricing the asset or liability
What the IASB says about fair value

 Has predictive value and confirmatory value (provides relevant information)

◦ Fair value reflects expectations about the amount, timing and uncertainties of
the cash flows (reflecting market participants‘ expectations).

39
  Provides comparable information (between entities and within an entity)market participant
perspective, identical assets (absent estimation error) measured at the same amount
irrespective of when and for what purpose they are acquired
Fair value hierarchy
 Level 1 – highest priority is given to quoted prices in active markets for identical assets or
liabilities
 Level 2 – observable inputs not included in level 1 (e.g. quoted prices for similar assets or
liabilities in active markets, quoted prices for identical or similar assets or liabilities in markets
that are not active)
 Level 3 – unobservable inputs developed using best information available (e.g. entity‘s own data)
Level 2 inputs:
 Quoted prices for similar assets or liabilities in active markets.
 Quoted prices for identical or similar assets or liabilities in markets that are not active.
 Inputs other than quoted prices that is observable for the asset or liability. Examples:-
 interest rates and yield curves observable at commonly quoted intervals; Implied volatilities; loss
severities; credit risks; a default rates
 Inputs that are derived principally from or corroborated by observable market data that, through
correlation or other means, are determined to be relevant to the asset or liability being measured
(market-corroborated inputs).
Adjustments made to Level 2 inputs necessary to reflect fair value, if any, will vary depending on
an analysis of specific factors associated with the asset or liability being measured. These factors
include:
 Condition
 Location
 Extent to which the inputs relate to items comparable to the asset or liability.
 Volume and level of activity in the markets in which the inputs are observed.
Fair value measurement techniques
 When transactions are directly observable in a market, the determination of fair value can
be relatively straightforward. In other circumstances, a valuation technique is used.
 IFRS 13 describes three valuation techniques:
1. Market approach – uses price information generated by market
transactions
2. Income approach – converts future amounts (e.g. cash flows or income
and expenses) to a single (present value) amount
3. Cost approach – determines the value that reflects current replacement
cost
 Valuation techniques used to measure fair value should maximise the use of relevant observable
inputs and minimise the use of unobservable inputs
 Observable inputs – developed using market data such as publicly available information about
actual events or transactions
Unobservable inputs – market data not available and developed using best information available about
assumptions that market participants would use
Fair value: non-financial asset

40
When determining the fair value of non-financial assets and liabilities, it is important to consider the
following fair value concepts:

 Selecting the appropriate market

 Identifying market participants
 Using market participant assumptions
 Determining the highest and best use of the asset
 Applying appropriate valuation techniques
Disclosure
An entity shall disclose information that helps users of its financial statements assess both of the
following:

 For assets and liabilities that are measured at fair value on a recurring or non-recurring basis in
the SFP after initial recognition, the valuation techniques and inputs used to develop those
measurements.
 For recurring fair value measurements using significant unobservable inputs (Level 3), the effect
of the measurements on profit or loss or other comprehensive income for the period.
Part II: IMPAIRMENT OF ASSETS (IAS 36)
Impairment = sudden diminution in value of an individual non-current asset or cash generating unit (CGU)

Impairment ‗concept‘: an asset should not be measured at an amount greater than the entity expects to
recover from its sale or use.

CGU is the smallest identifiable group of assets that generates cash inflows that are largely independent
of the cash inflows from other assets or groups of assetsCGUs are likely to follow the way in which
management monitors and makes decisions about continuing/discontinuing different parts of the business.

Fundamental principles

 To prescribe the procedures to ensure that non-current assets and CGUs are recorded at no
more than their recoverable amounts
 Recoverable amount is the higher of fair value less costs of disposal (FVLCD) and value in
use (VIU)
An impairment loss is the amount by which the carrying amount (NBV) of an asset or CGU exceeds its
recoverable amount.

Example: The impairment decision (1)

Take an asset at 31 December 2012:

Carrying amount €10,000

Fair value less costs to sell €12,000

Value in use €13,000 – take higher

41
No impairment because carrying amount < recoverable amount.

Example: The impairment decision (2)

Take an asset at 31 December 2012:

Carrying amount €10,000

Fair value less costs to sell €8,000

Value in use €9,000 – take higher

Impairment = carrying amount less recoverable amount = €10,000 - €9,000 = €1,000

The main accounting issues of IAS 36

 How is it possible to identify when an impairment loss may have occurred?

 How should the recoverable amount of the asset be measured?
 How should an 'impairment loss' be reported in the accounts?
Identifying an asset that may be impaired

External sources

 decline in assets‘ market value

 adverse changes in technological, market, economic or legal environment
 market interest rates
 carrying amount of the net assets is more than market capitalisation
Internal sources

 Obsolescence or physical damage of an asset

 Plans for a significant reorganisation/discontinuation or sale of an asset
 evidence that an asset‘s performance is worse than expected
Measuring recoverable amount

 Fair value less costs of disposal

 Value in use
Fair value less costs of disposal (FVLCD)

 The best evidence of an asset‘s FVLCD is a price in a binding sale agreement in an arm‘s length
transaction, after adjustment for incremental costs of disposal
 If there is no binding sale agreement, but the asset is traded in an active market, FVLCD is the
market price less costs of disposal. (The appropriate market price is usually the current bid price.)
 If there is no binding sale agreement or active market for an asset, FVLCD is calculated as
expected selling price in an arm‘s length transaction less direct costs of selling, such as stamp
duty or legal costs (but not items such as associated redundancy costs)
Value in use (VIU) or economic value (EV)

42
  VIU or EV is the present value of the future cash flows derived by the asset from its continuing
use and ultimate disposal
 Two key decisions – the discount rate to be used and estimating future cash flows
Characteristics of value in use

 is an entity-specific value
 takes account of uncertain future events, taking account of all possible outcomes in an unbiased
manner
 reflect changes in expected future cash flows, changes in interest rates and changes in the amount
of risk or in its price
 requires judgement to measure:
 determining discount rates/s
 estimating future cash flows from use and disposal

43
 3. ACCOUNTING FOR CASH & RECCIEVABLES
Part I: Accounting for cash
Cash includes money on deposit in banks and other items that a bank will accept for immediate deposit.
Money on deposit in banks includes checking and saving accounts. Other items such as ordinary checks
received from customers, money orders, coins and currency and petty cash also are included as cash.

To be report as ―cash‖ it must be readily available for the payment of current obligations, it must be free
from any contractual restriction that limits its use in satisfying debts.

 THE INTERNAL CONTROL OF CASH

The need to safeguard cash is crucial in most businesses because cash is mostly exposed to embezzlement.
Firms address this problem through the internal control system. An internal control system is a set of
policies and procedures designed to protect assets, provide accurate accounting records and evaluates
performances.

Internal control for cash should include the following procedures:

f) The individuals who receive cash should not also disburse (pay) cash
g) The individuals who handle cash should not access accounting records
h) Cash receipts are immediately recorded and deposited and are not used directly to make payments.
i) Disbursements are made by serially numbered checks, only upon proper authorization by
someone other than the person writing the check
j) Bank accounts are reconciled monthly.
Reconciliation of Bank and Book Cash Balances

Monthly reconciling of the bank balance with the depositor‘s cash accounts balance is essential cash
control procedure. To reconcile a bank statement means to verify that the bank balance and the
accounting records of the depositor are consistent. The balance shown in a monthly bank statement
seldom equals the balance appearing in the depositor‘s accounting records. Certain transactions recorded
by the depositor may not have been recorded by the bank and vice versa.

The most common examples that cause disparity between the two balances are:

a) Outstanding checks: Checks issued and recorded by the company, but not yet presented to the
bank for Payment.
b) Deposits in transit: Cash receipts recorded by the depositor, but not reached the bank to be
included in the bank statement for the current month.
c) Service charges: Banks often charge a fee for handling checking accounts. The amount of this
charge is deducted by the bank form bank balance and debit memo is issued for the depositor.
d) Charges for depositing NSF- checks: NSF stands for ―Not Sufficient Funds.‖ When checks are
deposited in an account,
The bank generally gives the depositor immediate credit. On occasion, one of these

Checks may prove to be uncollectible because the maker of the check does not

44
 Have sufficient funds in his or her account. In such a case, the bank will reduce the

Depositor‘s account by the amount of this uncollectible item and return the check

To the depositor marked ―NSF‖.

e) Notes collected by bank: If the bank collects a note receivable on behalf of the depositor, it
credits the depositor‘s account and issues a credit memorandum for the depositor.
f) Any errors in the bank statement or depositor‘s accounting records are adjusted.
g) The equality of adjusted balance of statement and adjusted balance of the depositor‘s record is
compared.
h) Journal entries are prepared to record any items delayed by the depositor.
When the depositor prepares bank reconciliation, the balances shown in the bank statement and in the
accounting records both are adjusted for any unrecorded transactions. Additional adjustments may be
required to correct any errors discovered in the bank statements or in the accounting records.

Illustration of Bank Reconciliation

The cash account for Alpine Sports Co. on April 30, 2016, indicated a balance of $14,284.88 and
the cash at bank statement indicated a balance of $18,880.45. Comparing the bank statement, the
canceled checks, and the accompanying memorandums with the records revealed the following
reconciling items:
 A deposit of $3,481.70, representing receipts of April 30, had been made too late to appear on the
bank statement.
 Checks outstanding totaled $5,180.27.
 The bank had collected for Alpine Sports Co. $3,424 on a note left for collection.
 A check for $479.30 returned with the statement had been recorded by Alpine Sports Co. as
$497.30. The check was for the payment of an obligation to Bray & Son on account.
 A check for $620 had been incorrectly charged by the bank as $260.
 Bank service charges for April amounted to $25.
 A check for $880 from Shuler Co. was returned by the bank because of insufficient funds.
Instructions: Prepare bank reconciliation as of April 30, 2016 and record the necessary journal
entries

45
Part II: Accounts Receivable
RECOGNIZING ACCOUNTS RECEIVABLE

Accounts receivable are recognized only when the criteria for recognition are fulfilled. They are valued at
the original exchange price between the firm and the outside party, less adjustments for cash discounts,
sales returns and allowances, trade discounts and uncollectible accounts yielding an approximation to net
realizable value, the amount of cash expected to be collected.

1. Trade Discounts

Typically, a single invoice price for a product is published. Then, several different discounts may apply,
depending on customer type and quantity ordered. Example: Assume an item priced Br. 50 is offered at a
trade discount of 40 percent for order over 1000 units. The unit price for an order of 1,100 units is
therefore Br. 30 (Br. 50 x 0.6). The percentage discount can be changed for different order quantities
without changing the basic Br. 50 price.

For accounting purposes, the listed invoice price less the trade discount is treated as the gross price to
which cash discounts apply.

USE OF ACCOUNTS RECEIVABLE AS A SOURCE OF CASH

Business enterprises generally raise the cash needed for current operation through the collection of
accounts receivable. It is possible to accelerate this process by

1) Selling receivables (Factoring)

2) Assigning receivables
3) Pledging receivables as collateral for loans.
Using accounts receivables to obtain financing effectively shorten the operating cycle, hastens the return
of cash to productive purposes, and alleviates short-run cash flow problems. The costs of these
arrangements include initial fees and interest on loans collateralized by the receivables. Also, certain risks
may be retained by the seller, including bearing the cost of bad debts, cash discounts, and sales returns
and allowances.

Agreements to transfer accounts receivables are made on a recourse or non-recourse basis. In recourse
financing arrangements, the transferee can collect from the transferor if the original debtor (customer)
fails to pay. If the arrangement is without recourse, the transferee assumes the risk of collection losses.
The fee is higher under non-recourse arrangement because more risk is transferred.

1. Factoring Accounts Receivable

Factoring refers to selling accounts receivable to another party. The enterprise selling the accounts
receivable is called the transferor and the company buying the receivables is called transferee (factor).

Factoring transfers ownership of the receivables to the factor. In some instances, the factor performs
credit verification, receivables servicing, and collection agency services, in effect taking over a
company‘s accounts receivable and credit operations. Other factoring arrangements are less inclusive.

46
Factoring is common in the textile industry and in retailing. Suppliers to apparel retailers, department
stores, and discount retailers prefer not to risk shipping merchandise without assurance that a factor will
purchase the resulting receivables.

The diagram below depicts the relationship among the parties.

Supplier Accounts Receivable Retailer

(Transferor) Merchandise

Accounts (5)

Cash Receivable Cash

(4) (3)
Factor

(Transferee)

When accounts receivable are factored (sold) the factoring arrangement can be with recourse or without
recourse. If receivables are factored on a with recourse basis, the seller guarantees payment to the factor
in the event the debtor does not make payment. When a factor buys receivables without recourse, the
factor assumes the risk of collectibles and absorbs any credit losses.

Factoring without recourse

A non-recourse factoring arrangement generally constitutes an ordinary sale of receivables because the
factor has no recourse against the transferor for uncollectible accounts. Control over the receivables
generally passes to the factor. The factor typically assumes legal title to the receivables, the cost of
uncollectible accounts, and collection responsibilities. However, any adjustments or defects in the
receivables (sales discounts, returns, and allowances) are borne by the seller (transfer) because these
represents preexisting conditions.

The receivables are removed from the transferor‘s books, cash is debited, and a financing fee is
recognized immediately as a financing expense or loss on sale. The factor may hold back on amount to
cover probable sales adjustments. This amount is recorded as a receivable on the seller‘s books.

Example:Largo Company factors without recourse Br. 200,000 of accounts receivable with a finance
company on a notification basis. The factor charges a 12 percent financing fee and retains an amount
equal to 10 percent of the accounts receivable for sales adjustments. Largo does not record bad debt
expense on these receivables because, in non-recourse transfers, the finance company bears the cost of
uncollectible accounts. The entry to record the transfer is:

47
Largo Company Books Finance Company Books

Cash - - - - - - 156,000 A/receivable - - - - - 200,000

(Br. 200,000 – ((0.12 + 0.1) Br. 44,000) finance rev. - - - - - - 24,000

Receivable from Factor - - - 20,000 payable to largo - - - 20,000

(0.1 x Br. 200,000) cash - - - - - - - -156,000

Loss on sale of receivable - - 24,000

(0.12 x Br. 200,000) ---24,000

A/receivable ----------------------------200,000

Largo company‘s loss equals the finance fee. This amount is also the book value of the receivables factors
less the assets received from the finance company (Br. 200,000 – Br. 156,000 – Br. 20,000).

As customer sales adjustments occur, Largo records these deductions in the proper contra sales accounts
and credits the receivables from factor. After all adjustments are recorded, anyexcess in the receivable is
remitted to largo. If adjustments exceed the amount withheld by the factor (Br. 20,000 in this case), either
the finance company or the seller absorbs this amount as a loss or the two parties agree to allocate it in
some other manner, The remaining entries are based on the following additional information concerning
the factored receivables:

a. Br. 2000 of estimated and actual bad debts

b. Br. 4000 of cash discounts

c. Br. 12,000 of sales returns and allowances

Therefore, customers remitted Br. 182,000 (Br. 200,000 – Br. 2000 – Br. 4000 – Br. 12,000) to the
finance company. The fiancé company records customer collections, reduces the payable to largo by the
amount of actual sales adjustment (Br. 16,000), records bad debts, and settles with Largo.

Largo Company‘s book Finance Company‘s book

Sales returns and allowance --------------12,000 *Bad debt Expense ----2000

Sales discount --------------------------------4000 All. For doubtful account ----2000

Receivable from factor ------------------16,000

* All.for doubtful accounts ---2,000

Cash (Br. 20,000 – Br. 4000 – Br. 12,000) --4000 Accounts receivable ---2,000

Receivable from factor -------------------4000 * Payable to Largo - - -16,000

48
Cash - - - - - - - - - - 182,000

A/ receivable -------198,000

* Payable to Largo -----4000

Cash -------4000

2. Assignment of Accounts Receivable

Assignment entails the use of receivables as collateral for a loan. An assignment of accounts receivable
requires the assignor to assign the rights to specific receivables. Frequently, the assignor and the finance
company (assignee) enter into a long-term agreement whereby the assignor receives cash from the finance
company as sales are made. The accounts are assigned with recourse; the assignee has the right to seek
payment from the specific receivables.

The assignor usually retains title to the receivables, continues to receive payments from customer (non-
notification basis), bears collection costs and the risk of bad debts, and agrees to use any cash collected
from customers to pay the loan. A formal promissory note often allows the assignee (lender) to seek
payment directly from the receivables if the loan is not paid when due.

The loan proceeds are typically less than the face value of the receivables assigned in order to compensate
for sales adjustments and to give the assignee a margin of protection. The assignee charges a service fee
and interest on the unpaid balance each month.

Example: Assume that on November 30, 1992, Frank Corporation assigns Br. 80,000 of its accounts
receivable to a finance company on a non-notification basis. Frank agrees to remit customer collections as
payment to the loan. Loan proceeds are 85 percent of the receivables less a Br. 1,500 flat-fee finance
charge. In addition, the fiancé company charges 12 percent interest on the unpaid loan balance, payable at
the end of each month.

Accounts receivable assigned is a current asset listed under accounts receivable in the balance sheet. All
entries are for Frank. To record receipt of loan proceeds:

Cash ((0.85 x Br. 80,000) – Br. 1500) -----------------------66,500

Finance expense --------------------------------------------------1,500

Notes payable (Br. 80,000 x 0.85) --------------------------68,000

To classify accounts receivables as assigned:

Accounts receivable assigned --------------------------80,000

Accounts receivable --------------------------------------80,000

49
By the end of December, assume that Frank has collected Br. 46,000 cash on Br. 50,000 of the assigned
accounts less Br. 3000 sales returns and Br. 1,000 sales discounts, and remits the proceeds to the finance
company.

To record sales adjustments:

Cash (Br. 50,000 – Br. Br. 3000 – Br. 1,000) ----------------------46,000

Sales discounts -----------------------------------------------------------1000

Sales returns and allowances -------------------------------------------3000

Accounts receivable assigned -------------------------------------------50,000

To remit collections to finance company:

Notes payable -------------------------------------------45,320

Interest Expense (Br. 68,00 x 0.12 x 1/12) ------------680

Cash -----------------------------------------------------46,000

Assigned accounts receivable are part of the total balance in accounts receivable. If the assigned amounts
are material, they should be reported as a separate subtotal within accounts receivable.

Assume now that in January 1993, Br. 2000 of the accounts are written off as uncollectible (the original
Br. 8000 of receivables is included in the normal bad debt estimation process). Also, Br. 25,000 is
collected on account. The remaining entries follow, assuming that the loan is paid in full at the end of
January

To record collection and write-off in January:

Cash ------------------------------------------25,000

Allowance for doubtful accounts -----------2000

Accounts receivable assigned ---------------27,000

January 31, 1992 payment of remaining loan balance;

Notes payable (Br. 68,000 – Br. 45,320) -------------------- 22,680

Interest Expense (Br. 22,680 x 0.12 x 1/12) --------------------227

Cash --------------------------------------------------------------22,907

To record reclassification of remaining accounts:

Accounts receivable (Br. 80,000 – Br. 50,000 – Br. 27,000) ----------3,000

50
 Accounts receivable assigned ----------------------------------------3,000

3. Pledging of Accounts Receivable

Pledging of accounts receivable is a less formal way of using receivables as collateral for loans. Typically,
the receivables are transferred as collateral to the lender, escrow agent, or trustee. Proceeds from
receivables must be used to pay the loan, but accounts receivable are not reclassified.

The original holder of the accounts receivables in pledging is called the pledge and the company
providing the cash is called the pledgee. If the pledge (borrower) defaults on the loan, the pledge (creditor)

51
4. INVENTORIES COST AND COST FLOW ASSUMPTIONS
4.1 INTRODUCTION

Inventories consist of goods owned by a business and held either for use in the manufacture of products or
as products waiting for sale. We typically think of inventories as raw materials, work in process, finished
goods, or merchandise held by retailers. But depending on the nature of the company‘s business,
inventory may consist of virtually any tangible goods or materials. Machinery and equipment, for
example, are considered operational assets by the company that buys them, but before sale they are part of
the inventory of the manufacturer who made them. Even a building, during its construction period is an
inventory item for the builder.

Inventories are classified as;

Manufacturing inventory

Raw materials

Work in process

Finished goods & Manufacturing supplies

Raw materials inventory: tangible goods purchased or obtained in other ways (eg. By mining) and on
hand for direct use in the manufacture of goods for resale parts or subassemblies manufactured before use
are sometimes classified as component parts inventory.

Work-in process inventory: goods requiring further processing before completion and sale. Work in
process, also called goods-in-process, inventory includes the cost of direct material, direct labor, and
allocated manufacturing overhead costs incurred to date.

Finished goods inventory: manufactured items completed and held for sale. Finished good inventory cost
includes the cost of direct material, direct labor, and allocated manufacturing overhead related to its
manufacture.

Manufacturing supplies inventory: lubrication oils for the machinery, cleaning materials, and other items
that make up an insignificant part of the finished product.

Merchandise inventory

Merchandise inventory represents goods on hand purchased for resale by a retailer or a trading company
such as an importer or exporter for resale. Generally, goods acquired are not physically altered by the
purchaser company; the goods are in finished form when they leave the manufacturer‘s plant.

4.2 INVENTORY PROCEDURES

The physical quantities in inventory may be measured by use of either a periodic inventory system or a
perpetual inventory system.

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4.2.1 Periodic Inventory System

The periodic inventory system relies on a physical count of goods on hand as the basis for control,
management decisions and financial accounting. Although this procedure may give accurate results on a
specific date, there is no continuing record of the inventory.

Under this system, an actual physical count of the goods on hand is taken at the end of each accounting
period for which financial statements are prepared.

4.2.2 Perpetual Inventory System

The perpetual inventory system requires a continuous record of all receipts and withdrawals of each item
of inventory. The perpetual record sometimes is kept in terms of quantities only. This procedure provides
a better basis for control than is obtained under the periodic system. When the perpetual system is used, a
physical count of the goods owned by the business enterprise must be made periodically to verify the
accuracy of the inventories reported in the accounting records. Any discrepancies discovered must be
corrected so that the perpetual inventory records are in agreement with the physical count.

Freight-in, purchase returns and allowances, and purchase discounts are recorded in Inventory rather than
in separate accounts.
4.3 COST FLOW ASSUMPTIONS

The term cost flow refers to the inflow of costs when goods are purchased or manufactured and to the
outflow of costs when goods are sold. The cost remaining in inventories is the difference between the
inflow and outflow of costs. During a specific accounting period, such as a year or a month, identical
goods may be purchased or manufactured at different costs. Accountants then face the problem of
determining which costs apply to items in inventories and which applies to items that have been sold.

Cost flow assumption relate to the flow of costs, rather than to the physical flow of goods. The question
of which physical units of identical goods were sold and which remain in inventories is not relevant to
income measurement and inventory valuation.

1. First-in, First-out method (FIFO)

2. Weighted-average method
3. Specific identification method
All methods of inventory valuation are based on the measurement principle; no matter which method is
selected, the inventory is stated at cost or market price.

4.4 LOWER-OF-COST-OR-NET REALIZABLE VALUE (LCNRV)

Inventories are recorded at their cost. However, if inventory declines in value below its original cost, a
major departure from the historical cost principle occurs. Whatever the reason for a decline -
obsolescence, price-level changes, or damaged goods - a company should write down the inventory to net
realizable value to report this loss. Acompany abandons the historical cost principle when the future
utility (revenue producingability) of the asset drops below its original cost.

4.4.1 NET REALIZABLE VALUE

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Recall that cost is the acquisition price of inventory computed using one of the historical cost-based
methods - specific identification, average-cost, or FIFO. The term net realizable value (NRV) refers to the
net amount that a company expects to realize from the sale of inventory. Specifically, net realizable value
is the estimated selling price in the normal course of business less estimated costs to complete and
estimated costs to make a sale

Example: To illustrate, assume that Tomy Co. has finished inventory with a cost of Br.950, a sales value
of Br.1, 000, and estimated selling costs of Br. 250. Tomy's net realizable value is computed as shown
below;

Computation of Net Realizable Value

Inventory sales value Br. 1,000

Estimated cost to sell 250

Net realizable value Br. 750

Tomy reports inventory on its statement of financial position at Br. 750. In its income statement, Tomy
reports a Loss on Inventory Write-Down of Br.200 (Br.950 − Br.750). A departure from cost is justified
because inventories should not be reported at amounts higher than their expected realization from sale or
use.

Companies therefore report their inventories at the lower-of-cost-or-net realizable value (LCNRV) at
each reporting date.

4.4.2 RECORDING NET REALIZABLE VALUE INSTEAD OF COST

One of two methods may be used to record the income effect of valuing inventory at net realizable value.
One method, referred to as the cost of goods sold method, debits cost of goods sold for the write-down of
the inventory to net realizable value. As a result, the company does not report a loss in the income
statement because the cost of goods sold already includes the amount of the loss. The second method,
referred to as the loss method, debits a loss account for the write down of the inventory to net realizable
value. We use the following inventory data for Tomy to illustrate entries under both methods.

Cost of goods sold (before adjustment to net realizable value) Br.1,500

Ending inventory (cost) Br. 950

Ending inventory (at net realizable value) 750

Cost-of-Goods-Sold Method

To reduce inventory from cost to net realizable value

Cost of Goods Sold 200

Inventory (Br. 950 – Br.750) 200

54
Loss Method

Loss Due to Decline of Inventory to NRV 200

Inventory (Br. 950 – Br. 750) 200

Or: Loss Due to Decline of Inventory to NRV 200

Allowance to Reduce Inventory to Net Realizable Value 200

The cost-of-goods-sold method buries the loss in the Cost of Goods Sold account. The loss method, by
identifying the loss due to the write-down, shows the loss separate from Cost of Goods Sold in the income
statement.

IFRS does not specify a particular account to debit for the write-down. We believe the loss method
presentation is preferable because it clearly discloses the loss resulting from a decline in inventory net
realizable values.

4.4.3 RECOVERY OF INVENTORY LOSS

In periods following the write-down, economic conditions may change such that the net realizable value
of inventories previously written down may be greater than cost or there is clear evidence of an increase
in the net realizable value. In this situation, the amount of the write-down is reversed, with the reversal
limited to the amount of the original write-down.

Continuing the AJ example, assume that in the subsequent period, market conditions change, such that the
net realizable value increases to €800 (an increase of €50). As a result, only €150 is needed in the
allowance. AJ makes the following entry, using the loss method.

Allowance to Reduce Inventory to Net Realizable Value 50

Recovery of Inventory Loss (€800 − €750) 50

4.5 ESTIMATING INVENTORY COST

In practice, an inventory amount is estimated for some purposes, when it is impossible to take a physical
inventory or to maintain perpetual inventory records.

Example

1. Monthly income statements are needed. It may be too costly, to take physical inventory. This is
especially the case when periodic inventory system is used.
2. When a catastrophe such as a fire has destroyed the inventory. In such case, to ask claims from
insurance companies, there is a need of estimated inventory.
To estimate the cost of inventory, two methods are used. These are retail method and gross profit method.

Retail method of inventory costing

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This method is mostly used by retail business. The estimate is made based on the relationship between the
cost and the retail price of merchandise available for sale.

The steps to be followed are:

(1) Calculate the cost to retail ratio = Cost of merchandise available for sale

Retail Price of merchandise available for sale

(2) Calculate the ending inventory at retail price

Ending inventory at retail price = retail price of merchandise available for sale – Sales

(3) Calculate the estimated cost of ending inventory

Estimated cost of ending inventory = Cost to retail ratio X Ending inventory at retail

Example

Cost Retail

Sep. 1, beginning inventory Br. 25,000 Br. 40,000

Purchases in September (net) 125,000 160,000

Sales in September (net) 140,000

(1) Cost to retail ratio = Br. 25,000 + Br. 125,000 = 0.75

Br. 40,000 + Br. 160,000

(2) Ending inventory at retail = (Br. 40,000 + Br. 160,000) – Br. 140,000 = Br. 60,000

(3) Estimated ending inventory at cost = 0.75 X Br. 60,000

= Br. 45,000

Gross profit method

This method uses an estimate of the gross profit realized during the period to estimate the cost of
inventory. The gross profit rate may be estimated based on the average of previous period‘s gross profit
rates.

The steps are as follows:

(1) The gross profit rate is estimated and then estimated gross profit is calculated.

Estimated gross profit = Gross profit rate X Sales

(2) Cost of merchandise sold is estimated

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 Estimated cost of merchandise sold = Sales - Estimated gross profit

(3) Calculate the estimated cost of ending inventory

Estimated cost of ending inventory =

Cost of merchandise available for sale – Estimated cost of merchandise sold.

Example

Oct. 1, beginning inventory (cost) – Br. 36,000

Net purchases during October (cost) 204,000

Net sales during October 220,000

Estimated gross profit rate is 40%

The ending inventory is estimated as follows:

(1) Estimated gross profit = 0.4 X 220,000

= Br. 88,000

(2) Estimated cost of merchandise sold

= Br. 220,000 – Br. 88,000

= Br. 132,000

(3) Estimated cost of ending inventory

= (Br. 36,000 + 204,000) – Br. 132,000

= Br. 240,000 – Br. 132,000

= Br. 108,000

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5. PLANT, PROPERTY AND EQUIPMENT
5.1 INTRODUCTION

Property, plant, and equipment are very important components of a company‘s assets. They include assets
that a company needs to conduct its business, such as land, office buildings, factories, machinery,
equipment, warehouses, retail stores, and delivery vehicles. They usually are a major portion of a
company‘s total assets. In this chapter we include a discussion of the costs of acquisition, costs
subsequent to acquisition, and disposal of property, plant, and equipment and its depreciation.

5.2 CHARACTERISTICS OF PROPERTY, PLANT, AND EQUIPMENT

Property, plant, and equipment are the tangible noncurrent assets that a company uses in the normal
operations of its business. Alternative terms are plant assets, fixed assets, and operational assets. To be
included in this category, an asset must have three characteristics:

1. The asset must be held for use and not for investment: Only assets used in the normal course of
business should be included. A particular type of asset may be classified as property, plant, and
equipment by one company and as inventory by another.

2. The asset must have an expected life of more than one year: The asset represents a bundle of future
services that the company will receive over the life of the asset. To be included in property, plant, and
equipment, the benefits must extend for more than one year or the normal operating cycle, whichever is
longer. Therefore, a company distinguishes the asset from other assets, such as supplies, that it expects to
consume within the current year

3. The asset must be tangible in nature: There must be a physical substance that can be seen and touched.
In contrast, intangible assets such as goodwill or patents do not have a physical substance. Unlike raw
materials, generally property, plant, and equipment do not change their physical characteristics and are
not added into the product. Wasting assets are natural resources, such as minerals, oil and gas, and timber
that are used up by extraction.

5.3 RECOGNITION OF PLANT, PROPERTY AND EQUIPMENT

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 proper1ty, plant and equipment depends on two criteria.

(a) It is probable that future economic benefits associated with the asset will flow to the entity

(b) The cost of the asset to the entity can be measured reliably

These recognition criteria apply to subsequent expenditure as well as costs incurred initially. There are
no separate criteria for recognizing subsequent expenditure.

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 wrongly classified as an expense and taken to profit or loss.

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5.4 ACQUISITION&MEASUREMENT OF PROPERTY, PLANT, AND EQUIPMENT

The major types of assets that a company includes in the category of property, plant, and equipment are
land, buildings, equipment, machinery, furniture and fixtures, leasehold improvements, and wasting assets.
The acquisition of an item of property, plant, and equipment raises many issues.

Determination of Cost

The cost of property, plant, and equipment is the cash outlay (not the ―list‖ price) or its equivalent that is
necessary to acquire the asset and put it in operating condition. In other words, the acquisition costs that
are necessary to obtain the benefits to be derivedfrom the asset are capitalized (recorded as an asset).
These costs include the contract price, less discounts available, plus freight, assembly, installation, and
testing costs. As for inventory, discounts available should be subtracted from the cost of the asset rather
than recorded as discounts taken, because the benefits to be received from the asset are not increased by a
discount not taken.

R Buildings

The recorded cost of buildings includes:

• The acquisition/ construction price

• The costs of remodeling and reconditioning

• The costs of excavation for the specific building

• Architectural costs and the costs of building permits

• Unanticipated costs resulting from the condition of the land (such as blasting rock or channeling an
underground stream)

A company should expense unanticipated costs, such as a strike or a fire, associated with the construction
of the building. The different treatment is justified because the avoidable costs of the unanticipated events
were not necessary to obtain the economic benefits of the building.

MACHINERY AND EQUIPMENT – include several items such as furniture, fixtures, Machinery,
vehicles, tools, computers, office equipment, etc.

Some examples of costs which can be included on acquisition of plant assets

 Purchase cost
 Costs of site preparation;
 Initial delivery and handling costs;
 Installation and assembly costs;
 Testing Costs
 Professional fees.
 Demolition cost
 Freight cost, depending on the characteristics of the asset

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 Commission
 deducting the net proceeds from selling any items produced while bringing the asset to that location
and condition ; and refundable taxes
5.5 Cost incurred after initial acquisition
Capital and Revenue Expenditures

- Capital expenditures:initial expenditures that are included in the cost of the plant assets and an
expenditure which improves service life, operating efficiency and service quality of an asset.
Examples: addition, replacement, extraordinary repair

- Revenue expenditures: expenditures that are treated as current period expenses.

It is an expenditure which will incur to keep the normal operating expenditure of an asset.

Example; ordinary repair and maintenance

5.6 PLANT DEPRECIATION AND DEPLATION

Depreciation is the process of allocating in a systematic and rational manner this total expense to each
period benefited by the asset. Land is not depreciated because itgenerally does not have a limited life and
its residual value usually is higher than its cost.

Thus, there is no expense to be recognized over the life of the asset and, therefore, no periodic cost
allocation.

Terms used to describe this allocation process depend on the type of asset:

1. Depreciation is the allocation of the cost of tangible assets, such as property, plant, and equipment.

5.6.1 FACTORS INVOLVED IN DEPRECIATION

A company considers four factors in the computation of depreciation for a period:

Asset Cost: The cost of an asset includes all the acquisition costs a company incurs to obtain the benefits
from the asset. These costs include the contract price plus freight, assembly, installation, and testing costs.

Service Life: The service life of an asset is the measure of the service units a company expects from the
asset before its disposal. Service life may be measured in units of time, such as yearsand months, or units
of activity or output, such as hours of operation of a machine, tonsproduced for a steel mill, or miles
driven for a truck.

The factors that limit the service life of an asset can be divided into two general categories:

• Physical causes include wear and tear because of operational use, deterioration and decay that is
independent of use but is a function of time (such as rust), and damage and destruction.

• Functional causes limit the service life of the asset through obsolescence and inadequacy, even though
the physical life is not exhausted.

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Residual Value: The residual (salvage) value is the net amount that a company expects to obtain from
disposing of an asset at the end of its service life. It is the expected value of the asset at the end of its
service life minus the costs of disposal, such as dismantling, removing, and selling the asset.

METHODS OF COST ALLOCATION

Accounting principles require that a company use a method of cost allocation that is ―systematic and
rational. ‖Systematic means that, the calculation should follow a formula and not be determined in an
arbitrary manner. Rational means that the amount of the depreciation should relate to the benefits that the
asset produces in each period.

Although these criteria may appear to be very general and to allow numerous methods, only the following
methods are used frequently in practice:

1. Time-based methods

 Straight line
 Sum of the years‘ digits
2. Activity (or use) methods

 Unit of production method

We discuss each of these methods in the following sections, using the data for the Troup Company shown
below. The depreciation base (depreciable cost) of the asset is the cost less the estimated residual value,
or $100,000.

Depreciable base = cost – estimated salvage value

The different depreciation methods all allocate the total of $100,000 over the expected service life of the
asset.

However, they differ in the pattern in which the cost is allocated to each year or each unit produced.

Asset information of the troup company

Asset cost $120,000

Date of purchase January 1, 2006

Estimated residual value $20,000

Estimated service life 5 years; 10,000 hours; 20,000 units

1. Time-Based Methods
A company should use a time-based method when the service life of the asset is affected primarily by the
passage of time and not by the use of the asset. This situation includes the physical causes of deterioration
and decay and the functional causes of obsolescence and inadequacy. Two general categories of time-
based methods are the straight-line method and the accelerated methods. The straight-line method is

61
appropriate when a company estimates that the benefits it will derive from the asset will be approximately
constant each period of its life.

 Straight Line method

The straight-line method allocates an equal cost to each period.

The formula for computing periodic straight-line depreciation is:

Cost  Re sidual Valuenet

Annual straight-line depreciation =
Years of estim ated Econom icLife

 Declining-Balance Method

This method utilizes a depreciation rate (expressed as a percentage) that is some multiple of the straight-
line method. For example, the double declining rate for a 10-year asset would be 20% (double the straight
line rate, which is 10%). The declining-balance rate remains constant and is applied to the reducing book
value each year. Unlike other methods, in the declining-balance method the salvage value is not deducted
in computing the depreciation base.

The declining-balance rate is multiplied by the book value of the asset is reduced each period. Since the
book value of the asset is reduced each period by the depreciation charge, the constant declining-balance
rate is applied to a successively lower book value that results in lower depreciation charges each year.
This process continues until the book value of the asset is reduced to its estimated salvage value, at which
time depreciation is discontinued. As indicated above, various multiples are used in practice, such as
twice (200%) the straight-line rate (double-declining-balance method) and 150% of the straight-line rate
etc.

2. Activity (or use) methods

Units-of-output method

This method assumes that depreciation is a function of use or productivity instead of the passage of time. The life of
the asset is considered in terms of either the output it provides (units it produces), or an input measure such as the
number of hours it works. Conceptually, the proper cost association is established in terms of output instead of hours
used, but often the output is not easily measurable. In such cases, an input measure such as machine hours is a more
appropriate method of measuring the birr amount of depreciation charges for a g iven accounting period.
See the case of Troup Co mpany;

Depreciat ion expense =

Cost  salvage value x Hours this year
Total estim ated hours

Illustration: Consider the Asset information of Troup Co mpany to illustrate the depreciation methods

Asset cost $120,000

Date of purchase January 1, 2006
Estimated residual value $20,000
Estimated service life 5 years; 10,000 hours; 20,000 units
Determine annual depreciati on by using the above depreciation methods

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 6. Investment property
Definition;

Investment property is property (land or a building – or part of a building – or both) held (by the owner
or by the lessee under a finance lease) to earn rentals or for capital appreciation or both.

Examples of investment property includes

 Land held for long-term capital appreciation rather than for short-term sale in the ordinary
course of business.
 A building owned by the reporting entity (or held by the entity under a finance lease) and leased
out under an operating lease.
Recognition: Investment property should be recognized as an asset when two conditionsare met.

1. It is probablethat the future economic benefitsthat are associated with the investment
property will flow to the entity.
2. The costof the investment property can be measured reliable.
Initial measurement
 An investment property should be measured initially at its cost, including transaction costs.
 A property interest held under a lease and classified as an investment property shall be accounted
for as if it were a finance lease. The asset is recognized at the lower of the fair value of the
property and the present value of the minimum lease payments. An equivalent amount is
recognized as a liability.
Measurement subsequent to initial recognition

IAS 40 requires an entity to choose between two models:

1. The fair value model

2. The cost model
Whatever policy it chooses should be applied to all of its investment property.

Where an entity chooses to classify a property held under an operating leaseas an investment property,
there is no choice. The fair value model must be usedfor all the entity's investment property, regardless of
whether it is owned or leased.

Fair value model: After initial recognition, an entity that chooses the fair value modelshould measure all
of its investment property at fair value, except in the extremely rare cases where this cannot be measured
reliably. In such cases it should apply the IAS 16 cost model.

 A gain or loss arising from a change in the fair value of an investment property should be
recognized in net profit or loss for the period in which it arises.
Cost model: The cost model is the cost model in IAS 16.

Investment property should be measured at depreciated cost, less any accumulated impairment losses.

An entity that chooses the cost model should disclose the fair value of its investment property.

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Example: A business owns a building which it has been using as a head office. In order to reduce costs,
on 30 June 2009 it moved its head office to rental and is now letting out its head office. Company policy
is to use the fair value model for investment property. The building had an original cost on 1 January
2000 of $250,000 and was being depreciated over 50 years. At 31 December 2009 its fair value was
judged to be $350,000. How will this appear in the financial statements at 31 December 2009?

Particulars Amount

Original cost 250,000

Depreciation 1.1.00 – 1.1.09, (250/50 × 9) (45,000)

Depreciation to 30.6.09, (250/50 × 6/12) (2,500)

Carrying amount at 30.6.09 202,500

Revaluation surplus 147,500

Fair value at 30.6.09 350,000

The difference between the carrying amount and fair value is taken to a revaluation surplusin accordance
with IAS 16.

Dr. Investment property 350,000 (at FV)

Dr. Acc Dep.…………… 47,500

Cr. Revaluation Surplus….147,500 (350000-202500)

Cr. PPE…………………. 250,000

Do not depreciate while classified as investment property

 However the building will be subjected to a fair value exercise at each year end and these gains
or losses will go to profit or loss.
 If at the end of the following year the fair value of the building is found to be $380,000, $30,000
will be credited to profit or loss.
Dr. Investment property………30,000

Cr. Gain on value appreciation….30,000

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 7. INTANGIBLE ASSET ISSUES
Characteristics

The Coca- Cola Company‘s success comes from its secret formula for making Coca-Cola, not its plant
facilities. America On line‘s subscriber base, not its Internet connection equipment, provides its most
important asset. For these companies, their major assets are often intangible in nature.

What exactly are intangible assets? Intangible assets have two main characteristics.

1. They lack physical existence. Tangible assets such as property, plant, and equipment have physical
form. Intangible assets, in contrast, derive their value from the rights and privileges granted to the
company using them.

2. They are not financial instruments. Assets such as bank deposits, accounts receivable, and long-term
investments in bonds and stocks also lack physical substance. However, financial instruments derive their
value from the right (claim) to receive cash or cash equivalents in the future. Financial instruments are not
classified as intangibles.

TYPES OF INTANGIBLE ASSETS

As indicated, the accounting for intangible assets depends on whether the intangible has a limited or an
indefinite life. There are many different types of intangibles, often classified into the following six major
categories.

 Marketing-Related Intangible Assets

Companies primarily use marketing-related intangible assets in the marketing or promotion of products or
services. Examples are trademarks or trade names, newspaper mastheads, Internet domain names, and
noncompetition agreements.

A trademark or trade name is a word, phrase, or symbol that distinguishes or identifies a particular
company or product. Trade names like google, Pepsi-Cola, create immediate product identification in our
minds, thereby enhancing marketability. Under common law, the right to use a trademark or trade name,
whether registered or not, rests exclusively with the original user as long as the original user continues to
use it. Registration with the U.S. Patent and

Trademark Office provides legal protection for an indefinite number of renewals for periods of 10 years
each.

 Customer-Related Intangible Assets

Customer-related intangible assets result from interactions with outside parties.

Examples include customer lists, order or production backlogs, and contractual and non- contractual
customer relationships.

 Artistic-Related Intangible Assets

Artistic-related intangible assets involve ownership rights to plays, literary works, musical works, pictures,
photographs, and video and audiovisual material. Copyrights protect these ownership rights.

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A copyright is a federally granted right that all authors, painters, musicians, sculptors, and other artists
have in their creations and expressions. A copyright is granted for the life of the creator plus 70 years. It
gives the owner or heirs the exclusive right to reproduce and sell an artistic or published work. Copyrights
are not renewable.

 Contract-Related Intangible Assets

Contract-related intangible assets represent the value of rights that arise from contractual arrangements.
Examples are franchise and licensing agreements, construction permits, broadcast rights, and service or
supply contracts.

A franchise is a contractual arrangement under which the franchisor grants the franchisee the right to sell
certain products or services, to use certain trademarks or trade names, or to perform certain functions,
usually within a designated geographical area. E.g A Toyota dealer, a McDonald‘s restaurant, coca cola

 Technology-Related Intangible Assets

Technology-related intangible assets relate to innovations or technological advances.

Examples are patented technology and trade secrets granted by the U.S. Patent and Trademark Office. A
patent gives the holder exclusive right to use, manufacture, and sell a product or process for a period of 20
years without interference or infringement by others. The two principal kinds of patents are product
patents, which cover actual physical products, and process patents, which govern the process of making
products.

 Goodwill
Although companies may capitalize certain costs incurred in developing specifically identifiable assets
such as patents and copyrights, the amounts capitalized are generally insignificant. But companies do
record material amounts of intangible assets when purchasing intangible assets, particularly in situations
involving a business combination (the purchase of another business).

To illustrate, assume that Portofino Company decides to purchase Aquinas Company.

In this situation, Portofino measures the assets acquired and the liabilities assumed at fair value. In
measuring these assets and liabilities, Portofino must identify all the assets and liabilities of Aquinas.

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 8. STATEMENT OF CASH FLOWS
Along with an income statements and balance sheet, a statement of cash flows is included in annual
reports to stockholders of publicly owned companies and is covered by the auditors‘ opinion. The
objectives of this statement are:

1. To summarize the financing, operating, and investing activities of a business enterprise during an
accounting period, including the amount of cash equivalent obtained from operations, and

2. To complete the disclosure for changes in financial position during an accounting period that is
not readily apparent in comparative balance sheets.

The statement of cash flows discloses transactions that affect cash directly, as well as significant investing
and financing transactions that do not affect cash.

The statement of cash flows is prepared in three sections.

Operating cash flows:includes cash transaction that enters into the determination of net income.
Reported under this classification are both the cash inflows and the cash outflows that are related to net
income. The usual cash flows identified are:

Inflows – cash received from; Outflows -cash paid for;

 Cash sales to Customers - Purchase of goods for sale

 Interest on receivables - Interest on liabilities
 Dividends from investment - Income taxes, duties, & fines
 Refunds from suppliers - Salaries and wages
There are two methods of reporting operating cash flows:

Direct method:cash received from operation will match with cash paid for operating activities.

Indirect method: Common adjustments to convert profit or loss to cash from operations which includes;
Changes in working capital accounts, Elimination of non-cash items and Elimination of investing and
financing items can be reported under this section.

 Investing cash flows:

This classification includes cash inflows and cash outflows related to the disposing of or acquiring
operating facilities (plant, property, equipment), the sale or purchase of investments, and other non-
operating (investment) assets. Inflows under this classification occur only when cash is received from the
sale or disposal of prior investments.

The following are typical cash flows under investing activities:

Inflows – cash received from; Outflows – cash paidfor;

 Disposal / sale of property – Acquisition / purchase of property

 Sale of investment securities – Long-term investment in debt & equity securities

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  Collection of a loan – Loans to other parties
 Principal repayment of loan by borrowers - Acquisition of intangible assets
 Financing cash flows

This classification inc ludes both cash inflows and outflows related to the financing activities (borrowing
or issuing stock) used to obtain cash for the business. Outflows occur when principle amounts are
returned to the owners and creditors for their earlier investments. The usual cash flows under these
classifications are:

Inflows – cash received from; Outflows – cash paid to;

 Owners from issuing equity securities - Owners for dividends

 Creditors from issuing debt securities - Repurchase of equity securities or treasury stock
 Issuing notes - Repayment of amount borrowed

Illustration:A comparative balance sheet for BICO Corporation is presented below.

Assets Dec. 2012 Dec. 2011
Cash $ 63,000 $ 22,000
Accounts receivable 82,000 66,000
Inventory 180,000 189,000
Land 71,000 110,000
Equipment 270,000 200,000
Acc- depreciation—equipment (69,000)(42,000)
Total $597,000$545,000
Liabilities and Stockholders’ Equity
Accounts payable $ 34,000 $ 47,000
Bonds payable 150,000 200,000
Common stock ($1 par) 214,000 164,000
Retained earnings 199,000134,000
Total $597,000$545,000
Additional information:
1. Net income for 2012 was $105,000.
2. Cash dividends of $40,000 were declared and paid.
3. Bonds payable amounting to $50,000 was retired through issuance of common stock.
Required: Prepare a statement of cash flows for 2012 for bico Corporation.

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 COURSE: ADVANCED FINANCIAL ACCOUNTING I
UNIT-ONE

Accounting for Joint Ventures

What is meant by a “joint venture”?

The term joint venture can describe a range of different commercial arrangements between two or more
separate entities. Each party contributes resources to the venture and a new business is created in which
the parties collaborate together and share the risks and benefits associated with the venture. A party may
provide land, capital, intellectual property, experienced staff, equipment or any other form of asset. Each
generally has an expertise or need which is central to the development and success of the new business
which they decide to create together. It is also vital that the parties have a ‗shared vision‘ about the
objectives for the JV.

A joint venture is a contractual arrangement whereby two or more parties undertake an

economic activity that is subject to joint control. A venturer is a party to a joint venture and has
joint control over that joint venture.

Joint control is the contractually agreed sharing of control over an economic activity, and exists
only when the strategic financial and operating decisions relating to the activity require the
unanimous consent of the parties sharing control (the venturers).

Contractual arrangement

The contractual arrangement may be evidenced in a number of ways, for example by a contract
between the venturers or minutes of discussions between the venturers. In some cases, the
arrangement is incorporated in the articles or other by- laws of the joint venture. Whatever its
form, the contractual arrangement is usually in writing and deals with such matters as:
a) the activity, duration and reporting obligations of the joint venture;
b) the appointment of the board of directors or equivalent governing body of the joint
venture and the voting rights of the venturers;
c) capital contributions by the venturers; and
d) the sharing by the venturers of the output, income, expenses or results of the joint venture.

A JV involves risk sharing; it is suitable where a jointly owned and managed business offers the best
structure for the management and mitigation of risk and realisation of benefits whether they involve asset
exploitation, improved public sector services or revenue generation. It should not be seen as a delivery
model in which the public sector seeks to transfer risk to the private sector through the creation of an
arm‘s length relationship.

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A joint venture is usually a temporary partnership without the use of a firm name, limited to carrying out
a particular business plan in which the persons concerned agree to contribute capital and to share profits
or losses. The parties in a joint venture are known as co-venturers and their liability is limited to the
adventure concerned for which they agree to contribute capital and share profits or losses. Joint venture
agreements can be made for other similar transactions, e.g,

 Joint consignment of goods

 Underwriting of shares or debentures issued by a company
 Purchasing and selling of a specific property
 Production of a motion picture
 Construction of huge projects

Why enter into a JV?

There are many reasons why a business might consider entering into a JV. Some of the reasons are:
Access to resources, Shared risk, Flexibility, New market penetration, etc

Common reasons for failure

Before entering into a JV, the parties should ensure their understanding of the project, commercial
expectations and culture are as aligned as possible. The most common causes of unsuccessful JVs can be
grouped into the following categories: Mismatch of objectives, Cultural mismatches, Imbalance in levels
of expertise, investment or assets, etc

Features of a Joint venture

The main features of a joint venture are specifically made clear.

 Two or more person are needed.

 It is an agreement to execute a particular venture or a project.
 The joint venture business may not have a specific name.
 It is of temporary nature. So the agreement regarding the venture automatically stands terminated
as soon as the venture is complete.
 The co-ventures share profit and loss in an agreed ratio. The profits and losses are to be shared
equally if not agreed otherwise.
 The co-ventures are free to continue with their own business unless agreed otherwise during the
life of joint venture.

Differences between Joint venture, Partnership and Consignment

In joint venture and partnership some business is carried on by two or more persons and the profits
are shared by all of them. But there are some basic differences between the two which are given
below:

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 Point of Joint Venture Partnership
difference
Meaning Joint Venture is a business formed by A business arrangement where two
two or more than two persons for a or more persons agree to carry on
limited period and a specific purpose. business and have mutual share in
the profits and losses, is known as
Partnership.
Ascertainment At the end of the venture or on interim Annually
of Profit basis as the case may be.
Business Co-venturers Partners
carried on by
Basis of Liquidation Going Concern
Accounting
Trade Name No Yes

Difference Between Joint Venture and Consignme nt

The main differences between joint venture and consignment are as follows:

Point of Joint Venture Consignment

difference
Nature It is a temporary partnership It is an extension of business by
business without a firm name. principal through agent
2. Parties The parties involving in joint Consignor and consignee are
venture are known as co-ventures involving parties in the
consignment.
3. Relation The relation between co-ventures is The relation between the
just like the partners in partnership consignor and consignee is
firm. 'principal and agent'.
4. Sharing Profit The profits and losses of joint The profits and losses are not
venture are shared among the co- shared between the consignor and
ventures in their agreed proportion. consignee. Consignee gets only
the commission
5. Rights The co-ventures in a joint venture In consignment, the consignor
have equal rights enjoys principal's right whereas
consignee enjoys the right of
agent.
7. Ownership All the co-ventures are the owners The consignor is the owner of the
of the joint venture. business.
9. Basis of Cash basis of accounting is Actual basis is adopted in

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Account applicable in joint venture. consignment
10.Continuity As soon as the particular venture is The continuity of business exists
completed, the joint venture is according to the willingness of
terminated. both consignor and consignee.
6. Exchange of The co- ventures exchange the The consignee prepares an
Information required information among them account sale which contains a
regularly. details of business activities
carried on and is being sent to the
consignor.

Forms of joint venture

Joint ventures take many different forms and structures. This Standard identifies three broad
types: jointly controlled operations, jointly controlled assets and jointly controlled entities, t hat
are commonly described as, and meet the definition of, joint ventures. The following
characteristics are common to all joint ventures:
a) two or more venturers are bound by a contractual arrangement; and
b) the contractual arrangement establishes joint control.

Jointly controlled ope rations

The operation of some joint ventures involves the use of the assets and other resources of the
venturers rather than the establishment of a corporation, partnership or other entity, or a financial
structure that is separate from the venturers themselves. Each venturer uses its own property,
plant and equipment and carries its own inventories. It also incurs its own expenses and liabilities
and raises its own finance, which represent its own obligations. An example of a jointly
controlled operation is when two or more venturers combine their operations, resources and
expertise to manufacture, market and distribute jointly a particular product, such as an aircraft.
Different parts of the manufacturing process are carried out by each of the venturers.

Jointly controlled assets

Some joint ventures involve the joint control, and often the joint ownership, by the venturers of
one or more assets contributed to, or acquired for the purpose of, the joint venture and dedicated
to the purposes of the joint venture. The assets are used to obtain benefits for the venturers. Each
venturer may take a share of the output from the assets and each bears an agreed share of the
expenses incurred.

These joint ventures do not involve the establishment of a corporation, partnership or other entity,
or a financial structure that is separate from the venturers themselves. Each venturer has control
over its share of future economic benefits through its share of the jointly controlled asset. Many
activities in the oil, gas and mineral extraction industries involve jointly controlled assets. For
example, a number of oil production companies may jointly control and operate an oil pipeline.

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Each venturer uses the pipeline to transport its own product in return for which it bears an agreed
proportion of the expenses of operating the pipeline.

Jointly controlled e ntities

A jointly controlled entity is a joint venture that involves the establishment of a corporation,
partnership or other entity in which each venturer has an interest. The entity operates in the same
way as other entities, except that a contractual arrangement between the venturers establishes
joint control over the economic activity of the entity.

A jointly controlled entity controls the assets of the joint venture, incurs liabilities and expenses
and earns income. It may enter into contracts in its own name and raise finance for the purposes
of the joint venture activity. Each venturer is entitled to a share of the profits of the jointly
controlled entity, although some jointly controlled entities also involve a sharing of the output of
the joint venture.

Equity method of accounting

A joint venturer is required to recognize its interest in a joint venture as an investment and shall
account for that investment using the equity method in accordance with IAS 28 Investments in
Associates and Joint Ventures unless the entity is exempted from applying the equity method.
Under the equity method, on initial recognition the investment in an associate or a joint venture
is recognized at cost and the carrying amount is increased or decreased to recognize the
investor‘s share of the surplus or deficit of the investee after the date of acquisition. The
investor‘s share of the investee‘s surplus or deficit is recognized in the investor‘s surplus or
deficit. Distributions received from an investee reduce the carrying amount of the investment.
Adjustments to the carrying amount may also be necessary for changes in the investor‘s
proportionate interest in the investee arising from changes in the investee‘s equity that have not
been recognized in the investee‘s surplus or deficit. Such changes include those arising from the
revaluation of property, plant and equipment and from foreign exchange translation differences.
The investor‘s share of those changes is recognized in net assets/equity of the investor.

An investment in an associate or a joint venture accounted for using the equity method
shall be classified as a non-current asset.

Application of the Equity Method

An entity with joint control of, or significant influence over, an investee shall account for its
investment in an associate or a joint venture using the equity method except when that
investment qualifies for exemption.

Exemptions from Applying the Equity Method

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An entity need not apply the equity method to its investment in an associate or a joint venture if
the entity is a controlling entity that is exempt from preparing consolidated financial statements
by the scope exception

a) The entity itself is a controlled entity and the information needs of users are met by its
controlling entity‘s consolidated financial statements, and, in the case of a partially
owned entity, all its other owners, including those not otherwise entitled to vote, have
been informed about, and do not object to, the entity not applying the equity method.
b) The entity‘s debt or equity instruments are not traded in a public market (a domestic or
foreign stock exchange or an over-the-counter market, including local and regional
markets).
c) The entity did not file, nor is it in the process of filing, its financia l statements with a
securities commission or other regulatory organization, for the purpose of issuing any
class of instruments in a public market, etc

Chapter Two
Accounting for Sales Agency, Branch, and Division

Introduction

Accounting for the operation of a business can become complicated whenever geographical separation is
encountered between the various facets of the organization. This unit examines the special procedures
necessary to record transactions occurring at significant distances from a central office. Branch
accounting is analyzed with illustrative examples.

Distinguishing Sales Agency, Branch, and Division

Sales Agency:

Sales agency is a term applied to a business unit that performs only a small portion of the functions
associated branch. A sales agency usually carries samples of products but does not have an inventory of
merchandise and usually lesser degree of autonomy.

Branch:

The term Branch is used to describe a business unit located at some distance from the Home Office.
Branches are economic and accounting entities. However, branches are not legal entity. Branches may

74
carry merchandise obtained from Home Office, make sales, approve customers‘ credit, and make
collections from its customers.

Division:

Division is a business segment or a business enterprise which generally has more autonomy than a branch.
Division may be as separate company or may not be a separate company. If the division is not a separate
company, the accounting procedures are the same as Branch. If the division is a separate company
(subsidiary company), the financial accounting requires consolidation.

Differences between Sales Agency, Branch and Division

Characteristics Sales Agency Branch Division

Degree of Autonomy Low Moderate High

Accounting Entity No Yes Yes

Legal Entity No No Possible

Economic Entity No Yes Yes

Accounting System for Sales Agency

The term sales agency sometimes is applied to a business unit that performs only a small portion of the
functions traditionally associated with a branch. For example, a sales agency usually carries samples of
products but does not have an inventory of merchandise. Orders are taken from customers and transmitted
to the Home Office, which approves the customers‘ credit and ships the merchandise directly to
customers. The agency‘s accounts receivable are maintained at the Home Office, which also performs the
collection function. An imprest cash fund generally is maintained at the sales agency for the payment of
operating expenses. A sales agency that does not carry an inventory of merchandise, maintain receivables,
or make collections has no need for a complete set of accounting records.

Overview of Branch accounting

The extensive use of branch operations is especially common in modern retailing where companies
attempt to attract customers by offering the convenience of numerous outlets. Relative small companies
often attempt to expand their market base by establishing additional outlets in nearby communities. This
type of internal division is not even restricted to the retail function. Branch operations are commonly
found in banking as well as in manufacturing and other industries.

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Branches of an enterprise are not separate legal entities; they are separate economic and accounting
entities whose special features necessitate accounting procedures tailored for those features, such as
reciprocal ledger accounts. A branch may obtain merchandise solely from the home office, or a portion
may be purchased from outside suppliers. The cash receipts of the branch often are deposited in a bank
account belonging to the home office; branch expenses then are paid from a bank account provided by the
home office. P/

Accounting systems

The home office must decide how to account for the activities and transactions of the branches.
Accounting systems can be categorized as either centralized or decentralized.

Central i zed Accou nti ng

Under a centralized accounting system, a branch does not maintain a separate general ledger in which to
record the transaction. Instead, it sends source documents on sales, purchases, and payroll to the home
office. Centralized accounting systems are usually practical when the operations of the branches do not
involve complex manufacturing operations or extensive retailing or service activities.

Decentralized Accounting

Under a decentralized accounting system, a branch maintains a separate general ledger in which to record
its transactions. Thus, the branch is a separate accounting entity, even though it is not a separate legal
entity. It prepares its own journal entries and financial statements, submitting later on to the head office,
usually on a monthly basis. The number and types of ledger accounts, the internal control structure, the
form and content of the financial statements, and the accounting policies generally are prescribed by the
home office.

Branch general ledger accounting

Intra Company/reciprocal ledger Accounts

A branch is established when a home office transfers cash, inventory, or other assets to an outlying
location. Because the home office views the assets transferred to the branch as an investment, it makes
the following entry:

Investment in branch - - - - - - - - - - - - - - - xx

Asset (s) - - - - - - - - - - - - - - - - - - - - xx

On receipt of the assets from the home office, the branch makes the following entry:

Asset(s) - - - - - - - - - - - - - - - - - - - - - - xx

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 Home office equity - - - - - - - - - - - - - - xx

The balance in the Investment in Branch account on the books of the home office always equals the
balance in the Home Office Equity account on the books of the branch. In practice, these accounts are
referred to as the Intra Company or reciprocal accounts.

The home office equity account is a quasi-ownership equity account that shows the net investment by the
home office in the branch. Investment in branch is a non-current asset account. It is debited for cash,
merchandise, and services provided to the branch by the home office, and for net income reported by the
branch. And it is credited for cash or other assets received from the branch, and for net loss reported by
the branch. A separate investment account generally is maintained by the home office for each branch.

Home Office Allocations

The home office usually arranges and pays for certain expenses that benefit the branches. The most
common example is insurance, advertisement, etc. In theory, some portion of the insurance expense
should be allocated to the various branches, so that the home office may determine the true operating
income or loss of each branch. In practice, however, allocation of home office expenses varies widely.
Numerous home offices allocate only those expenses that relate directly to the branch operations, such as
insurance. Some home offices without any revenue producing operations of their own allocate all of their
expenses to the branches.

An expense incurred by the home office and allocated to the branch is recorded by the home office:

Investment in branch………………………..xx

Appropriate expense account…………………..xx

The branch debits an expense account and credits home office account.

Inventory Transfer Accounts

When inventory is transferred from the home office to a branch, all that has really happened is that the
inventory has physically moved from one location in the company to another. A sale has not occurred,
because sales takes place only between the company and outside customers. To measure the profitability
of a branch, however, an intra company billing must be prepared. The branch uses special purchase
account called Shipment From Home office to record these inventory transfers and makes the following
entry:

Inventories (Shipments from home office) - - - - - - xx

Home office equity - - - - - - - xx

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The home office uses a special contra purchases account called Shipments to Branch to record inventory
transfers. If the inventory is transferred and billed at the home office‘s cost, the home office makes the
following entry:

Investment in branch - - - - - - - - - - - - - xx

Inventories (Shipments to branch) - - - - - - - - - - - - - - xx

Fixed Asset Accounts

Some home offices require their branches-fixed assets to be recorded on the books of the home office
instead of the books of the branches. Such a procedure automatically ensures that uniform depreciation
methods and asset lives are used for all branches. If plant asset is acquired by the home office for the
branch, the journal entry for the acquisition is: debit to an appropriate asset account and credit to cash or
an appropriate liability account. If the branch acquires a plant asset, it debits the home office ledger
account and credits cash or appropriate liability account. The home office debits an asset account and
credits investment in branch account.

The home office usually charges the branch for the depreciation expense of its fixed assets. It does this
by crediting accumulated depreciation and debiting the Investment in branch account instead of debiting
depreciation expense. The branch debits depreciation expense and credits the Home office Equity
account instead of crediting accumulated depreciation.

Transactions between branches

Efficient operations may on occasion require that merchandise or other assets be transferred from one
branch to another. Generally, a branch does not carry a reciprocal ledger account with another branch but
records the transfer in home office ledger account. The transfer of merchandise from one branch to
another branch does not justify increasing the carrying amount of inventories by the freight costs incurred
because of in direct routing. The amount freight costs properly included in inventories at a branch is
limited to the cost of shipping the merchandise directly from the home office to its present location.
Excess freight costs are recognized as expenses of the home office.

Separate financial statements for branch and home office

A separate income statement and balance sheet should be prepared for a branch so that
management of the enterprise may review the operating results and financial position of the
branch. The separate financial statements prepared for a branch may be revised at the home
office to include expenses incurred by the home office allocable to the branch and to show the
results of branch operations after elimination of any inter company profits on merchandise
shipments.

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Separate financial statements also may be prepared for the home office so that management will
be able to appraise the results of its operations and its financial position. However, it is important
to emphasis that separate financial statements of the home office and of the branch are prepared
for internal use only; they do not meet the needs of investors or other external users of financial
statements.

1.2.Combined financial statements for home office and branch

In preparation of a combined balance sheet, similar accounts are combined to produce a single
total amount for cash, trade account receivab le, and other assets and liabilities of the enterprise
as a whole. However, reciprocal ledger accounts are eliminated because they have no
significance when the branch and home office report as a single entity. The balance of the home
office account is offset against the balance of the investment in branch account; also any
receivable and payables between the home office and the branch (or between two branches) are
eliminated. The operating results of the enterprise (the home office and all branches) are shown
by an income statement in which the revenue and expenses of the branches are combined with
corresponding revenue and expenses for the home office. Any intra company profits or losses are
eliminated.

Chapter 3
IAS 12: Income Taxes
Learning Objectives

At the completion of studying this Standard, you will be able to:

 Define tax base and carrying amount

 Explain the difference between taxable income and accounting income
 Determine the temporary taxable and deductible difference
 Calculate the deferred taxes
 Identify the presentation and disclosure requirements related to income taxes
Basic Concepts

 Accounting profit: It is profit or loss for a period determined in accordance with IFRS
 Taxable profit (tax loss): It is the profit (loss) for a period, determined in accordance with income
tax law

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 Difference between AI
and TI

Permanent Temporary

Deductible Taxable

IAS 12: Accounting for Taxation

 The amount of revenues and expenses recognized on P/L statement in a given period for taxation
purposes (as per tax rule) may differ from what is reported as per the accepted Accounting
Standards. Similarly the carrying amount of assets and liabilities reported on SOFP as per the
accepted accounting standards may differ from the tax base of these amounts.
 These differences are resulted from the difference between the Tax rule and Accounting
standards.

As per IAS 12, income Tax Expense (benefit) consists two different taxes:

1. Current tax: The amount of income taxes payable (recoverable) in respect of the taxable profit (tax
loss) for a period.

2. Deferred tax represents taxes payable/recoverable in future periods in relation to transactions which
have taken place.

-Deferred tax Payable (deferred Tax Liability)

-Deferred tax Recoverable (deferred Tax Asset)

Is deferred tax an amount levied by government? Deferred tax is an accounting measure , rather than
a tax levied by government; used to match the tax effects of transactions with their accounting impact and
thereby produce less distorted results.

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Basic Concepts in IAS 12

IAS 12 does not provide rules for computing current tax (since it is the taxation rule in each jurisdiction
that is applied to compute current tax). But IAS 12 requires a tax liability to be recognized where an entity
has unpaid current tax, whether it arises from current/prior periods.

 any unpaid tax in respect of the current or prior periods to be recognized as a liability.

IAS 12 also requires a tax asset to be recognized where an entity has overpaid its tax liabilities

 any excess tax paid in respect of current or prior periods over what is due should be
recognized as an asset

If current taxes payable > taxes paid, there will be Income taxes payable (liability)

If current income taxes payable < taxes paid, there will be Income taxes recoverable/receivable (asset)

It is inherent in the recognition of an asset or liability that the reporting entity expects to recover or settle
the carrying amount of that asset or liability. This concept applies to taxes as follows:

 Tax Liability-Like any other liability it is recognized as a result of past transaction, expected to
result in future probable outflow of economic benefit, measurable, controlled by entity
 Tax Asset-Like any other asset it is recognized as a result of past transaction, expected to provide
probable future economic benefit, measurable, controlled by entity

Measurement of Current tax liabilities (assets)

Current tax liabilities (assets) for the current and prior periods shall be measured: at the amount
expected to be paid to (recovered from) the taxation authorities, by using the tax rates (and tax laws)
that have been enacted or substantively enacted by the end of the reporting period.

Normally, current tax is recognized as income or expense and included in the net profit or loss for the
period.

Accounting for operating losses

Recognition of benefit from Tax Loss (Pre -tax Operating Loss) as an Asset

IAS 12 requires recognition as an asset of the benefit relating to any tax loss (Pre-tax Operating Loss) that
can be carried back to recover current tax of a previous period.

Usually, the tax code allows companies that report operating losses to claim a tax credit related to these
losses for taxes paid in the past (referred to as ―carrybacks‖) and

– to offset taxable income in periods following the operating loss (referred to as

―carryforwards‖).
– An asset should be recognized in the period in which the loss is made

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Therefore, an operating loss is used to offset either the Taxable Past Income or Taxable Future Income
(Carried Backward and Carried Forward). An operating loss occurs for tax purposes in a year when tax
deductible expenses exceed or greater than the taxable revenues (long term projects/%completion
method).

 Loss Carry Backward and Carry forward can create a difference in taxable income and
accounting income.

Recognition of Current tax when Accounting Income differs from Taxable

Income
1. Accounting profit: Net profit or loss for a period before deducting tax expense. It is a financial
reporting term. It is also often referred to as pre tax accounting profit/income before taxes,
income for financial reporting purposes, or income for book purposes. Companies determine
accounting profit according to accepted accounting standards/rules. They measure it with the
objective of providing useful information to investors and creditors.
2. Taxable profit (tax loss). The profit (loss) for a period, determined in accordance with the
rules established by the taxation authorities, upon which income taxes are payable (recoverable).
It is a tax accounting term. It is also known as income for tax purposes. It indicates the
amount used to compute income taxes payable. Companies determine taxable income according
to the Internal Revenue Code (the tax code).

Presentation of current tax liabilities and assets

In the statement of financial position, tax assets and liabilities should be shown separately from other
assets and liabilities. The tax expense (income) related to the profit or loss from ordinary activities
should be shown in the statement of comprehensive income (i.e.. P/L statement)

Recognition of Deferred Tax Liabilities and Assets

When accounting Income & taxable income differs due to temporary/timing difference, there will be a
difference between:

 tax expense reported on P/L statement and

 tax payable reported on SOFP
1. Amount of Tax Expense Reported on P/L Statement:

Tax expense is calculated based on accounting profit adjusted for permanent difference.

Tax Expense= Tax rate x Accounting profit adj. for P/Diff.

2. Amount of Tax Payable/liability reported on SOFP:

Tax liability is computed by applying tax rate on Taxable income

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 Tax Liability=Taxable income x Tax Rate

Temporary differences will result In recording deferred taxes,(deferred tax liability/asset). Accounting
profit is thus not the same as taxable profit. The variation is caused by the difference between accounting
principles of revenue and expense recognition and taxation principles. The differences may be due to:

1) Permanent difference: This results from items that enter in computing accounting income but not
considered in computing taxable income Eg. Entertainment, donation
2) Temporary Difference/Timing difference: This results from timing difference in recognizing an
item as revenue/expense on P/L and asset/liability on SOFP due to the difference in methods
applied by tax authorities and accounting regulation. Temporary difference will result in deferred
tax.
1. Permanent Differences
Some items of revenue and expense that a corporation reports for financial accounting purposes are never
reported for income tax purposes. These permanent differences never reverse in a later accounting period.
For example, Entertainment expense, Donation
2. Temporary differences:
These are differences between the carrying amount of an asset or liability in the SOFP and its tax
base. In other words, where carrying amount of an asset or liability is different from the tax base a
‗temporary difference‘ arises.

Carrying amount vs. tax base of asset or liability

Carrying amount is the amount the asset or liability is recorded at in the accounting records.

Tax base : -is the amount attributed to an asset or liability for tax purposes

-
It represents the amount an asset or liability would be recorded at, if the SOFP
were prepared applying taxation rules.
Sources of Temporary differences

 Differences in depreciation method for Financial reporting & for tax purpose (effect is shown on
P/L statement)
 Revenue from the sale of goods is included in accounting profit when goods are delivered but is
included in taxable profit when cash is collected.
 An entity revalues property, plant and equipment (under the revaluation model treatment in IAS
16 PPE) but no equivalent adjustment is made for tax purposes.
 Prepaid expenses have already been deducted on a cash basis in determining the taxable profit of
the current or previous periods.
Temporary differences may be either: Taxable temporary differences or Deductable temporary
differences

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 1. Taxable temporary differences:
This results in an increase in future taxable amount as asset is recovered/liability is settled

-Creates a liability - Deferred tax liability

A deferred tax liability is the deferred tax consequences attributable to taxable temporary
differences. In other words, a deferred tax liability represents the increase in taxes payable in future
years as a result of taxable temporary differences existing at the end of the current year.

2. Deductable temporary differences

Deductable temporary difference (Future taxable amount decrease) -This results in a decrease in future
taxable amount when asset is recovered/liability is settled

-Creates an asset - Deferred tax Asset

Deferred tax Asset is the deferred tax consequence attributable to deductible temporary differences. In
other words, a deferred tax asset represents the increase in taxes refundable (or saved) in future
years as a result of deductible temporary differences existing at the end of the current year.

Presentation
 Current tax payable is always shown as a current liability.
 Deferred tax items cannot be shown as current assets or current liabilities.
 Current and deferred tax balances are to be shown as separate items (offsetting is not allowed).
 Deferred tax assets or liabilities should not be discounted
Disclosure
 current tax expense (or income);
 any adjustments recognized in the period:
 for current tax of prior periods;
 from a previously unrecognized tax loss
 from a previously unrecognized temporary difference
 the amount of deferred tax expense (or income)
 an explanation of the relationship between tax expense (or income) and accounting profit
 a numerical reconciliation between the average effective tax rate and the applicable tax rate

CHAPTER FOUR
SHARE BASED PAYMENTS (IFRS 2)

INTRODUCTION

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Relevant and faithfully represented financial information about an entity's share based payment
transactions is useful to existing and potential investors, creditors and employee in making decisions
about providing goods or services to the entity.

SCOPE OF IFRS 2

IFRS 2 applies to transactions in which;

 Share or other equity instruments are issued in return for goods or services (eg. Employee share
options)
 The payment amount is based on the price of entity's shares (eg. Share appreciation rights)
IFRS 2 doesn‘t apply to shares or other equity instruments issue as a consideration for business
combination

Objectives

The objective of this IFRS is to specify the financial reporting by an entity when it undertakes a share-
based payment transaction.

In particular, it requires an entity to reflect in its profit or loss and financial position the effects of share -
based payment transactions, including expenses associated with transactions in which share options are
granted to employees.

Definition

Share based payment?

It is an agreement between the entity and another party (suppliers, employee) to made payments based on
shares or share prices.

Or payment for goods or services in either:

 Shares
 Share options
 Cash payment based on share price
Share option: is the right to buy a certain number of shares at a fixed price, some period of time in the
future with in the company.

RECOGNITION OF SHARE BASED BAPMENT

Share based payment will be recognized when goods are obtained or services are received.

How share based payment will be recognized?

There are two alternatives;

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The entity shall recognize a corresponding increase in
equity if the goods or services were received in an equity-settled share-based payment transaction,

Asset/expense . . . . Xx

Equity . . . . . . . . . . . . xx

or a liability if the goods or services were acquired in a cash-settled share-based payment transaction.

Asset/expense . . . . . . xx

Liability . . . . . . . . . . . . . xx

Measurement of share based payments - Equity Settled

The entity shall measure the goods or services received at the fair value of the goods or services received
at the measurement date.

If the entity cannot estimate the fair value of goods or services received reliably , measure at the fair
value of equity instrument at the grant date.

For employee it might be difficult to measure the fair value services and, instead can use fair value of
equity instruments granted.

Important terminologies

Grant date: today, a date where an agreement is made between an entity and employee to receive cash or
share options.

Vesting date: Employees become entitled to the share based payment. ( no of years from the grant date
will be indicated or other vesting conditions).

Exercise date: employee receives share based payment.

No vesting condition, non employee

Eg1. Entity ABC acquires inventories with a fair value of $100,000 and issues 100 shares to its supplier
as consideration. The inventories are received by Entity ABC on 1 April 2022 when Entity ABC‘s share
price is $1200.

ABC recognizes the following journal entry on 1 April 2022:

Inventories …… $100,000
Equity . . . . ……$100,000

If Entity ABC cannot reliably estimate the fair value of the inventories on 1 April 2022, the journal entry
on 1 April 2022 will be:

Inventories . . . . . $120,000

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 Equity . . . . . . $120,000

Employee with no vesting condition

Eg2. Entity A contracted a consultant to advice on a new marketing campaign. The consultant agreed to
accept ordinary shares of Entity A as payment for his services. The consultant advice had an invoice price
of $ 3,000 and Entity A issued 100 ordinary shares with a par value of $10 each.
The entity determines that the invoice value of the consultant fees is the best estimate of the fair value of
the marketing advice. Consequently, Entity A accounts for the transaction as follows:
marketing expense……………..$3,000
ordinary share capital……………………………………… …………$1,000
Equity share premium account . . . . …………………………………..$2,000

Vesting conditions, employee service

Eg3. Entity B grants 100 share options to each of its 500 employees. Each grant is conditional upon the
employee working for the entity over the next three years. The entity estimates that, on the date of grant,
the fair value of each share option is $15. On the basis of a weighted-average probability, the entity
estimates that 20% of employees will leave during the three-year period and therefore forfeit their rights
to the share options.

If everything turns out exactly as expected, Entity B makes the following entries in the years during the
vesting period, for services received as consideration for the share options.
Year 1
staff compensation expense . . . . . $200,000
Equity . . . . . . . . . . . . . $200,000
(To recognize the receipt of employee services in exchange for share options)
Calculation: 50,000 options granted × 80% = 40,000 options expected to vest. 40,000 × $15 grant date
fair value of each option × 1/ 3 of vesting period elapsed = $200,000 recognized in Year 1, 2 & 3

The facts are the same as in Example 21. However, in this example not everything turns out exactly as
expected. In particular:

 During Year 1, 20 employees leave.

 At the end of Year 1 the entity revises its estimate of total employee
departures over the three-year period from 20% (100 employees) to 15% (75
employees).
 During Year 2, a further 22 employees leave.
 At the end of Year 2 the entity revises its estimate of total employee
departures over the three-year period from 15% to 12% (60 employees).
 During Year 3, a further 15 employees leave (i.e a total of 57 employees
forfeited their rights to the share options during the three-year period, and a
total of 44,300 share options (443 employees × 100 options per employee)
vested at the end of Year 3.

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  Entity B records the equity compensation scheme using the following entries.
Year1
staff compensation expense . . . . . $212,500
Equity . . . . . . . . . . . . . $212,500
i.e: 50,000 options granted × 85% = 42,500 options expected to vest. 42,500 × $15 grant date fair
value of each option × 1/ 3 of vesting period elapsed = $212,500 recognized in Year 1.
Year 2

Staff compensation expense . . . . . $227,500

Equity . . . . . . . . . . . . . $227,500
i.e: 50,000 options granted × 88% = 44,000 options expected to vest. 44,000 × $15 grant date fair
value of each option × 2/ 3 of vesting period elapsed = $440,000 recognized cumulatively to the
end of Year 2. $440,000 less $212,500 recognized in Year 1 = $227,500 recognized inYear 2

 Year3
staff compensation expense . . . . . $224,500
Equity . . . . . . . . . . . . . $224,500

i.e: 44,300 options vested × $15 grant date fair value of each option × 3/ 3 of vesting period
elapsed = $664,500 recognized cumulatively to the end of Year 3. CU664,500 less $227,500
recognized in Year 2 less $212,500 recognized in Year 1 = $224,500 recognized in Year 3

(To recognize the receipt of employee services in exchange for share options)

Measurement of share based payment transactions – cash settled

Cash-settled share-based payment transactions, the entity shall measure the goods or services acquired
and the liability incurred at the fair value of the liability, subject to re -measurement until the liability is
settled.

The entity shall remeasure the fair value of the liability at the end of each reporting period and recognized
the change in profit or loss for the period.

Possible adjustment to the liability should be made at each reporting date, i.e;

Liability . . . . . .xx

Fair value adjustment (gain) . . . .xx

Or

Fair value adjustment (loss) . . . . . Xx

Liability . . . . . . . . xx

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Disclosure

An entity shall disclose the following information about the nature and extent of
share-based payment arrangements that existed during the period:

 method of settlement
 Vesting conditions
 Method of measurement for liability and equity

Chapter Five
Agricultural activity (IAS 41)
This Standard shall be applied to account for the following when they relate to agricultural activity:

(a) biological assets; and

(b) agricultural produce at the point of harvest.

This Standard does not apply to:

 Land related to agricultural activity (see IAS 16 Property, Plant and Equipment and IAS 40
Investment Property).
 intangible assets related to agricultural activity (see IAS 38 Intangible Assets).
 Harvested agricultural produce (IAS 2, Inventory). However, it does apply to produce growing on
bearer plants.
 Bearer plants related to agricultural activity (see IAS 16). However, IAS 41 applies to the
produce on those bearer plants.
 Government grants related to bearer plants (see IAS 20 Accounting for Government Grants and
Disclosure of Government Assistance).
Agricultural activity is the management by an enterprise of the biological transformation of biological
assets for sale, into agricultural produce or into additional biological assets.

Terminology

Biological asset (classified as a non-current asset) is a living animal or plant, such as sheep,
cows, fruit trees, or cotton plants.
 Agricultural produce is the harvested product of a biological asset, such as wool from a sheep,
milk from a dairy cow, picked fruit from a fruit tree, or cotton from a cotton plant.
 Harvest – is detachment of produce from a Biological asset or the cessation of biological asset‘s
life.
 Entity A raises cattle, slaughters them at its abattoirs and sells the carcasses to the local
meat market. Which of these activities are in the scope of IAS 41?
Example 1

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The cattle are biological assets while they are living. When they are slaughtered, biological
transformation ceases and the carcasses meet the definition of agricultural produce. Hence, Entity A
should account for the live cattle in accordance with IAS 41 and the carcasses as inventory in accordance
with IAS 2 Inventories.

Recognition and measurement Biological asset

Initial measurement is:

 At Fair value less any estimated 'point of sale' costs

 If there is no fair value, then use the cost model
• This alternative basis is only allowed on initial recognition.
Subsequent measurement of Biological assets:

• Revalue to fair value less point of sale costs (net realizable value) at year end, taking any gain or
loss (changes in the NRV) to the statement of profit or loss.
Agricultural produce

• At the date of harvest the produce should be recognized and measured at fair value less estimated
costs to sell (NRV).
• Gains and losses on initial recognition are included in profit or loss (profit from operations) for
the period.
• After produce has been harvested:
 IAS 41 ceases to apply.
 Agricultural produce should be classified as inventory in the statement of financial position.
 Fair value less costs to sell at the point of harvest is taken as cost for the purpose of IAS 2
Inventories, which is applied from then onwards.
Fair value

Biological assets are measured at fair value less cost to sale and changes in fair value less cost to sale are
reported as part of profit for the period in the SPL.

 This means that a farmer’s profit for the year reflects:

 the increase in the value of his productive assets as a whole, as well as
 the profit on any sales made during the year.
Bearer plants

 Bearer plants are accounted for under IAS 16 Property, Plant and Equipment, rather than IAS 41
Agriculture. A bearer plant is a living plant that:
 is used in the production or supply of agricultural produce;
 is expected to bear fruit for more than one period &
 Is unlikely that entity will harvest the plant as agricultural produce

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  Therefore, items such as vines, tea bushes and fruit trees may be classed as bearer plants and
treated as property, plant and equipment rather than being accounted for under IAS 41
Agriculture.
Disclosures

 An entity shall disclose the aggregate gain or loss that arises on the initial recognition of
biological assets and agricultural produce and the change in Fair value less estimated point-of sale
costs of the biological assets.
 A description of each group of biological assets is also required.
 The methods and assumptions applied in determining fair value should also be disclosed.

CHAPTER SIX

INSURANCE CONTRACTS (IFRS 17)

Objectives of IFRS 17

• To establish principles for the recognition, measurement, presentation and disclosure of insurance
contracts.
• To ensure that an entity provides relevant information that faithfully represents those contracts.
This enables the users to assess the effect of insurance contracts on the financial performance,
financial position and cash flows of the company
Insurance contract: is A contract under which one party (the insurer) accepts significant insurance risk
from another party (the policyholder) by agreeing to compensate the policyholder if a specified uncertain
future event (the insured event) adversely affects the policyholder.

Models for treatment of insurance contracts

As per IFRS 17 there are three allowable models

1. GMM (General Measurement Model): is default model.

2. PAA (Premium allocation Approach): for the insurance company which gives mainly short term
insurance services.
VFA (Variable Fee Approach): for the insurance company mainly gives ―investment insurance contracts
with discretional participating features”.

Aggregation of Insurance Contracts

• Insurance company must assess the risk nature of each contracts

• The company must create portfolios of contracts subject to similar risks and managed together
• The board oblige to divide a portfolio into, at a minimum, groups of:
A. Contracts that are onerous at initial recognition
B. Contracts that are not onerous at initial recognition and that have no significant possibility of
becoming onerous subsequently
C. Other contracts

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Initial Recognition of Insurance contracts (GMM)

Basic steps in initial recognition

Step 1: Determination of fulfillment cash flows(FCF)

Step 2: Determination of Contractual Service Margin (CSM)

Steps to Determine FCF:

Step1: Estimation of cash inflows

Step2: Estimation of cash outflows

Step3:Determination of Present value of cash inflows & outflows

Step4: Non-financial risk adjustment

FCF is an explicit, unbiased, and probability-weighted estimate (i.e. expected value) of the present value
of the future cash flows that will arise as the insurer fulfils its insurance contract obligations, including a
risk adjustment for non-financial risk.

FCF= PV of inflows – PV of outflows - Risk adjustment

Where:

FCF: fulfillment cash flows

PV: present value

Risk adjustment: risk adjustment of non financial risks

Contractual service margin(CSM)

• Is the excess of estimated cash inflows over cash outflows including risk adjustment.
• CSM is unearned profit margin.
• CSM have to allocated to the coverage period
• The amount of premium collected or to be collected is not reported as revenue at the beginning.
• CSM is not reported as revenue at the beginning.

Subsequent Recognition

1. Determination of incurred claim and liability of the remaining coverage period.

2. Recognition of insurance service result (insurance service revenue and insurance service expense)
Example

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 • Awash Insurance Co. issues a group of insurance contracts with a coverage period of four years.
At inception, the total premiums from the group of 1,500 are received and insurance acquisition
cash flows of 100 are paid.
• Awash insurance: expects claims and expenses of 800 to be incurred evenly over the coverage
period. Claims are settled as they are incurred.
• The risk adjustment for non-financial risk on initial recognition is 80. For simplicity this example
assumes that it is released evenly over the coverage period.
• Over the coverage period, all events happen as expected and Awash does not change any
assumptions related to future periods.
Required: Show all necessary steps in initial and subsequent recognition of the contracts using
GMM.

To measure insurance contract liability on initial recognition and at the end of the period.

Initial Year 1 Year 2 Year 3 Year 4

recognition

Estimates of the present value of cash 1,500 - - - -

Inflows

Estimates of the present value of cash (900) (600) (400) (200) -

outflows, including
Acquisition cash flows

Risk adjustment (80) (60) (40) (20) -

Fulfilment cash 520 (660) (440) (220) -

Flows

CSM (520) (390) (260) (130) -

Insurance (1,050) (700) (350) -

contract liability -

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The change in the liability for remaining coverage for each period

Insurance Revenue and Expense for each year

Year 1 Year 2 Year 3 Year 4

Expected claims 200 200 200 200

Risk adjustment 20 20 20 20

CSM allocation 130 130 130 130

Revenue for services provided 350 350 350 350

Revenue to cover acquisition cash flows 25 25 25 25

Insurance Revenue 375 375 375 375

Service expense 200 200 200 200

Insurance acquisition expense 25 25 25 25

Insurance service expenses 225 225 225 225

Insurance service result 150 150 150 150

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 COURSE: ADVANCED FINANCIAL ACCOUNTING II
Chapter One
Business Combinations
Definition of Business Combination

Business combinations are events or transactions in which two or more business enterprises, or their net
assets, are brought under common control in a single accounting entity. Commonly, business
combinations are often referred to as mergers and acquisitions.

Business combinations are classified into two classes based on nature: friendly takeovers and unfriendly
(hostile) takeovers.

Friendly Takeover

 The Board of Directors of all constituent companies amicably (friendly) determine the terms of the
business combination.
 The proposal is submitted to share holders of all constituent companies for approval.
Hostile Takeovers

In this type of takeovers, the target combinees typically resist the proposed business combination.

Thus, the target combinee uses one or more of the following defensive tactics. Some of the tactics are:

 White Knight: a search for a candidate to be the combinor in a friendly takeover.

 Scorched Earth: the disposal of one or more business segments that attracts the combinor. The
profitable segment can be disposed through sale or spin-off. This is sometimes called selling the
crown jewels: The sale of valuable assets to others to make the firm less attractive to the would-
be acquirer.
 Poison Pill: an amendment of the articles of incorporation or bylaws to make it more difficult to
obtain stockholder approval for a takeover.

Types of Business Combinations

There are three types of business combinations: Horizontal Combination, Vertical Combination, and
Conglomerate Combination:

1. Horizontal Combination: is a combination involving enterprises in the same industry. E.g.

assume combination of BEDELE Brewery and HARAR Brewery
2. Vertical Combination: A Combination involving an enterprise and its customers or suppliers. It
is a combination involving companies engaged in different stages of production or distribution.
E.g.1: A Tannery Company acquiring a Shoes Company - Forward
E.g.2: Weaving Company acquiring both Ginning and Spinning Company - Backward

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 3. Conglomerate (Mixed) Combination: is a combination involving companies that are neither
horizontally nor vertically integrated. It is a combination between enterprises in unrelated
industries or markets.
Business Combinations: Why?

A bus iness co mbinatio n refers to any set of condit io ns in wh ich two or more organ izat io ns are jo ined
together throug h common co ntro l. The company whose bus iness is be ing soug ht is after called the ta rge t
co mpany.

Why do business enterprises enter into a business combination? There are a number of reasons for
business combinations, some of the reasons are: Growth, Economies of Scale, Operating Economies,
Better Management, Monopolistic Ambitions, Diversification of Business Risk, Tax Advantages,
Elimination of Fierce Competition, Better Financial Planning& Getting financial gains.

Methods for Arranging Business Combinations

The four common methods for carrying out a business combination are: Statutory Merger, Statutory
Consolidation, Acquisition of Common Stock, and Acquisition of Assets.

1. Statutory Merger
Statutory Merger is a merger in which one of the merging companies continues to exist as a legal
entity while the other or other are dissolved. A business combination in which one company (the
survivor) acquires all the outstanding common stock of one or more other companies that are
then dissolved and liquidated, with their net assets owned by the survivor. E.g. ABC Company
acquires all the outstanding common stock (net assets) of XYZ Company where XYZ Company
is legally liquidated

ABC Company
ABC Company
XYZ Company

2. Statutory Consolidation
It is a merger in which a new corporate entity is created from the two or more merging companies, which
cease to exist. E.g. ABC Company acquires XYZ Company; but a new Company AYZ is created to
issue common stocks for the two companies which are now defunct.

ABC Company
AYZ Company
XYZ Company

3. Acquisition of Common Stock

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One corporation (the investor) may issue preferred or common stock, cash, debt, or a combination thereof
to acquire a controlling interest in the voting common stock of another corporation (the investee). If a
controlling interest in the combinee‘s voting common stock is acquired, that corporation becomes
affiliated with the combinor (parent company) as a subsidiary but is not dissolved and liquidated and
remains a separate legal entity. E.g. ABC Company acquires over 50% of the voting stock of XYZ
Company, a parent–subsidiary relationship results and XYZ Company is now a subsidiary of ABC
Company (Parent)

ABC Company ABC Company Parent

Business Company

XYZ Company Combination XYZ Company Subsidiary

Company

4. Acquisition of Assets
A business enterprise may acquire all or most of the gross assets or net assets of another enterprise for
cash, debt, preferred or common stock, or a combination thereof. The transaction generally must be
approved by the boards of directors and stockholders of the constituent companies. The selling enterprise
may continue its existence as a separate entity or it may be dissolved and liquidated; it does not become
an affiliate of the combinor.

Accounting for Business Combinations

Acquisition method: The acquisition method (called the 'purchase method' in the 2004 version of IFRS 3)
is used for all business combinations.

The following steps should be undertaken in applying the acquisition method:

1. Identify the acquirer;

2. Determine the acquisition date;
3. Recognition and measurement of the identifiable assets acquired, the liabilities assumed and any
non-controlling interest (NCI, formerly called minority interest) in the acquiree, and
4. Recognition and measurement of goodwill or a gain from a bargain purchase

Accounting for a business combination by the acquisition method follows principles normally applicable
under historical cost accounting to record acquisition of assets and issuances of stock and to accounting
for assets and liabilities after acquisition.

 Assets (including goodwill) acquired for cash would be recognized at the amount of cash paid

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 Assets acquired involving the issuance of debt, preferred stock, or common stock would be
recognized at the current fair value of the asset, or the debt or the stock, whichever was more
clearly evident.
Computation of Cost of a Combinee

The cost of a combinee in a business combination accounted for by the acquisition method is the total of:

 The amount of consideration paid by the combinor &

 Any contingent consideration that is determinable on the date of the business combination
Amount of Consideration

This is the total amount of:

 cash paid
 the current fair value of other assets distributed
 the present value of debt securities issued, and
 the current fair/market value of equity securities issued by the combinor.
Contingent Considerations

Contingent consideration is additional cash, other assets, or securities that may be issued in the future,
contingent on future events such as a specified level of earnings or a designated market price for a
security that has been issued to complete the business combination. Contingent consideration that is
determinable on the consummation date of a combination is recorded as part of the cost of the
combination while that not determinable on the date of combination is recorded when the contingency is
resolved and the additional consideration is paid or issued or becomes payable or issuable. As per IFRS 3,
contingent consideration must be measured at fair value at the time of the business combination
and is taken into account in the determination of goodwill.

An acquirer might incur various transaction costs related to a business combination. Examples are:
finder‘s fees, professional or consulting fees (such as advisory, legal, accounting or valuation costs), are
collectively referred to as ―acquisition-related costs.‖ Acquisition-related costs generally must be
accounted for separately from the business combination and expensed as incurred. In other words, they
are not capitalized as part of the business combination transaction.

Goodwill

Goodwill is recognized frequently because the total cost of the combinee exceeds the current fair value of
identifiable net assets. The amount of goodwill recognized at the outset may be adjusted subsequently
when contingent considerations become issuable.

Negative Goodwill (A gain from a bargain purchase )

Negative goodwill means an excess of current fair value of the combine‘s identifiable net assets over their
cost to the combiner. IFRS 3 allows an accounting policy choice, available on a transaction by transaction
basis, to measure non-controlling interests (NCI) at the date of acquisition either at:

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Fair (FULL) value method: e.g. Share price of NCI equity shares; or using other valuation techniques if
not publicly traded; In the FV method goodwill is recognized for both parent and NCI

or

Proportionate share (PARTIAL) METHOD: of the net identifiable assets of the entity acquired. Argued
that PARTIAL method of calculating goodwill only recognises the goodwill acquired by the parent i.e.
any goodwill attributable to NCI is not recognised.

As a general rule, the amount of goodwill is determined using the fair value of the consideration
transferred. The basic formula used to calculate goodwill is:

Goodwill = FV of the consideration transferred + Non controlling interest – FV of net assets acquired

For business combinations achieved in stages, the fair value of the acquirer‘s previously-held equity
interest in the acquiree is added to the total before subtracting the fair value of net assets acquired, as
follows:

Goodwill = FV of the consideration transferred + Non controlling interest + FV of the acquirer‘s

previously-held equity interest – FV of net assets acquired

Positive goodwill

 Recognise as asset from date of acquisition

 Do not amortise
 Subject to annual impairment testing or more frequently if events or circumstances dictate

Bargain Purchase

If the calculation of goodwill results in a negative balance, the transaction might be a bargain purchase. In
a bargain purchase, the acquirer essentially buys the net assets of the acquire at a discount.

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  Bargain purchases are rare. They do, however, arise occasionally. For instance, a bargain
purchase might happen if the acquiree is under financial distress and must sell its business to
survive.
 Before concluding that a bargain purchase has occurred, an acquirer is required to revisit steps 3
and 4 of the acquisition method. Specifically, the acquirer must reassess:
 Whether it properly identified all assets acquired and liabilities assumed in the business
combination
 Whether these assets and liabilities were measured appropriately
 Whether the other amounts used to compute goodwill, such as the fair value of the consideration
transferred and non controlling interest, were determined correctly
 If, after this reassessment, the acquirer concludes that a bargain purchase has taken place, the
acquirer recognizes a gain on the bargain purchase.
 Treated as immediate income i.e. ‗credit P/L‘ in arriving at profit or loss

Illustration of Purchase Accounting for Statutory Merger, with Goodwill

On December 31, 2009, Mason Company (the combinee) was merged into Saxon Corporation (the
combinor or the survivor). Both companies used the same accounting principles for assets, liabilities,
revenue and expenses and both had a December 31 fiscal year. Saxon issued 150,000 shares of its $10 par
common stock (current fair value is $25 a share) to Mason‘s stockholders for all 100,000 issued and
outstanding shares of no-par, $10 stated value common stock. In addition, Saxon paid the following out of
pocket costs associated with the business combination:

Accounting fees:
For investigation of Mason as prospective combinee 5,000
For SEC registration statement for Saxon common stock 60,000
Legal fees:
For the business combination 10,000
For SEC registration statement for Saxon common stock 50,000
Finder‘s fee 51,250
Printer‘s charges for printing securities and SECreg statement 23,000
SEC registration statement fee 750
Total out of pocket expenses 200,000
There was no contingent consideration in the merger contract.

Immediately prior to the merger, Mason Company‘s condensed balance sheet was as follows:

Mason Company (combinee)

Balance Sheet (prior to business combination)

December 31, 2009

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 Assets
Current assets 1,000,000
Plant assets (net) 3,000,000
Other assets 600,000
Total assets 4,600,000

Current liabilities 500,000

Long term debt 1,000,000
Common stock, no par, $10 stated value 1,000,000
Additional paid in capital 700,000
Retained earnings 1,400,000
Total liabilities and capital 4,600,000

Using the guidelines in APB Opinion No. 16, the board of directors of Saxon Corporation determined the
current fair values of Mason Company‘s assets and liabilities (identifiable net assets) as follows:
Current assets 1,150,000
Plant assets 3,400,000
Other assets 600,000
Current liabilities (500,000)
Long term debt (present value) (950,000)
Identifiable net assets of combinee 3,700,000
The following are journal entries required by Saxon Corporation to record the merger. Saxon uses the
investment ledger to accumulate the total cost prior to assigning the cost to identifiable net assets and
goodwill.
Required:

a) Pass necessary journal entries in the books of Saxon Corporation & Determine the amount of
goodwill.
b) Record the liquidation of mason company in conjunction with merger with Saxon Corporation:

Business Combination Disclosures

 Disclosures for business combinations and intangible assets. This includes, but is not limited to:
 Reason for combination,
 Allocation of purchase price among assets and liabilities, and
 Goodwill or gain from bargain purchase.

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 CHAPTER TWO

CONSOLIDATIONS: ON DATE OF PURCHASE-TYPE BUSINESS COMBINATION

Parent Company- Subsidiary Relationships

IFRS 10 establishes principles for the presentation and preparation of consolidated financial statements
when an entity controls one or more other entities. If the investor acquires a controlling interest in the
investee, a parent- subsidiary relationship is established. The investee becomes a subsidiary of the
acquiring (parent) company but remains a separate legal entity. Strict adherence to legal aspect requires
issuance of separate financial statements for the parent company and subsidiary but disregards the
substance of the relationship. A parent company and its subsidiary are a single economic entity. In
recognition of this fact, consolidated financial statements are issued to report their financial and operating
results as though they comprised a single accounting entity.

Definition of Consolidation:

The process of combining the financial statements of a parent company and one or more legally separate
and distinct subsidiaries as a single economic entity for financial reporting purposes.

Consolidated financial statements are similar to combined financial statements of home office and its
branches:

 Assets, liabilities, revenue, and expenses of the parent and its subsidiaries are totaled
 Intercompany transactions and balances are eliminated
 And the final consolidated amounts are reported
The Financial Accounting Standards Board requires consolidation of nearly all subsidiaries except those
not actually controlled.

De FACTO CONTROL

Entity can control with less than 50% of voting rights. Factors to consider include:

 size of the holding relative to the size and dispersion of other vote holders
 potential voting rights
 other contractual rights
If the above not conclusive consider additional facts and circumstances that provide evidence of power
(eg voting patterns at previous board meeting, etc)

An entity that has one or more subsidiaries (a parent) must present consolidated financial statements.

PRINCIPLE

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Consolidated financial statements present the parent and all its subsidiaries as financial statements of a
single economic entity


uniform accounting policies

same reporting periods

eliminate intragroup transactions and balances

non-controlling interest (the equity in a subsidiary that is not attributable, directly or
indirectly, to the parent) is presented within equity, separately from the parent
shareholders‘ equity.
Consolidation of Wholly Owned Subsidiary on Date of Purchase - Type Business Combination

There is no question of control of a wholly owned subsidiary. To illustrate, assume that on Dec. 31, 1999,
Palm Corporation issued 10,000 shares of its $10 par common stock (current fair value $45 a share) to
stockholders of Star Company for all outstanding $5 par common stock. There was no contingent
consideration. Out of pocket costs consist of:

Finder‘s and legal fee relating to business combination 50,000

Assume also that the business combination qualified for purchase accounting. Star Company continues its
corporate existence. Both constituent companies had a December 31 fiscal year and used the same
accounting policies.

Financial statements of the constituent companies prior to consummation of the business combination
follow:

PALM CORPORATION AND STAR COMPANY

Separate Financial Statements (prior to purchase-type business combination)

December 31, 1999

Palm Star

Balance Sheet

Assets

Cash 100,000 40,000

Inventories 150,000 110,000

Other current assets 110,000 70,000

Receivable from Star 25,000

Plant assets (net) 450,000 300,000

Patent (net) 20,000

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 Total assets 835,000 540,000

Liabilities and Stockholders’ Equity

Payable to Palm 25,000

Income taxes payable 26,000 10,000

Other liabilities 325,000 115,000

Common stock, $10 par 300,000

Common stock, $5 par 200,000

Additional paid in capital 50,000 58,000

Retained earnings 134,000 132,000

Total liab& stockholders‘ equity 835,000 540,000

On December 31, 1999, current fair values of Star Company‘s identifiable assets were the same as their
carrying amounts except for the following items:

Inventories 135,000

Plant assets (net) 365,000

Patent (net) 25,000

Palm Corporation recorded the combination as a purchase with the following entries:

Required:

a) Determine the amount of goodwill

b) Pass necessary journal entries in the books of Palm Corporation
c) Prepare elimination journal entry
d) prepare the Consolidated Balance sheet of Palm Corporation and its subsidiary on December 31,
1999 without the help of working paper
e) prepare the Consolidated Balance sheet of Palm Corporation and its subsidiary on December 31,
1999 with the help of working paper

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 Chapter Three
Foreign Currency Accounting
Accounting for Foreign Currency Transactions (IAS 21)

 The objective of this Standard is to prescribe foreign currency transactions, foreign operations,
translate financial statements into a presentation currency.
 The principal issues are which exchange rate(s) to use and how to report the effects of changes in
exchange rates in the financial statements.
Businesses that involve in international trades or Multi-National Company (MNC) need foreign
currencies to enter into different transactions. A ―Multi-National Company‖ is one that conducts its
business in more than one country via branches, joint ventures, subsidiaries etc. In most countries, the
foreign currency is treated as a commodity or a money-market instrument. Thus, different Multi-National
Companies (MNCs) involve buying and selling of foreign currency. The following different Exchange
Rates are applicable for buying and/or selling foreign currency:

Spot Rates: are rates used by banks for immediate delivery or receipts of a foreign currency. The two
spot rates are (i) Spot Selling Rate : The rate charged by the bank for current sales in foreign currency;
and (ii) Spot Buying Rate : The rate applied by the bank to acquire a foreign currency. The spot buying
rate is usually lower than the spot selling rate.

Forward Rates: are rates applied to foreign currency transactions to be consummated at a future date.
The two forward rates are (i) Forward Selling Rate : The rate charged by the bank for future sales in
foreign currency, and (ii) Forward Buying Rate : The rate applied by the bank to acquire a foreign
currency in the future. The forward buying rate is usually lower than forward selling rate.

Spread: is the difference between the selling and the buying spot rates and represent gross profit to a
foreign currency trader

Currency Related Terminology

 Functional Currency – is the currency of the environment in which an entity primarily
generates and expends cash. Functional currency is the monetary unit of account of the
Principal Economic Environment in which an economic entity operates.
 Reporting Currency – It is a currency in which the parent firm prepares its own financial
statements; that is, US dollars for a US companies or Birr for Ethiopian companies.
 Foreign Currency – any currency other than the reporting currency of the parent company

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 Local Currency is the currency unit used in a country referenced. Local currency is the
currency in the country where the foreign subsidiary is operating. For example, Birr is the
local currency in Ethiopia.
 Exchange Difference (Spread)– difference resulting from translating a given number o f
units of one currency into another currency at different exchange rates
 Foreign Operation – a subsidiary, associate, joint venture, or branch whose activities are
based in a country other than that of the reporting enterprise

CURRENCY RELATED EXPOSURE

1. Economic Exposure
It is sometimes called operating exposure. This is an exposure that measures the extent to which a firm's
market value is sensitive to unexpected changes in foreign currency. Currency fluctuations affect the
value of the firms‘ cash flows, income statement and balance sheet by altering its competitive position.

2. Transaction Exposure
Transaction Exposure measures gains or losses that arise from the settlement of existing financial
obligations whose terms are stated in foreign currency. Transaction exposure measures the extent to
which income from individual transactions is affected by fluctuations in foreign exchange values. For
example, the transaction exposure may arise from the following transactions:

 Purchasing or selling on credit when prices are stated in a foreign currency

 Borrowing or lending funds when repayment is to be made in a foreign currency
 Being a party to an unperformed foreign exchange forward contract
 Acquiring assets or incurring liabilities denominated in a foreign currency
Foreign Currency Transaction Gains and Losses
IAS 21 states that: Recognize foreign currency transaction at the rate at the transaction date ;

 An average rate for a period (e.g. week or month) may be used if exchange rates don‘t fluctuate
significantly.
- Average rates not reliable if currency fluctuates significantly. In accounting policy note
in FS, disclose the policy. e.g. that rates at transaction dates are used.

During the period liabilities are open, if the selling spot rate decreases (foreign currency weakens against
the domestic currency), it results in a foreign currency transaction gain; if the selling spot rate increases
(foreign currency strengthens against the domestic currency), it will result in a foreign currency
transaction loss. Gains and losses are reported in a firm‘s income statement in the period in which they
occur.

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Example

Ethio Trading Company purchased goods on account from US Company on December 21, 2010 at
$100,000 terms n/30. The spot selling rate for a dollar is Br 16.60

Inventories ...............................................................................1,660,000

Accounts Payable ...................................................... 1,660,000

To record purchase on 30-day open account from US supplier for $100,000, translated at the spot selling
rate $1 = Br 16.60

Determine the foreign currency transaction gain or loss for the Ethio Trading Company assuming that on
December 31, 2010, the spot selling rate for a US dollar was Br 16.58

Liability on December 21, 2010............................................................. Br 1,660,000

Less: Liability on December 31, 2010 ($100,000 @ 16.58) ..................... 1,658,000

Foreign currency transaction gain .......................................................... Br 2,000

Journal Entry:

Accounts Payable ................................................................................. 2,000

Foreign Currency Transaction Gain ..................................... 2,000

Determine the foreign currency transaction gain or loss for the Ethio Trading Company assuming that on
maturity date, February 19, 2011, the spot selling rate for a US dollar was Br 16.61

Liability on December 31, 2010............................................................. Br 1,658,000

Less: Liability on December 31, 2005 ($100,000 @ 16.61) ..................... 1,661,000

Foreign currency transaction loss ........................................................... (Br3,000)

Journal Entry:

Accounts Payable .................................................................................1,658,000

Foreign Currency Transaction Loss........................................................ 3,000

Cash .................................................................................. 1,661,000

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3. Translation Exposure or Accounting Exposure
Translation exposure is a risk attributed to change in a firm's financial position when the firm's
consolidated financial statements are affected by changes in foreign exchange rates. Translation involves
converting financial statements of foreign subsidiaries from the local currency to the home currency. It is
also known as Accounting Exposure. Translation exposure or accounting exposure measures the potential
losses or gains that would appear on the consolidated financial statements following a change in exchange
rates. It is a risk that a company's equities, assets, liabilities or income will change in value as a result of
changes in exchange rate. This occurs when a firm denominates a portion of its equities, assets, liabilities
or income in a foreign currency.

Translation Exchange Rates

In translation of foreign subsidiary financial statements, there needs to raise two questions:

1. How should translation gains and losses be reported in the financial statements or should be
accounted for? Should they be included in income?
2. What exchange rate should be used to translate each line of the foreign financial statements into the
domestic currency? That is which exchange rate should be used to translate foreign currency account
balances to reporting currency?
Translation methods may employ a single rate or multiple rates. There are three alternative exchange rates
for translation of foreign subsidiary financial statements: current rate, historical rate, and average rate.

 Current Rate – exchange rate prevailing as of the financial statement date

 Historical Rate – exchange rate prevailing when a foreign currency asset was first
acquired or a foreign currency liability was first incurred
 Average Rate – is simple or weighted average exchange rate of either current or historical
exchange rates
Methods of Translation of Foreign Subsidiary's Financial Statement
If the exchange rate for the functional currency of a foreign subsidiary or branch remained constant
instead of fluctuating, translation of financial statements would be simple. All financial statement
amounts would be translated at the constant exchange rate. However, exchange rates fluctuate frequently.
Hence, a problem is faced which exchange rate to use. According to IAS 21, Monetary/ Non monetary
Method is use to translate foreign subsidiary financial statements from local currency to parent company
presentation currency.

Monetary/ Non-monetary Method

This method focuses on the financial character of assets & liabilities of the foreign subsidiary financial
statement rather than on their balance sheet classifications to determine appropriate rate. Foreign currency
assets and liabilities expressed as a fixed number of currency units are defined as monetary (rece ivables
and payables). Other items are non-monetary.

o Monetary Assets: are items that will be received in a fixed or determinable amount of cash.
Examples: Cash, Cash equivalents, Debt securities, Accounts receivable, Notes receivable

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 o Non-monetary Assets: are items that will not be received in a fixed or determinable amount of
cash. Examples: Inventory, Prepaid expenses, Equity securities, Investment property, Property,
plant, and equipment, Intangible assets (e.g. goodwill)
o Monetary Liabilities: are items that will be paid in a fixed or determinable amount of cash.
Examples: Accounts payable, Notes payable, Bonds payable, Leases payable, Accruals, Deferred
tax (usual classification)
o Non-monetary Liabilities: are items that will not be paid in a fixed or determinable amount of
cash. Examples: Deferred income, Government grant
Balance sheet translation:

 All monetary items (Monetary assets & Liabilities) are translated by using current exchange
rate.
 All non monetary items (non Monetary assets & Liabilities ) & all elements of stockholders‘
equity accounts are translated by using historical exchange rate.
 Revalued non-monetary items are translated by using the rate at the date of valuation.
Income statement translation:

3. In the income statement, average exchange rates are applied to all revenues and expense except
depreciation expenses, amortization expense, and cost of goods sold, which are translated at
appropriate historical rates.
Translation and Remeasurement: Producing Financial Statements Using
Translation or Remeasurement, or Both.
 Remeasurement - is a process of converting the accounting records of an entity maintained in a
currency other than functional currency into the functional currency;
 Non-monetary assets, liabilities, and related income and expenses - use historical exchange rate ;
 Monetary assets, liabilities, and related income and expenses – use current exchange rate

 If entity‘s functional currency is the reporting currency of the enterprise, re-measurement avoids
translation.
 If entity‘s functional currency is different from the enterprise‘s reporting currency, re-
measurement into the entity‘s functional currency is followed by translation into the reporting
currency
Disclosures
 The standard requires an entity to disclose some important disclosures for the purpose of fair and
faithful presentation:
 Amount of exchange difference be recognized in profit or loss;
 Net exchange differences recognized under other comprehensive income
 whether presentation currency is different from functional currency and the reason for this
difference; any
 Whether there is any change in functional currency and reason for the change

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