FOUNDATIONS IN ACCOUNTANCY
PAPER FFA [Foundation in Financial Accounting] 2012 Text Book Summary Please read through the text book. Do depend on this summary as errors & omissions may occur. Due to a lot of repetition from FA1 & FA2 (Chapter 1-18) some details have been left out, assuming you already know it very well.
Done By Tariq Suhail Al Shaibani
Part A: Chapter 1 A business main objective is to make profit. Profit is the excess of income over expenditure. Types of business entity: -
Sole traders: is a business owned and run by one individual, perhaps employee one or two assistants and controlling their work. Partnership: are arrangements individuals to carry on business in common with a view to profit. Unless it is a limited liability partnership LLP, they are legally responsible for debts and liabilities. Limited liability companies: means that the business debts and the personal debts of the business owners (shareholders) are legally separate.
To form a limited liability company you must be: -
Registered at companies house Complete and deposit a memorandum of association and articles of association Have at least one director Prepare financial accounts Have the financial accounts audited ( Distribute financial accountâ€™s to all shareholders Sole Trader Advantages Limited paperwork, low cost Owner has complete control over the business Owner is entitled to profits and the ownership of the assets No requirement and strict obligations to make financial statements, no audit! Can be highly flexible
Disadvantages Owner is personally liable for all debts (unlimited liability) Personal assets may be vulnerable against the debt and liabilities Large sums of capital are less likely to be available May lead to long working hours Continuity of the business may be an issue in the event of death or illness of the owner
Advantages Less stringent reporting obligations Additional capital can be raised Division of roles & responsibilities (increase skill) Sharing of risk and losses between more people No company tax on the business
Disadvantages Partners are jointly liable for all debts unless itâ€™s a Limited Liability Partnership Costs for setting up the partnership Continuity of the business may be an issue in the event of death or illness of a partner Slower decision making due to the need for approval from the partenrs Unless a clause is written into the orginal agreement, when one partner leaves, the partnership is autmotaically dissolved and another one must be done
Limited Liability Companies Advantages Disadvantages Limited liability makes the investment - They have to publish annual financial less risky statements Raising finance is faster and easier - They have comply with legal and It has a separate legal identity from accounting requirements the shareholders - It must be audited They are tax advantage. The rate for a - Share issues are regulated by law company may be lower than it would have been charged to the owners It is easily to transfer shares (ownership) from one to another
Users of accounting information -
Managers of the company Shareholders of the company Trade contacts Provider of finance to the company The Tax Authorities
Employees of the company Financial analysts and advisers Government and their agencies The public
Corporate governance is the system by which and other entities are directed and controlled. Financial statements are prepared and perhaps published for the benefit of other user groups, which may demand certain information; a) The national law of the country may demand to provide (provision) of some accounting information to the shareholders and the public 3
b) National taxation authorities will receive the information they need to make tax assessments c) a bank might demands a forecast of a companyâ€™s expected future cash flows as precondition of granting an overdraft d) The international Accounting Standards Board (IASB) has been jointly responsible for issuing International Accounting Standards (IASs) now to be called International Financial Reporting Standards (IFRS) and these require companies to publish certain additional information. Accountants (member of a professional body) are placed under a strong obligation to ensure the company accounts conform the requirements of IASs. e) Employee Reports specially prepared financial information for the issue to the employees (voluntarily) An asset is a resource controlled by an entity as result of past events and from which future economic benefits are expected to flow the entity. A liability is a present obligation of the entity arising from past events, the settlements of which is expected to result in an outflow from the entity of resources embodying economic benefits. Equity (share capital) is the residual interest in the assets of the entity after deducting all liabilities. Chapter 2 The International Accounting Board (IASB) is an independent, privately-funded accounting standard setter based in London. IASB is responsible for producing IFRSs. Formal objectives of the IASB: a) Develop, in the public interest, a single set of high quality understandable end enforceable global accounting of financial statements. b) To co=operative with national accounting standard setters to achieve convergence accounting standards in the world. The International Accounting Standards Committee Foundation (IASC) is an independent cooperate of 22 members having two main bodies; 1) The trustees a group of 19 people, with diverse geographic and functional backgrounds. They appoint the member of the board, the standing Interpretations committee, and the Standard Advisory council. They are also in charge of raising funds and monitoring IASCs effectiveness. 2) The International Accounting Board has the sole responsibility for setting accounting standards. 14 board members.
They are also two further bodies; a) Standard Advisory Council Experts from all over the world that advises the Trustees. b) International Financial Reporting Interpolations Committee (IFRICS) provides timely guidance on the application and interpretation of International Financial Reporting Standards. IASB and International Organization of Securities Committee (IOSCO) are working together to resolve issues and identify areas where the new IASB standards are needed. The standard setting process: 1) Advisory Committee 2) Discussion Documents 3) Exposure Draft 4) International Financial Reporting Standard These are the IFRS and IAS that we will be dealing in FFA/F3: IFRS 3 Business Combinations IAS 1 Presentation of financial statements IAS 2 Inventories IAS 7
Statement of cash flows
IAS 8 Accounting policies, changes n accounting estimates and errors IAS 10 Events after the reporting period IAS 16 Property, plant and equipment IAS 18 Revenue IAS 27 Consolidated and separate financial statements IAS 28 Investments in associates IAS 37 Provisions, contingent liabilities and contingent assets IAS 38 Intangible assets
Part B: Chapter 3 The IASB’s Framework is a conceptual framework on which IFRSs are based. The main underlying assumptions for financial statement are accruals and going concern. Going concern assumes that the business will continue operation for the foreseeable future. Accruals is that the effects and other events are recognized when they occur (and not as the cash is paid/received but as expenses are earned or incurred) are recorded and reported in according records The qualitative characteristics of financial information: The four principals are: 1) Understandability 2) Relevance a) Materiality 3) Reliability a) Faithful Presentation b) Substance over form – transactions should be showed in their economic form (true value) NOT legal form c) Neutrality – Information should not be bias to be reliable d) Prudence e) Completeness 4) Comparability Information must be consistent unless if there is; a) significant change in the nature of operation or a review of financial statements indicates a more appropriate presentation b) A change in presentation is required by an IFRS Part C: This part deals with the basics of doubly entry (bookkeeping). If you do not know it by now, you shouldn’t be doing this paper.
Part D: Chapter 7: This deals with Sales Tax, read it through. Chapter 8: Read as well, FIFO, LIFO, etc. 6
Inventory should be valued at the lower of historical cost or NRV. Inventory valuations are FIFO, LIFO (no longer used), AVCO (Average acculmulated). Standard cost. A pre-determined standard cost is applied to all inventory items. If this cost differs from the purchase cost. It should be written off in the income stamen as â€˜variance Replacement Cost is the cost that you will have to pay to replace the inventory. It is also known as NIFO (Next in, Next Out) Chapter 9: Capital Expenditure: does not reduce the assets. (When an asset goes down, another asset goes up) Revenue Expenditure: It does reduce the assets & increases the expenses. Capital income is the proceeds from the sale of non-trading assets. Revenue income is income derived from the following sources; sale of trading assets, provision of services, interest and dividends derived from investments held by the business. Capital transactions are transaction that ad cash assets of the business, thereby creating a corresponding liability (capital or loan) AND when a loan is repaid, it reduces the liabilities (loan) and the assets (cash) *:none of these transactions would be reported through the income statement
IAS 16 Property, plant and equipment Fair value is the amount for which an asset could be exchanged between knowledgeable, willing parties in an armâ€™s length transaction. Carrying amount is the amount which an asset is recognized after deducting any accumulated depreciation and impairment losses Recoverable amount is the amount which the entity expects to recover from the future use of an asset, including its residual value on disposal Recognition simply means that it is included in the businessâ€™s accounts. It depends on two criteria; future economic benefits & the cost of asset is measured reliably After recognition the asset value may increase if additional expenditure has been spent it on it which improves its economic benefits. Depreciation is the allocation of the depreciable amount of an asset over its estimated useful life. Depreciable amount of a depreciable asset is the historical cost (less estimated residual value). Residual value is the amount which the entity expects to obtain for an asset at the end of its useful life after deducting the expected costs of disposal. 7
*Even though, that sometimes the asset value in a period may rise than its NBV. You should still depreciate it regarding to the value rise. Factors when estimating the useful life: - Physical wear and tear - Obsolescence (when it’s no longer wanted) - Legal or other limits on the use of the asset In most cases the residual value of an asset is likely to be immaterial. The depreciation method selected should be applied consistently from period to period unless altered circumstances justify a change. When the method is changed, the effect should be quantified and disclosed and the reason for the change should be stated. Change is not allowed just because it will change the profitability of the enterprise. IAS6: requires the following to be disclosed for each major class of depreciable asset Depreciation method used Useful live or dep. Rate Total deprecation allocated for the period Gross amount of the depreciable assets and the related accumulated depreciation The need to depreciate non-current assets arises from the accrual assumption. Money (depreciation) should be spread out the period it is used. (Match revenue & expenditure) They are two main misconceptions about the purpose & effects of depreciation; 1) It is sometimes thought that the NBV is equal to the NRV and that the objective of charging depreciation is to reflect the fall in value of an asset over its life. 2) The asset can be replaced at the end of its useful life. Depreciation: - The Straight line method – equal amount every year - Reducing balance method – calculate a percentage from the NBV - Machine hour method – depends on expected hours of usage - Sum of digits – Ex. If dep is for 5 years (1+2+3+4+5=15) then year 1 would be 5/15, year 2 would be 4/15, etc. Sum of the digits = *If the asset been purchased at the middle of the year, you should ‘assume’ that the depreciation for the year would be charged fully unless stated otherwise.
When the value of a non-current asset falls so it is worth less than the NBV, and the fall is expected to be permanent, the asset should be written down to its new low market value.
Recalculation of future depreciation =
If the asset is revalued (even when the value goes up), land or building, the depreciation should be calculated on the revalued amount. Dr Asset Cr. capital (revaluation reserve/surplus) Profit/loss on disposal = Net Book Value â€“ Net Sale Price (Sale Price â€“ Costs incurred for making the sale) *Check the double entry on page 34 They are two models to measure the asset after its reconigstion; 1) Cost model, carry the asset cost less depreciation 2) Revaluation method. Carry the asset at a revalued amount, being its fair value at the date of the revaluation less any subsequent accumulation depreciation. Revaluation should be made regularly enough so that the carrying amount approximates to fair value at the reporting date. This model is only available if the item can be measured reliably. When an item of property, plant and equipment is revalued, the whole class of assets which it belongs to should be revalued. This is to prevent selective certain assets and to avoid disclosing a mixture of costs and values from different dates in the SOFP. IAS 2 Inventories NRV = expected selling price â€“ any costs incurred for getting them ready for sale and then selling them. An asset register is used to record all non-current asset and is an internal check on the accuracy of the nominal ledger. Chapter 10: Deferred development cost is the act of taking the debit balance of Development & Research Expense Account and making it as an intangible asset (capitalizing it). If this is not done, it will be charged as an expense in the in Income Statement. Research should be recognized as an expense & development should be recognized as an intangaibale asset. Amortization is the systematic allocation of depreciable amount of an intangible asset over its useful life.
Chapter 11: Accruals are expenses which relate to an accounting period but have not yet been paid for. Prepaid expenses (prepayments) are expenses which have already been paid but relate to a future accounting period. Transaction Accrual
(Reduction in) expense
Description Expense incurred in period, not recorded DECREASE PROFIT! Expense recorded in period, not incurred until next period. INCREASE PROFIT
Chapter 12: Irrecoverable debt & allowances, just read through. Chapter 13: A provision is a liability of uncertain timing or amount.
A contingent liability is a possible obligation that arises from past events and whose existence will be confirmed by the occurrence or non-occurrence of one or more uncertain future events.
A contingent asset is a possible asset that arises from and whose existence will be confirmed by the occurrence of one or more uncertain future events.
Part E: Chapter 14: Control Accounts & Discounts. Chapter 15: Bank Reconciliation Cause of Difference Error Bank charges/interest Timing Difference
Comments Errors in calculation or recording may be made by you or the bank. The bank can deduct charges that you are not informed about Un-cleared or un-presented checks will not show in your bank statement. However, it will be processed in a day or two, so do not do anything in the reconciliation. 10
Chapter 16: Correction of Errors Type of error
Complete omission Partial omission commission Principle Compensating Original entry Transposition
Reversal Reversal – one side Original entry – one side
Detected by trial balance No Yes No No No No Yes
No Yes Yes
Whole transaction missing One side of transaction missing Posting to wrong account Posting to category of account Errors cancel each other Wrong amount posted to both sides Detected if error made on one entry only (not detected if error is made in both debit and credit postings). Debit and credit entries reversed Gives two debits or two credits One entry has wrong amount
IAS * Material: Omissions or misstatements of items are material, if they could influence the economic decision of users. Prior period errors are omission from, and misstatements in, the entity’s financial statement for one or more prior periods. Impracticable: applying a requirement is impracticable when the entity cannot apply it after making every reasonable effort to do so. Chapter 17: Preparation of Financial Statements for Sole Traders
Part F: Chapter 18: Trade Receivables Opening Opening balance (if any) Sales Cash received Dishonored Bills or Checks Discounts allowed Cash paid Returns inwards Irrecoverable Debts recovered Irrecoverable debts Closing credit balance Cash from recoverable debts Contra with Payable Allowance on goods damaged Closing debit balances
Opening debit (if any) Cash paid
Payable Control Account Opening balance Purchases and other expenses Cash received from clearing Dr. Balances Closing debit balances
Discounts Received Returns outwards Contra Allowance on good damaged Closing credit balance
Lost/Damaged cost of inventory: Op. Inventory + Purchases (-) Remaining Inventory COGS + Cost of Inventory Lost COGS ďƒ§ you will calculate as a % from sales Inventory Lost Profit Markup= 125 x Percentage on sales = S100 P25 C75 Margin means to calculate as a % of the sales like the one above. (NOT SURE ABOUT IT) COGS = opening + purchases + carriage inwards â€“ closing
Chapter 19: Limited liability companies offer limited liability to their owners. In other words, the maximum amount an owner may lose if the business fails (or gets in deep debt) is their share of capital. No personal losses. The fundamental differences in the accounting of Ltd companies are; a) The national legislation governing the activities of Ltd companies tends to be very expensive. Unlike sole traders, they must disclose much information under strict rules. b) The owners of a company (members or shareholders) may be very numerous (many). Their capital is shown differently than a sole trader’s. The ‘apportion account’ is also different. Unlimited liability means that if the business runs up debts that it is unable to pay; the owners will become liable to pay them even if they had to sell their own private assets. This applies to Sole traders & partnerships Those would be included in the Statement of Comprehensive income are: 1) 2) 3) 4) 5) 6) 7)
Revenue Cost of Sales Expenses Managers’ salaries (even if the manager is also a shareholder) Finance cost Taxation Earnings per share
Items in the Statement of financial position are: 1) The capital of limited liability companies 2) Authorized, issued, called-in and paid-in share capital Authorized (or legal) capital: is the maximum amount of share capital that a company is empowered to issue Issued capital is the par amount of share capital that has been issued to shareholders. It cannot exceed the amount of authorized capital Called-in-capital When shares are issued, a company does not always issue all of the shares, so out of $400,000 they may issue only $300,000 3) Paid in capital like everyone else, investors are not always prompt or reliable payers. They may not pay the called-in-capital in full. The unpaid called-in-capital will show in the SOFT as a Receivable. Preference shares are shares which have preferential rights on their owner. A fixed dividend is paid to the preference shares (current year & accumulated) first before it can be paid to the ordinary shares. They do not have a voting right. 13
Ordinary shares are shares which are not preferred when it comes to dividends. They normally have a voting right, therefore ordinary shareholders are the effective owners of a company. They won the ‘equity’ of the business. They are sometimes referred to as equity shareholders. Redeemable preference shares mean that the company will redeem (repay) the nominal value of those shares at a later date. They are treated like loans and are included as non-current liabilities in the SOFP. Dividends paid on Redeemable preference shares are treated as loan interest (Finance Cost). Market value of shares is the value of the share if you will be selling it today. It will differ from the per value. It does not affect the company’s SOFP at all, no transaction is recorded. Therefore, the company does not have to worry about it at all. Loan notes or bonds: a) Shareholders are members of a company, while providers of loan capital are creditors b) Shareholders receive dividends (apportion of profit) whereas the holders of loan capital are entitled to a fixed rate of interest (an expense charged against revenue) c) Loan capital holders can take legal action if they are not paid. Shareholders can’t. d) Loan notes are often secured on a company assets, whereas shares are not. Equity consists of; Shareholders Equity - The par value of issued capital (minus any amounts not yet called up on issued shares) - Other equity Capital paid-in in excess of par value (share premium, issued only if shares issues are issued more than their value) Revaluation surplus Reserves a) Statutory reserves¸ reserves which a company is required to set up by law. Cannot be distributed as dividends b) Non-statutory reserves, reserves consisting of profits which are distributable as dividends, if the company wishes so. Retained Earnings they are most important reserves and is various describe as Revenue reserve, retained profits, accumulated profits, undistributed profits, and unappropriated profits. A share premium account is an account into which sums received as payment for shares in excess of their nominal value must be placed. One of the uses of premium account is the issue of ‘bonus shares’. A bonus issue (Scrip issue) is a re-classification of reserves as share capital A right issue is an issue of shares for cash to existing shareholders. 14
A Reserve is an apportion of distributable profits for a specific purpose. They are two main types: a) Statutory reserves, which are reserves which a company is required to set up by law, and which are not available for the distribution of dividends b) Non-statutory reserves, which are reserves consisting of profits which are distributable as dividends, if the company so wishes. Chapter 20: Preparation of Financial statements for companies. Chapter 21: Events after the reporting period are those events, both favorable and unfavorable, that occur between the reporting date and the date on which the financial statements are authorized for issue. Chapter 22: Cash flows are classfied by: a) Operating activities: the principal revenue-producing activities b) Investing activities: acquisition and disposal of non-current assets & other investments not included in cash equivalents c) Financing activities: activities that result in changes in size & composition of the equity capital & borrowings of the entity Cash equivalents are short-term, highly liquid investments that are easily convertible to known amount of cash and carry insignificant risk. Reporting cash flows from operating activities: a) Direct method: disclose major class of gross cash receipts and gross cash payments b) Indirect method: net profit/loss is adjusted for the effects of transactions of a non-cash nature. Ex. Accruals, depreciation, etc. The direct method is the preferred method because it discloses information, not available elsewhere in the financial statements. However, IAS 7 favors the indirect method, and it is widely used. It is easier to produce. *Check out the preparation of cash flow in direct & indirect method.
Advantages of cash flow over income statement: -
Ability for a business to generate cash It is more comprehensive (looks at the big picture) than ‘profit’ Creditors are more interested in the business ability to repay It is provides better means to compare the results of different companies It satisfies the management, shareholders, auditors and creditors It also satisfies the employees
Part G: Chapter 23: Consolidation means
Adding together Dedeucting the profit that restuls from intra-group trading Cancelling of like items interntal of the group If you woned everything then show the extent which do not own everything. - For Example Recievables and payables between the subsaidries should be shown as a NET figure. - The parents company will show the full asset and liability of its subsaidariy even if it owns just 80%. However, The remaining 20% would be shown as a non-controlling interest seperately in the quity of the consolated statement of financial postion
Parents an entity that has one or more subsidaries Group: a parent and its all subsadiries Subsidiary: an entity that is controlled by another entity (known as the parent) Control: the power to govern the financial & operating policies of an entity so as to obtain benefits from its activities Consilated fincial statements is that that the financial statements of a group presented as those of a single economic entity. Non-contolling interest is the equity in a subsidary not attributable, directly or indirectly, to a parent. A trade (or ‘simple’) investment is an investmenti n the shares of another quity, thati s held for accretion of wealth, and is not associate or a subsidary. Associate is an entity, including an unincorprated eneity such a partnership, in which an investor has asignficant infulence which is neither a subsidary nor a joint venture of the investor. The parent company usually controls the subsaidary by owin most of the shares, but that’s not always the case. Ex. KFC & Pizza Hut are subsairdies of Tricon.
In a legal point of view, the group result (financial statements) must be shown, not the subsaidries. Chapter 24: Exemption from preparing subsaidary account -
The parent itself is a wholly-owned subsidary or it is a partially owned subsidary of another entity & its owners, including those not othwwise entitled to vote. Its securities are not publicily traded It is not the process of issuing securities in public secruities markets The ultimate or intermediate parent publishes conolitaed financial staments that comply with IFRS
If a company takes advantgaes of any above it must dislocse; a) Why b) Basses on which subidiaries are account for in the parentâ€™s seprate financial statements c) Name, country of incorpration and registered office of its parent that published consilated financial statements Exlusion of a subsidary from consildation is strict (not allowed) because many entites use that to maniplate their financial statements. They would purposely exclude a company to reduce the Debt shown in the SOFP. Basic Procedure for SOFP consildation: a) Carryying amount of the parentâ€™s investment in each subsidiary and the parentâ€™s portion of equity of each subsidary are eliminated or cancelled b) Non-controlling interests in the net income conolidated subsidaries are adjusted agains group income, to arrive at the net income to the owners of the parent c) Non-controlling interests in the net assets of consolidated subsidaries should be preseented seprately in SOFP d) Dividends payable by a subsidary must be accounted for e) Goodwill arising on consildation is recgonised as an intangaible asset. Even if there is a non-controlling interest, good will be shown in full value 100% The consilated income statement is prepared by combinting the I/S of each group company. Consilated schedule is when the different I/S are set aside and totalled. You must combine both revenues and expenses and also do not forget to include the noncontrolling interest in which the interest of the parent company is only included. Intra-group trading is the transactions (sales) that may result from the groups trading with each other. This should be excluded from the profit. Check page 330 17
If a subsidary gives the parent dividends it will be recorded as intra-group income, therefore should not be consilated If a subsaidary is acquired during the year, its profit in the consilated income statement may show in two ways; a) The whole-year method b) The part-year method: Pre-accquisotion and post acquisition Chapter 25: Read Part H: Chapter 26: Profiballity ratios: 1) Return on capital employed ROCE = 2) Return on Equity: ROE = 3) Profit margin x Asset Turnover = ROCE x
4) Gross Profit margin, net profit margin
Debt and gearing/leverage ratios:
Debt ratio =
2) Gearing =
3) Leverage =
Interest cover =
Liquidity and working capital ratios: 1) Current ratio =
2) Quick ratio = 3) Estimated average accounts recievable collection period =
Inventory turnover period =
5) Accounts payable payment period =