FA Financial Accounting

A. The context and purpose of financial reporting

Financial reporting means recording, analysing and summarising financial data and communicating it to people outside the business. A sole trader is one person who owns the business and is personally responsible for its debts. A partnership is two or more people who share the profits under an agreement. A limited liability company is a separate legal entity owned by shareholders, whose liability is limited to the amount they have agreed to invest. Companies must publish financial statements, which is the main reason they follow accounting standards.

Different users want different things from the financial statements. Investors look at profit and risk, lenders at the ability to repay, employees at the stability of their jobs, suppliers at whether they will be paid, and tax authorities at whether tax has been calculated correctly. Management can ask for any report it likes, but external users rely on the general purpose financial statements.

There are four main statements. The statement of financial position shows assets, liabilities and equity at one date. The statement of profit or loss and other comprehensive income shows performance over a period. The statement of changes in equity shows the movement in each part of equity. The statement of cash flows shows the cash generated and used in operating, investing and financing activities.

An asset is a resource controlled by the entity as a result of past events that is expected to bring economic benefits. A liability is a present obligation to transfer an economic resource as a result of past events. Equity is what is left after liabilities are deducted from assets. Income increases equity (other than owners' contributions) and expenses decrease it (other than distributions to owners).

IFRS Accounting Standards are set by the International Accounting Standards Board (IASB), which is overseen by the IFRS Foundation. The IFRS Advisory Council advises the IASB, the IFRS Interpretations Committee (IFRIC) gives guidance on how standards should be applied, and the International Sustainability Standards Board (ISSB) sets standards for sustainability disclosures. Following the same standards makes financial statements consistent and comparable between entities.

Governance is the system by which an entity is directed and controlled. The directors are responsible for preparing financial statements that present the entity's position and performance fairly, for keeping adequate accounting records, and for the internal controls that protect assets and help prevent and detect fraud.

Key terms

• Stakeholder: A person or group with an interest in the entity, such as investors, lenders, employees, suppliers and tax authorities.
• General purpose financial statements: Statements prepared for a wide range of external users who cannot ask for tailored reports.
• IFRS Accounting Standards: The standards issued by the IASB that set how items are recognised, measured and presented.

Study tip: Learn the four statements and what each one answers. Questions often ask which statement a given item appears in.

Practice questions for section A

B. Accounting principles, concepts and qualitative characteristics

Going concern assumes the entity will continue to operate for the foreseeable future. If it will not, assets and liabilities cannot be valued on the usual basis. Accrual accounting records income when it is earned and expenses when they are incurred, not when cash moves. Materiality means an item matters if leaving it out or misstating it could change a user's decision. Consistency means treating similar items the same way from one period to the next. Prudence means taking care not to overstate assets or income or understate liabilities or expenses.

Offsetting means assets are not netted against liabilities, and income is not netted against expenses, unless a standard allows it. Duality means every transaction has two effects, which is the basis of double entry. The business entity concept treats the business as separate from its owner, so an owner's personal spending is not a business expense. Historical cost records items at what was paid, while current value uses a present value such as fair value. Substance over form means recording the economic reality of a transaction and not just its legal form.

Useful financial information has two fundamental qualitative characteristics. Relevance means the information can make a difference to decisions, and faithful representation means it is complete, neutral and free from error. Four more enhance usefulness. Comparability allows users to compare over time and between entities, verifiability means different knowledgeable people would agree it is a faithful representation, timeliness means it is available in time to influence decisions, and understandability means it is clearly presented for users who study it with reasonable diligence.

Key terms

• Going concern: The assumption that the entity will keep trading for the foreseeable future.
• Fundamental characteristics: Relevance and faithful representation.
• Enhancing characteristics: Comparability, verifiability, timeliness and understandability.

Study tip: A useful memory aid is to remember that two characteristics are fundamental and four enhance them. Exam questions often ask you to classify one as one or the other.

Practice questions for section B

C. The use of double-entry bookkeeping and accounting systems

The accounting equation is assets = liabilities + equity. Every transaction has two effects, so the equation always balances. In double entry, one account is debited and another is credited with the same amount. Debits increase assets and expenses and decrease liabilities, equity and income. Credits do the opposite.

Transactions start with business documents: a quotation, a sales order, a purchase order, a goods received note, a goods despatched note, a customer (sales) invoice, a supplier (purchase) invoice, a supplier statement, a credit note, a debit note, a remittance advice and a receipt. In the sales process the entity issues a quotation, a sales order, a goods despatched note and an invoice to the customer. In the purchasing process it issues a purchase order and receives a goods received note and the supplier's invoice.

The general ledger holds an account for each type of asset, liability, equity, income and expense. Routine transactions are recorded through sales and purchases records, while less common items such as depreciation, accruals and error corrections are recorded by journal entries. At the end of the year, income and expense accounts are closed to profit or loss, and the profit is transferred to retained earnings. Asset, liability and equity balances are carried forward to the next period.

A computerised accounting system records data automatically and can be hosted on external servers, which is known as the cloud. It reduces manual posting errors and gives faster reporting, but it relies on secure access and on the accuracy of the data entered.

Example: a credit purchase

Goods costing $5,000 are bought on credit. Debit purchases (or inventories) $5,000 and credit payables $5,000. Assets or expenses increase and liabilities increase, so the accounting equation still balances.

Key terms

• Journal entry: A record of a transaction showing the accounts to debit and credit, used mainly for non-routine items.
• General ledger: The main set of accounts for all assets, liabilities, equity, income and expenses.
• Carried forward: Balances of asset, liability and equity accounts that continue into the next period.

Study tip: Practise stating the two entries for any transaction before you look at the options. It is the fastest way through journal questions.

Practice questions for section C

D. Recording transactions and events

Sales and purchases. Sales are recorded as debit receivables (or cash) and credit revenue. Where sales tax applies, the entity collects it on behalf of the tax authority, so the tax is not revenue: debit receivables with the full amount, credit revenue with the amount excluding tax and credit the sales tax account with the tax. On purchases the tax can usually be reclaimed. Returns reverse the original entries. A trade discount is deducted from the list price on the invoice. A settlement discount is offered, on condition, for prompt payment and is applied when the invoice is paid.

Inventories are valued at the lower of cost and net realisable value. Cost includes the purchase price and the costs of bringing the goods to their present location and condition. It excludes selling costs, general administration and abnormal waste. FIFO assumes the oldest items are used first, so closing inventories are valued at the latest prices. AVCO uses a weighted average cost. In a period of rising prices, FIFO gives a higher closing inventory and a higher profit than AVCO.

Tangible non-current assets are held for use in the business for more than one year. Spending is capitalised (added to the asset) if it gives the entity lasting benefits, such as the purchase price and the costs of getting the asset ready for use. Repairs and maintenance are expenses. When an asset is sold, the gain or loss is the sale proceeds less the carrying amount. A non-current asset register records each asset, its cost, depreciation and location, so it can be checked against the ledger and against the physical assets.

Depreciation spreads the cost of an asset over its useful life. Under the straight-line method the charge is (cost less residual value) divided by the useful life. Under the reducing balance method a fixed percentage is applied to the carrying amount each year. If the useful life or residual value changes, the carrying amount less the new residual value is spread over the remaining life. If an asset is revalued, the surplus goes to the revaluation surplus in equity (other comprehensive income), depreciation is charged on the revalued amount, and the extra depreciation can be transferred from the revaluation surplus to retained earnings.

Intangible non-current assets have no physical form, such as development costs, licences and brand names. Under IAS 38 research costs are always expensed. Development costs are capitalised only when criteria such as technical feasibility, intention and ability to complete, probable future benefits, adequate resources and reliable measurement are met. Capitalised intangible assets with a finite life are amortised over that life in the same way as depreciation.

Accruals, prepayments, accrued income and deferred income apply the accrual concept. An accrual is an expense incurred but not yet paid (debit expense, credit accruals). A prepayment is a payment made for a future period (debit prepayments, credit expense). Accrued income is income earned but not yet received (debit accrued income, credit income). Deferred income is cash received in advance of the period earned (debit income, credit deferred income). Accruals and deferred income are liabilities, and prepayments and accrued income are assets.

Receivables and payables. A credit period brings sales but also costs such as irrecoverable debts and financing. An aged receivables analysis shows how long each balance has been outstanding, and credit limits control the exposure to each customer. Writing off an irrecoverable debt: debit irrecoverable debts expense, credit receivables. If it is later recovered, reinstate the debt and then record the receipt. An allowance for irrecoverable debts is an estimate of the amount that may not be collected. An increase in the allowance is an expense and a decrease is a reduction in expense. Receivables are shown net of the allowance. A contra sets off an amount owed by a customer against an amount owed to the same party as a supplier.

Provisions and contingencies (IAS 37). A provision is recognised when there is a present obligation from a past event, a probable outflow of economic benefits and a reliable estimate. A contingent liability is a possible obligation, or a present obligation that is not probable or cannot be measured reliably. It is disclosed but not recognised, unless the chance of payment is remote. A contingent asset is a possible asset. It is disclosed if an inflow is probable and recognised only when it is virtually certain. An increase in a provision is an expense and a reduction is a credit to profit or loss.

Capital structure and finance costs. An entity can be financed by ordinary shares, preference shares and borrowings. Ordinary shareholders have the residual claim and receive dividends at the discretion of the directors. Redeemable preference shares are treated as liabilities and their dividends as finance costs. A share issue is recorded by debiting cash and crediting share capital with the nominal value and share premium with the excess. A bonus issue turns reserves into share capital and raises no cash. A rights issue offers new shares to existing shareholders, usually at a discount, and raises cash. Loan interest is accrued over time, and dividends are recorded when they are paid or declared. The statement of changes in equity shows the movement in share capital, share premium, the revaluation surplus and retained earnings.

Worked figures

Inventory: opening 100 units at $10, then a purchase of 200 units at $12, and 150 units are sold. Under FIFO the 150 units left are all from the later purchase, so closing inventories are 150 x $12 = $1,800. Under periodic weighted average the average cost is $3,200 / 300 = $11.33 per unit, so closing inventories are about $1,700.

Depreciation: cost $50,000, residual value $5,000, life 5 years. Straight line: ($50,000 - $5,000) / 5 = $9,000 a year. Reducing balance at 20 percent: year 1 $10,000, year 2 $8,000 (20 percent of $40,000).

Prepayment: rent of $12,000 is paid for 12 months from 1 October. At 31 December, 3 months have been used, so $3,000 is an expense and $9,000 is a prepayment.

Key terms

• Net realisable value: Expected selling price less the costs to complete and sell.
• Carrying amount: Cost (or revalued amount) less accumulated depreciation.
• Capitalise: Record spending as an asset instead of an expense.
• Irrecoverable debt: A receivable that the entity does not expect to collect.
• Provision: A liability of uncertain timing or amount that meets the recognition criteria in IAS 37.

Study tip: This is the largest section. Practise one journal entry for each topic until you can write the two lines without hesitation.

Practice questions for section D

E. Reconciliations

A bank reconciliation explains the difference between the bank balance in the general ledger (the cash book) and the balance on the bank statement. The usual reasons are timing differences: cheques written but not yet presented (unpresented cheques) and receipts paid in but not yet credited by the bank (outstanding lodgements). Other items are in the bank statement but not yet in the ledger, such as bank charges, interest, direct debits, standing orders and dishonoured cheques. These need a journal in the ledger. Errors can arise in either record.

First update the ledger for the items on the statement that are not yet recorded. Then reconcile the adjusted ledger balance to the statement balance by adjusting for the timing differences. The adjusted cash book balance is the figure reported in the financial statements. A bank overdraft is a liability.

A payables reconciliation compares the payables balance in the general ledger with supplier statements. Differences come from timing (goods or payments in transit), disputed items and errors. The reconciliation shows which entries need correcting and confirms the payables balance to report. It is also a control that helps to detect fraud and double payments.

Worked figures

The cash book shows $4,200. Bank charges of $60, a direct debit of $140 and a dishonoured customer cheque for $300 are not yet recorded, so the adjusted cash book balance is $4,200 - $60 - $140 - $300 = $3,700. The bank statement shows $5,000, there are unpresented cheques of $1,500 and an outstanding lodgement of $200, so $5,000 - $1,500 + $200 = $3,700. The two agree.

Key terms

• Unpresented cheque: A cheque issued and recorded in the ledger but not yet paid by the bank.
• Outstanding lodgement: A deposit recorded in the ledger that has not yet appeared on the bank statement.
• Dishonoured cheque: A cheque received from a customer that the bank has returned unpaid.

Study tip: Always start by correcting the ledger. The statement balance only changes for timing differences.

Practice questions for section E

F. Preparing a trial balance

A trial balance lists every general ledger balance in debit and credit columns. If double entry has been kept, the totals agree. It is a check on the arithmetic of the ledger and a starting point for the financial statements. An opening trial balance lists the balances brought forward at the start of the period.

A trial balance can balance even when there are errors. Errors that it does not show include an error of omission (a transaction left out completely), an error of commission (posted to the wrong account of the same type), an error of principle (posted to the wrong type of account, for example an asset treated as an expense), a compensating error (two errors that cancel) and an error of original entry (the wrong amount recorded on both sides). A reversal of entries also does not show up. A one-sided entry, a wrong amount on only one side or a casting error will cause the trial balance not to balance.

If the trial balance does not balance and the cause cannot be found immediately, the difference can be put in a suspense account so that the trial balance totals agree while the errors are investigated. As each error is found, a journal clears the suspense account. At the end, the suspense account should have no balance. Corrections are made by journal entries, and the effect on profit and on the statement of financial position should be worked out for each.

Example: a one-sided entry

A customer pays $900. Cash is debited $900 but receivables are credited only $90. The credits are $810 short, so a suspense account is credited $810. The correcting journal is debit suspense $810 and credit receivables $810.

Key terms

• Suspense account: A temporary account that holds an unexplained difference until the errors are found.
• Error of omission: A transaction not recorded at all. The trial balance still balances.
• Error of principle: A transaction recorded in the wrong type of account. The trial balance still balances.

Study tip: For every error, ask two things: would the trial balance have caught it, and what is the effect on profit?

Practice questions for section F

G. Preparing financial statements

The statement of financial position shows non-current assets, current assets, equity, non-current liabilities and current liabilities at the reporting date. It rests on the accounting equation and on the business entity concept. The statement of profit or loss and other comprehensive income shows revenue, cost of sales, gross profit, operating expenses, operating profit, profit before financing and income taxes, finance costs, profit before income taxes, income tax expense and profit for the year. Other comprehensive income, such as a revaluation gain, is added to give total comprehensive income.

Income tax. The income tax expense in profit or loss is the estimate for the current year plus any under-provision, or minus any over-provision, from the previous year. The unpaid amount is shown as income taxes payable in current liabilities. The statements are linked: the profit for the year goes to retained earnings, and the closing balances in the ledger are the amounts in the statement of financial position.

Disclosure notes give the detail behind figures on the face of the statements, such as a note for tangible and intangible non-current assets, provisions, events after the reporting period and inventories. They help users to understand the figures and to compare them.

Events after the reporting period are events between the reporting date and the date the statements are approved. Adjusting events give more evidence about conditions that existed at the reporting date, for example a customer going bankrupt after the year end because of an earlier unpaid debt, and the figures are changed. Non-adjusting events relate to conditions that arose after the reporting date, for example a fire after the year end, and are disclosed if they are material.

The statement of cash flows shows where cash came from and where it went. Profit and cash differ because of accruals, depreciation and working capital. It is split into operating, investing and financing activities. Operating cash flow before income taxes can be found by the direct method (receipts and payments) or the indirect method, which starts with profit before income taxes and adjusts for depreciation, finance costs, gains and losses and changes in inventories, receivables and payables. Buying and selling non-current assets are investing flows, and issuing shares, borrowing, repaying loans and paying dividends are financing flows. A statement of cash flows helps users to judge liquidity and the ability to generate cash, but it does not show profit.

Incomplete records. When the records are not complete, missing figures can be worked out in several ways: the accounting equation (profit = closing net assets less opening net assets plus drawings less capital introduced), ledger accounts to find a missing figure (for example credit sales from a receivables account), cash and bank summaries, and profit percentages. A margin is a percentage of sales and a mark-up is a percentage of cost.

Worked figures

Income tax: the current year estimate is $50,000. Last year's provision was $40,000 and the final amount was $42,000, an under-provision of $2,000. The expense is $50,000 + $2,000 = $52,000.

Cash flow: profit before income taxes $80,000, depreciation $12,000, interest expense $4,000, receivables decreased by $3,000, inventories increased by $5,000, payables increased by $2,000. Cash generated from operations before income taxes is 80,000 + 12,000 + 4,000 + 3,000 - 5,000 + 2,000 = $96,000.

Mark-up: goods cost $80 and are sold with a mark-up of 25 percent on cost. The selling price is $100, the profit is $20 and the margin on sales is 20 percent.

Key terms

• Operating profit: Profit from the entity's main activities before financing and income taxes are considered.
• Adjusting event: An event after the reporting date that provides evidence of a condition that existed at the reporting date.
• Indirect method: Reconciling profit to operating cash flow through non-cash items and working capital changes.

Study tip: For cash flow questions, work out each movement carefully: an increase in receivables or inventories reduces cash, and an increase in payables increases it.

Practice questions for section G

H. Preparing basic consolidated financial statements

A parent controls a subsidiary. Control means power over the investee, exposure to its variable returns and the ability to use the power to affect those returns. It usually arises from owning more than half of the voting shares. The parent and its subsidiaries are presented as a single economic entity in consolidated financial statements. A holding of shares without control or significant influence is a trade (simple) investment, which is not consolidated.

In the consolidated statement of financial position, 100 percent of the assets and liabilities of the subsidiary are added to those of the parent, line by line, even when the parent owns less than 100 percent. The part of the subsidiary's net assets not owned by the parent is shown as non-controlling interests (NCI) in equity. The parent's investment in the subsidiary is removed and replaced by goodwill. Goodwill at acquisition is the fair value of the consideration, plus the fair value of the NCI, less the fair value of the subsidiary's net assets at the acquisition date. The syllabus uses the NCI valued at fair value at acquisition. Fair value adjustments to the subsidiary's assets are made at acquisition.

Group retained earnings are the parent's retained earnings plus the parent's share of the subsidiary's profits since acquisition. NCI at the reporting date is the NCI at acquisition plus its share of the subsidiary's post-acquisition profits.

Intra-group balances are removed because the group cannot owe itself money: a receivable in one company and the matching payable in the other cancel. Intra-group sales and purchases are removed from revenue and cost of sales. If goods bought from a group company are still in the buyer's inventories at the year end, the profit the seller made on them is unrealised for the group and is removed from inventories and from profit. If a subsidiary is acquired part way through the year, only its results after the acquisition date are included.

An associate is an entity over which the investor has significant influence but not control, usually shown by owning 20 to 50 percent of the voting power. Associates are not consolidated line by line. They are accounted for under the equity method: the investment is shown at cost plus the investor's share of the associate's profits since acquisition, and the group profit or loss includes the share of the associate's profit.

Worked figures

A parent pays $800,000 for 80 percent of a subsidiary. The fair value of the NCI is $180,000 and the fair value of the subsidiary's net assets at acquisition is $900,000. Goodwill = 800 + 180 - 900 = $80k.

NCI at the reporting date: if the subsidiary's net assets rose by $200,000 after acquisition, the NCI is $180,000 + 20 percent x $200,000 = $220,000.

Unrealised profit: the parent sold goods costing $1,000 to its subsidiary for $1,500, and 30 percent are still held. Unrealised profit = $500 x 30 percent = $150. Revenue and cost of sales are each reduced by the full $1,500 of intra-group sales, and cost of sales is then increased by the $150 unrealised profit.

Key terms

• Control: Power over an investee, exposure to its variable returns and the ability to use that power to affect them.
• Non-controlling interest: The part of a subsidiary's equity not owned by the parent.
• Unrealised profit: Profit on intra-group sales that has not yet been earned outside the group because the goods are still held.
• Significant influence: The power to take part in an investee's financial and operating decisions without controlling them.

Study tip: For consolidation tasks, set out the net assets of the subsidiary at acquisition and at the reporting date first. Goodwill, NCI and retained earnings then follow from those figures.

Practice questions for section H

I. Interpretation of financial statements

Analysis helps users to judge performance and position, to compare an entity over time and against others, and to decide what to do next. Ratios on their own mean little. They need a comparison, such as the previous year, a competitor or an industry average, and an explanation. Ratios also have limits: they use historical figures, accounting policies differ, and a year end snapshot may not represent the whole year.

Profitability ratios include gross profit margin (gross profit / revenue), operating profit margin (operating profit / revenue) and return on capital employed (profit before financing and income taxes / capital employed, where capital employed is total assets less current liabilities).

Liquidity ratios include the current ratio (current assets / current liabilities) and the quick or acid test ratio ((current assets less inventories) / current liabilities).

Efficiency ratios include the receivables collection period (trade receivables / credit sales x 365), the payables payment period (trade payables / credit purchases, or cost of sales, x 365), inventory holding period (inventories / cost of sales x 365) and asset turnover (revenue / capital employed).

Position ratios include gearing (debt / equity, or debt / (debt + equity)) and interest cover (profit before financing and income taxes / finance costs). Higher gearing means more risk for shareholders because interest must be paid whatever the profit.

The ratios are linked. For example, a lower gross margin with a higher asset turnover can give the same return on capital employed. A longer receivables collection period reduces liquidity unless it is matched by a longer payables period. When you comment, say what the figure shows, give a likely reason, and say what a user should do.

Worked figures

Trade receivables $24,000, credit sales $300,000: collection period = 24,000 / 300,000 x 365 = 29.2 days. Current assets $90,000 including inventories of $30,000, current liabilities $60,000: current ratio 1.5, quick ratio 1.0. Profit before financing and income taxes $60,000, capital employed $400,000: ROCE 15 percent.

Key terms

• Capital employed: Total assets less current liabilities, which equals equity plus non-current liabilities.
• Gearing: The proportion of finance that comes from debt.
• Quick ratio: Current assets excluding inventories divided by current liabilities.

Study tip: In comments, always compare with something. A ratio of 1.5 means nothing until you say what it was last year or what is normal for the industry.

Practice questions for section I