SECRET SAUCE

(A2 LEVEL ACCOUNTING THEORY NOTES FOR 2020-2021)

OMAIR MASOOD

CEDAR COLLEGE (CLIFTON|PECHS)

 PARTNERSHIP
What if there is no partnership agreement?

The partnership Act of 1890 will apply which states

No interest on capital or drawings

No Salaries

Profits to be shared equally ( Not in capital ratio)

Interest on Loan from partner ( if not stated) is taken at 5%.

What is a partnership change?

A partnership change occurs when there is a change in structure of the partnership .

The partnership is not dissolved it is only changed. i.e Admission of a new partner,
Retirement of an existing partner , or simply a change in existing profit sharing ratio.

Why do we have to treat for goodwill in a partnership change?

Any goodwill generated till date belongs to the old partners. So the goodwill
adjustment is done in such a way that old partners will benefit and the new partners
will loose out. This is because goodwill is kept in line with the profit sharing ratio .
The new partner ends up paying for goodwill and the old partner if he is leaving gets
paid for his goodwill. This way all partners are treated fairly.

How do we have to treat for goodwill in a partnership change?

There are two methods to treat goodwill

Method 1: Goodwill is kept in the books

In this method we create goodwill in the old profit sharing ratio in capital accounts
and leave it ( so that it can be shown in the balance sheet as a non current asset).
This method is rarely used and is not preffered because its not in line with the
Prudence and Money Measurement Concept.

Method 2: Goodwill is Created but then written off right away

In this method we create goodwill in the old profit sharing ratio in capital accounts but
then write it off in the new profit sharing ratio. This method is frequently used and
follows Prudence and Money Measurement Concept.

Note: If Question doesn’t specify clearly always use method 2

What if Goodwill is already recored on the balance and has to be adjusted?The
amount of goodwill on the balance sheet is already in capital accounts of the partner
so we only need to create the difference ( increase ) in the goodwill in old profit
sharing ratio ( and then write off the entire amount if required to write it off. Alternate
method would be to treat the change in goodwill in revalution account and then write i
off the full amount from the captial account.

What is the difference between revalution account and realization(dissoulition)

account?

Revalution account is made at the time of change in a partnership ( see above) . This
is done to change the values of asset to the current market value so that any gain or
loss that has arised before the change can be adjusted in capital of partners. When
making revalution account if only take the changes in assets ( the difference in
values) and close it off in the old profit sharing ratio

Realization account is made when the partnership business is dissolved or sold . The
aim of this account is to calculate the overall gain or loss upon closure of the
partnership business.In this we fisrt close the assets at net book value and compare
it with the amount realized upon sale . The difference ( overall gain or loss) is closed
off in the profit sharing ratio aswell.

What are the possible reasons for dissolution in a partnership?

• Business is making losses and future prospects are not good.

• Death/Retirement of a partner ( Specially in case of two partners in a
partnership)
• Legal authorities have forced the business to close down
• Dispute between the partners
• Business is very illiquid and about to get bankrupt
• Partners want to form a limited company.
 COMPANY ACCOUNTS
RESERVES
The net assets of the company are represented with capital and reserves. While
Capital represents the claim that owners have because of the number of shares they
own, reserves represent the claim that owners have because of the wealth created
by the company over the years but not distributed to them. There are two main types
of reserves.

Revenue Reserves: The reserves which arise from profit (Trading activities of the
company) . These are transferred from the Appropriation Account. Examples include
General Reserve and Retained Profit (Profit and Loss) .Dividends can only be paid to
the amount of revenue reserves on the balance sheet. I.e. the maximum dividend
possible is the sum of both revenue reserves.

Capital Reserves:These are reserves which the company is required to set up by

law and cannot be distributed as dividends. They normally arise out of capital
transactions. These include Share Premium and Revaluation Reserve and also
Capital Redemption Reserve (See details of CRR)

Revaluation Reserve

This is created when the value of an asset is increased in the books due to a
permenant increase in market value. The amount of revaluation reserve is difference
between net book value at the time of revaluation and the market value. This is a
gain which cannot be transferred to the profit and loss account as it is still not
realized (earned) by the company. This reserve can be used in the future if the same
asset (on which the reserve was created) value goes down ( the loss can be written
off against this reserve). This can also be used for Bonus Issue

Share Premium

Share premium occurs when a company issues shares at a price above its nominal
(par) value. This excess of share price over nominal value is what is known as share
premium.

What are the uses of Share Premium?

• Issue Bonus Shares

• Write off Formation ( Preliminary Expenses)

• Write off Goodwill

What are the different Types of Preference Shares?

• Non Cumulative Preference Shares: In case company doesn’t have enough

profits these shareholders will get no dividend in the year and that amount of
dividend will never be given

• Cumulative Preference Shares : : In case company doesn’t have enough

profits these shareholders will get no dividend in the year and that amount of
dividend will be carried forward to next year , when the company makes
enough profit the entire amount will be payable as dividend.

• Participating Preference Shares: A participating preferred share gives the

holder the right to receive dividends equal to the normally specified rate that
preferred shareholders receive as well as an additional dividend based on
some predetermined condition ( like if profit exceeds a certain level)

• Redeemable Preference Shares : These shares are temporary shares

which can “redeemed “(bought back ) by the company after a specified period
of time. Thery are recorded as non current liabilities and the dividends paid to
them are treated like interest ( finance cost)

ISSUE OF SHARES
Public Issue: This is normal issue of shares to general public. A company can issue
shares to public to raise more capital , this is done at the market price. Public issues
have higher cost of issue ( this means the company has to incur high expenses when
issuing the shares I.e. advertising and administration ). The main advantage of
issuing shares is that no interest has to be paid on it and the company only have to
provide a return when they actually make profits.

Rights Issue : A rights issue represents the offer of shares to the existing
shareholders in proportion to their existing holding at a lower price compared to the
market value.

Advantages of Rights Issue over Public issue

• Rights issue are cheaper to administer and less risky way of raising capital

• Shareholders will get some incentive as they will get shares at a lower price.

Disadvantages

• Market price will fall

• The company could have raised more funds through a public issue
Bonus Issue:

Is the issue of shares to existing shareholders for free .When the company is short of
cash and can’t give dividends so they give out shares for free to the ordinary
shareholders. Other reasons for bonus issue include.

• To utilize the capital reserves

• To increase confidence in the company’s future prospects as it is normally

taken as a signal of strength by the general public.

When doing bonus issue company will always use capital reserves first and then the
revenue reserves i.e.

We can use either of revaluation reserve or share premium first but if we don’t have
enough balance in both of these reserves then we will move to

• General Reserve

• Profit and Loss.

WHAT IS CONVERTIBLE DEBENTURE/CONVERTIBLE LOAN STOCK?

Special type of debenture which can be converted into shares at a specified date.
Upon conversion the debenture holder receives ordinary shares and he gives away
is debenture certificate. The shares are sold to them in return of debentures, so that’s
usually done at market price of share ( so share premium will be involved) . For
example
A company has convertible loan stock worth $60000. They decided to convert it into
shares by issuing 10 Ordinary shares of $1 each for every $15 of debenture. This
means company will issue 40000 shares to settle the debenture , each share which
is for $1 was sold for $1.5 .
Debit : Debenture 60000
Credit : Ordinary Shares 40000
Share premium 20000
PURCHASE AND SALE OF BUSINESS
Purchased Goodwill is calculated by the company which is buying the business . The
formula used is

PURCHASE CONSIDERATION ( PURCHASE PRICE) – FAIR VALUE OF NET

ASSETS ACQUIRED.

IF THE GOODWILL IS NEGATIVE IT IS RECORED AS A NEGATIVE ASSET IN

THE BALANCE SHEET i.e in brackets . It is called negative goodwill . We also use to
call it capital reserve.

The Business which is being sold will not calculate goodwill , infact it will calculate
gain or loss on realization (sale) , which will be done thorugh a realization account

Following Table is useful to summarize the differences in Sale and Purchase of

Business

Sale of Business Purchase of Business

Assets are recorded at net book values Assets are included at revalued amount
in realization for calculating gain or loss (fair value) when calculating goodwill

Profit or Loss on disslution is shared by Goodwill is directly shown in the balance

partners in profit sharing ratio and sheet as an intangible asset. In brakets if
become part of capital goodwill is negative

Shares given to seller are recorded at Shares issued are recorded in the
market value (including premium) in his financed by section of balance sheet ,
capital account where we separate par value and share
premium

Include all asset and current liablities in Only include those assets and current
your realization account, irrespective of liablities which are taken over in the
take over or not ( excluding bank calculation of goodwill.
account , only include if take over) .

Note: Bank Account will only be taken over if the question says clearly , or if it says
All assets and liablities were taken over , or the entire business was taken over. If
the seller still has to receive or make a payment from bank account , ( say for debtors
or creditors) and the question is silent about the bank account ,assume it was not
taken over.
 STATEMENT OF CASHFLOWS
A cashflow statement is intended to disclose the information on actual movement of
cash in the business during the financial year. It helps to assess the liquidity of the
business and to judge the quality of profit earned by the business which can not to be
assessed from the Income statement ( Trading ,Profit and Loss account) and
Balance Sheet.

The Cashflow statement outlines the sources of cash received and specifies
activities on which the cash was spent. It explains why business has overdrawn from
the bank in a year although it has earned a good amount of profit.

The Cashflow statement is a bridge between the two balance sheets and it expalins
in details the changes took place during the year.

Why is Cashflow Statement important?

The statement of cash flows tells you how much cash went into and out of a
company during a specific time frame such as a quarter or a year. You may wonder
why there's a need for such a statement because it sounds very similar to the income
statement, which shows how much revenue came in and how many expenses went
out.

The difference lies in a complex concept called accrual accounting. Accrual

accounting requires companies to record revenues and expenses when transactions
occur, not when cash is exchanged. While that explanation seems simple enough,
it's a big mess in practice, and the statement of cash flows helps investors sort it out.

The statement of cash flows is very important to investors because it shows how
much actual cash a company has generated. The income statement, on the other
hand, often includes noncash revenues or expenses, which the statement of cash
flows excludes.

One of the most important traits you should seek in a potential investment is the
firm's ability to generate cash. Many companies have shown profits on the income
statement but stumbled later because of insufficient cash flows. A good look at the
statement of cash flows for those companies may have warned investors that rocky
times were ahead.

The Three Elements of the Statement of Cash Flows Because companies can
generate and use cash in several different ways, the statement of cash flows is
separated into three sections: cash flows from operating activities, from investing
activities, and from financing activities.

The cash flows from operating activities section shows how much cash the
company generated from its core business, as opposed to other activities such as
investing or borrowing. Investors should look closely at how much cash a firm
generates from its operating activities because it paints the best picture of how well
the business is producing cash that will ultimately benefit shareholders.
The cash flows from investing activities section shows the amount of cash firms
spent on investments. Investments are usually classified as either capital
expenditures--money spent on items such as new equipment or anything else
needed to keep the business running--or monetary investments such as the
purchase or sale of money market funds.

The cash flows from financing activities section includes any activities involved in
transactions with the company's owners or debtors. For example, cash proceeds
from new debt, or dividends paid to investors would be found in this section.

To summarize

The cashflow statement helps the shareholders, investors and others users in
assessing

* Company’s ability to generate cash internally (operating activites) to meet its

obligations and to pay dividends

* The causes of changes in liqudity (cash inflows and outflows)

* Whether the business can generate to cash to service finance and pay taxes
and also maintain its fixed assets

* How much the business is relied on long term finance

* How much cash has been raised externally

* Indication of future cash flows for capital investments

* Reconciles profitability with liquidity

What is the Difference between Cash budget and Cashflow statements.?

Cashflow Statements Cash Budgets

Based on Actual transactions
Based on Strict format
Published for external users ( Shareholders,
lenders, Future investors)
It is required by law to make cashflow
statements
Based on Future estimates
Prepated as per company’s policy
It is for managements internal use
No legal Requirement.
 RATIOS (A2)
Note: ALL AS LEVEL RATIOS ARE ALSO IN A2 SYLLABUS

All of these ratios are calculated from the point of view of ordinary shareholders. Its
useful to understand the term Earnings .

What is Earning? ( Profit attributable to ordinary shareholders)

This is Profit After Interest , tax and preference share dividend. Basically whatever
goes to ordinary shareholders.

1. Earning Per Share

Earning/# of ordinary Shares

How much profit after tax and preference share dividends is attributable to each
ordinary share. Simply shows how much the company has earned for one ordinary
share, since all the earnings belong to ordinary shareholders. Investors regard EPS
as a measure of success of the company. Obviously the higher this number the more
money is made by the company. This ratio allows us to compare different companies
power to make money. The higher the EPS (with all else equal), the higher each
share should be worth. When we do our analysis we should look for a positive trend
of EPS in order to make sure the company is finding more ways to make more
money. Otherwise the company is not growing. The main problem with EPS is since
it is expressed on per share basis it becomes difficult to compare companies with
different amount of number of shares.
An important aspect of EPS that's often ignored is the capital that is required to
generate the earnings in the calculation. Two companies could generate the same
EPS number, but one could do so with less equity (investment) - that company would
be more efficient at using its capital to generate income and, all other things being
equal, would be a "better" company.

2. Dividend Per Share

Ordinary Dividend Paid /# of Ordinary Shares

This is calculated using dividends paid . Dividends are a form of profit distribution
to the shareholder. Having a growing dividend per share can be a sign that the
company’s management believes that the growth can be sustained. A high
Dividend per share also means the company has enough cash available to pay
for dividends.
3. Dividend Cover

EPS/DPS or Earnings/Ordinary Dividends Paid

This shows the relation of earning to dividends . How many times the dividend for
the year can be covered(paid) from this year’s earnings. A low cover indicates
future dividends are at risk if company’s profitability falls in the future( as they are
not retaining enough profits and are distributing the majority) .A high dividend
cover is an indication of safety of dividends in the future ,as the company has
retained enough profits. The long term investors look for high dividend cover
companies, because they believe if the company is retaining more profits then
they have more growth opportunities. If the ratio is under 1, the company is using
its profit from a previous year to pay this year's dividend. This ratio also shows
the dividend policy of the company , a high cover indicates a very conservative
approach where majority of the profits are invested back in the business.

4. Dividend Yield :

Ordinary Dividend Paid and Proposed/MPS * 100 where MPS is Market Price
per Share

This shows the dividends as a % of market price. This is used to calculate cash
return on investment. We take investment as market price because that is the
opportunity cost of holding a share. High dividend yield makes the share more
attractive.

5. Interest Cover

Operating Profit/Interest

Shows how many times the operating profit can cover for the interest expense. A
high ratio is desirable to this would mean company has more ability to handle its
interest charges and to more amount will be available to pay for dividends. A low
cover may turn a small profit into a loss due to the interest expense. Low cover
also makes it difficult for the company to raise more debts and loans as the
financial intuitions demand a minimum interest cover level.

6. Price to Earning Ratio

MPS/EPS

This relates market price to the Earning per share. High Ratio shows the investor
has more confidence in this company’s future to maintain its current level of
earning , that is why they are willing to pay more . The ratio should be compared
with the average ratio of the similar companies.
Some believe that the high ratio may mean that share price is overvalued and will
fall in future. But a growing PE ratio shows increase in the confidence level of
investors.
 7. Gearing Ratio

Fixed Return Capital/Total Capital Employed * 100

This shows how much of the total capital employed ( total amount invested in the
business) is coming from external sources (not by ordinary shareholders) . The
amount of financing provided by long term liabilities and preference shareholders.
This is measure of risk because if a high proportion is coming from these sources
than majority of the profits will go as interest payments and preference dividends
( specially In the low profitability years), infact the interest expense has to be paid
even in case of losses. If a company is already highly geared then its difficult to raise
more loans (obviously). Gearing of more than 50% is considered high and risky.
Remember high gearing is not necessarily bad (but its risky) , it depends on risk
preference of the investor. A high geared company tends to grow faster because
they rely on debt and external financing, it can give amazing returns in good years
but in a bad year it can also go bankrupt.

8. Income Gearing
Interest/Operating profit *100

This shows how much% of operating profit has to go for interest

Its same as interest cover but calculated as a %.

9 . Net Asset Value Per Share ( Book value Per Share)

Ordinary Share Capital + All Reserves /# of Ordinary Shares

This is the value of one ordinary share according to the balance sheet. Remember
all reserves belong to ordinary shareholders. This indicates the amount of cash each
share will receive if the company is liquated at that date. Theoretically the book value
of one share should also be the market value , but market value tends to be higher
because
- Balance sheet does not include internally generated intangible assets
such as human capital and goodwill.
- Balance Sheet is historical and cant take into account future gains
- Speculations in stock market effects the share price.

10.RETURN ON EQUITY :
Shows how much return as a percentage of capital is earned by the company
Earnings/total ordinary shareholders funds *100
11.Net Working Assets to Revenue (Sales)

Net working assets X100 = %

SALES

The net working assets are not liquid as cash. This calculation shows the proportion
of sales revenue that is tied up in the less liquid net current assets. A lower ratio is
better which means that if sales increase the net working assets will increase in a
lower rate as the company would desire to hold current assets in liquid form.

Note:Net working assets =Inventory + Trade Receivables – Trade payables

RATIOS(AS LEVEL)
PROFITABILITY
GROSS PROFIT MARGIN ( Gross Profit x 100 )
Net Sales
While the gross profit is a dollar amount, the gross profit margin is expressed as a
percentage of net sales. The Gross Profit Margin illustrates the profit a company
makes after paying off its Cost of Goods sold. The Gross Profit Margin shows how
efficient the management is in using its labour and raw materials in the process of
production (In case of a trader, how efficient the management is in purchasing the
good). There are two key ways for you to improve your gross profit margin. First, you
can increase your process. Second, you can decrease the costs of the goods. Once you
calculate the gross profit margin of a firm, compare it with industry standards or with
the ratio of last year. For example, it does not make sense to compare the profit
margin of a software company (typically 90%) with that of an airline company (5%).

Reasons for this ratio to go UP (opposite for down)

1. Increase in selling price per unit
2. Decrease in purchase price per unit due to lower quality of goods or a different
supplier.
3. Decrease in purchase price per unit due to bulk (trade) discounts.
4. Extensive advertising raising sales volume (units) along with selling price.
5. Understatement of opening stock.
6. Overstatement of closing stock.
7. Decrease in carriage inwards/Duties (trading expenses)
8. Change in Sales Mix (maybe we are selling some new products which give a
higher margin).
NET PROFIT MARGIN (Operating Profit x 100 )
Net Sales
Net profit margin tells you exactly how the management and operations of a business
are performing. Net Profit Margin compares the net profit of a firm with total sales
achieved. The main difference between GP Margin and NP Margin are the overhead
expenses (Expenses and loss). In some businesses Gross Margin is very high but Net
Margin is low due to high expenses, e.g. Software Company will have high Research
expenses.

Reasons for this ratio to go UP (opposite for down)

All the reasons for GP margin apply here. Additionally
1. Increase in cash discounts from suppliers
2. A decrease in overhead expenses
3. Increase in other incomes like gain on disposal, Rent Received etc.

Return on Capital Employed (ROCE)

This is the key profitability ratio since it calculates return on amount invested in the
business. If this ratio is high, this means more profitability (In exam if ROCE is
higher for any firm it is better than the other firm irrespective of GP and NP Margin).
This return is important as it can be compared to other businesses and potential
investment or even the Interest rate offered by the bank. If ROCE is lower than the
bank interest then the owner should shoot himself. This ratio can go up if profits
increase and capital employed remains the same. Also if Capital employed decreases,
this ratio might go up.

Operating Profit_ x 100

Capital Employed
Net Profit before Interest and Tax

Return on Total Assets

This shows how much profit is generated on total assets (Fixed and Current). The
ratio is considered and indicator of how effectively a company is using its assets to
generate profits.

Operating Profit_ x 100

Total Assets
Return on Shareholders’ Funds/Return on Net Assets/Return on
Owners capital

Since all the capital employed is not provided by the shareholders, this specifically
calculates the return to the shareholders (It’s almost the same thing as ROCE)

Net Profit after Tax x 100

Shareholders Funds

O.S.C + P.S.C + RESERVES

NOTE:
Capital Employed = Fixed Assets + Current Assets – Current
Liabilities

OR

= Ordinary Share Capital + Preference Share

Capital + Reserves + Long-term Liabilities
LIQUIDITY AND FINANCIAL
As we know a firm has to have different liquidity. In other words they have to be able
to meet their day to day payments. It is no good having your money tied up or
invested so that you haven’t enough money to meet your bills! Current assets and
liabilities are an important part of this liquidity and so to measure the firms liquidity
situation we can work out a ratio. The current ratio is worked out by dividing the
current assets by the current liabilities.

CURRENT RATIO = Current assets _

Current liabilities

The figure should always be above 1 or the form does not have enough assets to meet
its liabilities and is therefore technically insolvent. However, a figure close to 1 would
be a little close for a firm as they would only just be able to meet their liabilities and
so a figure of between 1.5 and 2 is generally considered being desirable. A figure of 2
means that they can meet their liabilities twice over and so is safe for them. If the
figure is any bigger than this then the firm may be tying too much of their money in a
form that is not earning them anything. If the current ratio is bigger than 2 they should
therefore perhaps consider investing some for a longer period to earn them more.

However,  the  current  assets  also  include  the  firm’s  stock.  If  the  firm  has  a  high  level  of  
stock,  it  may  mean  one  of  the  two  things,  
1. Sales are booming and they’re producing a lot to keep up with demand.
2. They can’t sell all they’re producing and it’s piling up in the warehouse!

If the second of these is true then stock may not be a very useful current asset, and
even if they could sell it isn’t as liquid as cash in the bank, and so a better measure of
liquidity is the ACID TEST (or QUICK) RATIO. This excludes stock from the
current assets, but is otherwise the same as the current ratio.
ACID TEST RATIO = Current assets – stock
Current liabilities

Ideally this figure should also be above 1 for the firm to be comfortable. That would
mean that they can meet all their liabilities without having to pay any of their stock.
This would make potential investors feel more comfortable about their liquidity. If the
figure is far below 1, they may begin to get worried about their firm’s ability to meet
its debts.

Rate of Stock Turnover

It shows the number of times, on average, that the business will sell its stock in a
given period of time. It basically gives an indication of how well the stock has been
managed. A high ratio is desirable because the quicker the stock is turned over, more
profit can be generated. A low ratio indicates that stocks are kept for a longer period
of time (which is not good).

Cost of Goods Sold = ____ Times

Average Stock

Stock Days:
This is Rate of stock turnover in days. Lower the better.

Average Stock x 365 = ____ Days

Cost of Goods Sold

Debtor Days:
Shows how long it takes on average to recover the money from debtors. Lower the
better.

Debtors x 365 = ____ Days

Credit Sales

Creditor Days: (Creditor Payment Period)

Shows how long it takes on average to payback the creditors. Higher the better.

Creditors x 365 = ____ Days

Credit Purchases

Working Capital Cycle: (Lower the better)

Stock Days + Debtor Days – Creditor Days = ____ Days

Note:
Average Stock = Opening + Closing
2
IF Average cannot be calculated use Closing Figures as average.
Utilization Ratios (All higher the better)
Total Asset utilization (Total Asset Turnover)

Shows how much sales are being generated on Total Assets. Higher ratio indicates
better utilization of Total Assets.
Net Sales = ____ Times
Total Assets

Fixed Asset Utilization (Fixed Asset Turnover)

Shows how much sales are being generated on Fixed Assets. Higher ratio indicates
better utilization of Fixed Assets.
Net Sales = ____ Times
Fixed Assets

Working Capital Utilization (Working Capital Turnover)

Sows how much sales are being generated on Working Capital. Higher ratio indicates
better utilization of Working Capital.
Net Sales = ____ Times
Working Capital

Advantages of Ratios
1. Shows a trend
2. Helps to compare a single firm over a two years (time – series)
3. Helps to compare to similar firms over a particular year.
4. Helps in making decisions
Disadvantages (Limitations):
1. A ratio on its own is isolated (We need to compare it with some figures)
2. Depends upon the reliability of the information from which ratios are
calculated.
3. Different industries will have different ideal ratios.
4. Different companies have different accounting policies. E.g. Method of
depreciation used.
5. Ratios do not take inflation into account.
6. Ratios can ever simplify a situation so can be misleading.
7. Outside influences can affect ratios e.g. world economy, trade cycles.
8. After calculating ratios we still have to analyze them in order to derive a
conclusion.
PUBLISHED FINAL ACCOUNTS
The shareholders are the owners of the public limitied company, but they are not
permitted to manage their company unless they qualify as a director. The
shareholders elect a Board of Directors and delegate the authority to them. As there
is a divorce between owenership and control , it is a legal requirement for all
companies to publish the financial statements for the use of shareholders. The
companies publish the accounts in form of an ANNUAL REPORT.

CONTENTS OF ANNUAL REPORT:

1 . Financial Statements ( Income Statement , Statement of Financial Position

(balance Sheet) and a Statement of Cashflows)

2. Accounting Policies (see below)

3. Explaintory notes to financial statements

4. Directors Report

5. Auditors Report

What are Accounting Policies ?

Accounting policies are the specific principles, bases, conventions, rules and
practices applied by an entity in preparing and presenting financial statements. In this
section companies show change in accounting policies over last year and the
reasoning behind the changes applied. ( SEE IAS8)

What are explanatory notes?

The published financial statement only show the headings like Sales , COGS ,
Operating expenses, Non current Assets on the face of the statement , all the
details are shown under footnotes to these Profit and Loss and Balance Sheet

NOTES TO PROFIT AND LOSS

1. Details of Sales (turnover)

2. Details of Interest and Finance Cost

3. Details of Cost of goods sold

4. Details of Taxation

5. Details of wages , specially of highly paid staff)

6. Directors Salary and other compensations ( emoluments and remuneration )

7. Auditors fees
 NOTES TO BALANCE SHEET

1. Schedule of Fixed Asset

2. Details of revaluation

3. Treatment of Goodwill

4. Basis of Stock Valuation

5. Details of Share Capital

6. Analysis of Long term Liablities

What is Directors Report and what are the contents?

Directors report is a summary provided by the directors to the shareholders and other
stakeholders on the performance of a company for a particular year. What you
should realize is that the financial statements are just numbers and not everyone can
comrehend the numbers , A report from the director becomes absolutely important
for the shareholder if he wants to know his companys financail performance . It
includes

1. An overall business review

2. Main (operations ) activities carried on by the company

3. Particulars of events occuring after the balance sheet which effects the
company

4. Recommendation of dividends

5. Name of directors and their financial interst (stake) in the business

6. Health and safety arrangement details

7. Donations to political parties

8. Signifcant changes in Fixed Assets during the year

9. An indication of future plans of the business

10. Information about research and devlopment expenditure carried out by the
busienss.

What is An Auditors Report?Auditors are hired by the shareholder to provide

assurance on the data provided by the directors to the shareholders. They check the
validity of data provided in the annual report ,and give an independent opinion on
whether the financial statements provide a true and fair view of companys position.
They also make sure that the financial statements comply with the International
Accounting Standards (IAS see next pages).
What is not included in the Directors Report ?

• Directors salary/ Remunerations ( because this is shown as a note to the

profit and loss account)

• Details of export sales

• Accounting Policies ( they have a separate section)

What is not disclosed at all ?

• Any day to day expense ( like rent , vehicle running cost or electricity )

• Scrap Value of asset

• Basis of calculation of provision for bad debt.

What is Window Dressing ?

Window dressing refers to actions taken prior to issuing financial statements in order
to improve the appearance of the financial statements. These are techniques in
accounting that can be used to present the financial position of the company in a
favourable light

• Reducing the rates of depreciation

• Failure to write down a decrease in value of asset

• Anticipating profits on long term contracts

• Including unrealized profits in profit and loss account.

What are exceptional items?

Some events or expenses do not normally occur, they are rare exceptional items
such as

• cost of capital reconstruction

• profits or losses from sale of an operation

• profits or losses from sale of a fixed asset

The exceptional items must be shown separately on the face of the profit and loss
account to give a better view to the shareholders as the exceptional item wont occur
every year.
INTERNATIONAL ACCOUNTING STANDARDS
The International Accounting Standard Board (IASB) have set rules and regulation
on how cetain accounting transactions should be recorded and presented by a
company. In most of the countires all companies are required to comply with these
standards, and auditors make sure that all public limited companies are following the
standards.

The main purpose of Accounting standards is to reduce the range and variety in
accounting practices thorughout the world. It does not form uniform accounting basis
but it does form similar accounting bases. They restrict the oppurtunity of frauds and
creative accounting( window dressing) , but they cannot prevent frauds. They also
assist inyvestors to understand financial statements as the IASB issues notes and
explanations of every accounting standard.

You are suppose to remember standards with name and number . You are also
required to know details of a few standards.

IAS 1 – PRESENTATION OF FINANCIAL STATEMENTS:

Gives format of income statement , balance sheet and Cashflow Statements.

Changes the name of balance sheet to “STATEMENT OF FINANCIAL POSITION”

A company must report the following documents

A complete set of financial statements includes: [IAS 1.10]

◦ a statement of financial position (balance sheet) at the end of the period(
see below)
◦ a statement of profit or loss and other comprehensive income for the period
(presented as a single statement, or by presenting the profit or loss
section in a separate statement of profit or loss, immediately followed
by a statement presenting comprehensive income beginning with profit
or loss)
◦ a statement of changes in equity for the period
◦ a statement of cash flows for the period
◦ notes, comprising a summary of significant accounting policies and other
explanatory notes
◦ Information given should be comparative .
Statement of comprehensive income ( Total recognized gains and losses). This
statement for our syllabus only includes two items.

Profit for the Financial year ( after Tax) xxx

Add Gain on Revalution of Assets xxx

Total Gains and Losses xxx

Proposed dividends for ordinary shares should be shown as a note to account and
not deducted from profits ( obviously also not shown as a liablity in the balance sheet)

Redeemable shares are now treated just like debentures , they should not be
included in the equity of the company, they should be shown in the long term
liabilities. The dividends paid to them are now treated like interest ( Finance
Cost) in the profit and loss account.

IAS 1 also states that the following accounting princples must be applied which
presenting financial statements.

-Going Concern

-Accural

-Consistency

-Materiality

-Offsetting ( Incomes and Expenses shoudnt be offset against each other, Or same
goes for Assets and Liablities)

-Prudence

-Comparative Information ( An entity should report all the financial statements ,by
showing comparision with last year statements).
IAS 2 – INVENTORIES

Stock should be valued at lower of cost or net realizable value.

LIFO method is no longer acceptable.

Valuing Work in Progress and Finished Goods

IAS 2 requires that the valuation of these two items includes not only their raw or
direct material content, but also includes an element for direct labour, direct
expenses and production overheads

The cost of these two items therefore consists of:

- direct materials
- direct labour
- direct expenses
- production overheads, these are costs to bring the product to its present
location and condition

Other overheads which may be applicable to bring the product to its

present location and condition
The cost of these two items excludes:
- storage costs
- selling costs
- administration costs not related to production

IAS -7 CASHFLOW STATEMENTS

Statement of cashflows is now made under three headings

Operating

Investing

Financiang

The standard has also defined cash equalivent as :

Cash Equavlaient : Cash in hand , Amount in Normal Bank account and also Amout
in bank deposit account which is matured within 3 months.
IAS 8 ACCOUNTING POLICIES /ACCOUNTING ESTIMATES/ERRORS

Accounting policies are the specific principles, bases, conventions, rules and
practices applied by an entity in preparing and presenting financial statements.Once
an entity adopts an accounting policy then it must be applied consistently for similar
transactions. An entity can change the Accounting Policy only if

-It is required by a new Accounting Stadard

-Results in Financial statements providing more reliable and relevent information.

Example of a change in accounting policy would changing inventory valuation from

FIFO to AVCO. Or changing from Straight Line method of depreciation to Reducing
Balance Method.

As a General Rule if there is a change in policy it should be applied Retrospectively

(this means all the account balances from previous years should be adjusted ,as if
the new policy was always in place).

Accounting Estimates: The reasonable esitmates are needed to prepare financial

statements, e.g to determine net book value of assets. Provision for doubtful debts.
Estimates must be revised when new information becomes available which indicates
a change in circumstances upon which the estimates were formed. A change in
Accounting estimate must be accounted for Prospectively ( i.e the previous accounts
are not required to be changed).

Accounting Errors: If errors from previous periods are discovered later then they
should be accounted for Retrospectively( (this means all the account balances from
previous years should be adjusted)

IAS 10 – Events occuring after the Balance Sheet Date ( Post Balance Sheet
Events)

These are events, either favourable or unfavourable, which occur between the
balance sheet date and the date on which the financial statements are authorised for
issue. Such items may occur as a result of information which becomes available after
the end of the year and, therefore need to be disclosed in the accounts.
The key is the point in time at which changes to the financial statements can be
made. Once the financial statements have been approved for issue by the board of
directors they can not be altered. For example, the accounts are prepared up to 31
December. They are approved for issue by the board of directors on 30 April in the
following year. Between these two dates, changes resulting from events after the 31
December can be disclosed in the accounts.

The statement distinguishes between two types of events:

1. Adjusting events
If, at the date of the balance sheet, evidence of conditions existed that would
materially affect the financial statements then the financial statements should be
changed to reflect these conditions.
Examples of adjusting events could include:
- the determination after the date of the balance sheet of the purchase price or
sale price of a non-current asset bought or sold before the year end.
- inventories where the net realisable value falls below the cost price.
- assets where a valuation shows that impairment is required.
- trade receivables where a customer has become insolvent.
- the discovery of fraud or errors which show the financial statements to be
incorrect.

2. Non – Adjusting Events

No adjustment is made to the financial statements for such events. If material, they
are disclosed by way of notes to the financial statements.
Examples include:
- Proposed Dividends
- major purchase of assets.
-losses of production capacity caused by fire, floods or strike action by
employees.
- announcement or commencement of a major reconstruction of the business.
- changes in tax rates.
- entering into significant commitments or contingent liabilities.
- commencing litigation based on events arising after the date of the balance
sheet.
- major share transactions.

IAS 16 PLANT PROPERTY AND EQUIPMENT ( FIXED ASSETS)

Assets must be shown at original cost less accumalated depreciation. Or the

revaluation model can be applied on regular basis.

Revalution of assets must be consistent , if any asset is revalued all similar assets
should also be revalued. All gains are transferred to revaluation reserve

Any loss on revaluation is transferred to pnl (unless the asset was revalued upward
before then the devaluaion can be charged from revaluation )

Once the Asset revalued is sold , the balance on revaluation reserve can be credited
to retained earnings.

This Standard has also given details of what can be counted as capital expenditure.
Any cost incurred before the asset can be used is treated as capital expenditure.
IAS 36- IMPAIRMENT OF ASSETS

This standard seeks to ensure that non current assets on the balance sheet are not
shown at an overstated value (Including Goodwill). When Net book value ( reffered
as Carrying amount) is more then its recoverable amount , the asset is impaired. An
impairment loss is shown in the income statement as an expense.

What is recoverable amount?

This is the higher of the following two values

- Current market value (Fair Value ) less cost to sell

- Present value of future cashflows derived from the Asset ( Value in

Use)

So if net book value is above the Recoverable amount , the asset value is reduced to
its recoverable Amount.

IAS 37- PROVISIONS ,CONTINGENT ASSET AND LIABLITES

Gives details on how to treat different provisions ,also gives details on contingent
liabilities ( a liablity which is not definite , e.g a company was sued by someone but
the court case is still pending ) and also contingent assets ( asset which might come
in for example there is court case which the company might win.)

Provisions:

IAS 37 establishes the definition of a provision as a "liability of uncertain timing or

amount", and requires that all the following conditions be fulfilled before a provision
can be recognized:
◦ the entity currently has a liability as a result of a past event;
◦ an outflow of resources is likely to be needed to settle the liability; and
◦ the amount of the obligation can be estimated reliably

Contingent Liabilities:

A present obligation that arises from past events but is not recognized because the
timing or amount cannot be estimated reliablly . They should not be recognized but
disloced to shareholders unless the chances of them are very rare(remote) then they
can completely ignored.

Contingent Assets:
A possible asset arising from past events but will be confirmed in the future. They are
disclosed if the chances of occurance are high.

IAS 38 – INTANGIBLE ASSETS AND GOODWILL

Intangible Assets might Include

- Goodwill

- Patents

- Licenses

- Franchises

Companies are only allowed to record goodwill , when they purchase a business .
Company is not allowed to record any inherent goodwill ( goodwill of their own ) on
the balance sheet. Goodwill is also tested for impairment regularly.

This standard also gives details of accounting for research and development.

The amount of money spent on Research and development is classified into

research phase and development phase. When we start doing research it is not
necessary that the company will start developing the product. So if we are only doing
research ( intially) the amount is treated as an expense in the profit and loss. The
moment it reaches the devlopment stage it becomes eligble for balance sheet and
any further amount spent and can be shown as an asset in the balance sheet.

BUDGETING
A budget is based on the objectives of a business and enables the manager to set
operational targets for the department and then to control operations by comparing
the actual results with those in the budgt.Please remember budgets are always short
term plans ( maximum one year) and they can never satisfy the long term needs.

ADVANTAGES :

• Budgets formalize management plans. ( better planning)

• Co-ordinate all functions of a business. ( better planning)

• Gives a warning for future shortages of resources.

• Increases management particiaption ( while preparing budgets) which gives

them a sense of commitement …> motivation

• Budgeted results can be compared with actual results

• Cash budgets are required by financial institutions when taking finance

( loans)
DISADVANTAGES:

• Might cause de-motivation for workers if they feel budgted figures are way too
high to achieve

• A budget will only emphaize on results and the real reasons ( non financial)
will be ignored.

• The budgeting process will also incur cost and time.

• There is a neeed to revise the budget because circumastances will change in

every period.

What is a master budget?

A set final of accounts ( profit and loss and balance sheet) prepared using figures
from sales, purchases and cash budget.

TYPES OF BUDGETING

Incremental Budgeting: Incremental Budgeting uses a budget prepared using a

previous period’s budget or actual performance as a base, with incremental
amounts added for the new budget period. The allocation of resources is based
upon allocations from the previous period. This approach is not recommended as
it fails to take into account changing circumstances

Zero- Based Budgeting: is a technique of planning and decision-making which

reverses the working process of traditional budgeting. In traditional incremental
budgeting, departmental managers justify only increases over the previous year
budget and what has been already spent is automatically sanctioned. By contrast,
in zero-based budgeting, every department function is reviewed comprehensively
and all expenditures must be approved, rather than only increases. No reference
is made to the previous level of expenditure. Zero-based budgeting requires the
budget request be justified in complete detail by each division manager starting
from the zero-base. The zero-base is indifferent to whether the total budget is
increasing or decreasing

What is a principal budget factor?

Limiting factors, sometimes called principal budget factors are cicrumstances

which restricts the activiteis of a business. Examples include

• Limited demand for a product

• Shortage of material, which limits production

• Shortage of labour,which also limits production

• Shortage of amount of money to be spent.

The importance of limiting factor is that they must be identified at the start of the
budgeting process. This is because all other budgets will be dependant on the limit
factor. For example, if the limiting factor is demand for the product ( which is usually
the case), a sales budget must be prepared and all the other budgets will than be
prepared to fit in with the sales budget. But if the limiting factor is shortage of material
or labour then the production budget will be prepared first and the sales budget will
then be based on that.

What steps can be taken if the cash forecast highlights future cash shortages?
Please realize every action will have a disadvatnage aswell. So the company decides
the best possible action with least effect .

• Delay capital expenditure for a later period

• Delay payment of dividends

• Search for short term borrowings

• Issue shares

• Control expenses

• Encourage debtors to pay earlier

• Sell Surplus fixed assets

• Negotiate better credit terms with suppliers

What is Flexible Budget and Fixed Budget? ( Done with Standard Costing)
A flexible budget is a budget which is designed to change in accordance with the
LEVEL OF ACTIVITY actually produced. The budget is designed to change

appropriately with such fluctuation in units. Main purpose of this is to take effect

of VOLUME away from the budget so that we can compare it with actual

performance.

A fixed budget, the budget remains unchanged irrespective of the level of activity
actually attained. The fixed budget is prepared based only on one level of output.

Fixed budget approach helps to ensure that each department within the

organization always knows exactly how much they have to spend at the

beginning of the period and how much is remaining at any given point during the

budgetary period as the target is pre-set this may increase motivation

 INVESTMENT APPRAISAL
Investment appraisal is a process of evaluating whether it is worthwhile to invest your
funds in a project. The projects can be of different nature and can be in both; the
private and the public sector. They can range from acquiring a new non-current
asset , replacement of an existing asset, introducing a new product, buying an
already established business or even buying a new player (for a sports club).
Different Accounting techniques are used to evaluate these projects. While
evaluating any project, an investor will look for profitability, liquidity and feasibility of
the project. Good companies should also take the social implications of the project
into account e.g. external costs like pollution.
Most commonly used techniques include Accounting Rate of Return (ARR), Payback
Period, Discounted Payback Period, Net present Value and the Internal Rate of
Return. ARR and payback period are non-discounted methods while others are
discounted techniques. By discounting we mean, taking the “time value of
money” into account. The investment has to be made today but returns are coming in
the future. Future cash flows are discounted to present day values so that they can
be compared with the initial outlay on a realistic basis. To understand this consider
the following example
Assuming the interest rate is 10%. And I owe you $11000 but I will pay you in twelve
months’ time. You should be willing to accept $10000 from me today because you
can put that $10000 in the bank and after 12 months, it will automatically grow up to
$11000 (including the interest). So we can say that the present value of receiving
$11000 in one year’s time is $10000. Or simply the real worth of $11000 coming in
12months are equal to $10000 today.
As we know money coming in the future won’t be worth the same in today’s terms, so
we reduce the size of the cash-flow according to the discount factor (which will
always be available in CIE exam, may be not in my tests). Question might give you
full discount factor table with different percentages remember the discount factor you
have to use should be the cost of capital of the company.

So what the hell is Cost of Capital?

While explaining you concept of discounting in class I must have referred to cost of
capital being the inflation rate or sometimes the interest rate. But it is actually the rate
at which the company can borrow funds from debt and shareholders. For E.g. If a
project is financed through borrowing money from a bank loan at 8%, the cost of
capital for this project will be 8%. If it is partially financed by loan and shareholders
then an average percentage should be used (will be discussed in class during later
chapters).
What is the difference between Profit and Net Cash-flow?
Technically profit and cash-flow are very different concepts. When we calculate profit
we subtract all expenses (cash and non-cash) from our revenue (which can be on
cash or credit). Non-cash expenses might include depreciation and other provisions.
Cash-flow is calculated by simply subtracting all cash paid from total cash received.
It’s helpful to remember that while doing this chapter, we are making a lot of basic
assumptions. Firstly there are no credit sales; no other provisions except straight line
depreciation and all expenses are paid on time (no Owings or prepayments). If we
consider this then the only difference between profit and cash-flow is the depreciation
of asset, and in the last year Scrap value. While calculating profits we don’t take
scrap value into account (because profit is only calculated from revenue) but in cash-
flow calculation we got to include it. Following equation summarizes this concept
Profit = Cashflow – depreciation –Scrap Value (last year)
Note: ARR is the only method which takes profit into account. All other methods are
either based on Cash-flows or Discounted Cash-flows

KEYPOINTS TO REMEMBER
• While solving any question, you have to take the incremental approach.
A lot of questions will give data in such a way that you can calculate
revenue/expenses without project and revenue/expenses with project.
In this situation always take the increase in values because we can
associate that directly to the project. Existing profits and cash flows are
ignored as being irrelevant because they will continue whether the new
project is undertaken or not.
• Sunk Cost consists of expenditure that has already been incurred
before the new project has been considered. While appraising the new
project this should be ignored.
• Some projects do not increase cash flows but reduce operating
expenses (Savings). While evaluating such projects we have to
evaluate how much money will be saved against the cost of the project.
Savings are treated as cash inflows.
• If a project requires an increase in working capital this should be
treated as a cash outflow at the start of the project and as a cash inflow
in the last year of the project.
• Unless stated in the question we assume that the initial cost will have
to be paid in year 0 (which means start of the project). All other cash
flows are assumed to occur at the end of the particular year. For
example it is assumed that all revenue of first year is received at the
end of the first year. (Similarly operating payments are also treated in
the same way). That Is why we write sales of first year as year 1
( which means after 12 months)
• But if the question states that a particular operating expense is paid at
the start of the year this would have a significant impact on our
cashflows. If like let’s say rent has to be paid at the start of the year
then first years rent will be paid in year 0 and 2nd years rent will be paid
in year 1.
ADVANTAGES AND DISADVANTAGES OF ALL METHODS
Out of all the methods the best and most commonly used (and the criteria to decide
an investment) is the net present value method. If NPV is positive the project should
always be accepted unless there is another project with a higher NPV and funds are
limited.
1. ACCOUNTING RATE OF RETURN/AVERAGE RATE OF RETURN
(ARR)

ADVANTAGES
1. Focuses on Profitability
2. Management can compare the expected profitability with the present return
on capital employed of the existing business
3. Easy and simple to calculate and understand

DISADVANTAGES
1. It is based on profit which is subjective. Deprecation is a management
decisions and can be manipulated
2. Average Profit is not earned in any of the year
3. The time value of money is ignored
4. Ignores the risk factor as it doesn’t tell when the initial cost will be recovered
( ignores liquidity )
5. There is no common method to calculate average investment

2. PAYBACK PERIOD

ADVANTAGES
1. Based on Cash flows which is more accurate profits
2. Evaluates risk and it focuses on liquidity
3. Easy and Simple to calculate

DISADVANTAGES
1. The time value of money is ignored
2. Ignores cashflow occurring after the payback period is achieved
3. Ignores the timing of cashflow( two projects can have same payback but
with different timings of cashflow and can hence effect the liquidity)

Note: Discounted payback is very similar it’s just that it takes time value of money
into account.

3. NET PRESENT VALUE

ADVANTAGES
1. Considers time value of money
2. Based on cash flows
3. Consider all the cashflows of the project
4. It can directly be linked with shareholders wealth. A positive NPV of $50000
means the wealth of company will increase by $50000
DISADVANTAGES
1. Difficulty in estimating the discounting rate ( Cost of capital)
2. More complicated and doesn’t give a return in % form.
4. INTERNAL RATE OF RETURN (IRR)
ADVANTAGES
1. Considers time value of money
2. Based on cashflows
3. Indicates a return in % form.

DISADVANTAGES
1. More complicated than other methods
2. Ignores the size of investment
3. Is only estimated because we need spreadsheet to determine it accurately
4. Multiple IRR problem

How to compare two projects?

A lot of examination questions are designed in a way that we first have to evaluate
two or more projects using different investment appraisal techniques. The projects
are usually similar in nature and then based on our appraisal we have to eventually
recommend which project the company should go for. As discussed above the rule is
to maximize the net present value.
Following Example should be helpful:
Two projects X and Y have the following results after appraisal.
Project X (Cost Project Y (Cost
$100000) $100000)
Accounting Rate of Return 23% 26%
Payback Period 2 years 8 months 3 years
Net Present Value $23000 $28000

From the above figures it can be seen that Project Y should be selected as it is
relatively more financially sound and feasible due to a higher NPV. NPV of $28000
indicates the amount earned after recovering the original cost and also catering for
time value of money. In simple words company’s wealth will increase by $28000 in
real terms if they invest in project Y as compared to Project X which only brings in
$23000.
However Project X is relatively more liquid, as the investment is recovered 4 months
earlier than Project Y. This means that risk involved is relatively less for Project X. If
the company will be really short of liquid funds in the future and is a risk-averse
company then they might consider Project X but since the difference is not that
significant, I think Project Y is still better.
Project Y is also more profitable than Project X according to ARR. This indicates only
an average during the life of the two projects we will earn more profits if we choose
project Y. ARR is not a very important determinant of choosing a project due to its
several disadvantages.
The company should also consider social implications of both the project. Will it
cause pollution? Will it create more jobs? Etc.
To conclude based on the numbers available. I would advise the company to invest
in Project Y
NOTE:
• Usually when doing comparison projects are of similar nature, life and
similar investment cost. If size of the investment is different than
deciding purely on NPV will not be correct. You can use the following if
size of the investment is really different.

Calculate a ratio (known as profitability index)

NPV/ Initial Cost
The project giving highest answer should be most beneficial.
• Usually all the methods (Payback/ARR/NPV) will suggest that one
project is superior to the other so it will be really easy to write about it.
(Unlike in the example above where Project X has a better payback).

Standard Costing
Standard cost is the amount the firm thinks a product or the operation of the process
for a period of time should cost, based upon certain assumed conditions. The
technique of using standard cost for the purpose of cost control is known as standard
costing. It is a system of cost accounting which is designed to find out how much
should be the cost of a product under the existing conditions. The actual cost can be
calculated only when the production is undertaken. The pre-determined cost is
compared with the actual cost and a VARIANCE between the two is calculated. This
enables the management to take necessary corrective measures.

Advantages:

* Helps in prepration of budgets.

* Activities which are responsible for variances are highlighted

* Varianaces allow management by exception to be practiced. Management by

exception means that everybody is given a target to be aceivhed and
management need not supervice each and everything. The responsiblities
are fixed and everybody tries to achieve his/her targets.

* As Standard cost is already calculated it helps in preparation of estimates for

the cost of new products and quoatations for orders.

* Motivation increases as it a taget of effeciency .

* Standards provide a benchmark against which actual cost can be compared.

* Managers of deparment with favourable varainces can be rewarded.

* Increases workers participation.

Disadvantages:

* There is cost involved in establshing and mantaing a standard costing system

* There be may be reluctance from workforce to establish the system

* Results in increase in admin work

* Can de motivate ( if standards are not met constantly)

TYPES OF STANDARDS:

Standard here means expectation from your workforce.

Basic Standards:

These allow for a low level of effeciency . Workforce is not expected to be very
good and low standards are kept which will allow for wastage. Basic standards are
set at the intial time the company has started, as the workforce gets more trained the
company will move towards more strict standards.

Attainable Standards:

These are relatively more strict than the basic standards but do allow for some
wastage and recognizes that not all hours worked are productive.

Ideal Standards:

are standards that can only be met under ideal conditions. They allow for no
wastage or no idle time .

Causes Of Variances.

Direct Material Usage Varaince

Favorable Unfavorable (adverse)

Better Quality Material Poor Quality
Efficient Workers Ineffecient Workers
Better Machinery Poor Machinery/More spoilage/ Theft of
material
Direct Material Price Variance

Favorable Unfavorable (Adverse)

Fall in Price (Deflation)
Supplier charging lower price due to less
demand of material
Use of different type of material
Buying in bulk (trade discount)
Favourable change in currency ( in case of
imported material)
Inflation
Supplier charging higher price due to shortage
Use of different type of material
Buying less (loss of discount)
Unfavorable change is currency ( in case of
imported material)
Direct Labor Effeciency Varaince

Use of higher or lower skilled labor

Poor or good machinery

Poor or good working methods

Poor or good morale

Poor or good quality control / Training

Direct Labor Rate Variance (opposite for unfavorable variances)

Use of higher lower skilled labor

Wage inflation

Minimum Wage requirement by government

Overtime Conditions

Sales Price Variance Sales Volume Varaince

Change in price for bulk cosumers Change in marketing strategy

Price redution (summer sale) Change in consumer taste

Price increse ( new models) Competition within the sector

What is the link between Material usage and Labor Effeciency Varaince?

These varainces generally go in same direction , if one is favourable other one is

also favourable ( not every time but generally) . The reason behind this is that if we
use better quality material it wil give a favourable usage varaince , now since better
quality material has less spoilage and is much easier to handle this will also save on
the time consumed by labor ( hence a reduction in actual labor hours worked) which
will lead to a favourable labor effeciency varaince. The opposite Is also true if we use
relatively poor quality material.
SENSIVITY ANALYSIS
A technique used to determine how different values of an independent variable will
impact a particular dependent variable under a given set of assumptions. This
technique is used within specific boundaries that will depend on one or more input
variables, such as the effect that changes in interest rates will have on a bond's price.

Sensitivity analysis is a way to predict the outcome of a decision if a situation turns

out to be different compared to the key prediction(s). It is used in
Breakeven Analysis
Calculation of Selling price
Investment Appraisal
Budgeting and Standard Costing

Some important Formules:

Sensitivity Applied to Marginal Costing

(a) Sensitivity of Selling Price : Profit /Sales *100

(b) Sensitivity of Fixed Cost : Profit /Fixed Cost *100
(c) Sensitivity of Variable Cost : Profit/Variable Cost *100
(d) Sensitivity of Volume Margin of safety (Units)/Total Units * 100

Sensitivity Applied to Investment Appraisal

(a) Sensitivity of Selling Price : NPV/Present Value of Sales * 100
(b) Sensitivity of Intial Cost : NPV/Intial Cost *100

MANUFACUTURING ACCOUNTS
COST OF PRODUCTION = PRIMECOST +FACTORY OVERHEADS

Goods are transferred from factory to warehouse at a factory markup. Inventory of

finished goods are also kept at marked up values . The amount of profit included in
these items has to be adjusted at the end of the income statement.

Net profit from trading

Add Factory Profit
Add opening URP
Less closing URP

If nothing is specified in the question then assume Inventories of finished goods are at
marked up price ( they include profit).
The amount of profit in opening inventory is Opening Unrealized profit and in closing
is called Closing unrealized profit.
If breakeven for factory is required then the transfer value should be considered as
selling price.
NON-PROFIT ORGANIZATION (CLUBS
AND SOCITIES)
The non-profit organization is with a view of providing services to its members. The
aim is not to make profits out of trading activities, but to increase to welfare of
members through social interaction and other activities. A club is owned by all the
members collectively and since there is no single owner, there are no DRAWINGS.

TERMINOLOGY DIFFERENCE
Non-profit organizations Normal trading Businesses
Receipts and Payments Account Bank Account
Income and Expenditure Account Trading, Profit and Loss Account
Surplus Profit
Deficit Loss
Accumulated Funds Capital

Why is a Receipts and Payments Account unsatisfactory for the members?

The receipts and Payments account does not provide information to the members
relating to
1. Assets owned by the club
2. Liabilities owed by the club
3. Surplus or Deficit
4. Depreciation of fixed assets
5. Performance of the club
6. Financial position of the club.

In order to make the income and expenditure account, you will need to determine the
incomes separately. Incomes may include:
-­‐ Refreshment Profit/Bar profit (make a separate account to calculate net profit
from this)
-­‐ Annual subscription (separate subscription account for this)
-­‐ Gain on disposal.
-­‐ Interest on deposit account or investment account.
-­‐ Profits from different events (say Dinner dance)
-­‐ Life Subscription (don’t mix this with Annual Subscription)
-­‐ Donations (only day to day)

Check debit side of Receipts and Payments account for anything else.
What is the difference between receipts and payments account and Income and
Expenditure account?
Receipts and Payment account
It shows balance of bank at start and end
It records money coming in and going out
It considers all type of money coming
including capital receipts, e.g. Long term
donations and all type of money going out,
e.g. Purchase of fixed asset
It is an alternative name for cashbook
Income and Expenditure account
It shows Surplus of Deficit for the year
It records Incomes and expenses incurred
It considers only revenue incomes and
expenditure.
It is an alternative name for profit and Loss

What is a donation and what are two accounting treatments for it?
An amount received by a club which the club does not have to pay back. This
includes donations, gifts, legacy and grants.

If donation is for a day to day expenditure or will remain with the club only for a
short period then it should be treated as an income in the income and expenditure
account.

If donation is for purpose of capital expenditure on long term assets, then it is shown
as a special fund in the balance sheet. (Financed by section added it to accumulated
funds).

What is life subscription (Life membership or admission fees)?

All of these are treated in the same way.
The club receives money for subscription for the entire life of the member. This is put
in a separate life membership account. Every year an amount of it is transferred to the
income and expenditure account (this will be given in the question), e.g. the amount
of money received from this life membership scheme is $300 and club decides to
transfer 20% every year. This would mean that $60 (20% of $300) is transferred to
income and expenditure account and the remainder $240 should go to the balance
sheet as a long term liability. If the life membership fund already has a balance, let’s
say $2 000 and we have received $500 during the year and club transfers 10% year.
This would mean we would show 250 (10% of 2 500) as an income and the remainder
2 250 (2 500 – 250) as a long term liability.
ACCOUNTING FOR CONSIGNMENTS

What is a consignment?
A business may want to expand its trading activities. For this purpose, it may
introduce its product to the consumers of other localities, like other cities or countries.
However, it may not be feasible at the initial stage to open sale terminals/branches at
such places. Therefore the business may negotiate and arrange sale of goods
through local businesses/retailers for a commission. This arrangement is known as a
“consignment”. The business which sends the goods is called a “consignor´ and
the agent whom goods are sent on sale or return basis is known as a “consignee”.

Accounting for consignment

A consignment account is made by the consignor to determine profit or loss .
Debit side is used to record expenses and credit side is used to record incomes
(Difference being the profit or loss)

The consignor will also make an account for Consignee. This is like a trade debtor
account . At the end of the contract if the payment is received this account is closed
via bank ( else you can bring down the balance)
The consignee will make an opposite account for the consignor .

Valuation of unsold goods

If there are some units unsold then we have to value them and record as Bal c/d
( credit side ) in the consignment account . This value should include the following
cost:
1.Original Cost of the goods
2. Any expenses paid by the consignor to dispatch goods to consignee.
3. Any expenses paid by the consignee to receive the goods and turn them into a
salebale condition.
Please note expenses like marketing , selling cost ,commission should not be
included in the inventory
 JOINT VENTURES
What is a joint venture?
A joint venture is a temporary partnership. It is formed for a particular purpose and it
is terminated on completion of a job or a venture for which it is formed.

For example:
1. A joint venture may be formed between two individuals for construction of
residential apartments. One may have expertise in construction work and the
other one may provide the required finance.

2. A joint venture may be formed between a construction company and an

architect firm for construction of a bridge or a housing society.
Features of a joint venture:
1. It is a particular partnership.
2. It does not entail continuing features after completion of the task.
3. The business is dissolved after completion of the venture.
4. It applies cash accounting concept rather than going concern concept.
5. Calculation of incomes is relatively simple.
6. All the assets are timely received in cash and all the liabilities are paid in cash.
7. Profit is determined as the difference between cash received and cash paid.
8. It does not use a business name.
Bookkeeping methods for a joint venture:
1. No separate books are kept:
In a small joint venture which may expect to last for a short time period, no
separate books are kept. Each party records only those transactions with
which it may concern.

2 Separate books are kept: ( Not in syllabus)

For a large-scale joint venture which may expect to last for a longer period a
separate set of books are kept. In such cases the calculation of profit is not
difficult. It is similar to preparing the financial statement for a firm.

NO SEPARATE BOOKS ARE KEPT

In this method accounting is done in the existing books of parties involved in the
venture ( 2 or more). For example if Harold and Kumar enter into a Joint Venture then
following accounts will be made.

In the books of Harold : Joint Venture with Kumar Account

In the books of Kumar : Joint Venture with Harold Account.

Both parties will record Payments on the debit side and receipts on the credit side.
Once all transactions are recorded , both parties will share the respective accounts
with each other and a memorandum joint venture account will be prepared ( which is
simply a merger of both accounts ). The main purpose of this account is to calculate
the profit or loss from the venture . This profit is then divided in the profit sharing
ratio and transferred to individual joint venture accounts ( Profit on the debit side and
loss on the credit side) .

The trick to find out if answer is correct or not is that the individual joint venture
account balances will add up to zero.
 ACTIVITY BASED COSTING

Product costing requires an accurate measurement of the resources consumed to

manufacture a product. If a product is undercharged it may result into a loss to the
business. Contrary to that if a customer is overcharged, there are ample chances
that the business may not be able to compete and lose a customer.

The conventional absorption costing method absorbs support overheads simply

on production volume measured in terms of labour hours worked or number of units
produced. In case the proportion of support overheads is quite low in total cost of a
product and the manufacturing process is labour intensive, as a result, the direct
costs would have been much higher than indirect costs and it may have an
insignificant impact on realistic product pricing.

However, the modern manufacturing process has become more machine intensive
and as a result the proportion of production overheads have increased as compared
to direct costs, therefore it is important that an accurate estimate is made for the
production overheads per unit.

The activity based costing (ABC) adopts more realistic approach to charge
production overheads to determine the product cost. It charges overheads on the
basis of benefits received from a particular overheads. It considers the relationship
between the overheads costs and the activity which causes incurring of such costs,
known as cost drivers.

The examples of transactions-based cost drivers are given below:

Support department (Cost centre) Possible cost driver

1. Production scheduling Number of production runs
2. Set-up costs Number of machine set-ups
3. Store department Number of store requisitions
4. Purchasing department Number of purchase orders
5. Finished goods handling Number of orders delivered
6. Canteen Number of employees
7. Power generation Number of kilo-watts consumed
Steps to calculate cost of production using ABC

There are following five basic steps:

1. Classify production overheads into activities according to how they are driven.
2. Identify the cost driver for each activity, which causes these activities to incur the
costs.
3. Calculate an overheads absorption rate (OAR) for each activity.
4. Absorb the activity costs into the product based on the benefits received by the
production process.
5. Calculate the total cost of the product.

Uses of Activity Based Costing

1. It is used to calculate a more accurate and realistic cost of a product.

2. It is used in an organisation where production overheads form a significant
portion of total cost of production.
3. It gives a better insight to consider what factors drive overheads costs.
4. It recognises that all overhead costs are not related to production and sales
volume.
5. It is used to control overhead costs by managing cost drivers.
6. It is used to apply on all the overhead costs not only the production overheads.
7. It is used just as easily as it is used in product costing.

Limitations of Activity Based Costing

1. It has limited benefit if the overhead costs are a small proportion of the total costs.
2. The choice of both activities and cost drivers might be inappropriate.
3. It is more complex method of calculating the cost of a product.
 AUDITING
Auditing is normally associated with the accounts of limited companies. It is
compulsory that larger limited companies have their financial statements audited by
external auditors.

An external auditor investigates whether or not the business has kept adequate
records, that financial statements are consistent with the records from which they are
prepared and that financial statements prepared by management give a true and fair
view of the business’s state of affairs. The auditor verifies that transactions have
actually taken place and that they have been recorded in the books of account
accurately.

The audit provides the users of financial statements with an assurance that the
statements provided to them can be relied upon.

The auditor’s opinion

If, in the auditor’s opinion, adequate records have not been kept of the company’s
financial statements or the auditable part of its directors’ report is not in agreement
with the company’s records and returns, the auditor will issue a qualified opinion to
the report.

A qualified report will raise points that the auditor considers have not been dealt with
correctly by the directors in their preparation of the financial statements.

Where such points are not of a serious nature, the report might state ‘...with the
exception of ... the financial statements do show a true and fair view ...’ If, however,
the auditor is of the opinion that there has been a serious breach the statement will
state that ‘the financial statements do not show a true and fair view’.

The Audit Report

The auditor’s report has three main sections:

1 Responsibilities of directors and auditors

a Directors are responsible for preparing the financial statements.

b Auditors are responsible for forming an opinion on the financial statements

2 Basis of opinion – the framework of auditing standards within which the audit was
conducted, other assessments and the way in which the audit was planned and
performed. If the auditor fails to obtain information and explanations necessaryto
support his audit then this must be reported. Any deviation from the necessary
disclosure requirements must be identified. 

3 Opinion – the auditor’s view of the company’s financial statements. 

Audit requirements
The main statements that have to be audited are:

● the income statement

● the statement of financial position

● statement of cash flows

● statement of total recognised gains and losses

● reconciliation of movements in shareholders’ funds

● accounting policie

s● notes to the accounts.

True and fair view

A true and fair view requires that the auditor must give an opinion as to whether the
financial statements presented to the shareholders are truthful and unbiased.

The auditor must verify that financial statements agree with company records. They
must confirm that:

◦ ● results shown in income statements are truly and fairly stated 

◦ ● fundamental accounting concepts have been applied 

◦ ● the accounting convention followed in the preparation of financial

statements is stated 

◦ ● the preparation of financial statements is consistent with previous

periods. 

The auditor must verify that:

◦ assets exist and are owned by the company and are stated at amounts
●
that are in accordance with accepted accounting policies 

◦ ● all liabilities are included and stated at amounts that are in

accordance with accepted accounting policies. 
The Role of Directors
Shareholders provide the capital of limited companies by the purchase of
shares. In the case of public limited companies there are often many thousands
of shareholders. Clearly, all these shareholders cannot run the business on a
day-to-day basis, so it is the responsibility of shareholders to appoint directors
to run and manage the business on their behalf. The directors of a limited
company are responsible for the preparation of annual financial statements
that are then used by shareholders to assess the performance of the company
and the directors whom they have appointed. The directors must ensure that
the provisions of the Companies Act 1985 are implemented. Directors are paid
emoluments as their reward for running the business. ‘Divorce of ownership
and control’ is the term often used to describe the relationship between
shareholders and directors because although shareholders are the owners of a
company, it is the directors who control the day-to-day affairs of the business. 

Directors’ responsibilities
Directors have a responsibility to: 

● keep proper accounting records that allow financial

statements to be prepared in accordance with relevant companies
legislation 

● safeguard business assets 

● select the accounting policies to be applied to the business

books of account 

● state whether international standards have been applied 

● report on the state of the company’s affairs 

● ensure that the financial statements are signed by two

members of the board of direc- tors. 

If the directors are responsible for keeping financial records and the
preparation of the annual financial statements, how can shareholders be
guaranteed that the records are prepared in an objective way? Shareholders
appoint a team of professionally qualified accountants (auditors) to check and
verify the financial statements and the transactions that led to their
preparation. 
Computerized Accounting Systems.
The business world is becoming increasingly competitive with each passing year and
changing at a pace never before seen. Businesses today are competing in a global
economy and to cope with these pressures managers need to take full advantageof all
aspects of information technology. It has been said that ‘information is one of the
most important resources’ that managers have. This information includes records of
the activities of all stakeholders – customers, suppliers and staff – and how the
business deals with them through its activities that involve inventory, payroll, etc.
Customers and suppliers expect a business to be efficient. Managers need to react to
stakeholder requirements quickly and efficiently, so reaction time is of the essence.
Information technology (IT) makes relevant and detailed data available at the click of
a mouse.

Nearly all managers of businesses that use a double-entry system of recording

financial transactions will use a computer in some, if not all, parts of their business.

As the use of computers has increased in all kinds and sizes of business, the use of
handwritten entries in the accounting system has steadily decreased; paper documents
have given way to onscreen documents and computer printouts.

The underlying system of accounting remains unaltered but the speed at which
information is processed and made available to users has greatly increased. In any
accounting system all transactions have a ‘knock on effect’; all transactions are
interrelated and interdependent and an efficient computerised accounting system will
provide useful feedback to management and staff.

A good IT system of computerised accounting will allow all levels of management to:

◦ ● create plans 

◦ ● put those plans into practice 

◦ ● control activities 

◦ ● evaluate outcomes so that adjustments to the business can be made

and any errors can be rectified quickly. 

A computerised accounting system provides managers with instant and up-to-date

reliable information in real time that can be used to plan and control the business,
allowing prompt decision making. Information obtained from the computerised
accounting system can be used to help guide and control business policy.
Advantages of introducing a computerised accounting
system
◦ ● Speed: Data entry into the system can be carried out much more
quickly than if done manually. One entry can be processed into a multitude of
different areas. For example one entry can be made that will simultaneously
update a customer’s account, sales account in the general (nominal) ledger and
inventory records. 

◦ ● Accuracy: Provided that the original entry is correct there are fewer
areas where an error can be made since only one entry is necessary to provide
the data that is replicated throughout the system. 

◦ ● Automatic document production: Fast and accurate invoices and

credit notes are produced and processed in the appropriate sections of the
system. 

◦ ● Availability of information: Accounting records are automatically

updated once information is keyed in. This information is then readily
available to anyone within the organisation who requires it. 

◦ ● Taxation returns: Information required by tax authorities is

available at the touch of a button. 

◦ ● Legibility: Data are always legible, whether shown on screen or as a

printout. This reduces the possibility of errors caused by poor handwriting. 

◦ ● Efficiency: Time saved may mean that staff resources can be put to
better use in other areas of the business. 

◦ ● Staff motivation: Since staff require training to acquire the

necessary skills to use a computerised accounting system, their career and
promotion prospects are en- hanced, both within their current role and for
future employment. Some staff may benefit from increased responsibility, job
satisfaction and pay. 

Disadvantages of introducing a computerised accounting

system 
● Hardware costs: The initial costs of installing a computerised accounting
system can be expensive. Once the decision has been made to install a system,
the hardware will inevitably need to be updated and replaced on a regular
basis, leading to further costs. 

● Software costs: Accounting software needs to be kept up to date.

Investment in software therefore requires a long-term financial commitment. 

●Staff training: Staff will need training to use the software and training
updates each time the system is modified. 
 ● Opposition from staff: Some staff may feel demotivated at the prospect of
using a computerised system. Other members of staff may fear that the
introduction of a new system will lead to staff redundancies, which could
include them. Changing to a computerised system can cause disruption in the
workplace and changes to existing working practices may make staff feel
uneasy. 

● Inputting errors: Staff can become complacent because inputting into the
system becomes more repetitive and therefore they may lose concentration
which can lead to input errors. 

● Damage to health: There are many cases of reported health hazards to staff
working long hours at a computer terminal. The health issues range from
repetitive strain injuries through to backache and headaches. 

● Back-up requirements: All work entered into the computerised

accounting system must be backed up regularly in case there is a failure of the
system. Much workhas to be printed out on paper as a back-up, so hard copies
might require further expenditure on secure storage facilities. 

● Security breaches: There is always a danger that computer hackers

might try to breach the security of the accounting system while others may try
to gain access to hard copy. Some might argue that a computerised system
makes staff fraud simpler to achieve. A computer system that communicates
with outside agencies such as customers, suppliers and government agencies
means there is always the danger of infection from software viruses. Robust
anti-virus protection and firewalls will need to be put in place to protect
sensitive and important data. 

Moving from a manual to a computerised system

When a computerised accounting system is first installed great care must be taken
to ensure that the transition from manual records to computer records is
smooth and accurate. The opening entries in the computerised system should
be double checked by different members of staff. The check can take the form
of, say, a manually prepared control account which is then compared with a
printout; clearly the two should match. Similarly, a manually prepared trial
balance can be compared to a trial balance extracted from the computer. A
system of protective devices (firewalls, virus protection, etc.) must also be
introduced into the system. Each member of staff should have a unique
password allowing access to their area(s) of responsibility within the system.